What about market stabilization reasons?

That was a comment from Jeff Olin, in response to a recent column on over-allotment options, a feature that’s been included in about 44% of the equity financings done over the past five years. Once included, the option, that in effect allows the issuer to sell an additional 15% shares on the same terms and conditions as the base issue, has been exercised on about 73% of occasions.

Olin, a former investment banker, who now manages a series of real estate investment funds at Vision Capital, said the underwriters will “typically recommend and encourage” issuers to include an over-allotment option in financings to enable a market stabilization period for the trading of the shares. “The only reason that the regulatory framework provides for an over-allotment option is to facilitate market stabilization, post-financing,” he noted.

In his view, the option will be included, if the underwriters “are driven primarily to provide an orderly market stabilization period, not to potentially benefit from earning more fees on a larger financing.”

So what happens?

The underwriters focus on two things: the number of shares sold in the offering relative to their commitment; and the price of the shares in the secondary market.

Accordingly, if there is demand for additional shares, the financing is oversold by 15%, meaning the shares are placed with investors but not formally allocated.

In the secondary market, one of two things happens: either the share price falls or it rises.

If the price declines, the underwriter can purchase shares in the market (at lower prices.) The idea, Olin says, is “to stabilize and support the price knowing that they have previously oversold the shares but have yet to exercise their option to purchase these shares from the issuer and are not at risk for a loss on the shares purchased in the after-market.”

If the share price increases, then a different set of factors comes into play. In that situation, the underwriters can exercise their option to buy up to the 15% over-allotment option at any time up to the 30-day stabilization period at the issue price.

Olin said underwriters do that with the knowledge “that they had previously oversold the stock without the risk of a loss from selling the shares at a lower price than the issue price at the time of the initial over-allotment.”

How does it work in practice?

In October 2012, the Federal Reserve Board of New York published a research piece on over-allotment options, a feature it said, “lends some elasticity to the supply of shares so that the price impact of demand fluctuations is dampened.”

The study was centered around the efforts of the underwriters to stabilize the share price in the Facebook IPO in the Spring of 2012. Using a technique known as “large integer-price bid identification assumption……. we find evidence of significant trading by underwriters seeking to stabilize the stock’s price. This evidence suggests that underwriters incurred significant costs as a result of these activities.”

Facebook priced the shares at US$38. After a wild first day with massive trading (582 million shares, 20% more than were sold) the shares closed at US$38.23. Two weeks later, they were at US$28.19.