In a previous post I made, I used WeWork and Saudi Aramco as two examples to show how Behavioral Finance can help financiers understand the psychology behind things like IPO’s. Both of these companies and their respective IPO processes merit a deeper look from the perspective of Behavioral Finance as there are many more concepts prevalent than simply just the Endowment Effect. Keeping in mind that Behavioral Finance assumes that people are predictably irrational, these well-documented stories can be further broken down.
WeWork
The case of WeWork has been one of the most dramatic collapses we have seen in recent times on Wall Street. Although it is certainly not the end for WeWork, the company and SoftBank have a lot to do. The IPO fiasco has hurt their public image and raised plenty of questions on the sustainability of their business model as well as how they can even begin to turn a profit.
Where did it all go wrong for the once promising company that was initially valued at $40 billion? Typically a company should pursue an IPO because they have a profitable business model, strong fundamentals, and they want to raise capital to push their growth even further, while also accepting the responsibilities to shareholders as a publicly traded company. In recent times however, companies that are yet to profit or that don’t even have a path to profitability (Uber for example) have been the hottest IPO’s, essentially selling shareholders on untapped potential and the opportunity to invest early in what could be a company of the future. That is the responsibility that private equity funds and venture capital firms should take on, not the average investor in the stock market. These companies clearly still need the guidance and time provided as a private company before they even consider selling their shares to the public.
Throughout the process, a big component of what misled investors was how WeWork and their numbers were framed. This office leasing company was labeled by themselves and the bankers promoting their shares as a “tech” company. In reality, there was not much tech involved in what WeWork actually does. The reason they would want to push themselves as a tech company is in part because of how successful tech stocks have performed, especially in 2019. Tech stocks have dominated, reaching new highs almost every month at this point and pushing up their respective indexes. WeWork likely wanted to ride the tail of the “tech” label in an effort to keep up with the high flying sectors’ returns. We have now come to learn that WeWork also framed their accounting numbers in violation to GAAP standards (specifically contribution margin among others) which was flagged by the SEC. They touted this miscalculated metric all over their revised prospectus. Originally labeled as “Community Adjusted EBITDA”, it turned an actual 2018 net loss of $1.9 billion into a $467 million profit. This behavior is extremely misleading to potential investors who may have seen the potential in WeWork when framed in this light. Instead, they ran the numbers and saw themselves that it did not make sense, ultimately leading to the company scrapping its IPO. Framing is a powerful tool that was used to mislead investors in this case by trying to make WeWork out to be something they were not.
The initial $40 billion valuation of the company served to play into a heuristic called Anchoring Bias. It is similar to behavior exhibited in contract negotiations for example where one party may give an initial offer 50% higher than what they expect so that negotiations will be anchored around that given price. Despite having their initial valuation torn apart, this is exactly what they attempted to do by giving such a high number to begin promoting shares at. The last thing they expected was to have that number fall $8 billion and lower today as financiers try to determine the company’s true worth.
In my previous post about Behavioral Finance, I briefly mentioned the role that the Endowment Effect played in this IPO process. To be more specific, the key players that exhibited the Endowment Effect as this played out were SoftBank and Adam Neumann. SoftBank, known for investing in potential tech unicorns, and Adam Neumann, WeWork’s eccentric CEO, both held this company at a much higher valuation because of the time, money, and responsibility they had to the company. This attachment and association to WeWork led them to a skewed price at which investors actually wanted to buy shares for. The good thing about roadshows is that they will put these valuations to the test and in most cases will lead to a more realistic valuation if the company is even ready to IPO at all. By understanding that private investors and CEOs are influenced by the Endowment Effect, bankers can put focus towards better explaining the shortcomings of a potential IPO and guiding company leaders to setting a price more realistic from a public investors’ point of view.
At this point having held WeWork for too long, SoftBank is dealing with Loss Aversion. Instead of of loading the wreck caused by the scrapped IPO, they must now work to turn things around in an attempt to gain some sort of return on their investment in the company. SoftBank still holds their position in WeWork so it is yet to be seen whether or not they can restructure and reform it into the company it was supposed to be before the IPO process revealed the reality of the situation.
Saudi Aramco
When it comes to the oil giant that is Saudi Aramco, there are a lot of behavioral factors that play into their IPO as well as the company itself. It is a unique case and different in many aspects to WeWork primarily because it is a government controlled entity. This means that Saudi Arabia have had a big influence throughout the entire process of taking the company public.
Like WeWork, the IPO played into the Endowment Effect as well as Anchoring Bias. This explains the initial valuation they gave themselves of $2 trillion while also being attached to the idea of having the biggest IPO in history. Anchored at such a high price tag, it was difficult to talk Aramco down to a price that would be more appealing, especially to foreign investors who had a number of doubts surrounding the company. The bankers working on the deal had a hard time justifying the number, especially considering the value of comparable companies such as Exxon and Chevron. Being that it is a nationally held company, the government is only selling a 1.5% stake. This shows how hard it is for them to let go of a bigger percentage of a company that is seen as a crucial component of what Saudi Arabia is today. Buying shares of Aramco, as a result, gives investors very little influence because of the control and equity that the government will maintain. Investing a company’s shares are meant to grant some form of ownership to buyers, but in this case there is very little ownership even being offered in Aramco.
Not willing to budge, Aramco decided on a local listing and hired a new team of bankers. This move was a display of Confirmation Bias, where someone may seek information that supports their claims while rejecting anything that goes against them. The new bankers were willing to play up to their high expectations and essentially saved the IPO from being scrapped. By opting for a local listing and foregoing international roadshows, Aramco sought confirmation through domestic markets and investors. They even offered loans and bonus share opportunities for locals so that they could invest into the IPO, making it likely that early investors hold onto their positions for the long term.
This leads into the final heuristic that was in effect; Familiarity Bias. Saudi Aramco, an oil behemoth and the biggest source of exports for the country, is held as a symbol of national pride for Saudi Arabians. As a result, local investors are all in on Aramco. Familiarity Bias in this case is when investors put their money and interests into something they know very well and recognize. Aramco clearly understands this, which is why they decided on the local listing while granting locals the opportunity to heavily invest into the IPO. This gives some room to push up the price as they attempt to reach and surpass the $2 trillion mark.
Having gone public at $1.7 trillion, it remains to be seen whether the company and government were justified in demanding such a high price tag or whether the price will meet a harsh reality. They were able to go public at a price they were comfortable at while also avoiding the scrutiny they may have faced at foreign roadshows. Given the biases and behavioral concepts that they used to push their IPO, it is likely that the stock will rise for a while as locals power the price upwards. It will be interesting to see how things turn out once they decide on a foreign listing and begin promoting shares to investors outside of the Middle East.
In Conclusion…
IPOs signal a big change for a company, going from privately held to public. For the owners and founders, this means giving up a stake in the company they helped build. For bankers, this is the opportunity to raise capital for the technologies and services that push our society forward. For investors, it is the chance to own a piece and have influence over the companies that drive our economy. It is thus crucial all around that the parties involved understand what to look out for in terms of the patterns that humans behave predictably irrational in. WeWork and Saudi Aramco are two recent examples that clearly show the things that can go wrong in an IPO as well as the influence that some parties have over determining its success.
ASVP Capital Insights 