Tuesday column on why initial public offerings fall on their first day of trading overlooked a key factor: participation by the underwriter in the aftermarket.

I had framed the issue in very simple terms: A lack of demand, once an IPO starts trading, can cause the stock to fall below its offering price. If shares are sold to every possible buyer during the offering, no one is left to buy the stock in the aftermarket.


Sarah Davidson

, managing director of equity capital markets at

Sanford C. Bernstein

, says there's more to it than that.

"You missed perhaps the most important and key point around stabilization of a new issue, and that's the importance of having available capital to support an issue in the first few hours and days after pricing," Davidson writes. (Bernstein, an investment bank and money manager based in New York City, doesn't lead-manage deals but does co-manage some.)

"The traditional investment banks win business not only on the strength of the banking team and its track record, trading stats and the promise of aftermarket research, but also on the willingness of the lead manager to commit the firm's capital in the aftermarket... There is an implicit responsibility of the lead manager to provide some support by buying unwanted shares. However, the underwriters are not in the business of 'owning' stocks. Eventually, the shares must trade on their own."

Davidson is right. The lead underwriter is indeed expected to support a new stock, and it can turn to what's called the "green shoe" for that purpose.

A green shoe, or overallotment option, allows underwriters to buy up to an extra 15% of shares at the offering price from the issuer for a period of several weeks after an offering.

On a 10 million-share deal, for example, the underwriter will actually take orders for 11.5 million shares, which includes the 15% represented by the green shoe. The underwriter is in effect short 1.5 million shares, says Scott Sipprelle, co-founder of

Midtown Research

in New York City.

If demand is sufficient and buyers support the stock on their own, the underwriter will go ahead and take those extra shares at the issue price from the issuer -- called exercising the green shoe -- to meet this demand. If the demand is not there, the underwriter won't exercise the green shoe but will instead buy the shares back from the market. This tactic reduces the amount of supply in the market and can help support the stock price.

"The first line of defense is to oversell the deal," says Kathleen Smith, co-manager of

Renaissance Capital's


IPO Plus Aftermarket fund.

The underwriter can also dip into its own pocket to take a position in a new stock. If the investors are selling shares of a new IPO in the aftermarket, the investment bank can use its own capital to help buttress the stock. However, "the underwriter can lose money by doing that," says Smith.

Trying to hold up a stock means the firm is probably buying in a falling market. Investment banks aren't designed to hold massive positions over the long term. These firms want to be in and out.

But at some point, supporting the stock can become too costly or dangerous for the underwriter and the firm has to let the stock trade on its own.

If the stock is under a lot of pressure, the underwriter can step out of the way and the stock will fall, which can happen even on its first day of trading.

In Defense of Retail Investors


D. Yoo

took issue with my characterization of retail investors as being more likely than institutional investors to dump an IPO. "However, you are correct about one thing," he writes. "Small investors are the last investors of choice, but not because they are the worst holders of IPOs. They are the least favored, because hot IPOs have been ways to reward favorite institutions that do a lot of trading through the investment bank, and to reward high net-worth clients who also generate other revenues for brokerage houses."

To back up for a second, I wrote, "Small investors are seen as the people most likely to immediately dump a stock and are considered by many a last resort in selling an IPO."

Yes, maybe that's a weak excuse to avoid allocating more shares to individuals. But the excuse does still exist, and it's a factor.

Also, it is easier for underwriters to gauge the intentions of a few big clients than a bunch of little clients. "It's hard to control a whole lot of retail investors," says Renaissance's Smith. "It's a lot easier for an underwriter to place shares with a fewer number of accounts. And bigger accounts are bigger commission generators."

Surely, both institutional and retail investors flip IPOs. But some evidence does back up reader Yoo's view, suggesting that retail investors shouldn't take the brunt of the blame. Mark Loehr, co-head of online investment bank

Wit SoundView

, says that among Wit's roughly 100,000 customers, 80% of IPO shares are still held after 60 days.

Those statistics aren't going to change the thinking of Wall Street overnight. But it is a start.

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