The Wall Street fable behind Alibaba’s IPO

September 10, 2014, 7:10 PM UTC
Alibaba Group Holdings Ltd. and Founder Jack Ma As Company Files for U.S. Initial Public Offering of E-Commerce Giant
FILE PHOTO: Jack Ma, chairman and then-chief executive officer of Alibaba Group Holding Ltd., speaks during a news conference in Tokyo, Japan, on Tuesday, June 1, 2010. Alibaba, which rode China's emergence as an economic superpower over the last 15 years to become a massive online marketplace for everything from forks to forklifts, filed today for what could become the largest U.S. initial public offering ever. Photographer: Tomohiro Ohsumi/Bloomberg via Getty Images
Tomohiro Ohsumi/Bloomberg—Getty Images

A friend who’s a major money manager—call him Oscar—recently related a story about just how intoxicating a big-pop IPO can be. On a flight from LA to New York a few years ago, Oscar was seated across the aisle from the CFO of a California company that had just gone public. “It was fantastic!” crowed the executive, his volume rising as he downed one gin and tonic after another. “Our stock jumped 30% the first day! That’s tens of millions of dollars!” As they deplaned, Oscar remarked to the stumbling CFO, “Wouldn’t your company be worth a lot more if you’d put those tens of millions in your treasury, instead of giving that money away?” The CFO suddenly turned reflective, as if he’d never heard of that idea—though it’s unlikely the facts stopped his binge of self-congratulation for long.

It now appears that BIG POP is working its intoxicating spell on Alibaba—soon to trade under the ticker (BABA). The road show for its forthcoming IPO is now in full swing, and its shares are reportedly proving a huge hit with institutional investors. Big fund managers, anticipating an overnight windfall, are reportedly requesting far more shares for their portfolios than Alibaba is selling at a price somewhere between $60 and $66 a share—the exact number will be determined on September 18, on the eve of its eagerly awaited debut.

What appears to be growing excess demand for Alibaba stock is likely to cause what it always causes: a steep rise in the share price in the first days of trading. That pop is one of Wall Street’s prized events. The term evokes images of exploding champagne corks, a sign of flush times in the markets—and if you believe what Wall Street is selling, the hallmark of a successful IPO.

In reality, a big first-day pop means that the underwriters have sold the shares too cheaply, at far below the price those institutional buyers were really willing to pay. The major beneficiaries are the famous Wall Street names and their commission-paying clients; the loser is the company that raises far less cash than if its shares had sold at market prices. What’s remarkable is that so many great companies voluntarily leave so many billions “on the table.” And it’s amazing how many supposedly sophisticated entrepreneurs are conned by the prospect. Especially since Wall Street has only the weakest rationale for selling it: Pin-striped bankers promise that those first-day price surges will make for great “publicity” for the newbie companies, and attract a coterie of loyal investors.

In reality, the only coterie it’s likely to attract is the crowd of celebrating bankers that night at Peter Luger’s.

Successful newly public companies don’t always start with a pop. Facebook’s (FB) shares famously dropped in early trading, meaning it raised more cash than it deserved at its 2012 debut. And it’s not certain that Alibaba’s shares will pop at all, once all is said and done. But to hear the hype surrounding what is likely to be the biggest IPO in tech history, it sure likes like Wall Streeters expect it to. Should that be the case, the amount of money Alibaba could forgo—and the size of the prize for Wall Street—are unprecedented.

To understand the jubilation among the fraternity of capital-markets types, let’s examine Alibaba’s plan, as revealed in its prospectus released on Sept. 5. The Chinese online and mobile commerce colossus is offering a maximum of 368 million shares for sale through six principal underwriters: Credit Suisse (CS), Morgan Stanley (MS), JPMorgan Chase (JPM), Goldman Sachs (GS), Citigroup (C), and Deutsche Bank (DB). If the shares sell at the top of the pricing range, at $66, the IPO would raise more than $24 billion, putting Alibaba’s market cap at $163 billion.

So what happens if the company’s shares pop 25% on Day One? They would then close at $82.50, handing the institutions that purchased them through the underwriters a gain of $16.50 a share. If Alibaba and insiders had gotten that real market price instead of $66, they would have collected an additional $6 billion. That’s right: $6 billion. As far as tips go, that’s a staggering sum. (Any waiter at Peter Luger would be thrilled to get it.) But a tip is what it is—because that’s what’s being left on the table.

The losers would divide into two categories. Large shareholders including Yahoo! and founder Jack Ma are selling as many as 219 million shares, so their portion of the foregone cash comes to about $3.6 billion. The company itself is selling the balance of the shares. Hence, it’s leaving around $2.4 billion on the table. It’s reasonable to assume that the same company with $2.4 billion more in cash is worth $2.4 billion more than the same company sans that cash. It’s therefore likely that Alibaba would sacrifice about 1.5% of its potential market value by allowing its shares to be 25% underpriced.

So who are the major winners? No surprise here: the Wall Street firms and their high-roller clients who get to buy the underpriced shares. It’s not in banking fees where the big money resides. “The underwriters wanted higher fees but Chinese companies and those outside the U.S. pay less for a given sized deal,” says Jay Ritter, a professor at the University of Florida. “This is also a high-profile deal that put Alibaba in a strong bargaining position.” The investment banks are garnering around $350 million in fees, or only around 1% of the proceeds, well below the norm on most IPOs.

No the cash payout to the bankers travels in a more circuitous route. These fabled Wall Street firms are handing their favorite clients $6 billion in quick profits. That’s around 10% of the total amount left on the table in the entire tech boom from 1999 to 2001. Investors, in turn, are very likely to repay the firms with big trading commissions in the days and weeks to come. The biggest such payers tend to be hedge funds, so hedge funds usually get the meatiest share allocations. Mutual funds that pay low commissions have less favored status.

The rule of thumb, says Ritter, is that Wall Street recoups 30% of the total windfall in commissions. That’s $1.8 billion. So including fees, Wall Street’s potential take mounts to well over $2.1 billion.

Of course, we don’t know if Alibaba will pop at all—or if so, by how much. But this is one of the great spectacles in the financial world. Wall Street is trying to work its intoxicating magic once again, and they’ve got folks who should know a lot better believing a tale no more believable than the Arabian Nights: the fables that brought us the first Alibaba.

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