It’s nearly the end of the year, so how about an alternative award?
Award category: Least-Understood-And-Yet-Easy-To-Understand-Capital-Markets-Thing
Winner: The Greenshoe
As the recent Aramco IPO has shown yet again, the greenshoe (or over-allotment option, to give it its proper name) still proves confusing to some. That's surprising, because there's not really a whole lot to grasp.
Underwriters routinely over-allocate IPOs, typically by 15%. They do this by short-selling the extra shares, borrowing them from some investors in order to allocate them to others. This means the underwriters have a short position (at issue price) that at some point they will have to close out.
The reason the underwriters do all this is to give them the flexibility to stabilize the market price of the shares once they start trading. Since they are already short, they can happily buy stock in the market up to the size of their short position, knowing that those shares are already spoken for.
If the shares fall in the secondary market when it starts trading, the underwriters can cover their short by buying shares in the market and delivering them back to the investors they borrowed them from. If they do this they make a profit, since they have allocated the shares at issue price but are buying them in the market at below issue price. In this case the IPO deal size obviously does not increase, since the issuer or selling shareholder has not sold any more shares into the market.
If the shares rise in the secondary market, the underwriters cover their short by exercising the over-allotment option in order to buy the extra shares from the issuer or selling shareholder. In this case they make no profit (although they do earn commissions on the extra) because they buy the shares at issue price. But the deal size does increase by the extra amount because the issuer or selling shareholder has sold more shares.
If you want to get nerdy about it (and heck, you’ve read this far, so why wouldn't you?), you could also note that because the greenshoe option is provided to the underwriters without a premium, they get a further technical gain because it is a free insurance policy.
Also, 1: usually the underwriter would have a 30-day period in which to exercise the over-allotment option. So over that time it's entirely possible for them to cover their short using a combination of buying from the market and exercising just part of the option, depending on the behaviour of the shares.
Also, 2: while one of the priorities of an underwriter once an issue has gone public will be to cover its short, another is to ensure the optimal trading of the stock they have shepherded to market, hence the whole over-allotment palaver in the first place. Happily, the effect of buying back from the market if the shares have fallen is not only to provide buying support, but also a further technical lift because it actually reduces the supply of available stock by 15%.
Also, 3: while the usual approach these days is to cover your short by buying in the market if the share price falls, it is also often possible for the underwriters to put in stabilizing bids at anything up to the issue price if they wish to. They give up some or all of their short-covering profit by doing so, of course, so it's not done a lot now unless there is real pressure for it.
Also, 4: no, this whole arrangement doesn't create a perverse incentive for underwriters to have deals trade badly. Any profit they book from short-covering at below issue price would have to be offset not only against the lack of commissions from that portion but also the much more important reputational damage of a deal gone badly wrong.
And finally: yes, the underwriters could also naked-short the IPO beyond the 15% covered by the over-allotment option. But for that bit they're on their own.