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.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Yoyo (@yoyo_w) September 22, 2014 at 11:07
Pretty much doing the same thing on Friday. this IPO is the epitome of income inequality in the modern world. IPO was filled by something like 25 institutional investors. Rich get richer, and the retail mom & pop investor is here like why can’t I buy at $68???Reply
Jayson September 22, 2014 at 11:25
It’s true – equal opportunity here, there is not.
On the other hand, I guess that the institutional investors hold the pension and provident funds of the mom & pop investors – so maybe it’s okay if they make the big profits?
Also, the usual argument is that the institutions are going to be the guys that form the bulk of demand – and therefore, they should have some incentive to put up the big money.
That said: on Friday, 272 million shares changed hands after the share price settled at $92.70. Out of a total issue of 369 million (at least, that’s my calculation). Seems to me that the mom & pop demand was definitely there to cover the full issue…Reply
Nicolette Rosin September 23, 2014 at 15:32
Thanks Jayson, I was just about to try and research this myself, so you saved me a lot of hassle. Also, I probably understand it a lot better now than I would have done had I done the research myself. I love how you simplify things.Reply