Uber IPO Underwriting Banks Seems To Have Bet On Failure

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The initial public offering of the world's largest rideshare company, Uber (NASDAQ:UBER) was easily the most anticipated IPO of the year, and probably the most hyped reaching back within recent memory. Yet that did nothing to help the company once shares were finally listed, shares have plummeted - sometimes by double-digit percentage - since last Friday.

Uber and some major banks were claiming the company should be valued at $120 billion as recently as last Fall. Now that the company has turned to reality for its valuation, its worth about half of that, coming around $69 billion at today's close.

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Uber's underwriting banks take a naked short position - and it pays off

It seems that the underwriters of Uber's IPO, large banks like Morgan Stanley, performed a somewhat unusual move by opening a naked short position in Uber. Typically an underwriter will buy say, 100 shares from the company that is going public and turn around and sells 115 shares to the general public. Since the bank sells more shares than it owns, this creates a short position.

Unlike a typical short position, the underwriting banks have a guaranteed option to purchase those extra 15 percent worth of shares back from the company's insider shareholders at a set discount. In this case, the agreement was for $44.41 per share so Morgan Stanley and the other banks could net a nice 10 percent profit from the shares it sold then repurchased at a discount. This is standard-fare for IPOs and how it usually works. This is called the greenshoe, where banks sell more than they first purchased, and then buy the shares back either from company insiders (IPO did well and prices went up) or buy them from the market (IPO didn't do well and prices went down).

In this case, Uber's IPO flopped completely. Prices were as low as $42.67 last Friday and then the following Monday they were as low as $36.08! Why would a bank buy the shares back at $44.41 when they could purchase them from the open market at a massive discount? The answer is they wouldn't, and so in buying shares on the open market, demand is driven and prices would be pressured to increase, and for the IPO this is viewed as a positive, which it generally is.

Its what comes next that's indeed very rare. It was reported earlier this week that the major underwriters sold more than the 15 percent "greenshoe" guaranteed buy-back allotment, and this creates what's known as a "naked short". The banks had no promise of a buy-back price, and if shares had climbed to say, $60, each share sold over the greenshoe amount would have lost the banks $15 dollars. However, as now know, that didn't happen. Prices dropped well below IPO levels, and Morgan Stanley and the other underwriters increased their profits even more by buying back more shares at discount prices after having sold them for $45.

We don't know just how many extra shares were sold by the banks, so we can't say how much they profited. Management at those firms would say that they wanted to provide additional buying support for Uber's shares, but at the same time, this increase in initial supply reduced relative demand and netted the banks a nice sum.

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