The Missed Red Flags on Groupon

The Groupon case is an interesting look at IPOs and how the investment banks that underwrite them suffer from very real conflicts of interests.

Groupon’s initial filing for an IPO valued the company at around $30 billion, but after the SEC found accounting and disclosure problems analysts decreased their valuations to as low as $10 billion. The article below raises an interesting question. If the investment banks (Morgan Stanley, Goldman Sachs, and Credit Suisse) fought so hard to win the underwriting mandate for the IPO, shouldn't they have caught these warning signs? Or as former SEC chief accountant Lynn Turner said, have they simply become sales and marketing agents? The article suggests that the higher fees associated with a higher valuation could be a reason the underwriters turned a blind eye. But shouldn't they also act in the interest of their institutional clients and the general public?

The underwriting firms seemed to have turned a blind eye and let several things slide. First, many have questioned the high valuation of $30 billion, especially given the company’s slowing growth rate and unsustainable working capital deficit. The above-mentioned accounting gimmick refers to a new metric that Groupon introduced in it’s filing, in which it conveniently left out major expenses such as marketing and acquisition-related costs. In addition, since the initial filing the SEC has twice forced Groupon to change the way it records revenue. Although technically legal, the previous methods for recording revenue were misleading investors on how fast Groupon has grown over the past two years. And since revenue was one of the main drivers for Groupon’s lofty valuation, lower revised revenue figures significantly altered the valuations in a very negative way.

However, it is hard to believe that investors were actually fooled by some of the metrics Groupon used. The generous valuations that were given to companies like Groupon and Linkedin have more to do with the hype surrounding their IPOs than the actual numbers involved. In a tech bubble-like scenario, firms can get away with much more "creative accounting," as evidenced by the fact that Zynga too created some obscure accounting metrics in their filings, and is now being valued at $15-20 billion.

But the investment bank’s role in all of this is a little more nuanced. Of course, it has to appease the interests of the company who is IPOing (and who wants to raise as much money as possible), but on the flip side it has to appease the interests of its institutional investors who are buying into the IPO (and who want to pay the lowest price possible to buy the company's shares). Therefore, it is still in the investment banks' best interests to properly value companies like Groupon and to raise the red flag when they see questionable accounting. At the end of the day, they might get higher commissions from the company for raising more proceeds in the IPO, but they will sour their relationships with institutional investors who get screwed over by overpaying for the company's shares.

In the Groupon case, it comes down to the fact that, like the rest of the market, investment banks got caught up in the hype of all of these tech IPOs. For example, Linkedin IPO'd at a ridiculous valuation (something like 17.5x 2010 sales), and yet it's stock more than doubled on the first day of trading. For the underwriters who led the IPO (Morgan Stanley, Bank of America Merrill Lynch, and JP Morgan), it was a win-win situation - the company received a generous valuation and its institutional investors made a killing. It's not really a surprise that the investment banks overlook some of these accounting gimmicks because, in a bubble-like environment, they can get away with it.

http://dealbook.nytimes.com/2011/10/17/the-missed-red-flags-on-groupon/

-- Sameen