Why the Alibaba IPO Could Trigger a Selloff

The initial public offering of shares in Chinese e-commerce company Alibaba Group Holding Ltd. could prove to be the biggest in history. Depending on where the money comes from, it could also bring an unpleasant surprise for stock-market investors.

When a company sells shares to the public, investors get the money from various sources. Some borrow it, some use cash they had been keeping on the sidelines, some raise the money by selling other investments. The bigger the IPO, the more it can affect the amount of debt in the system and the prospects for stocks as a whole. The impact is particularly notable if the company and its venture partners are using the money for long-term investments, rather than putting it back into stocks and bonds.

Plenty of investors appear interested in Alibaba. Initial indications from the roadshow for the IPO suggest that demand will far exceed the amount of shares on offer. Indeed, Bloomberg News has reported that the company plans to increase the offering prices, and hence the amount of capital it will raise.

Granted, one must always take the marketing chatter ahead of an IPO with a large grain of salt. Investors have an incentive to exaggerate their initial interest, so the banks running the IPO will be sure to allot them enough shares. The banks want a bigger deal so they can get more fees. The company wants to raise as much money as possible.

That said, the Alibaba IPO will be a very big deal, with potentially marketwide impact. At a possible $22 billion to $24 billion, it could well be the largest IPO in history. So it really matters how investors fund their purchase of Alibaba shares.

The broader market would be least affected if the incremental funds came from a healthy and sustainable increase in borrowing, associated with a greater willingness (and ability) on the part of investors to assume risk. The deployment of idle cash would also have minimal effect on the rest of the market. Although both will occur to some extent, they are unlikely to be the main drivers.

This leaves plenty of potential for downward market pressure as investors sell existing holdings in order to make room for their Alibaba purchases. Given that most investors don’t know as yet how many shares they will receive, most of the selling wouldn't materialize until quite far into the IPO process. The combined effect could be quite significant.

Hence, don’t be surprised if the Alibaba IPO leads initially to a market selloff. What's harder to predict is how long it might last. This will depend on other investors' willingness to jump in and buy the dip — a phenomenon that has already kept the market rally going well beyond what fundamentals justify.