Morgan Stanley made big bet on Facebook

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The remote server returned an unexpected response: (417) Expectation failed.
By Nadia Damouni and Olivia Oran

NEW YORK | Fri May 18, 2012 10:05pm EDT

NEW YORK May 18 (Reuters) - Lead Facebook Inc underwriter Morgan Stanley took a bet earlier this week when it increased the size of the social networking firm's $16 billion initial public offering and it boosted the price.

Thanks to massive hype surrounding Facebook's historic public offering, the wager looked safe. But a rocky first day of trading has raised questions about whether it paid off.

After a delayed start to trading, Facebook's shares spent much of the day struggling to stay above the $38 IPO price - and ended with just a 23-cent gain.

As a result, Morgan Stanley may have spent billions of dollars to support the stock price by buying shares in the market. Some market participants said that the underwriters had to absorb mountains of stock to defend the $38 level and keep the market from dipping below it.

The firm did this by tapping into a 63 million share over-allotment option, or greenshoe, according to sources familiar with the deal.

As an indication of the cost, had Morgan Stanley bought all of the shares traded around $38 in the final 20 minutes of the day, it would have spent nearly $2 billion. Underwriters are not obligated to prop up a stock on debut, but typically do.

Morgan Stanley declined to comment.

The debut marks a rare stumble for a high-profile IPO. Facebook is the only recent U.S. internet listing not to enjoy a large price jump on its first day of trading. LinkedIn, Groupon and Pandora Media all saw significant gains at their public debuts.

The debut also underscores Morgan Stanley's go-it-alone handling of the offering process. Though 32 other underwriters signed on to the deal, Morgan Stanley retained tight control over information, decisions and allocations of shares, according to other underwriters.

To be sure, Morgan Stanley's strong approach may have been crucial to managing such a large, high-profile offering with so many underwriters. And the fact that the stock didn't soar on its first day means they achieved full value for their client.

Some issues were beyond Morgan Stanley's control. Glitches at the Nasdaq stock exchange delayed the start of trading by 45 minutes, and throughout the day many investors did not receive confirmations that their orders had been completed, brokers at Morgan Stanley, Raymond James & Associates and others said. That uncertainty about their positions may have prompted some investors to sell, worsening the downward pressure on the stock.

Nasdaq posted a notice late in the day saying that orders entered for the stock before trading started "resulted in nothing being done" and offering to match orders if customers send in requests by Monday. Sources said the exchange was working through the weekend to deal with the botched trades.

Facebook also altered its guidance for research earnings last week, during the road show, a rare and disruptive move.

In many ways, the deal is a crowning moment for Morgan Stanley. When it won the coveted role as Facebook's primary underwriter for its IPO, veteran technology banker Michael Grimes managed to convince executives at the social media giant that his bank would single-handedly control the process.

And as Grimes, co-head of global technology investment banking, boarded a Bombardier Global Express jet at Mineta San Jose International Airport with Facebook executives last week along with Morgan Stanley Internet banker Marcie Vu -- according to documents obtained by Reuters -- he had effectively accomplished his goal.

Successfully pulling off one of the largest IPOs in U.S. history would underscore Morgan Stanley's status as the top underwriter for tech offerings and set it above arch rival Goldman Sachs, with total global proceeds last year of $2.2 billion, according to Thomson Reuters data. But even with high profile deals like LinkedIn and Zynga under its belt, Morgan Stanley had to be careful.

And so the bank led a highly secretive, tightly controlled process in which other institutions -- including top underwriters JPMorgan Chase & Co and Goldman -- were effectively shut out.

"There was some frustration by JPMorgan and Goldman, as they were getting limited information. They thought they would be more inside the process," one source close to the matter said.

Goldman Sachs declined to comment. JPMorgan did not return calls seeking comment.

For its efforts, Morgan Stanley will receive 38 percent of the overall IPO fees, about $67 million, which is more than JPMorgan and Goldman combined, according to regulatory filings.

But more importantly, Morgan Stanley was the only bank actively talking to investors on the deal and able to pull the order book together, a rare feature for IPOs where top underwriters typically split the work more evenly.

At one of the venues during the investor roadshow, dozens of fund managers congregated at the St. Regis Hotel in New York including Neuberger Berman, SAC Capital Advisors LP, Soros Fund Management LLC, Tiger Global Management LLC and Och Ziff Capital Management Group LLC, trying to get a piece of the pie, according to the sources.

Representatives for Neuberger Berman, Tiger Global and Och Ziff declined to comment. The other funds were not immediately available for comment.

With almost all 33 Facebook underwriters kept in the dark about the deal, including additional changes to terms such as pricing range and IPO size, one underwriter called the process the "Morgan Stanley show" while another underwriter said the bank is "essentially running it by themselves."

JPMorgan pulled out all the stops when Facebook executives visited its New York headquarters. A Facebook-branded flag adorned the building and the bank gave out Facebook baseball hats and coffee cup holders. But the moves "mostly attracted press," said one source.

Facebook Chief Financial Officer David Ebersman and VP of Finance & Treasurer Cipora Herman were the primary executives working with underwriters, a separate source close to the matter said. Facebook Chief Operating Officer Sheryl Sandberg also remained actively involved.

Ebersman had been very thorough in his thinking throughout the process, one of the sources close to the matter said, considering everything from the more transparent Dutch Auction process that Google Inc used to a directed shares program. In the end, Facebook decided it wanted a traditional IPO process.

Their thought was to "bring in the right shareholders" as part of the IPO process and not get tangled up in other strategies that would be disruptive to the running of Facebook's business, the source said.

Zuckerberg was less involved, and also chose not to attend a majority of the roadshow stops last week, other than a brief appearance in his trademark hooded sweatshirt on May 7 at the Sheraton Hotel in New York and then again in Palo Alto that Friday.

The roadshow -- in which Zuckerberg was treated less as CEO and more as rockstar -- only lasted nine days rather than the typical 12.

Security was so tight that in New York attendees were asked for multiple forms of identification and were cross- checked against a list of names. According to one source, even one of Morgan Stanley's equity sales heads had difficulty entering the roadshow lunch because his name was accidentally left off of the list.

Until late Thursday night, co-managers were still left in the dark about their allotments and if they were even going to get shares, said one underwriter who preferred anonymity because the talks are private.

"Everything was very hush hush," he said.

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UPDATE 7-Historic Facebook debut falls flat

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The remote server returned an unexpected response: (417) Expectation failed.

* Shares close flat

* Analysts blame large float, advertising revenue concerns

* Nasdaq investigating trade execution issues

By Alexei Oreskovic

SAN FRANCISCO, May 18 (Reuters) - The historic initial public offering of Facebook Inc did not go as planned on Friday, as the social networking company's sky-high valuation combined with trading glitches left the stock languishing near its offering price at the market close.

Facebook shares began trading late Friday morning and opened 11 percent above the $38 offering price, but after peaking at about $45 slid rapidly at the end of the day to close at $38.23. The IPO was the third-largest in U.S. history and valued eight-year-old Facebook at $104 billion.

The surprisingly weak debut of a stock that analysts had predicted would climb between 10 and 50 percent is not likely to dent the business prospects of Facebook, which boasts 900 million users and is upending business practices and social relationships around the world.

But the unexpected developments were a clear setback for Morgan Stanley, the lead underwriter on the deal, which sources said was forced to defend the $38 price level by buying shares on the open market. Many market participants said they expected the stock to remain under pressure next week.

The offering also proved an embarrassment for the NASDAQ: the opening was delayed as the exchange struggled with a huge volume of orders, and for much of the day there were long delays in order confirmation. The SEC said late Friday that it was reviewing the situation.

Social media companies and Internet companies that had hoped to benefit from a Facebook halo effect were instead dragged down Friday, with social gaming giant Zynga dropping almost 15 percent.

Analysts said Facebook may simply have over-reached in raising the IPO price range, pricing at the top of the range and increasing the size of the offering earlier in the week.

"The underwriters got greedy on behalf of selling shareholders and bumped the price high enough that they didn't get much of a bump on the first day," said Bill Smead, chief investment officer at Smead Capital Management, which did not buy Facebook shares in the IPO. "They increased the size of the deal and that really did a number on it."

Skeptics have argued all along that a valuation of more than $100 billion -- about equivalent to Amazon.com Inc and exceeding that of Hewlett-Packard Co and Dell Inc combined -- was far too high for a company that posted $1 billion in profit and $3.7 billion in revenue in 2011.

Concerns about Facebook's earnings potential were highlighted by General Motors' announcement this week that it would no longer buy paid advertising on Facebook.

"You don't need more than a small pencil and napkin to do a valuation on this, to say there are heroic assumptions in earnings growth to keep this at $100 billion, much less $115 billion or $120 billion," said Dave Rolfe, fund manager at River Park Wedgewood Fund, which does not own shares in Facebook.

"I know there's a lot of excitement and exuberance, but it seemed today that the market is starting to do some hard valuation math early on."

Facebook's opening day on Wall Street does not bode well for the stock's performance in the days ahead, said Channing Smith, portfolio manager at Capital Advisors Growth, which does not own shares in Facebook.

"If you're an investment banker or if you're long the stock, I would definitely be a bit worried as we walk away to the weekend," he said.

The weak IPO may also give pause to private investors in Silicon Valley who have been pouring money into next-generation Internet companies at very high valuations in the hope of eventually taking them public.

MEDIA CIRCUS

At Facebook's headquarters in Silicon Valley, the day began with company founder and Chief Executive Mark Zuckerberg, 28, symbolically ringing the opening bell for stock trading on Friday morning.

Wearing his trademark black hoodie, Zuckerberg, whose shares are worth nearly $20 billion and who retains voting control over the company, hugged and high-fived Sheryl Sandberg, Facebook's chief operating officer, who is credited with bringing crucial business discipline to a company founded in a Harvard dorm room.

The area outside Facebook's offices was packed with photographers, more than a dozen television trucks, and a TV news helicopter hovering overhead.

Outside Nasdaq headquarters in New York, crowds also gathered, even as exchange officials struggled to sort out trading problems that left investors guessing whether their buy and sell orders had actually been executed.

The IPO minted thousands of new paper millionaires among Facebook's 3,500 employees -- and a handful of billionaires among its founders and early investors. More than half of the proceeds of the IPO will go to existing shareholders, including early backers such as Accel Partners and Russia's DST Global.

In the run-up to the IPO, demand from institutional investors was strong, and many analysts had expected an influx of retail investors keen on owning a slice of a cultural phenomenon regardless of price. But that did not materialize.

"Flippers who waited all day for a pop that did not come decided to throw in the towel and get out," said Mohannad Aama, managing director at Beam Capital Management LLC in New York.

"That group also includes people who over-extended themselves in getting more shares than they can afford to hold -- whether they got it from the syndicate or from the open market once it opened around noon."

Still, from Facebook's perspective, the stock performance could be seen as reflecting smart pricing: Zuckerberg and early investors pocketed maximum gains and left little of the easy money on the table.

"You want to price the offering correctly. Institutional buyers get a little bump and the company raises the right amount of money," said Kevin Hartz, co-founder and CEO of Eventbrite, an online ticketing startup that is integrated with Facebook's platform. "If the stock has a massive bump on day one, that means you misread market demand and the company could have raised more money with the same amount of dilution, or could have raised the same amount of money with less dilution."

BATTLE OF THE GIANTS

Facebook faces many challenges as it takes its place beside Google, Apple and Amazon as one of the giant public companies defining the next-generation Internet economy. Google in particular views Facebook as a mortal threat and is moving aggressively to integrate social networking features across its products.

At the same time, scores of young companies are building new products and services, in some cases on top of the Facebook platform and in some cases in competition with it, and attracting huge amounts of investment capital.

A handful of such so-called Web 2.0 companies, including Zynga Inc, LinkedIn Corp, Yelp Inc and Groupon Inc, have already gone public, and others have been acquired by the industry giants. All of those stocks fell on Friday in sympathy with Facebook's weaker-than-expected debut.

In an indication of the land grab now under way in the Internet world, Facebook in April spent $1 billion to acquire Instagram, a tiny photo-sharing company with lots of users but no revenue. A Facebook rival, social scrap-booking site Pinterest, raised money earlier this week at a valuation of $1.5 billion in a sign that venture capitalists and other private investors still see enormous potential in Web 2.0 companies.

Many of Facebook's users spend hours a day on the site and share enormous amounts of personal information. That in turn enables Facebook to target its advertising to people's specific interests, and many analysts believe the huge store of personal information gives Facebook an advantage that Google and other cannot match.

"Literally everything you see on the Internet, you could see inside Facebook -- but done with much more of the social graph built into it," said Siva Kumar, CEO of e-commerce company TheFind. "In a way, they operate the mall, and everybody in the mall will pay some way or the other to Facebook."

Analysts say the company has vast untapped opportunities in mobile computing, where it has been weak thus far, and potentially in other Internet services such as email and search. Zuckerberg, though unproven as a public company CEO, is widely admired as a product visionary who has done a masterful job in continually improving the Facebook experience.

Skeptics, though, note that only a small percentage of Facebook users respond to advertising on the site. Google retains a big advantage in that regard, because advertising related to specific Internet searches is by nature far more relevant and thus more valuable.

In Silicon Valley, though, the conventional wisdom is that Facebook and its social media brethren will be an increasingly important force in the business world for many years to come.

And no matter how the industry dynamics unfold over the long term, the influx of wealth arising from Facebook's extraordinary growth has already helped drive a mini-boom in San Francisco Bay Area real estate. Income tax revenues related to the IPO will cut the state of California's budget deficit by an estimated $2 billion.

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