Banks make bank on ‘Brokenstock’ IPO

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Birkenstock sandals may have gone from frumpy to fashionable, but investors in its $1.5bn IPO have gone from grumpy to miserable. Shares in the German footwear firm have crashed by 21 per cent in one of the worst after-market performances ever for a jumbo float.

While IPO buyers suffer, the stock price nosedive means that the underwriting banks stand to make a lot more money than expected — thanks to the way in which IPOs are “stabilised”.

The Birkenstock flotation launched with both heft and hype to support it. Three cornerstone investors — Bernard Arnault’s holding company Financiere Agache, the Norwegian sovereign wealth fund NBIM and Henry Ellenbogen’s Durable Capital Partners — committed to purchase up to $625mn. And Birkenstocks went viral online after Stereotypical Barbie, played by Fulham FC supporter Margot Robbie, wore a pink pair in the final scene of the movie.

Many investors found the valuation very pricey but still came into the IPO book, because recent IPOs had popped at the open, even if they later fizzled. The Birkenstock offering was quickly oversubscribed, and sources told the media that the IPO would price at the top of its $44-49 per share offering range. 

And yet . . . And yet . ..

As perhaps a sign of soggy demand, the price was set at slightly below the midpoint at $46. Since then, the stock has crumbled in three straight sessions to $36.38.

It’s clear that many fund managers who put in orders acted on the greater fool theory: they counted on other investors, including Barbie-besotted retail punters, to bid up the shares and allow them to exit at a profit. When the stock opened at $41 (-10.9 per cent), they ran for the hills.

The lead banks on the deal — Goldman Sachs, JPMorgan and Morgan Stanley — must have suspected the deal could trade poorly in the after-market. That explains why allocations were (I’m reliably told) strongly skewed towards “long-only” investors and away from hedge funds. Unfortunately, many long-only investors couldn’t tough it out when the shares hurtled downward. 

The stock price collapse will hurt those investors who didn’t flip this flop. Even a blue-chip, long-term investor like NBIM can’t be pleased with a $25-30mn mark-to-market loss after just three days (I’m assuming that as a cornerstone it hasn’t sold any shares, although it is not formally locked up). 

Meanwhile, the deal has its winners. For one thing, Birkenstock succeeded in raising equity at a favourable price to reduce its debt; for another, private equity firm L Catterton could sell some of its shares at a much higher price than what it paid two years ago. 

But there’s another group which is a big winner: the investment banks in the IPO syndicate. They will earn a lot more than the $63.1mn they collectively earned from the 4.25 per cent underwriting fee — and it’s precisely because the share price has dropped so much. 

To understand why, we need to explain how banks stabilise IPOs. Underwriters typically allocate 15 per cent more shares to investors than are initially offered at IPO, meaning they have a “short” position. Then they cover this short in two ways:

— If the share price goes up, the underwriters exercises the “greenshoe” or overallotment option to buy shares. (The greenshoe is a 30-day option for the underwriters to purchase an additional 15 per cent of an offering.)

— If the share price goes down, the underwriters buys shares in the market, thus stabilising the price.

So for the Birkenstock float, the base IPO offer consists of 32.2mn shares, and the underwriters have a 30-day option to purchase another 4.8mn shares. Thus at the outset, the lead managers allocated 37mn shares to investors at $46.

Ergo: 

— If the share price had risen, then Goldman Sachs as stabilisation manager would have covered the syndicate’s short position by exercising the greenshoe option to buy 4.8mn shares. This would have resulted in another $9.4mn of underwriting fees (4.25 per cent spread) for the syndicate banks.

— Since the share price instead has fallen, Goldman has presumably been buying shares in the market to stabilise the price, covering the short position.

Now we don’t know the price or size of Goldman’s purchases so far, but we can make some ballpark assumptions. Let’s assume it has bought 1mn shares at a $40 average price, leaving a short position of 3.8mn shares.

At Friday’s closing price, the syndicate stands to earn $42.6mn on stabilisation — a realised gain of $6mn and an unrealised gain of around $36.6mn! In other words, the stabilisation gain may end up representing another 67 per cent of fees for the underwriters.

Or maybe more? This example assumes the lead managers didn’t create a “naked short” — ie allocate even more than 37mn shares to investors at $46 — which would result in an even higher stabilisation gain. Now, we don’t know that there was a naked short, but underwriters use this tactic when they’re worried the share price will plummet — as, for example, in the case of Uber’s IPO in 2019. At Friday’s closing, a 1mn share naked short would equate to an additional gain of $9.6mn.

Just to be crystal clear, none of this is nefarious! The windfall profit just stems from the fact that the IPO was overpriced vis-à-vis “real” investor interest: the shares fell so fast and so hard that there was no way for Goldman to stabilise anywhere near the IPO price. And the lower the price at which Goldman buys shares, the greater the stabilisation profit, because the syndicate had sold shares “short” at $46. 

So if the offering had been more accurately priced, the banks would never stand to earn so much from stabilisation.

There is one final irony. In most European IPOs, companies and selling shareholders negotiate agreements to require underwriters to hand over all or most of any stabilisation gain. But that is not the market practice in the US. If Birkenstock had gone public in Frankfurt and not New York, there would be no extra bonanza for the banks. 

Maybe that’s another reason for strengthening European exchanges as IPO listing venues.