It befits a provider of stock market plumbing that we only tend to notice float stabilisation managers when things go wrong. Yet the inquest into Deliveroo’s flop IPO has drawn overdue attention to their role.
To summarise, finding a flotation price is a messy affair. Little is fixed until the very end of the bookbuilding process, meaning underwriters tasked with selling the stock want flexibility and the promise of a safety net. An overallotment option known as the greenshoe, providing for the sale of an extra block of shares, ought to provide both.
In the case of Deliveroo, stabilisation manager Goldman Sachs was given an option to draw down an extra 38.5m of new shares at any point within 30 days from when trading started last week. These greenshoe shares would enlarge Deliveroo’s share issue by 10 per cent and raise an extra £150m or thereabouts for the company, before costs.
Goldman also agreed a separate option with Accel Partners, a long-term Deliveroo investor, to borrow up to the same number of shares. This stock needs to be handed back at the end of the 30-day stabilisation period.
Using borrowed stock gives the underwriters wriggle room. Most importantly, it allows them to sell more shares than allocated. Backstopped by Goldman’s loan, underwriters to Deliveroo’s IPO were able to sell up to 110 per cent of the shares to be issued.
After trading begins, the stabilisation manager has two ways to square off what is in effect a short position. When the market price is above the flotation price, triggering the greenshoe will deliver enough shares to match the number borrowed. If the stock slips lower it can leave the greenshoe alone and buy for cheaper in the secondary market.
Here, in theory, is a risk-free product. Strong initial demand for its stock allows a company to raise extra capital via the greenshoe, generating bigger commissions to the underwriters that got the pricing wrong. And if the price flops the stabilisation manager can cover its loan with market purchases on which it extracts a trading profit (which it may or may not pass to the company), These purchases are artificial demand that helps damp losses. Everyone’s happy.
So what went wrong?
In the past week, the City has been rife with speculation about tensions between Deliveroo’s underwriters over whether to pull the float. Threatening to withdraw is a proven strategy whenever the price wanted does not match the one investors offer: its power is how banks have long resisted a push to provide hard underwriting, where they guarantee proceeds before starting the bookbuilding process.
But Deliveroo was hamstrung — not just by early investors wanting to sell but by its elevation into a political good news story about the London market. Pricing also lacked flexibility: a fundraising agreed in January had put the headline value on the company at just over $7bn, which was widely seen as the reserve value.
In the end, according to people involved, support was blown away because underwriters had tapped all available demand. Their clients paid up for Deliveroo expecting priority treatment for the underwriter’s next float. After them there was no one.
As a result, the stock dropped immediately to the assumed reserve value when trading began. Goldman ended up absorbing nearly a quarter of the value of shares traded during the first two days of trading in a failed attempt to prop up the price, the FT reported this week.
While Deliveroo is an oddity, its flop highlights wider questions about the value of over-allotments options.
A growing body of academic research suggests greenshoes do little to calm volatility or stem IPO underpricing. Recent papers from Patrick M Corrigan, associate professor of Law at University of Notre Dame, set out evidence that greenshoes incentivise underwriters to get float prices wrong, either to maximise the overallotment value or to profit on grey-market trading.
Yet greenshoes have been part of the scenery for so long that investors rarely question their inclusion, even though they are the ones ultimately footing the bill. It’s about time that greater scrutiny was given to what has for underwriters been a risk-free bet.