You might be a bit forgiven for getting distracted on Friday. All kinds of exciting things were happening:
- The Scotland referendum results (alright UK – it’s your turn now).
- The public shaming of Alex Salmond.
- The release of the new iPhone 6s (involving long queues, size-of-pocket complaints, and the first iPhone 6 ever sold getting dropped on live television).
- The release of iOS8 (marked by much complaint about having to temporarily delete entire music libraries in order to make space for the 5GB download – although, to be frank, it’s time that these people threw away their 16 GB phones and stepped up their capacity – because you can’t tell me that they’re not already having to delete songs each time they snap a photo).
As for me, I spent most of Friday afternoon watching the live updates of Alibaba’s IPO.
And I fielded some questions on the day. Mainly along the lines of…
- The bell was rung two hours ago – ARE THEY LISTING OR NOT?
- An auction range of between $89 and $91? But what of that IPO price setting of $68?
- AN AUCTION RANGE OF BETWEEN $92 AND $93???
- What is an auction range?
- Excuse you:
I will confess that some of those questions were my own, which made me feel like the financial equivalent of an Appalachian hillbilly (and I guess, given my African status, that’s exactly what Wall Street would think).
So I did some research on the IPO pricing process, and I’m taking today’s post to explain what I have since learned (I’m mostly summarising this article in Forbes).
How an IPO goes from $68 to $92.70
In any IPO, you have some key players:
- The company and original shareholders and employees thereof (the hopefully soon-to-be-minted millionaires).
- The underwriters and advisors (the big banks).
- The big institutional investors.
- The Dedicated Market Maker, or DDM for short (another of the big banks).
- All the other investors in the stock market (you and me).
So most people are familiar with the basics:
- The company decides to list and/or sell itself.
- It hires some underwriters.
- The underwriters prepare all the necessary paperwork.
- The company goes on a “roadshow”, where it flirts with all the big institutional investors.
- There is media hype.
- And eventually, the IPO price is “set”.
- Someone important from the company rings a bell on the opening day of trading.
- *some time passes*
- At some indiscrimate point on that first day of trading, the company’s shares become freely traded – and not necessarily at all near the IPO price (in fact, by all accounts, an IPO has failed if it lists too near the IPO price – because it’s usually a sign that the IPO price was set too high, or the underwriters didn’t do their job right).
I’ve drawn some pictures.
Step 1: Release a Prospectus
Step 2: Go on a roadshow
So the order book starts to fill up. Until…
Step 3: Have an IPO that looks a lot more like an Initial Private Offering to those institutions that are important enough to get allocated some shares.
Step 4: List the shares on the New York Stock Exchange, where some time passes
To start, here is how things look at 9:29am on listing day, just before the market opens:
At 9:30am, Jack Ma rings the bell to open trading. And immediately, the DDM (aka The Market Maker) gets inundated with orders:
It’s the Market Maker’s job to get trades to happen at the market price. Only – there’s no market price yet. There’re just bids and asks.
So actually, we’re dealing with an auction – with the Market Maker as auctioneer trying to work out what the best price is for the most amount of trades to settle at.
The Market Maker (usually – a designated bank – and in Alibaba’s case, it was Barclays) then reviews all the bid orders (from buyers) and the sell orders (from the institutional investors, no doubt) to try and see what a good price would be for the trades to settle at.
So they look at the new order book, and announce a price range based on what they’re seeing:
This results in a flurry of new orders:
So the Market Maker updates his/her price range:
More updated price ranges:
Still more orders:
And finally, the price settles:
And on a really successful day, like last Friday, you get the proverbial “pop” where the share lists at nearly 40% above the initial IPO price.
Moral of the story: be a big institution.