Investment banking is not investment research

by Kris_Tuttle on October 18, 2011

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.

Con­clu­sion

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.

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