The Wall Street Journal recently reported on the trend of IPO underwriters to allow lockup restrictions to prematurely lapse at some companies. A lockup restriction is an agreement between an underwriter (an investment bank) and a company’s insiders and other large shareholders stating that they will refrain from selling any stock during a designated period of time (typically between 90 to 180 days) following an IPO. The purpose of a lockup is to prop up the share price and promote early investor confidence, thereby enabling a stable market price to emerge for a new company’s stock.
According to the article, “since 2008, underwriters have allowed insiders at 11.4% of all IPOs to sell shares before lockup expirations,” which is nearly double the percentage allowed in the previous five years. While that, in itself, isn’t exactly encouraging, it is interesting to note the implications of these lockups lapsing early—underwriters’ fees don’t necessarily cease at the IPO, as post-IPO offerings can continue to generate revenue for the underwriter. As the WSJ article explains, lead underwriters for secondary offerings that occur before lockup expirations are almost always identical to the lead underwriter for the IPO. In essence, the underwriters have an implied conflict of interest as one of their only two duties is to make as much money as they can for their own firm on the deal (the other being to maximize the raising of capital for the company undergoing the IPO).
The recent IPO landscape is littered with companies with sky-high initial valuations that eventually fall back to earth. While this is profitable for the underwriters, the pre-IPO investors and the company in question, it leaves other post-IPO investors out in the cold. One could argue that the releasing of the locked-up shares is already included in a security’s value – that is, the market knows that the lockups are set to expire at some point and that knowledge is “priced in” to a share’s initial price. However, these prematurely ending lockups ignore a fairly important aspect: Timing.
Given the rash of insider trading cases over the past several years, and most recently, the SEC’s fining of the NYSE Euronext (regarding allegations that the exchange provided market data to certain high-frequency traders seconds earlier than other traders), one can see that timing is more critical than ever. An informed, rational investor who believes that locked-up shares will not be available until after the lockup date and who values the company’s stock accordingly will be surprised at best, and at a significant disadvantage at worst, if the locked-up shares arbitrarily become available prior to the lockup date. A significant number of shares prematurely unloaded into the market by an insider could surely impact the stock price, most likely downward.
Ultimately, investors should be concerned with the independent oversight of a company’s use of lockup restrictions and ensuring that appropriate processes are in place to mitigate any potential conflicts of interest. This is especially the case considering that the authority to end lockup restrictions prematurely is kept with the underwriters, rather than some other overseer such as the SEC. Intuitively, underwriters care about their own bottom-line and are accountable to their own investors, not necessarily the shareholders who purchased a company’s stock following its IPO. As such, absent any explicit regulatory oversight of lockups or the prevention of premature lapses of such agreements, purchasers of post-IPO common stock have little to no reason to place their faith in such agreements.
Article by True McKee and Alex Miller