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.

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.

They're baaack. With the strong stock market performance of the first six months of 2013 (+15%) and with the swing to positive inflows to active equity funds, rather than out, investors have clearly signaled that once again, their interest lies on the denominator side of the risk/reward equation.  Not only are equity investments appealing, but also, even those with higher risk profiles including IPOs are again catching investor's fancy. 

On many fronts, that's good news.  Many are cheering the uptick in IPOs, particularly dramatic in the med/tech space, but don’t be fooled, a robust IPO market conjures up both good and bad memories for investors. 

Never forget that it's one thing to "get a company public", but for those who choose that route, the misnamed IPO "exit" is really just an important milestone on the way to building a sustainable business with the opportunity to thrive in the years ahead.  Unfortunately, as we know too well, the majority of IPOs, even some of the most highly anticipated, race out of the gate only to stumble during the first 18 months on the public company track, often failing to regain their footing fast enough to ever realize a fraction of their potential.

With that in mind, and based on years of working closely with institutional investors, in two parts, we offer our guide for newly public management teams to the top 10 things fledgling public issuers should not do. Ever.

10 Ways to go from super steed to dog chow in record time

1.       MISS YOUR NUMBERS:  Miss the numbers in one of the first 2 quarters after IPO and investors will quickly assume that management is incompetent.  Institutions know that bankers urge conservatism on the early quarterly forecasts.  In fact, the rule is "set expectations that you can not miss". Therefore, if you miss that inch-high hurdle, you either didn't listen or don't have a grip on your business, and it's a very long road to recovery and credibility.  Make sure the model you bless with the street is conservative. They are perfectly happy to have you "beat and raise".  If you miss Q1 or Q2 nothing else much matters from an investor's perspective.

2.       Be naive about the ways of Wall Street;  If you beat the analyst’s model but miss their real expectations, and worse, fail to understand that you missed you will again have credibility issues.  Marin Software is one (of many) poster children for this problem.  The company went public with what appeared to be extremely conservative research analyst forecasts.  Unfortunately, its first quarter results narrowly beat those forecasts and worse, showed growth decelerating more rapidly than the street expected. Oops. Management then compounded the error by meeting with top investors, failing to acknowledge the problem, saying they could not understand the selloff as after all, “We beat the analyst’s models!” Double oops. 

Make no mistake, investors will pummel your stock for any miss, but if management owns up to a rookie mistake, the trip back to credibility will likely be much faster.

How to avoid this pothole? Management should clearly communicate the core metrics by which analysts should measure the business performance and from the start, should maintain a dialog with both the buy and sell side to really understand (not to comment on or change, just to understand) street expectations.  In the event of an unexpected deviation from plan, be ready to fully explain the delta and how you hope to avoid a similar surprise in the future.  Most buyside investors will tell you "there's no such thing as a one quarter problem".  The more rapidly management owns up to the realistic magnitude of the hiccup, the quicker investors will rebuild trust. 

3.       Bash your direct competitors:  In big growth markets there should be plenty of room for multiple players. Bashing competitors sends a message that the market may not be as big or fast growing as investors hoped.  Furthermore, a lower competitor valuation is bound to hit your stock as well, so wish them the best.  Explain to investors factually how you are different, preferably in terms of product performance, architecture, and technology.  Explain why you win when you compete, but do not make your success contingent on beating the other guy.   And one more thing, suing your competitor while they are on their roadshow, particularly about some issue that has been in the markets for months, makes your team look scared, wasteful and just a little pathetic.  It also generally makes the buy side laugh as they have seen that movie before.  Tread lightly on your competitors.

4.       Casually dismiss the behemoths:  Pooh-poohing the ability of those big, well-funded technology companies to respond nimbly and competitively, is never a good story.  At least from our observations, it also generally isn't a good business practice, but that's a different column.   Investors like management teams that are wary, respectful and paranoid.  Acknowledge investors' fears that competitors are big and well-funded and cannot be ignored.  Then tell the buyside what you are doing to maintain your lead, how you have built your financial model to leave room to respond if need be and how paranoia drives you.

5.       Sell too fast:  Sorry folks, active management should not sell stock before reporting two clean quarters.  While this is always true, it is even more distressing to the buyside when individuals who sold in or just before the IPO, hit the cashout button again at first opportunity.  Investors identify management selling in an early lock-up release as a major red flag that can trigger institutional selling or give investors pause about building a bigger position or making a long term commitment.  Public investors prefer management 10b-5 plans as a means of monetization.  That said, sometimes individual management members have been patient or are concerns about diversification.  If an individual hasn't sold recently he or she can sell early (again much better if after two strong and clean quarters) without freaking out investors. The key is to sell 10% or less of vested holdings in the early going.

There you have it; part 1 of our thoughts on errors a newly public company should never make, based on conversations with the buyside.  But wait, there's more... part 2 coming soon.