E. Pape is Chief Executive Officer of R.E.Technologies,a
multi-family housing real estate data services company, providing resident
lead generation, data management technology and management tools for the
Q. Mark, are you going to be discussing initial public offerings, or all public offerings in general? Is there any difference?
My comments here will refer primarily to the initial public offering
of a business. Prior to the IPO there was no public trading of the stock.
An IPO is bit different than any other offering, since follow-on offerings
mean you have already jumped the hurdle of problems with IPO. Of course
you can always repeat problems but usually you have a new set.
Q. For American Income's IPO you selected Morgan Stanley for their so called institutional sales strength, and Prudential for their broker distribution. But very little stock was apparently made available to Pru, or its individual customers. Some junior people from MS hauled us around on the road show to 30 or more big funds who bought most of it, and then flipped it back into the market fairly quickly. It looked to me like there was a kind of symbiosis between the investment bankers and the funds. The bankers go over and over to the same funds, and the funds buy pretty much whatever the bankers bring them, for if they don’t, then the bankers stop cutting them in on the deals. This means the funds are the real conduit to the public, shaving a quick profit on the way, and the bankers actually don’t perform much of a function for what they get paid. And the stock doesn’t get widely distributed initially, and may take a dip while it is being flipped. Where have I got this wrong?
You will get investment bankers who argue strongly on this issue, especially those at "retail" firms like Merrill Lynch.
But I am absolutely confident that there is no distribution to individual
investors. It is too hard to round them up, their orders are too small
and they will flip as soon as it rises a little. (herding cats) The stock
in any equity offering will never be widely distributed to "small
investors". Recent sales to preferred well-connected individuals
(like CEOs of prospective clients) have gotten the investment banks in
trouble since it seems to be a payoff to "influence" future
investment banking business (a practice known as "spinning').
to invest money and the investment bankers need a customer to sell shares
to. The big funds don't actually make a profit on the shares for themselves.
They make their money off the management fees that the ultimate investor
pays them to manage the portfolio or mutual fund.
Q. Then what it means when there is no “window” to do public offerings is that the big funds can’t count on a generally rising market to profit quickly, so the conduit is “down”.
The window for public offerings is based on the willingness of the
big institutional investors to look at new offerings, largely because
they are comfortable that the new offerings will rise in the future. If
they are gloomy about the overall market, they will not spend time on
IPOs. They always have money, because they can sell existing ownership
positions to get cash for the new investment, but that means they incur
a capital gain/loss that they might not want to realize.
Q. The “road show” drags the top officers of a company all over the country for weeks, telling the company story to all those fund managers. I remember three weeks and 13 cities, or rather that is what my notes say. All I actually remember was this blur of getting on airplanes. I earned my Advantage Gold in that blur. But why is this necessary? If the buyers are already all set up by the sell side talking to the buy side, and the fund manager is going to buy anyway, is all this running around just to make sure the officers realize how hard it is, so as to justify the cost?
On the contrary, the road show is absolutely essential, even though it is also extremely irritating, time-consuming and
expensive. Believe me, if the investment bankers could get out of doing
a road show, they would jump at the chance because they would rather be
out soliciting the next client, a much more profitable use of their time.
They get no benefit from the road show and, in fact must bear/assuage
lots of grief from the management team suffering the indignities of the
process, including missed flights, bad connections, offensive interviewers,
and long days of repetitive presentations. Remember, the investment banks
are probably going to get the same fee, with or without a road show, so
they, too, would prefer to save all that cost, much which comes out of
their fee. They pay their share of the cost and usually end up picking
up most of the costs for the limos, meeting facilities, rubber chicken
group meals, etc.
management team. The institutional investors have the money and lots
of other alternative places to invest it, so they think managers must
come crawling to them to "request the pleasure of their company"
or "plead for their participation" in the deal. Taking the "mountain
to Mohammed", so to speak. In the future, the institutional investors
will have little influence on the management team, be begging the company
for up-to-date information and be at the whim of the management's skill,
but for this one time, they can make management do the pleading.
Q. Which individuals from the company should go on the road show? I know you are going to say that it is essential for the CEO to be there. And probably the CFO. But do you need anyone else? Like the public relations person, or the agency head? I remember in one city we were on the same schedule as a company that had about 8 people on the show, who would all traipse in in a line, led by the CEO, as we were leaving. I remember thinking about Snow White and the 7 dwarves. Doesn’t some number just become a negative?
Well, the simple answer is you need to have whoever the institutional investor wants to question. Generally, the CEO
and the CFO are adequate for IPOs, since the management team is pretty
small anyway. However, when there is an offering for a public company,
particularly a large one, other management team members may be necessary
to represent their division/group/subsidiary since the investor wants
to see "depth of management". In the future, the institutional
investor may not get much chance to talk with the CEO but they will have
detailed questions for the head of a division/group/subsidiary. For example,
if GE were doing a large common stock offering, the heads of several major
subsidiaries would be necessary, particularly the subsidiaries where significant
future earnings will be derived or that are in the midst of crisis.
Q. The pricing of the deal, what the stock is sold at, is mysterious. There is the preliminary price sort of agreed upon at the outset, and then the price goes up or down depending on “demand”. But how is that demand expressed? A banker told me that many buyers say they will take so many shares at this price, so many more at that lower price, but so many less at that higher price. That sounds sort of artificial to me. Is that for real? And if that is the case, why wouldn’t the road show just go see a few more prospects to get a higher price. I got the impression that the visitation list was preset, and would not change no matter how the book was going.
Pricing of shares in an IPO is definitely an art. In the final analysis,
it is actually set by the demand level for the shares. It is like any
other investment that you are considering: if it very cheap, you might
buy more of it. At a higher price, you still like it but your return potential
goes down so you don't buy as much. At some price, you won't buy any because
you do not see the return potential on that high price. The final pricing
is done by the "syndicate desk" personnel at the "book-running"
investment bank, not the investment bankers or the stock analyst, since
the syndicate desk has all the data concerning demand for the new shares.
with the institutional investors and from the syndicate desks at other
"non-book-running" investment banks that are participating in
the offering, including both co-managers and non-managers. Co-managers
get their name on the cover of the prospectus and get a bigger cut of
the fees on the offering. They also contribute a little to the project
by contributing to the due diligence effort and the writing of the prospectus.
definition of "similar". The investment bank's sales representatives
use the "similar" company data/analysis to talk to the institutional
investors to get them interested in the deal and in hosting the road show.
The institutional investors use the prospectus, the sales materials, the
road show and their own analysis to determine their price levels. If there
is too big a disparity or significant disagreement on what is "similar",
the institutional investors will just pass on the offering.
Q. Many life companies, particularly the ones that are the most successful at putting on new business, are short of surplus. They believe they could write more business if they had the surplus to support it, or the improved Best rating that more surplus would justify. How does such a company know whether they could do a public offering? Are there rules of thumb that would help determine which ones should explore that option?
A public company can do an offering almost any time (assuming
they like their current market price and don't want to raise too much
money) and I would guess their investment bankers have already pushed
them in that direction, so I will focus my comments on private companies
considering going public.
Multiplying that price per share times the number of shares will generate
a rough valuation for the company. But this is only a general rule so
management should not expect to receive that valuation on the actual offering.
In fact, the total valuation would usually be at a 10-15% discount from
that value (assuming the ratio stayed the same all the way until the time
of the offering, which is probably at least 4-6 months away).
Q. The reader is now thinking, “How do I do
that, sell some stock to a private investor?” A venture capital
firm won’t be interested unless they can foresee an exit strategy,
which essentially means a public offering or the sale of the whole company
to another company. Are there other reasonable options, and who would
you talk to about that?
Selling stock to private investors is even more difficult than doing an IPO because there is no obvious place to begin looking. Venture capital firms are only interested in high growth companies with a clear exit strategy. If the company fits that profile, the management team should review the many available resources to determine which venture firms
are interested in their industry. Raising venture capital is a subject all on its own, but it is difficult and time-consuming even at its easiest.
Some investment banks have private placement departments that are able to do large sized private placements of equity, but even the most active in this field can be hard to entice. They need to be "excited" about the deal, just as the investment bankers need to feel "excited" about an IPO in order to devote the time and energy to exploring the feasibility of the offering. Private placement experts are generally more oriented towards raising debt than equity, so the offering may need to be a "pseudo-equity" instrument like convertible debt or convertible preferred stock. Again, it makes sense to contact investment banks with a specialization in the company's industry to see if a meeting can be arranged with the private placement personnel and it is very helpful to have close relationship with one of the investment bankers who can facilitate that meeting.
It is very difficult to locate individual private investors. Often, a
successful business person in the same town or the same industry might
be interested in making an investment in a private company. The company's
law firm, accounting firm or other business advisor can be helpful in
introducing the company to potential investors. However, ultimately, the
management team will be dependent upon networking with "friends and
family"-type investors. Negotiating the valuation will always be
Raising private equity is extremely time-consuming and more often than not fruitless. There are many individuals who hold themselves out as "money raisers" or "sources of capital" and there are probably a few who are really capable of helping the company raise private equity. But the majority of such service providers do not actually have access to capital and will want a large commission on any capital raised. These relationships are always doomed to acrimony, even when the service provider performs well and delivers some capital. Their fees seem perfectly reasonable when the company is desperate for funding, but seem unconsciously greedy once the money is actually found. There will be disputes on who made what introduction and who really raised the financing. If the company has no other way to raise private equity, then this is definitely a route to pursue, but the management team should have an excellent attorney drawing up the contract with the fund-raiser and the documents to be provided to prospective investors. A mistake in either of these areas may result in dangerous litigation in the future.
Note: Mark has not been very encouraging about the possibilities for raising capital for a company that is too small to do an offering or interest venture capital. For a life company the issue is always surplus, not cash. That is, of course, unless you are actually losing money. Sometimes a careful analysis of what is causing your surplus drain can get you out of the squeeze without raising outside capital. The problem is often agent advances, and financing may be available to convert these accounts receivable to admitted assets. See the first paragraph under Regulation.
Q. When a company hopes to do an IPO in the future, there are things they should be doing now to prepare. For example, apparently underwriters want 5 years of GAAP earnings for a life company. Most companies that are not public don’t bother with GAAP, relying solely on statutory earning reporting in their annual statement in the blue book. Is this a strict requirement, and are there ways to reconstruct GAAP for past years? Generally what records must you have to do that?
The things a company should be doing to prepare for an IPO are usually just good business procedures that are often neglected because they create additional administrative costs at a time when going public is not a consideration. The most common example is audited financial statements. Privately held companies often don't have annual audits, or use a cut-rate audit firm that is not qualified in the preparation of financial statements for the SEC. If the company subsequently decides to go public, the lack of historical audits is a huge hurdle. Going back to audit
past years can be expensive and maybe impossible because some of the
required information may not exist or be in an auditable form. Other statistics
of an operational nature that show important facts about the company should
also be preserved for use in an IPO document, such as number of customers
or average purchase amount. The SEC requires the auditors to "vouch"
every number in the prospectus so if there are statistics required to
support management's "selling points" about the company's history
and success, the basic data needs to be maintained in an "auditable"
form that can be checked by the investment bankers doing their due diligence
and the auditors.