Robinhood
We are all investors now
Robin Hood is a legendary figure in English folklore, a righteous outlaw who took from the rich and gave to the poor. And the Robin Hood Foundation is known for its legendary (but not mythical) fundraising events at which hedge fund supremos are cajoled into making multi-million dollar charitable contributions to aid the poor and fund other worthy causes. But what are we to make of Robinhood, the popular (in certain circles) commission-free trading app? Is it following in the Robin Hood tradition or is it really doing something quite different?
I suspect that many readers of this newsletter know more about Robinhood than I do, and many of you perhaps have active trading accounts at Robinhood. I know about Robinhood only because it has been much in the financial news lately and so I have been prompted to do a bit of my own background research. I will share below a few perspectives, but I welcome and encourage those of you who are more knowledgeable on this topic to correct me if I have missed something or gotten it wrong. You can do this via email or by by using the Comment button below.
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Robinhood has been much in the news lately, so let’s begin by reviewing some of the news flow. I am putting most of the related links at the end of the article, to clean things up a bit, but there is some good in the linked documents so please do click through if you are so inclined and have the time.
GameStop. I first started following Robinhood during the GameStop frenzy, as did many of you I suspect. I wrote about the GameStop (GME) situation in a prior version of this newsletter, so won’t go into great detail again. The story as picked up by the mainstream press and on social media went something like this: Large numbers of small individual investors, many of them first-time investors, communicating on Reddit and trading via Robinhood, pile into GME’s stock in an unprecedented but largely successful effort to drive up the share price and ‘squeeze the shorts’, delivering a massive and well deserved financial blow to the hedge fund short sellers. When the narrative was spun this way, which I think was fair at the time, the GME story seemed very Robin Hood indeed. Financial victory at last for the little guy. Take that you hedge fund Sheriffs of Nottingham!
Retail trading activity explodes during Covid. Trading in “meme stocks” is not limited to GME of course, and it seems to have became somewhat of a national pastime during Covid, with many individuals reportedly using their Covid stimulus checks and rent and loan deferrals to begin trading, often for the first time. These stocks were hyped in online forums and their share prices quickly became divorced from any objective measure of intrinsic value, as we saw with GME. Robinhood was a big beneficiary of this trend, with monthly active users more than quadrupling from under 5mm pre-Covid to over 20mm post-GME, many of them first time investors. NBC News described this phenomenon as “Charles Schwab meets Candy Crush”. While the press largely portrayed retail meme stock trading as a new phenomenon in the investment world, those of us who have been around the block a few times may see some interesting parallels to the “day trading” phenomenon during the dotcom era of the late 1990s. Back then, individuals were reportedly quitting their jobs to “day trade” dotcom stocks, driving TMT stocks to unprecedented and unrealistically high share prices. Some of the day traders got out early and made a lot of money along the way, but when the dotcom bubble collapsed things did not end well for many of the day traders who had to go back to work in the real economy, no richer but perhaps a bit wiser.
The DTCC Collateral Call. At the height of the GameStop trading fury, the Depository Trust and Clearing Corporation (DTCC) temporarily shut down Robinhood’s ability to clear customer trades in GME and several other stocks. This was portrayed on social media (and to some extent in the mainstream press) as a coordinated outrage committed by the financial establishment against the righteous Robinhood warriors in order to defend the big money hedge funds. The cultural and political response was immediate and furious, so much so that we saw Ted Cruz and AOC join hands in solidarity with the customers of Robinhood, no doubt the first and only time we will see these two politicians joining hand in common cause. In fact, what happened here was quite different than the cultural narrative. The DTCC temporarily shut down Robinhood’s ability to clear trades in GME and other selected stocks pending receipt of additional cash collateral, which Robinhood did not have to hand. The additional collateral was required because of the dramatically increased settlement risk associated with the rapidly increasing volume of trading at Robinhood in shares with high and increased volatility. The size of the DTCC collateral call was quite large, around $3bn, reflecting the magnitude of the increased settlement risk. The fact that Robinhood management did not see this coming probably says more about the inadequacy of financial planning and risk controls at Robinhood than it does about any precipitate or unwarranted action by the DTCC. The DTCC’s trading halt gave temporary respite to the hedge funds, who were frantically covering their short positions in GME and other stocks, but I think it is fair to say that this was not the DTCC’s motivation.
Robinhood raises capital. Robinhood was able to clear up its DTCC issues only by conducting a large rescue financing with existing and new investors, who in January 2021 purchased in two tranches a total of $3.5bn of convertible notes with an exercise price set at a big discount to the eventual IPO price of Robinhood. Raising these funds allowed Robinhood to post more collateral with the DTCC and relax restrictions on its customers’ trading activity. The exercise price on the convertible notes was set by formula equal to 70% of the future IPO price (as things turned out, an exercise price of $26.60 vs an IPO price of $38). Seven months after initial issue, the total intrinsic value of the convertible notes (ie the market value of the notes if converted into shares) was about $5bn at the IPO price ($38) and about $7.3bn at Friday’s closing price ($55), reflecting a big profit for the convertible investors. (Distressed investing can be very remunerative, but it is risky.) As things turned out, this was very expensive capital for Robinhood, with substantial dilution of non-participating shareholders, but if Robinhood had not raised the money quickly the Company would likely have been out of business. This brings to mind an old investment banking adage: “Raise equity when you can, not when you have to”. Robinhood was forced to raise money when they had to, at a very high price, but as things played out the expensive fundraising kept Robinhood alive and allowed the Company to raise even more money (on much better terms) when they could, ie at the IPO.
The IPO. On July 29 of this year, Robinhood completed its long awaited IPO of 55mm shares, which raised just under $2bn for the company and another $100mm for selling shareholders. The transaction was managed by Goldman Sachs and JP Morgan and was priced at $38 per share, at the low end of the indicated $38-42 price range. At the IPO price, the total implied equity value of Robinhood was about $32bn. At Friday’s closing price of $55, the total market value or Robinhood is in excess of $46bn. Robinhood’s ticker symbol is “HOOD” and the shares trade on Nasdaq.
The Robinhood IPO had some interesting structural features which diverged from traditional market practice. Shares in the offering were to be allocated disproportionately to retail (individual) investors, primarily Robinhood customers. Whereas in a traditional IPO, retail investors are typically allocated 10% or fewer of the shares on offer, Robinhood targeted to sell 20-35% of the total offering to its own (retail) customers. In a traditional IPO, the book runners try to optimize aftermarket supply and demand dynamics by allocating IPO shares to long-term buy and hold institutional investors and eliminating from the book short-term investors (so-called flippers) as well as price-insensitive retail investors who will then be forced to buy shares (and support the IPO price) in the aftermarket. This traditional approach to IPO book building was considered by Robinhood to be inconsistent with the Company’s ethos, with its strong focus on small individual investors. As stated in the prospectus, Robinhood’s mission is to “democratize finance”, which in the IPO context meant allocating a large portion of shares to small investors, primarily those trading on Robinhood.
Another interesting feature of the Robinhood IPO was the lack of a traditional 6-month “lock-up” on large shareholders not selling in the offering. The Robinhood IPO was for a total of 55mm shares, of which 52.4mm were offered by the Company (a “primary” offering) and another 2.6mm shares were offered by selling shareholders (a “secondary” offering). But the secondary shares sold in the IPO did not include any of the 134mm common shares underlying the $3.5bn of convertible notes sold in the Company’s rescue financing in January 2021. This created a large “overhang” of shares potentially available for sale in the aftermarket, which as you can imagine is problematic for investors who buy shares in the IPO, hence the traditional use of a 6-month lock. (A lock-up relieves immediate selling pressure in the IPO aftermarket and essentially pushes the problem out into the future at which point the market may more easily digest it.) The fact that Robinhood did not include a lockup in its IPO, or more precisely that the convertible investors did not agree to be locked up, was no doubt a big issue in the IPO, but not as big a one as it was soon to become. (See below.)
Aftermarket trading. In a traditional IPO, the managing underwriters “build a book” and allocate shares to achieve two primary goals: (1) to raise the amount of money required, at a price that investors and the issuer (or selling shareholders) find agreeable, and (2) to manage aftermarket supply and demand so as to generate a quick 10-15% pop in the share price (the so-called “IPO discount”), with some element of share price stability thereafter. Things don’t always quite work out that way, of course, and in the case of Robinhood they certainly did not. As noted above, the shares were priced July 29 at the bottom of the filing range and then fell 10% or so in the immediate after-market. The shares continued to trade below the IPO price for three days, before jumping 25% on day four, to a price of $47. On day 5, trading in Robinhood options began and all hell broke loose. The price of HOOD shares jumped 80% to an intra-day high of $85, before settling down to a closing price of $70. And then on day 6, the share price fell by 25% or so when Robinhood unexpectedly announced that it had filed with the SEC to register another 95mm shares for sale, on behalf of institutions who had invested in the first tranche of the January 2021 convertible note offering. (See my comments on the absence of a lockup, above.) The HOOD shares recovered a bit during the trading day Friday, and closed at a price of $55, well below the $85 intra-day high but still well above the IPO price. Suffice it to say that the first seven days of trading in HOOD shares were quite wild, with lots of money made and lost along the way but leaving Robinhood investors who held onto their shares no doubt very pleased.
Valuation implications. Pro forma for the IPO, Robinhood has about 842mm common shares outstanding. This includes 710mm shares of Class A common, held by the public and non-founding shareholders, and another 132mm shares of Class B (high vote) shares held by the founders. Upon completion of the IPO, all of the convertible notes purchased by investors in the January financing were converted into Class A common shares as were the shares underlying the Company’s convertible preferred shares. At the IPO price of $38, the implied market value of Robinhood’s equity (total shares outstanding x share price) was about $32bn. At Friday’s closing price of $55 the market value is about $46bn. And at this week’s high intra-day price of $85, the valuation was about $72bn, albeit only briefly.
How do these public market valuations of HOOD compare to the pre-IPO valuations of the Company? Before going public Robinhood raised about $5.6bn in private capital over 25 different funding rounds, of which $3.5bn (62% of the total) was raised in the January 2021 convertible note offering (one tranche of $2.5bn in early January and another of $1bn in late January, both at the same valuation I believe). By my calculations the convertible note offerings were done at a pre-money valuation of $18.5bn. I have seen press reports indicating that several hundred million dollars of private capital was raised in 2020 at valuations of $10-12bn but I have not seen the data on this or any of the other pre-IPO funding rounds.
At the IPO price Robinhood was valued by the market at $32bn, but the current market cap is now more like $46bn (at Friday’s closing price). Do these valuations make any sense, in either absolute or relative terms? I am skeptical about the absolute valuations, but I do not know enough about Robinhood or its industry to make any sort of informed judgement.
As for the relative valuation, I note that the current market cap of Charles Schwab (SCHW) is about $135bn, up 30% YTD. Schwab is of course a much bigger company than Robinhood, with total annual revenues in excess of $12bn during 2020, compared to HOOD’s $2bn of annualized Q1 2021 revenues. But SCHW and HOOD both benefit from some of the same market trends, most notably the explosion in trading activity by individual (retail) investors. Historically, from 2002-2019, Schwab customers traded on average 2-4x a quarter (while paying commissions, albeit discounted ones), but their trading activity jumped to 8x during 2020 and to 16x in 2021. The same thing happened at Robinhood, where customer trades per quarter jumped from 13x in 2019 to 30x in Q1 2021. But while HOOD customers trade more actively than those at SCHW, the SCHW customers have a lot more money with which to trade; average customer deposits at SCHW are about $200,000 vs. $4,500 at HOOD.
And as one B&B reader has reminded me, Morgan Stanley paid $13bn for E-Trade in an all-stock deal announced in October 2020. Suffice it to say that E-Trade a year ago was a much more developed and valuable company than Robinhood seems to be today. Either MS got a great deal, or HOOD’s public investors seem to be massively overpaying.
The future of Robinhood. I do not have a view on the future outlook for Robinhood, or for the brokerage business more generally. (The fact that I call this business “brokerage” probably reflects my age, but please humor me for now.) Fintech is disrupting this industry segment very quickly and companies like Robinhood are an important part of that process. But in order to have a view on the future it is generally helpful to have a clear understanding of the past and the present. I won’t get into the history of transformation in the brokerage business—although this might be a good topic for a future post—but let’s talk about where Robinhood is today, with the understanding that business models evolve and sometimes do so very quickly. The Robinhood of tomorrow, if there is one, may look very different from the Robinhood of today.
Robinhood today. Robinhood today is essentially a fast growing digital platform for trading shares, options and crypto currencies, adopted (so far) by a certain class of individual (retail) investors with a high propensity for speculative trading in so-called “meme stocks” (and related securities). Robinhood’s business model is commission-free to its “customers” (more on this below) and so it relies on other sources of revenue, in particular something called “payment for order flow” (PFOF).
Payment for order flow (PFOF) is the compensation a broker (eg Robinhood) receives for agreeing to route its customer order flow—ie the trades placed by its account holders—to a third party, for example a high frequency trader or a market maker. PFOF is widely used in the options business and is a common source of revenue for commission-free brokers, but it is quite controversial and the regulators are examining it closely. Big sophisticated financial institutions do not pay for order flow out of the goodness of their heart, they do it to make money for themselves and the end result may be more costly execution for the brokerage firm’s trading customers. The SEC is investigating the role of PFOF in the discount brokerage industry and has previously charged Robinhood with a variety of securities law violations in this regard, which Robinhood settled for $65mm shortly before going public. If the SEC comes down hard on PFOF, the current Robinhood business model will likely be disrupted, but to what extent is hard to say.
Who are Robinhood’s customers? You may have noted above that I described Robinhood’s account holders as “customers” (in quotes). I did this for a reason. It is an old saying in the media world that “if you don’t pay for it, you’re not the customer, you’re the product”. This was true of network tv, it is true of most social media companies and it is true of Robinhood. One could say that the true customers of Robinhood are not the account holders who trade through Robinhood, but instead the financial institutions who are paying for order flow. The individuals who trade through Robinhood may view themselves as customers, and think that their trading is free, but the reality may be quite different.
Many people think of Robinhood as primarily an equities (share) trading platform, but this is not entirely accurate. In financial terms, Robinhood is a primarily an options trading platform with a bit of share trading and crypto on the side. Options represent well under 5% of the customer assets under custody (AUC) at Robinhood, but options represent 15% of trading activity and almost 50% of transaction revenues. The average price paid for option orders at HOOD is $2.90. (I understand that this is very high compared to average options industry PFOF, which may be attributable to the specific securities traded on the Robinhood platform.) Compare this to equities (shares), which account for 75% of AUC and 65% of trading volume but only 30% of transaction revenues, with an average transaction price of $0.40. Cryptocurrencies by contrast account for 10% of customer assets but 20% of trading and transaction revenues at an average price of $1. (The AUC numbers don’t total to 100% due to cash holdings.) With respect to crypto, I note that 40% of HOOD’s total crypto trading in Q1 2021 was attributable to Dogecoin. I am not sure whether this is significant or not, but I have to say that I am not surprised.
Are we all investors now? One of the Robinhood mantras is “We are all investors now”. This is no doubt how Robinhood views things but I have to ask, somewhat rhetorically, what they and we mean by the term “investors”. I think it would perhaps be more accurate to describe much of what happens on the Robinhood platform today as “speculation” or even “gambling” rather than as investing. But is this really much different than what occurs at more established investment or brokerage firms or on Wall Street more generally? And what are the broader economic, political and cultural implications of this broadening “financialization” of our economy? The day trading phenomenon of the late 90’s didn’t really surviver the dotcom collapse, but perhaps the impacts of increased securities trading by small individual investors facilitated by Robinhood and other similar platforms will be more long lasting and more impactful. And perhaps this too will develop in ways that we don’t now foresee, as was the case when ETFs were first launched or perhaps with ESG investing. I really can’t say, at least not now. Perhaps this too will be a good topic for a future post. But in the meantime give it some thought.
Related Links
What is Robinhood? Net Interest, July 9, 2021
SEC charges Robinhood with Misleading Investors,SEC.gov. December 17, 2020
Robinhood’s Debut is Clouded by SEC Investigation of PFOF, WSJ July 7, 2021
Great points!