Ironically, it was at a posh meal on Nantucket this summer that Ralph Castner, CFO of sporting goods retailer Cabela's Inc., saw a vivid example of how much tougher life has become for investment bankers.
Wachovia Securities, which served as co-manager of Sidney, Nebraska-based Cabela's 2004 initial public offering, had invited Castner and several other major clients to an annual event it sponsors on the island. Castner arrived at a dinner one evening to find investment bankers and sell-side analysts wearing color-coded name tags — a fact that struck him as odd until he noticed the team of compliance officers roaming the party.
In a setting tailor-made for deal-making, he recalls, "there was a group of people at the party to make sure the investment bankers and the sell-side guys were never talking to me at the same time."
The chummy world of investment banking hasn't been the same since New York State Attorney General Eliot Spitzer exposed widespread conflicts of interest and pervasive unfair trading back in 2002. Spitzer's investigation proved that the compensation of sell-side equity analysts was tied to their ability to pull in big IPO clients, giving them an incentive to hype mediocre stocks. It also showed that investment bankers were attracting new clients by promising CEOs preferential treatment in the allocation of shares in valuable IPOs.
The revelations eventually caused 10 major investment banks to agree to the so-called global settlement in 2003, which obliged them to pay sizable fines, bar analysts and investment bankers from collaborating, and make IPO allocations more fair. Investment banks were thus deprived of their two best tools for attracting potential IPO clients — a particularly hard blow, coming as it did just as the IPO market went into the doldrums, from which it is only now beginning to recover.
"How banks sell themselves and try to gain underwriting business is what has really changed," says David Fisher, CFO of Chicago-based online options and stock broker OptionsXpress Holdings Inc. Fisher, who helped take OptionsXpress public in January, also has experience in the pre-Spitzer era, having been CFO of Prism Financial when it went public in 1999.
"Before Spitzer, they would lead with their analyst, and a primary selling point was analyst coverage," says Fisher. "Now, investment bankers need to try to differentiate themselves. The problem is that they all do the same thing. If you are sitting there in a pitch meeting and going through five or six different bulge-bracket firms, they can all do the job. They can all get you a meeting with Fidelity or Putnam."
Lost in the Crowd
To the extent that investment banking services have been commoditized, it's not easy for specific banks to stand out in the crowd. Assuming that most have relationships with key investors in the IPO candidate's field, a major selling point is the bank's distribution network — which suggests a competitive advantage for large institutions that have networks of retail brokers.
"The IPOs are clearly going to the large banks, and they are doing it on distribution strength," says Glenn P. Sblendorio, CFO of Eyetech Pharmaceuticals Inc., a New York–based biotechnology company that went public last year in an offer led by Merrill Lynch and Morgan Stanley, with Bear Stearns and Credit Suisse First Boston as co-managers. Without the promise of positive coverage from a "rock-star analyst," Sblendorio says, "distribution is key. It is one of the reasons we went with four relatively large banks."
To counter such a distribution disadvantage, smaller investment banks can compete based on their "stand-alone expertise" in one or more sectors, says Craig R. Johnson, president of JMP Securities in San Francisco. "What we have to offer is a very focused distribution effort and deep relationships in the institutional community with growth-stock buyers," he says. "What we're selling is our mind share, if you will."
For CFOs, such competition may hold out the prospect of a deeper relationship with underwriters. OptionsXpress looked at 10 potential lead underwriters but went with Goldman Sachs in large part because the bank got involved with the company well before it was ready to go public. "They gave us time, attention, and resources during a time when not a lot of investment banks would," says Fisher. "I think that is what you see now, post-global settlement. They can't wait until right before the IPO and trot out their superstar analyst."
But even an existing relationship is no guarantee of future business. For example, Morgan Stanley was the lead bank for the 2003 leveraged recapitalization of San Antonio–based medical technology firm Kinetic Concepts Inc. However, when Kinetic went public last February, Merrill Lynch and JPMorgan were the lead banks. Why not Morgan Stanley? "Each transaction is independent, and you are very much looking at the [entire] team and their approach, and their knowledge of the industry and of that transaction," says Kinetic CFO Martin J. Landon.
Not Going Dutch
If there is any good news for investment banks these days, it's that they appear to have dodged a different threat — one that some had predicted would alter the landscape more than the Spitzer settlement ever did.
The decision last year by Google, the Internet search engine giant, to entirely bypass the traditional IPO in favor of an Internet-based Dutch auction model was seen by many as the beginning of the end for investment banks' dominance in the IPO market. But few companies have followed Google's lead, and most of the CFOs interviewed for this story said their firms had dismissed the idea of a Dutch auction almost as soon as it was raised.
Paul Kim, CFO of Cogent Inc., a South Pasadena, California, company that went public in September 2003, spoke for many finance chiefs when he said that Cogent had not seriously considered a Dutch auction as an alternative to the traditional approach. "This is still new, and I didn't know what the end result was going to be," explains Kim. "And when I don't know what the end result is going to be, I like to stick with something that works."
Rob Garver is a freelance writer based in Springfield, Virginia.
See a list of the 25 most recent IPOs (as of September 15, 2005).