The Ten IPO Commandments
Via Nic Colas of ConvergEx Group,
There's been a lot of hand-wringing about busted Initial Public Offerings of late, but the process itself is hardly rocket science. Like Tolstoy's comment about families, every "Happy" IPO is essentially the same, while every miserable one is different in its own way. There are rules to the successful IPO, and today we offer up Nic Colas' manual, a step-by-step checklist for investors to assess if an offering is on track. From maintaining the illusion of scarcity to managing company and investor expectations, the road from salesforce "teach-in" to final pricing is narrow but well-marked.
I spent the better part of a decade as a senior U.S. equity research analyst at Credit Suisse in the 1990s, covering the auto and auto parts sector. This was in many ways the heyday of the equity research function at large investment banks, largely because analysts were so deeply involved in capital markets transactions as well as mergers and acquisitions. In my nine year run I did a variety of lead and co-managed Initial Public Offerings as well as secondary equity issuances for the likes of Chrysler, General Motors, Budget and Dollar Thrifty Rent-a-Car, Goodyear Tire, Ducati, as well as a variety of lesser-known auto aftermarket parts companies and foreign automakers and suppliers.
The process of raising capital in U.S. equity markets has changed very little in the last decade – far less than other parts of the market such as electronic trading. Companies still choose bankers based on formalized pitch meetings with positioning and valuation discussions. Analysts do play a smaller role at the front end of the process, but their buy-in is every bit as critical during the marketing of the deal. And equity salesforces still have an important position in the workflow, pitching the investment merits of the company at hand to first get a meeting and then an order from a long-only or hedge fund client. Issuing stock is still a basically a specialized house-to-house search for appropriate owners, setting market expectations for near term performance, and getting the equity story out in a consistent and accurate manner.
At the same time, mistakes still happen in even the most well established business processes, as we have seen over the past week. No need to “Name names” here, because it is not the point of this note to rewarm the leftovers of an already well-publicized failure. Rather, as I watched the drama unfold in all its can’t-look-away-from-the-car-accident glory, it occurred to me that the wounds of the past week were somewhat self-inflicted. There are rules to doing an Initial Public Offering. By and large, investment banks follow these “Commandments” to the letter. But when they don’t, well, that’s when someone loses an eye.
As I reminisced about the various transactions I witnessed during the 1990s, I started to jot down what I realized are the unwritten, but critical, rules to a successful public offering. They apply reasonably well to both IPOs and secondaries. And – conveniently – there are ten of them.
Our “Ten IPO Commandments” are as follows:
- 1) Create The Illusion of Scarcity. The biggest challenge to a successful stock offering is to convince the base of buyers that there is much more demand than supply. Raising the price range of an offering a good sign. Increasing the number of shares is much more problematic and requires a “Measure twice, cut once” approach. It is, after all, a signal that the sellers – who are almost always better informed than buyers – think the price of the offering is compellingly attractive versus their knowledge of the company and its prospects.
- 2) Maintain a Consistent and Improving Narrative about the Business. For an IPO, there is a fairly long window between when you FedEx the initial documents to the Securities and Exchange Commission and the pricing of the deal. Months, in fact. Investors’ initial contact with the company comes when they read that initial filing. From that point on, they want to see and hear an improving story about the business and its prospects. If that means keeping expectations and commentary about the business modest at first, so be it. Trajectory is everything.
- 3) Make Management Available To Investors. Chairmen/women and Chief Executive Officers rarely achieve those positions without a healthy dose of self-esteem. And they often bridle at being quizzed about their company by investors who know much less about the business than they do. Fair enough, but it is part of the process and investment bankers need to deliver that message and get the most senior people to travel on the roadshow. My most memorable experience with rocks-star management was Lee Iacocca, the former Chairman of Chrysler, and a bigger-than-life personality. The key to making sure he was happy on the roadshow was to simply book the biggest hotel meeting space in all the major cities on the agenda. We called him “Sinatra” and he enjoyed the nickname. And he was happy to go anywhere and meet anyone after selling out the big rooms. Investors appreciated that, and I believe they cut the company a lot more slack over time because they had seen Sinatra up close and personal.
- 4) Talk to your fellow underwriters. The best capital markets officers I worked with always maintained an open dialog with their fellow lead and co-manager counterparts. More information about how the market hears a story is always helpful. And yet certain investment banks have a reputation for keeping things very close to vest. Caveat emptor there.
- 5) Know Who is Buying. “Building a book” is the tough part of any stock offering. How much is “Real” – legitimate orders from institutions who want to own the stock – and how much are “Flippers?” Sadly for many capital markets desks, buy-and-hold institutions now trade far less than faster-moving hedge funds. As deals heat up, customers will try to leverage their importance to the day-to-day trading operation of the underwriters in return for better a allocation.
- 6) The IPO is Just the “First Date.” Many companies think of the IPO as the end of a long journey, which may have started in a dorm room or a garage and ended by ringing a buzzer or a bell. But for investors, that sound is the beginning of their involvement with the company. No matter how great the business model or convincing the management team might be, the goal posts have shifted. Bottom line – as a company, want your IPO to work on day one, week one, and month one. It will pay dividends when you come back to the capital markets. And, trust me, you’ll be back.
- 7) Know Who is Selling. No matter how carefully constructed the deal book might be, some significant portion of the accounts will be sellers. The underwriter needs to have a home for those shares (see Commandment #5).
- 8) Retail Is Different. Most equity offerings allocate 20-30% of the deal to what investment banks call “Retail.” This term connotes individual investors, but can also mean smaller institutions. If the business is consumer-focused, it will be at the higher end of the range, since these buyers are thought to be customers as well. And retail is considered “Sticky” money, less likely to sell into any initial stock price pop. The relationship, however, cuts both ways. A poorly executed IPO stands the chance to alienate customers and damage the company’s brand. All of which means retail-heavy stock offerings need to be especially well run.
- 9) Bankers – Manage Your Client. The best bankers I have worked with over my career had one thing in common: they established themselves as a financial expert with their clients and never let go of that position. This is not an easy thing to do, but the reason bankers add value to the process of raising capital is not their ability to socialize or play golf or feign enthusiasm for a company in a pitch. Their value is that they know more about the intersection of business analysis and capital markets than the clients they serve. If the client comes to feel that they know more about the process than their bankers, and is allowed to act on that impulse, you can turn out the lights and head home. The deal isn’t going to work.
- 10) Don’t be Afraid to Walk Away. This applies to both buyers and bankers alike. The stock market in the U.S. is open from 9:30am to 4:00pm every day. If you are unsure about the deal, you can still buy it the next day, or the next week, or the next month. The illusion of scarcity is just that.
And for my hustling banker friends, a story to close out this note…
The most stressful 24 hours of my professional career occurred when I found out a company I was working to take public had inadvertently hired a senior person with falsified credentials. I took the information to the head of equities, a tough as nails West Point grad. He immediately called the head of the firm and said the deal was off unless the individual with the fake resume was removed from the transaction. This was a courageous move, for the deal was extremely high profile and we were the lead manager. No one argued. I never saw the fellow again. I think he is a potato farmer somewhere.