Matthew Krantz - Investment Banking For Dummies

Because of the intense competition for deals to bring companies public, investment bankers often have to sweeten the pot and pitch all the support they can provide to the deal.

One thing nobody wants to happen, and that includes companies and investment bankers, is for the IPO to break, or fall below the offering price. Companies worry that if they become just one of the thousands of stocks available for trading, they may get lost in the Wall Street shuffle.

One way investment bankers allay this concern is by offering aftermarket research support. Most large investment banking operations employ teams of sell-side analysts who research companies, including many of the ones that the investment bank brought public, and produce reports to tell investors if the stock is worth a look.

The sell-side analyst at a firm that does investment banking has a somewhat complicated job. Their primary job is to use fundamental analysis (the ability to determine the value of a company examining the details of the business) to help investors decide whether to invest. But here’s where things get complicated. Sell-side analysts are writing about companies that just so happen to be some of the investment bank’s best clients and generate large fee income from IPOs, mergers, or follow-on offerings.

Given the conflicts that sell-side analysts face, it’s important to understand the roles that these professionals serve, including the following:

Protecting new stocks from being lost and forgotten: When a company goes public, it’s suddenly in competition with thousands of other publicly traded companies. There are massive companies with huge market values, like Microsoft and Exxon Mobil, in addition to small and midsize companies. Investors have no shortage of choices when it comes to finding stocks to buy.Reminding investors to take a look at a newly public company is one role of the sell-side analyst. By providing research coverage on a newly public company, the sell-side analyst is drawing attention to that stock. And having analyst coverage from a major Wall Street firm is a way for a company to avoid being an orphan (forgotten stock) with investors.

Performing surveillance for investors: Pity the poor mutual fund manager. These buy-side investors need to scour Wall Street for the very best investments that will help them beat the market and justify the fees they charge their investors. But even for large mutual funds, with sizeable teams of analysts, doing in-depth research on every stock out there is virtually impossible. That’s why buy-side investors often look to the sell-side analysts for help. The sell-side analysts are laser focused on a somewhat limited universe of stocks. This specialization helps them establish an expertise in certain industries. Their research summarizes the risks and opportunities of a certain company, saving the buy-side investors lots of time and potential mistakes. Reports from sell-side analysts may highlight stocks that buy-side investors weren’t even following or aware of. Buy-side analysts rely mostly on their own research, but sell-side research might be something they would consider, too.

Highlighting anomalies: Because sell-side analysts are so focused on certain companies, they’re able to pinpoint stocks that may be attractive, but overlooked, because other investors aren’t paying attention to the full story. Sell-side analysts can afford the time to really dig into a company and see, for instance, that revenue may have fallen not due to a problem with the business, but because it sold off a business unit.

Sell-side analysts are the line into the company for some investors. Sell-side analysts take the time to read the reports companies put out and listen into all the earnings conference calls, where the management teams discuss the performance of their company during the previous three months.

And for that reason, investors have some pretty high demands of their sell-side analysts, including the following:

Research reports: The primary product from sell-side analysts is the research report. These reports (covered in more detail in the “ Examining a Sample Research Report” section, later in this chapter) are where sell-side analysts spell out everything they know about the company and communicate their findings to investors.

Instant updates: Following any big news from a company, investors expect sell-side analysts to be on top of the development. Instant updates are rapid dispatches from the sell-side analysts explaining what the takeaway from the new development is and whether it changes their opinion on the stock.

Industry analysis: Although sell-side analysts primarily concern themselves with individual companies, most recognize the importance of industry factors. Many top sell-side analysts produce an industry analysis where they look at the larger forces at play in the industry and how they could affect companies within the industry.

Research doesn’t do anyone any good if it’s just sitting on an investor’s shelf. Getting the word out, and sharing research ideas, are how sell-side analysts get noticed. When sell-side analysts make a name for themselves, they often draw attention to their firms. Sometimes a sell-side analyst gets so well known in an industry that companies looking to go public look to the firm as an underwriter. It’s much how real-estate agents who focus on specific neighborhoods often win many of the listings in that area.

Investment banks get out the research from their sell-side analysts in a number of ways, including through the following:

The broker network: Most of the large firms with investment banking operations — the Bank of Americas and Morgan Stanleys of the world — employ armies of brokers around the globe. These brokers provide investment help and guidance to clients. The brokers often refer to the research of sell-side analysts when making investment recommendations.

Buy-side connections: Big mutual funds and other institutions tend to have ongoing relationships with certain large investment banks. It’s a tangled relationship with the buy-side investors looking to the investment banks as a source of all sorts of services, including trading and research. Big investment banks typically forward all their research to these large customers.

Electronic distribution: As more individual investors try their hand at picking stocks themselves, there’s been increased demand for them to obtain sell-side research. Most of the large online brokerage firms, including TD Ameritrade and Charles Schwab, provide research reports from some of the big investment banking operations.

Sell-side analysts have to walk a fine line between serving the wants of the companies going public and the demands of investors who rely on the research being accurate and truthful. This divide is so blurred that periodically an analyst or firm steps over it.

Perhaps the biggest crackdown in the failure of investment banks to preserve the integrity of their research reports came in 2003. The Securities and Exchange Commission (SEC) and other regulators penalized ten of the largest investment banks at the time for conflicts of interest between their investment banking units and their research teams. This incident is covered in more detail in Chapter 19. For now, just know that regulators found that the investment banks were more interested in currying favor with companies looking to go public, and generate big IPO fees, than providing helpful and accurate information to investors. And huge changes were made to the research business as a result. For instance, research analysts were no longer allowed to join in any pitches (including at the roadshows) to get investment banking business.