Despite Facebook’s trading flop, underwriters on the deal, led by Morgan Stanley, are in line to turn a potentially substantial profit through a trading mechanism designed to stabilize the share price, according to people familiar with the matter.
While the exact amount the syndicate will make remains uncertain, the amount could be north of $100 million, depending on certain variables, according to these people.
The mechanism that Facebook’s bankers are using is called an overallotment (known on the street as a “greenshoe," an eponymous reference to the 1929 IPO of The Greenshoe Manufacturing Company which pioneered this kind of offering).
The mechanism, which is approved by regulators, gives bankers a cluster of shares that can help smooth out trading during an offering’s first few volatile trading days.
It works like this: In all IPOs, bankers sell more shares than they have to distribute, creating a short position on the stock. In Facebook’s case, the company filed to sell 421 million shares to the public. Lead underwriter Morgan Stanley (along with other banks like JPMorgan , Goldman Sachs and others) sold 484 million shares to clients (all of them priced at $38), creating a short position of 65 million shares that needs to be covered.
Bankers have 30 days to cover that position, and can do it in two ways: go back to the issuer (in this case Facebook) and buy them, or get them on the open market.
When a stock performs well, the underwriters “exercise” the greenshoe and get those remaining shares from the issuer. The banks make the same fee on those shares as all the others in the deal (in Facebook’s case, it’s 1.1 percent of the proceeds) — which would mean roughly $26 million in fees.
If the stock goes lower, however, the banks can then buy the shares on the open market, on the cheap. In Facebook’s case, shares were trading as low as $30.94, meaning underwriters could have made a $7 spread by picking up those shares — which would equate to a near-20 percent profit.
According to a person familiar with the matter, Morgan Stanley and others on the deal used up roughly half of their overallotment by buying shares on the open market at $38, meaning a zero percent spread, which helped keep the stock above the issue price.
But on Monday, shares tumbled, providing Morgan Stanley and others with the opportunity to cover their short position at a significantly discounted price. Banks bought shares at around $33.50 or $34, according to this person, which is a spread of roughly 10 percent.
If the banks used up the remaining half of the overallotment on Monday, they would have made more than $100 million that day. While it remains unclear exactly how many shares were bought and at what specific price, the banks on the deal did make money on the trade, according to a person familiar with the matter.
While bankers use the overallotment for the benefit of the issuer — and to investors — the side-effect often means a little extra money in bankers’ pockets, in some cases more if the stock goes lower.