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Mar 3, 2017

S3 BLACKLIGHT: Shorting the SNAP IPO Based on Precedent-Setting Examples

Snap Inc – A (SNAP US), the parent company of the mobile application Snapchat priced its 200 million share offering on March 1st, with an expected price of $17, generating a total stock offering worth $3.4 billion, and went public today. The offering was only for non-voting shares, with co-founder and CEO Evan Spiegel and co-founder and CTO Robert Murphy owning a total of 40% of SNAP’s market cap and 89% of the voting rights. Morgan Stanley was the lead underwriter of the IPO syndicate, which consists of Deutsche Bank, Goldman Sachs and JP Morgan. Notably, the co-founders are hoping to convince 25% of the IPO buyers to agree to an extended lockup period of 1 year.

Twilio Inc.’s (TWLO US) IPO in June 2016 provides insight into SNAP’s preliminary short activity. TWLO’s short interest climbed to $80 million in the first week after its IPO, which was 20% of the initial offering. By the middle of July, three weeks after the IPO, short interest continued to increase, and was $123 million, or 25%, of the offering.

Because of supply tightness, stock borrow rates were high right from the start. Stock loan fees started at 20% and quickly increased to 70% and higher by mid-July 2016. Short interest stabilized around the $175 to $200 million level, with 40% to 50% fees as TWLO’s stock price traded in the $50-$60 dollar range from August to mid-September.

Short interest and TWLO’s stock price peaked in late September, with short interest hitting $360 million and stock borrow rates running into the high 50’s% and 60’s%. By the end of the summer, almost half of TWLO’s stock was being borrowed to cover short sales. Stock borrow fees increased to the mid 80’s% right before TWLO’s secondary offering on October 20th, but once shares settled from the 11.5 million share secondary, stock borrow fees dropped below the 10% level. Today, with lendable supply replenished, stock loan fees are below 2% even though short interest has increased to $425 million.

Looking back at recent IPOs, including Twilio, Nutanix (NTNX US), Planet Fitness (PLNT US), Athene Holding (ATH US) and Shake Shack (SHAK US), to use as examples of post-IPO short interest, we see the results are binary in nature. Either short demand continues to increase in the name if the stock’s price has a significant follow-up rally in the stock after the initial post-IPO run-up with borrow supply tightening and borrow rates spiking into the 20% to 50% fee range. If the secondary rally is absent or muted, which allows short interest to either decrease or stabilize, borrow availability will increase over time and borrow rates will remain within the 1% to 3% fee range.

With the lack of recent exciting IPOs and SNAP’s IPO a constant media topic, we expect that demand for this IPO will be high, a premise supported by the fact that the $17 offer price is above the initial $14-$16 range. There is a strong chance that the initial IPO rally will continue into a follow-up rally, which will spur even more short demand. We expect that 10% to 20% of the initial offering will be shorted in the first week of trading, which roughly translates into $500 million to $1 billion of short interest right from the start. Stock borrow availability will be tight initially and stock borrow fees should start around the 25% fee range. If there are settlement issues early on in the IPO process, share availability will be limited in lending programs and stock borrow rates could quickly increase. If, as expected, SNAP’s stock price rallies, short demand would increase in tandem and short interest would quickly climb to 25% of the initial offering – pushing total short interest well above the $1 billion mark, and stock borrow levels into the 30% to 50% fee range.

Case in point, TWLO short sellers were down $116 million, or 63%, in the first three months after their IPO, but were able to recoup those losses and more with a profit of $149 million from October 2016 to March 2017. TWLO short sellers are now in the black, up $32 million or 12.5%, even after paying over $56 million of stock borrow finance fees in just over eight months.
SNAP short sellers will certainly need conviction in their trades.

The Regulation SHO Locate Requirement states that “no broker-dealer may accept a short sale order from any person unless the broker-dealer has borrowed, entered into an agreement to borrow the security, or has reasonable grounds to believe the security can be borrowed such that it can be delivered when due in order to settle the short trade.” An IPO, because there are no settled positions to loan and borrow, creates issues for brokers trying to provide locates for their customers trying to short the IPO stock.

A 2008 SEC study by Edwards and Hanley dismissed the idea that IPO-related regulatory and settlement constraints limited the ability to short IPO shares on its offering day. The study found that 99.5% of all IPO’s had short sales on their offering day (primarily executed at the open), on average totaling 7% of the total shares traded.

Brokers may limit locate “fills” based on internal compliance and operational restrictions, perceived tightness of future stock loan borrow availability and client profitability, but the majority of brokers can approve locates on IPO securities.

One exception is when brokers are lead (or co-lead) underwriters in an offering. In these instances, they may delay approving locates to clients until the first settlement period of the issuance has occurred and may not use rehypothicated stock as lendable inventory. Otherwise, brokers will calculate their perceived allocation of stock loans from the street (from agency lenders and other brokers) and usable rehypothicatable long inventory and allocate these shares to their clients.

The distribution amongst a broker’s clients may be based on overall profitability of the client (commissions and fees paid), first come first served, expectation of future business, level of competition from other brokers, size and trading activity of their overall portfolio, tolerance to high stock lending rates or “squeakiness of the wheel.”

For more information on the above analysis, please contact:
Ihor Dusaniwsky, Head of Research, S3 Partners, LLC     Ihor.Dusaniwsky@S3Partners.net
Matthew Unterman, Director, S3 Partners, LLC     Matthew.Unterman@S3Partners.net
The information herein (some of which has been obtained from third party sources without verification) is believed by S3 Partners, LLC ('S3 Partners') to be reliable and accurate. Neither S3 Partners nor any of its affiliates makes any representation as to the accuracy or completeness of the information herein or accepts liability arising from its use. Prior to making any decisions based on the information herein, you should determine, without reliance upon S3 Partners, the economic risks and merits, as well as the legal, tax, accounting and investment consequences, of such decision.

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