Thursday, August 15, 2013

Analysts and IPOs... Here We Go Again

Analysts and IPOs - (We apologize for the length of this post)

In the background since the 2004 consent decree, analysts and banker selections are again making news (New York Times Dealbook, Suzanne Craig and Peter Lattman, August 11, 2013) and not in a good way.  This renewed scrutiny is:

a) Not a bad turn of events at all - particularly given some rumors of very bad (analyst pressuring) behavior on the part of those working with the large private equity-backed IPOs.
b) Not as clear cut as it may seem at first and
c) Probably just another bonus unintended consequence of the JOBS act, which encourages, or at very least now allows, conversations to between issuers and analysts in the middle of the IPO preparation process, while ignoring the constraints of the aforementioned consent decree.

Reasons why bankers and analysts should not work together on potential IPO candidates. 

It all boils down to this; bankers are generally paid on quantity, some combination of the number of deals done and the count of dollars raised.  With this sort of all important (bonus determining) performance measure, pragmatic bankers have every incentive to pursue as many reasonable transactions as possible.  This is generally possible because when they finish one deal, they are on to the next.  There are only limited, on-going time commitments to the now-public client, at least until it's time for a secondary or some M&A.  Please note, we are not implying that bankers don't care about the quality of the companies they take public; they do care as each success can be leveraged into new mandates. Nonetheless, assuming a reasonable quality screen, quantity matters most of all.

Analysts on the other hand, generally earn their bonuses based on the quality of their work.  A strong - or weak placement in the various buyside investor polls like the detailed Greenwich Associates poll or the more far-reaching but less precise Institutional Investor poll can have an enormous impact on the annual take-home pay of an analyst. That reality has two implications.  First, on an ongoing basis, analysts need to keep investors accurately informed about the goings on in the industry and at each particular company.  That service requires a very definite time commitment.   Additionally, analysts need to be selective about which companies they cover, as their obligations are on-going and cumulative.  Writing detailed research on stocks about which investors care little will not garner enough bonus generating votes to be worth the effort.  Said succinctly, bankers would like analysts to cover more and more and more companies.  Analysts, should they aspire to keep their audience of investors/voters, have to be credible and need to enforce a quality screen and can not over commit.

Here is where the plot thickens: bankers directly generate revenue for their firms while analysts, most directly are a cost center, generating revenue for the home team only indirectly via the trading desk or banking wins....

Why shouldn't analyst be involved in the banking process?  Because bankers have every incentive to pressure analysts into agreeing to cover a company, whether or not the analyst is genuinely enthusiastic about the prospect.  Analysts, well aware that as a cost center, every "NO" has negative short term P&L implications for their employer, clearly feel that pressure.  In a business beset by routine layoffs, no one wants to be the Little Engine that Couldn't.

The solution?  Keep analysts out of the banker selection process to eliminate this sort of pressure.


Reasons why analysts and bankers need to work together on potential IPO candidates.

It all boils down to this: If an analyst is not impressed by a company or a segment of a larger industry, if the analyst is not inclined to stay involved with a newly public company, then that analyst's bank should not attempt to sell that IPO to its investing clients.  Period.

Therein the problem: if the analyst doesn't meet with the prospect before the banker selection process, how is he or she to evaluate the potential issuer's opportunity and decide whether or not the new company is worthy of ongoing coverage?

Furthermore, if a potential issuer has not met with an analyst, it can not be comfortable that the analyst understands the company's story and potential. These meetings are not about eliciting a "Yes, I will recommend this stock"! statement.  They are exploratory two-way evaluations that can be very valuable to analysts both because they learn about new products, services and companies, and because they gain a better understanding of what competition is coming round the bend for the existing public incumbents.  Analysts who met with a private Workday long before it's bakeoff were able to raise yellow flags for investors in Oracle or ADP to pay attention to this new competitor.  That is exactly why analysts are helpful to investors; they exist to gather and distribute a deeper level of insight.  Denying analysts the chance to meet with private companies would hurt all investors.  Yet there can be no doubt that those early meetings are about gaining both insight in the industry and favor for their banks: favor that should hopefully place them on the banker selection short-list when it comes time for the lucrative public offering.

But wait, there's more. These private company, pre-IPO meetings matter not only to bankers and analysts but also are critical for investors. When it comes time to make the "invest" or "pass" decision on IPOs, one of elements buyside investors consider is how well they will be able to track the changing fortunes of the new issue.  Analyst coverage is a very important element of that information flow.  If the buyside can not be sure that someone they respect will be covering the stock - covering does not mean perpetually recommending - then the risk they take in buying a new issue increases dramatically.

There are clear conflicts of interest between parts of investment banks when it comes to IPOs and yet, should analysts be completely excluded from the IPO process, bankers, analysts, issuers and investors would all be meaningfully less informed. No one but litigators would benefit from that arrangement.