Much ado about liquidity? Lockup expirations and stock prices

Last week shaped up as a big one for Facebook. On Wednesday (November 14), the company faced the steepest of its lockup expiration cliffs so far, with 777 million shares released for sale by insiders. Its two earlier lockup expirations, of 271 million shares on August 16 and 234 million shares on October 29, did cause stock price pullbacks of about 5% and 3% respectively. Consequently, there was concern that Facebook’s stock price would take a beating on November 14, but the stock price climbed 12.6% on that day.

There are a host on intriguing questions that derive from lockups, their expiration and the market reaction to them, and I think it is worth taking a look at them.

The mechanics of and rationale for a 'lockup"
            Facebook is not unique. Most initial public offerings (IPOs) have lockup agreements that prevent insiders (which include owners/founders and VC investors) from selling their shares for a period after the offering. These lockups are not mandated by regulatory authorities but are contractual agreements between issuers and underwriters, with the terms disclosed in the IPO prospectus. While the most common lockup period for IPOs in the US is 180 days, there are quite a few firms that stagger their lockup dates (as Facebook did).  So, why do we see lockup periods in initial public offering? There are at least three reasons for the practice.

1. Skin in the game:  There are many risks that investors face when investing in newly public companies, but one is that the investors and founders of the company will cash out and leave behind a vacuum. Lockup periods ensure that the venture capitalists and owners of a business have skin in the game at least for a limited period after a stock goes public.
2. Signal of company quality: As a related point, having a lockup period makes the offering price more credible for outside investors, since insiders have to wait to sell their shares (rather than dump them at the offering price). A study of British IPOs found that longer lockup periods are associated with better performing IPOs (both in terms of profitability and stock price performance). In fact, it is worth remembering that Facebook, in its pre-offering hubris cut the lockup period to three months for some holders just before the offering date.
3. Stage management of offering: Having a lockup period for insiders also ensures that only a small fraction of the outstanding shares  hit the market on the offering date. This, in turn, enables investment bankers to "discount the price" at the offering and allows them to use the initial offering more as a marketing event leading up to the main event (which is the sale of shares when the lockup period expires). As this study notes, there is evidence that investment bankers and insiders both have an interest in underpricing the offering shares to create price momentum, which can then be ridden (hopefully) to the end of the lockup period. 

Lockup expirations: The insiders' choice to sell (or not)
When a lockup expires, insiders get the right to sell their shares, though they can choose not to sell. While there may be other motives at play, there are three reasons why insiders may sell at the end of the lockup period:

1. Need for cash: Some insiders, while wealthy in terms of the market value of their holdings, a can still be cash poor if the bulk of their wealth is tied up in the shares of the company. If they need the cash (to either fund conspicuous consumption or to pay taxes), they may have to liquidate at least some of their holdings.
2. Diversification : In a related point, the founders and even some of the venture capitalists in a company that has just gone public may find that they have too much of their wealth tied up on that company. Having weighed the desire for control of having a concentrated position against the peace of mind that comes from diversification, some of them may choose to cash out on at least a portion of their holdings and invest that cash elsewhere.
3. Information: Perhaps the trickiest part of the equation is that insiders do have access to information that the rest of the market does not about how a company's operations are performing. If they feel that the market price is too high (relative to their judgment of value), they will be inclined to sell their holdings.

The rest of us get to observe the actions (whether insiders sell at the end of the lockup period and how much they sell) but not the motives. Not surprisingly, we still try to find signals in the actions and react to how much insider selling there is, relative to our expectations.

Lockup expirations: The evidence and analysis
Lockup periods are therefore par for the course in initial public offerings and insiders have multiple motives for selling when lockup periods end. So, what typically happens when lockup periods end? To understand the market reaction when lockup periods expire, let's look at the effects, both positive and negative, of these events:

1. Liquidity effect: In the short term, the end of the lockup period releases shares for sale into the market, creating a demand/supply story that goes as follows: the end of the lockup releases news shares into supply, and holding the demand for these shares constant, this should reduce price. In the longer term, the release of the “locked up” shares to the market increases the shares that are available for trading (the float) and may should improve liquidity. 
2. Information effect: When insiders exercise their right to sell their shares, they are also conveying their views on what they think about the market price. As we noted in the last section, you are more likely to see heavy insider selling, if insiders view the stock to be over valued and less if it is under valued. In particular, markets form expectations about how much insider selling you should observe and if there is less (more) insider selling than anticipated, it is viewed as good (bad) news. 
3. Backstop effect: While investment banks may be under no legal obligation to provide support services beyond the immediate IPO, there is evidence that issuing banks continue to provide at least partial support for an offering until the lockup date. That support can range from buying shares, if the stock price goes into free fall, to favorable recommendations from the issuing banks’ equity research analysts. The removal of the investment banking support system may have negative consequences for stocks. 

Looking at the trade off, the net effect should vary then across companies. You would expect the most negative price impact from lockups ending at small lightly-traded firms (where the near term trading imbalance can overwhelm the long term liquidity benefits), where there are few institutional investors or analysts tracking the firm (making insider trading that much more informative) and where issuing banks have been active in providing support (ensuring that the removal of the backstop will have more consequences.  The effect should be more muted with larger firms that are already actively traded by institutions and tracked by analysts. Since these firms are already heavily traded, the liquidity impact is likely to be smaller, the institutional and analyst following should reduce the information impact of insider trading and the size of these firms will make it impractical for investment bankers to provide more than surface level backstop support.

The studies that have looked at this phenomenon seem to reach consensus on two broad conclusions::
1. The price impact is negative: When lockups expire, stock prices drop. The drop is statistically significant (between 2 and 5%) and there is no rebound from this price drop.  In case you are tempted to try to take advantage of this price drop by selling short prior to lockup expirations, it is too small (relative to transactions costs) and too unpredictable (about a third of lockups end with increases in stock prices) to build a profitable investment strategy around.
2. The trading volume surges: Trading volume increases  on the expiration of lockup periods, with volume increasing substantially both at the time of the expiration and the periods after.  One study finds that the price impact on the lockup expiration is related to the change in liquidity in the post-lockup period, with more positive (negative) stock price reactions correlating with increases (decreases) in liquidity.


Looking at Facebook
Based on the last section, I would argue that analysts who have used the lockup expirations as a rationale for Facebook's stock price performance since its IPO  have been reaching for straws. Facebook is a large market cap firm (market cap > $50 billion), with substantial trading volume and a heavy analyst following. It is not the type of company where you would have expected to see dramatic up or down moves on lockup expirations.

That is not to say that lockup expirations are non-events, since even at Facebook, there have been sizable price reactions to the first three lockup expirations - negative (-5%) for the first one, slightly less negative on the second one (-3%) and positive (13%) for the third.  Rather than search for elaborate rationale for the different market reactions, I would point to price momentum around each of the expirations. The first lockup period expired in the immediate aftermath of a bad earnings report in August, with the stock price already sliding, and the market reaction was negative. The second lockup period expired after the stock had spiked on the third quarter earnings report but was retracing its steps in the days after. The lockup period that expired last week (on November 14) was after the second earnings report, which was viewed as good news, and when the stock had upward momentum. Looking at this small sample, it seems to me that at least in Facebook, insiders have behaved like other momentum investors, selling when everyone is selling and holding if the prevailing sentiment is positive.  If there is a broader lesson to be learned from these experiences, it is that we attribute too much wisdom and knowledge to insiders, at least at young growth companies.  Rather than being ahead of the market in their assessments of value, insiders at these companies are often just as uncertain as the rest of the market and just as likely to follow the crowd. As a stockholder in Facebook now (my limit order did come through), I am less inclined to pay attention to what Zuckerberg thinks or does about the company and more to the fundamentals that will drive its value over time.