We tend to be generally sceptical about initial public offers, as the seller has a strong incentive to obtain the highest price. They achieve this by painting a glowing picture of the business they are selling and by choosing the most favourable moment (to them) in the business cycle to offer the shares for sale to the investing public.
Additionally, during the marketing period, new investors generally have only a few weeks to research the new company, mostly using financial data provided by the seller and carefully choreographed visits to inspect the soon-to-be-listed company’s assets. Today I am going to outline how institutional investors generally approach an IPO and the game of “Liar’s Poker” that goes on between fund managers and the investment banks running the IPO process.
Liar’s Poker was the title of the 1989 book by Michael Lewis. It refers to a game played by bond traders at Salomon Brothers that involves gambling on the serial numbers of bank bills, where the strategy revolves around bluffing one’s opponents. In the case of an IPO or a capital raising , Liar’s Poker refers to the dance that goes on between institutional investors and the investment banks, especially one in which the pricing is yet to be determined.
The investment banks listing the company are motivated to exaggerate both the demand for and the superior investment merits of the company, whereas institutional investors will downplay their interest. Investors are attempting to develop a picture of the real underlying demand, and also are trying to talk the issue price down. This process will involve numerous conversations with the investment banks listing the new company, the company’s competitors, and other large institutional fund managers to gauge their interest.
In 2018, the Australian Securities and Investments Commission’s civil action against ANZ Bank around the bank’s $2.5 billion capital raising from 2015 revealed to the investing public how this game of Liar’s Poker is often played. The basis of the allegation is that ANZ did not reveal to the market that demand was muted, which left the underwriting banks with $791 million of ANZ shares to be sold as quietly as possible over the next few months. ANZ is defending the action.
At the time of the raising, ANZ and the underwriters, JP Morgan, Citigroup and Deutsche Bank, indicated demand was solid. Revealing the shortfall would have put ANZ’s share price immediately under pressure as hedge funds would have short sold ANZ shares, expecting they could cover their position later.
While there was a cacophony of outrage in the press, few institutional investors would have been surprised that the banks involved misrepresented demand to minimise their losses from underwriting the capital raising.
Who gets what?
One reason investment banks are keen to run an IPO process or a capital raising (other than the fat fees) is that in the allocation of holdings they can reward their good clients and use it as a lever to attract new clients. From my observations, large allocations tend to go to the funds that generate the largest brokerage commission, which are often high-turnover hedge funds rather than long-term owners of the company.
Occasionally the company runs the allocation process, as Amcor did in its 2009 $1.6 billion capital raising conducted at $4.30 per share, which mainly went to loyal, long-term shareholders.
When I started in the industry more than 20 years ago, the thought process for a hot IPO was to work out what you wanted and then bid for five to 10 times that amount.
Then when your fund is allocated a fraction of the bid amount, the fund manager can either stoically accept the allocation or engage in a high-drama scenario: threatening to reduce trading with the investment bank in question, while secretly being satisfied.
The investment bank running the IPO process is happy to indulge in this charade as it allows it to tell the company the issue was five times oversubscribed, implicitly highlighting the bank’s superior relationships with institutional fund managers.
In any IPO or capital raising, it is normally considered unfavourable to receive the number of shares originally requested. Getting your full allocation is rarely an indication that that company is very keen to have your fund as a shareholder, but rather reveals that the fund manager has misread the demand and investment merits of the IPO.
This article originally appeared in the Australian Financial Review