Investment Banking For Dummies. Matthew Krantz
Source: Renaissance Capital (
www.renaissancecapital.com
)
The role of the investment banker in IPOs
Investment bankers are involved in the very onset of a company going public, and they’re the keys to making the deal happen. When investment bankers assume the role of selling securities, especially in an IPO, they’re often called the underwriters.
A typical IPO usually follows these steps:
1 The company produces information about its stock sale.The company must give investors an extremely detailed outline of its opportunities, financial results, and risks. This filing is called the prospectus. Investment bankers assist in making sure the company includes all the material information investors need to know about the offering. You’ll learn more about what’s in the prospectus in Chapter 4.
2 The company takes its story to the streets.If companies are going to ask investors to pony up millions of dollars for the company, they’re going to have to convince them to buy. That’s the role of the roadshow. Roadshows are events and meetings investment bankers arrange between companies selling stock and prospective investors.
3 The investment bankers gather up the investors in the book-building process.The traditional IPO is a process shrouded in a bit of secrecy. During the roadshows, investment bankers get an idea of how likely it is for specific investors to buy stock, how many shares, and at what price. The investment bankers record this indicated interest, or general idea of how much buyers want to invest, to gauge how many shares are likely to be bought when the IPO is sold. This process of tallying up how much interest there is in the stock is called book building. The book-building process is critical because it tells the investment banks selling the deal at what price the shares should be sold.
4 Underwriters price the deal.Underwriters typically work late into the night before the stock starts to trade, assembling all the orders of investors. The underwriters look at all the orders for the stock and at what prices investors are interested. The underwriters then find the highest possible price at which all the shares would sell. The IPO is priced, or the initial price charged to these initial investors is set.
5 Underwriters support the IPO.The initial price of the new stock is set by the investment bankers the night before, and all the shares are sold to the initial investors. The initial investors in IPOs are typically the friends and business partners of the underwriting firms. For instance, large institutions that use the investment bank’s other services are often given access to IPOs, as are wealthy individuals that may be clients of the investment banks.After the deal is priced, these initial investors are free to sell on the open market, in what’s called aftermarket trading. And it’s during the first day of regular trading when regular investors, customers of brokerages like TD Ameritrade and Charles Schwab of the world, are able to buy the stock.
What matters in an IPO
Underwriters stay involved in the process during this tenuous first day of trading. Investment banks want to do whatever they can to make sure the shares of the newly public company don’t break (close below the initial price). A broken deal is often looked at negatively by investors; plus, a broken deal makes it look like the investment bank didn’t set the initial price correctly.
Investment bankers try to balance the needs and wants of the buyers and sellers. If the price of the IPO zooms upward, the investors who sold their shares may feel like they were shortchanged and missed out on gains. However, if the price drops after the stock starts trading, the buyers may feel cheated and avoid that investment banking firm’s deal in the future. There’s also a risk that if an investment bank prices shares too high, it might need to step in and buy the shares to stop them from falling too much. On the first day of trading of Internet stock Facebook in May 2012, for instance, underwriters had to step up and buy to hold the stock from closing below the $38-per-share offering price.
Lastly, several months after the IPO has been trading, the investment bank’s research unit will initiate coverage on the new stock. A research analyst at the bank will write a report describing the company and the stocks, advising the investment bank’s clients on whether to invest in the new stock. This investment research capability of investment banks is covered in the next section as well as in Chapter 3 in greater detail.
Helping Investors Decide Whether to Buy or Sell
Investment banks make most of their money helping companies and governments raise money by selling securities. But most important, the investment bankers act as middlemen between buyers and sellers. Investment bankers not only help the sellers prepare securities to be sold, but also interact with potential investors. One of the great values offered by investment bankers to their customers selling securities is their ability to find buyers.
The importance of research
Even if there were thousands of companies lined up to sell securities, that wouldn’t necessarily translate into big profits for investment banks. The fees, generated by underwriting securities, only materialize if there are ample buyers to soak up the stock being offered. And that’s the role of the research unit of investment banks. By tasking research analysts with closely following developments in industries or by individual companies, the investment bank can assist investors on deciding whether to buy into securities. Chapter 3 describes this process in more detail, but here you can find out why research is so important.
Sell-side and buy-side analysts
Most large investment banks have entire research divisions that employ armies of research analysts. These research analysts pick apart the prospects of a company and tell investors whether to buy the stock. These analysts are called sell-side analysts because it’s their job to highlight stocks they say are worthy of investment, but they don’t actually invest in the stocks themselves. Sell-side analysts typically are creating research to be used by investors actually doing the buying, called buy-side analysts. These research reports are also often provided to individual investors who are clients of the firm for free, or sometimes made available through discount brokerage firms or for purchase.
Buy-side analysts are the ones who will be actually plunking down cash if they decide to purchase a security. These analysts consider the demands of the investors who have given them money to invest, be it mutual fund investors or pensioners with money in the pension plan. Buy-side analysts typically work for large mutual funds, which have pooled money from smaller investors to build a diversified portfolio. Buy-side analysts rely primarily on their own in-house