This Is A Post About Greenshoes

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Why don't we talk abstractly about greenshoes for a while, because for some reason some people want to talk about them and hey, why not, they're a thing. In talking about greenshoes, though, we are not going to use the F-word, because I swore to myself that last week was the end of that. We're just going to talk about greenshoes. Greenshoes.*

Let's start with a very basic thing about greenshoes, which is that they make no sense! If you are a company, or an executive or investor or whatever in a company, and you want to raise money and/or sell your shares, here are things that you could want:
(1) to raise $100 million
(2) to sell 5mm of your shares

Here are things you are unlikely to want:
(1) to raise $100 or $115 million
(2) to sell 5mm or 5.75mm of your shares

Obvs, no? Keep in mind that, when you launch the deal, you don't know exactly what price you'll get - you'll just have a range - which is an annoying enough uncertainty. Throwing in the additional binary that you'll get either an uncertain $X or 115% of $X seems a bit much. So here is what happens when a naive company comes to an underwriter:

NC: We would like to sell 5mm shares.
UW: Okay. Of course there will be a greenshoe, so we will have a 30-day option to make it 5.75mm shares instead.
NC: What?
UW: Everyone does it.
NC: Well, why don't we not?
UW: No one will buy it
NC: Really?
UW: Sure. I'm gonna go with sure.
NC: That seems strange.
UW: Yeah, but here we are.

Is this true? Meh. Plenty of block trades and secondary sell-downs have no greenshoes, while pretty much all marketed equity offerings have them, so you could question the notion that investors will straight up refuse to buy a deal with no greenshoe. IPOs, on the other hand, basically always have greenshoes, either because they are actually necessary to get an IPO done as no investor would buy a brand new company without the promise of aftermarket support, or because IPOs are where underwriters have the most power and issuers are most naïve and trusting.**

In any case, though, these options get introduced into deals because underwriters want them, not because issuers do. So why might they want them? Well Felix Salmon hazards a guess:

Chances are, no one outside the company will ever know for sure what Morgan Stanley’s P&L on [a certain company's] IPO [that Morgan Stanley lead-underwrote last week] ends up looking like. But it would make sense, if Morgan Stanley saw a lot of selling pressure on Friday, for the bank to keep onto at least a little bit of its short position into Monday morning. At which point it could make a tidy profit on that plunging share price.

So, yes, this is theoretically possible and I alluded to it on Friday. But at this point if I had to guess I'd say it's more likely that MS bought more than 63mm shares (the full size of this IPO's greenshoe) at $38 or higher - that is, that it put some of its own fees to work in stabilizing the deal and trying to protect the $38 deal price - than that it bought fewer than 63mm shares at or above deal price, letting the deal crater so as to make a profit by buying in its short at $34ish. [Update: actually, let me walk this back a bit. It's I guess unlikely that they'd have bought much above $38; they'd have defended it as much as they could on Friday but I guess that that defense was somewhat less than 63mm shares - I guessed "more than half" on Friday. Then they'd come in today expecting to defend it more, even committing capital if necessary, but with an open $1.47 below the IPO price there was no buying to be done at $38. Not sure if that meant some stabilizing on the way down or not, or perhaps saving some dry powder. The broader point is that the stabilizing is good-faith and done on behalf of the deal - not, usually, to maximize trading profits.]

Why wouldn't Morgan Stanley just sit out Friday's carnage and then buy in its short with a $33 handle today, making hundreds of millions of dollars in profits? You could have two theories. One, less compelling but more cynical, theory is that the greenshoe is a valuable option for economic reasons: let's pretend that banks regularly do defend weak deals only halfheartedly, and then make lots of money buying in their short at well below the deal price. If that were true - and it seems unlikely to be a regular thing but it probably happens sometimes - then obviously screwing your biggest client in the highest-profile deal in, I don't know, ever*** would be a pretty good way to draw attention to your behavior and have every future issuer client demand a no-greenshoe deal. Or, more to the point, a no-Morgan-Stanley deal. Best to take your nefarious profits in other, lower-profile deals, while being squeaky-clean on this one.

The other theory is that Morgan Stanley actually takes its role as stabilization agent seriously: it wants to stabilize the deal. It is hampered by that most fundamental of problems, more sellers than buyers, but it tried its darndest. You can see roughly how much of its darndest it tried by looking at things like how many shares traded at the deal price on Friday, or how deep a bid there was at $38, and you'd probably conclude from that data that MS was buying in size. It's hard to know exactly because (1) you don't know where MS was buying (it may have wanted to defend slightly above or below the deal price) and (2) you don't know who else was buying there (hoping to scalp a few pennies while protected by MS's stabilization bid), but the overall impression is not one of Morgan Stanley caving quickly in its defense of the deal price.

On this theory, Morgan Stanley would make a note of facts like these:

  • You can more or less see how strongly they supported the deal, using Bloomberg and your mind and stuff.
  • There are shitloads more shares coming when insiders get out of lockup; Eduardo Saverin's got bills to pay.
  • There are more tech equity offerings coming ...
  • ... but there would be even more if this deal had gone better.
  • JPMorgan and Goldman Sachs have Bloombergs, and minds, and frustrations, and very strong incentives to go to every potential tech issuer and say "look what a shitshow that deal was, and how poorly Morgan Stanley defended it. Don't you want your deal to go well?"
  • JPMorgan and Goldman Sachs have Bloombergs etc., and very strong incentives to go to every investing client and say "hey, did Morgan Stanley allocate you shares in that IPO? Did you notice how it cratered? Did you notice how they didn't support it? Maybe you should punish them by trading with us, or by not buying into their next struggling deal."

And Morgan Stanley would conclude from those facts that it would be more in its interest to defend the deal, and to do so as strenuously as possible - even throw a bit of its own capital into the effort - so that it can tell its issuer client, and future issuers, and investors who bought in the deal and got hosed, that it was there for them. Because there will be a post-mortem on this deal, and Goldman and JPMorgan will say to the client "yeah, it was great working with Morgan Stanley, they did a great job and we got along really well, I can't really fault them at all for not consulting us on the stabilization and letting the price drop to $34 and then buying there, I mean, we might have done it differently and kept the stock above the deal price but, hey, their way is good too, team players, rah," and when that happens the Morgan Stanley banker is going to really, really want to be able to say "we defended this deal as well as anyone could have, spent the whole greenshoe supporting the price and even threw in a lot of our own money, taking a loss on the way down to help you and your insiders who after all still own tens of billions of dollars of stock."

So I suspect he'll be able to say exactly that. But he'll be kind of kidding, because the goal is not really to help the issuer and the insiders. The goal is to help the investors who bought the stock in the first place: the guys who took a risk and helped out both the issuer and, more to the point, the underwriters by placing an order that was filled a bit more than they expected. The investors are the ones who want the greenshoe; they want to be sure that the underwriters will be properly incentivized to support the deal in the aftermarket.

People talk about the IPO "pop" as the incentive for investors to take a risk on a new company, but the greenshoe is part of the same package of incentives: the expectation of a pop gives investors some upside for taking that risk, while the underwriters' stabilization efforts gives the investors some near-term downside protection. Losing it, either by not having a greenshoe in the first place or by having underwriters primarily concerned with gaming it for short-term profit, would make investors angry, and less interested in buying.

We've talked before about how securities offerings are a nice clear case of a key conflict of interest within investment banks, who are charged with helping both their issuer and investor clients even when, as in an IPO, issuer and investors are more or less playing a zero-sum game where every dollar saved by the investors is a dollar lost to the issuer. The greenshoe is a non-zero-sum way of adding value with optimal risk-shifting: it takes some uncertainty about aftermarket performance from skittish investors and gives it, in the form of uncertainty about deal size, to an issuer who is probably better able to bear it (because selling 15% more shares at the price you agreed on three days ago is rarely a tragedy). The structure of the greenshoe, though, adds an additional conflict, in that banks can hoard the value of the greenshoe for themselves rather than spending it on their investor clients. The fact that they basically don't do that suggests that motive and opportunity aren't everything: sometimes banks just do the right thing for capital allocation and risk shifting, even when they could make more money doing the wrong thing.

Morgan Stanley’s $2.4 billion Facebook short [Reuters / Felix Salmon]
Bankers Under Fire as Facebook Slips 11% [WSJ]
Morgan Stanley made big bet on Facebook [Reuters]

* Um. So. If you are reading this you know how a greenshoe works, right? But if not? A company does an offering of 100 shares of stock. The company almost always includes a 15-share "greenshoe," or "overallotment option," in the offering. (15% is the near-universal norm.) This is just a 30-day call option, struck at the IPO price less underwriting fees, that the company sells to the underwriters for $0. (Exercise for the reader: what is the fair value of this option?) What this means is that the underwriters, when the IPO is priced and allocated, actually lay out 115 shares. Let's say the IPO prices at OH I DON'T KNOW $38: the underwriters sell 115 shares to investors at $38. They don't immediately deliver those shares since stocks settle T+3. So now investors have 115 shares - but the underwriters have only bought 100 from the company. They are short the remaining 15 shares. Then they wait. If the stock goes up, as it often does, they just exercise the option and buy stock at $38 less the underwriting fees, giving them a profit equal to the underwriting fees. If it doesn't particularly go up, they tend to buy a lot of stock at right around $38, to "defend" the IPO price, or "stabilize" it in the lingo. The greenshoe allows them to do this buying without getting massively long the stock for their own account, which would I guess be TERRIFYING PROP TRADING or whatever and which, more to the point, they probably wouldn't want to do because buying lots of a cratering stock on the way down seems like a bad idea when it's your own money though perfectly pleasant when it's not. Typically a deal either "goes well" or "doesn't go well" within a day or two, so the greenshoe is either exercised or bought in pretty quickly and the 30-day term of the option is irrelevant; it's unusual for the underwriters to remain short much past the T+3 settlement of the IPO (if they did how do they deliver stock? I think they fail. Whatever).

** Which? Does Fa-, sorry, do recent IPO issuers strike you as naïve and trusting?

*** When was the last time there were eight thousand news articles about greenshoes?


This Is The Last Greek CDS Post Ever*

There's that famous scene in Liar's Poker - are there non-famous scenes in Liar's Poker? - where the much maligned equity department sends a program trader to impress Michael Lewis's jackass fellow Salomon trainees with his brilliance. It does not work: He lectured on his specialty. Then he opened the floor to questions. An M.B.A. from Chicago named Franky Simon moved in for the kill. "When you trade equity options," asked my friend Franky, "do you hedge your gamma and theta or just your delta? And if you don't hedge your gamma and theta, why not?" The equity options specialist nodded for about ten seconds. I'm not sure he even understood the words. ... The options trader lamely tried to laugh himself out of his hole. "You know," he said, "I don't know the answer. That's probably why I don't have trouble trading. I'll find out and come back tomorrow. I'm not really up on options theory." "That," said Franky, "is why you are in equities." This is totes unfair to the actual equity vol traders I know, but I kind of felt like that guy after talking to a CDS lawyer yesterday about this craziness in Greece. It went something like this: Me: As an equity derivatives guy, I expect derivatives to transform into derivatives on whatever their underlying transforms into. And I'm troubled by them not doing that. Lawyer: You should not be troubled by the concept of cheapest to deliver. Yeah fair! That's the thing about CDS. Dopes like me think of it as just a rough proxy for default risk but when things get real like with Greece it turns into a cheapest to deliver convexity play and then I slink away in embarrassment. But yeah, as a matter of rough justice, if you can go be opportunistic about finding the cheapest to deliver bond, Greece can go be crappy about leaving you with only expensive to deliver bonds. I guess.