This is a guest post by Henry Davis, a London-based investor at Index Ventures

There is nothing really that “public” about an IPO.

The reality is that whoever gets shares in an offering is typically carefully selected by the syndicate banks — and who they choose to give shares to can have a meaningful impact on the share price after trading begins. In short, the allocation matters.

When pricing an IPO, there are many more stakeholders than just the public relations team looking for a good story, and the selling shareholders looking for a good exit. Indeed, when IPOs move significantly on initial trading, a lot of the problem comes not from mispricing, but from misallocation.

If the allocation is inconsistent with the mix of investors looking for shares, it can create un-sated pockets of demand or excess liquidity. These can lead to price distortions in early trading, as the book balances itself out to its more natural standing position.

Related — Read our analysis of stock pops: “Balancing positive press with economic realities”

Every allocator in an IPO is looking for a mix of investors in the book that will give a balance between long-term holders, who provide price support going forward, and short-term holders who provide immediate liquidity. This is a difficult line to tread. The company often dislikes having hedge funds in the book, as they mistrust their motives.

But hedge funds create liquidity and if you have too many long only funds that intend to hold at flotation, you can create a short-term squeeze on the stock.

In Twitter’s case, on top of this, perhaps the 11 percent held back for retail investors may not have been enough. Retail investors are notoriously price insensitive so if they decide they want to own the stock they will chase it, even as the stock rises, especially on a high profile launch day.

Given Twitter’s extreme prominence, it is not inconceivable to imagine many stockbrokers going into Twitter’s first day of trading clutching open orders to buy for their clients up and down the country. 

Both of the above points are exacerbated by an inherent conflict of interest for banks. While in theory investment banks are paid fees in the IPO only by the listing company, banks act as middlemen with the ultimate buyers of the shares. As such, the people who are allocated shares in an IPO are also clients of the same banks and they can often be paying annual commissions orders of magnitude bigger than the corporate IPO client fees.

Equity sales teams at banks would therefore like to maximize allocations to their most profitable investor clients. These wishes can sometimes feed into the process and further lead to mismatches in the mix of allocation and demand.

The effect of the share register mix at IPO can be seen starkly in the recent Royal Mail IPO in the UK (though admittedly this may be the most un-techy company ever). Shares rose 38 percent on the first day of trading (and still more subsequently) after the government allocated one third of the offering to retail investors, while also not allocating to thousands more individuals who sought shares.

Retail investors make up less than 20 percent of total AuM in the UK so, in this case, shares were over-allocated to this group, which created a block of illiquidity, while jilted and other retail investors trying to buy more helped squeeze up the price. It may have been politically expedient for the UK government to give retail investors a quick buck, but it was not textbook IPO pricing by any means.

The “correct” pricing of an IPO is just as much a function of allocation as it is the share price itself. Price is, by definition, driven by supply and demand and the shape of allocations can materially alter these dynamics once trading begins.

I would argue that Twitter was not so much “underpriced” in absolute. Rather, it was underpriced for the shape of its share register at the opening bell.

HD Headshot ColorHenry Davis used to be an Equity Capital Markets banker, during which time he worked on IPOs for numerous companies. The highest first day performance of any of these was blinkx, which is headquartered in San Francisco and whose stock rose 40% on its market debut. Henry now works as a venture capitalist in Europe.

Follow him on Twitter @henryshandle

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