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.
HOWEVER - IT'S NOT THAT SIMPLE
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.
