It was odd to read the article by Andrew Ross Sorkin today in the WSJ. In it he talks about how all the major investment banks “missed the red flags” around Groupon as the company selected bankers for their planned IPO. He mentioned the balance sheet, the sales model and the fact that insiders already cashed out. Much of this was already discussed and written about when the filing came out and subsequent events made the story even more distressing.
Investment banking is purely about transactions
Mr. Sorkin is an experienced journalist and the WSJ certainly should know their way around Wall Street. What’s going on? Investment banks are hired to support a transaction. It’s true they sometimes call their services “advisory” when it comes to M&A but they only get paid when transactions happen and their fee is based on the size of the deal. It’s not hard to imagine what their motivations and priorities are. They get paid the same for good deals and bad deals.
Of course banks care about their brand and prestige. Goldman has standards. However those standards are driven by the market rather than from within. In other words if the market will accept it and thinks it’s good, Goldman is happy to get the print and take the fee.
All this is especially true during the “bake-off” portion of the IPO process. At this stage a company like Groupon invites all the banks to come and do a dog and pony show with the senior management team to prove how valuable they would be as an underwriter. They are not in evaluation mode, they are in selling mode.
Much like a courtship the banks are invited by the company to “show how much they love them.” Only one suitor gets to be the lead bank (although in large deals there can be two or three) and the rest settle for placement that earns then a nice fee for which they will do zero work. And I can tell you it is zero. (The research analysts at those firms will eventually have to provide stock coverage (buy, hold or even sell which never happens) but the bankers and the distribution network does nothing if they are not the lead bank.)
A key part of the process is where each banks provides a “valuation estimate” for where the shares should be priced and expect to trade. This is the most absurd part of the process because the banks all try and find the highest number. They do need some justification which typically involves sending associates out looking for “companies that have something in common with this one and trade at or have traded at obscene valuations.” They put these in a sheet and find the metric that will create the highest valuation. Banks don’t spend anytime on how much *they* would pay to buy stock in the company. Thanks to the new regulations separating research from banking they can’t even involve the one person or people at their firm that would have worthwhile analysis.
It doesn’t have to be this way
In the “old day” some investment banks like Morgan Stanley tried to maintain high standards that they demanded companies meet before being willing to underwrite an IPO. As they watched other banks run away with deals in the mid-1990’s they changed their approach and created one of the best known “investment banking research analysts” in Mary Meeker.
Before regulations there were some small firms (like SoundView) that actually aligned the interests of the firm with investors in an IPO stock. For example before agreeing to be part of the deal the research analyst had to support a “strong buy” rating on the company with some caveats around pricing. More importantly the compensation of research analysts were tied to deals but subject to company execution. For example if a company came public and either missed published estimates or lowered guidance the analyst would not be paid on the deal. Pretty simple but it made analysts much more certain about their estimates which investors in the company would be relying upon.
The little research investors had back then was all stripped away with the new regulations put in place to “protect them” from the unscrupulous research analysts at other firms (guys like Henry Blodget and a few others at the “bulge brackets”.) It’s not unusual for regulators to get it wrong since they don’t have a deep understanding of the markets they are tasked to regulate. Today investors have to realize that “buyer beware” is just as valid in IPO stocks as it is in most other transactions. It’s unlikely that regulations or markets will get more investor friendly.
This situation is one of the reasons we cover newly-public and even some emerging private companies. There’s opportunity to help investors make decisions and in some cases to exploit solid investment opportunities in the absence of strong independent coverage. Much of our IPO-focused research comes out over at IPO Candy.
I hope the WSJ and Mr. Sorkin can start writing from their knowledge base which should be much deeper around investment banking and Wall Street than this article suggests.