In difficult markets, deals don't always go to plan. This year, with multiple initial public offerings cancelled and some performing badly in the aftermarket, it is unsurprising that equity market participants are disgruntled. But the current level of antagonism between issuers, bankers, investors and advisors seems to point to something more fundamental than tricky market conditions. Is the IPO process broken and, if so, how can it be fixed?

How much is a company worth? Sometimes, its assets provide a clue. Sometimes past performance offers guidance. And sometimes the calibre of its management can be a useful pointer. Ultimately though, when a company floats, it is worth what investors will pay for it.

In good times, investors are willing to pay handsomely for companies joining the stock market. They rush to subscribe to initial public offerings (IPOs), demand exceeds supply, the share price goes to a premium on the first day of dealing and everyone is happy. The management or private equity firm selling the business feels valued, book-runners feel vindicated, independent advisers feel appreciated and institutions feel satisfied.

In 2011, this happy confluence of events has been a rarity. In the first half of the year, 15 European IPOs were pulled, 20 traded down after launch and only 12 traded up. Such statistics do not inspire confidence. Perhaps it is not surprising therefore, that one of the world's leading fund managers has publicly complained about the IPO process.

Write to complain

BlackRock, which controls assets worth $3700bn, sent an open letter to bankers, which argued that fund managers are expected to hand over large sums of money on the basis of one short meeting, that fees are inappropriately structured, that governance standards can be too lax and that syndicates are too large.

The Glencore prospectus was 631 pages long, virtually incomprehensible and there were 23 banks in the syndicate. This deal encapsulates everything that is wrong with IPOs at the moment.

Fund manager

The letter, signed by Luke Chappell and James Macpherson, two of the company’s top UK executives, argued that bankers are wooing issuers with unrealistic valuations and claimed that bankers' fees are underpinned by short-term incentives to get the highest flotation price possible rather than guaranteeing long-term success. This, they argued, is encouraging aggressive tactics.

The letter states: "We are concerned about the structure of incentive fees, which maximise your returns for the price achieved on the first day of trading rather than at some, more distant date, for example, six months after float. Such fees do not represent an alignment of interests between us and seem to drive increasingly aggressive behaviour from syndicates."

Cashing out?

The letter was sent at the end of May, less than two weeks after the biggest IPO ever seen in London – the $11bn fund-raising by commodities trader Glencore. The transaction was deemed a success at the time. Three months later, however, the shares were more than 10% lower than their 530p ($8.61) flotation price, at 403p, having hit lows of 363p.

“The Glencore prospectus was 631 pages long, virtually incomprehensible and there were 23 banks in the syndicate. This deal encapsulates everything that is wrong with IPOs at the moment. It was not about raising long-term finance. It was more about the owners cashing out,” says one leading fund manager.

Lengthy documentation and extensive syndicates have become a feature of the IPO process, to the frustration of many institutions. These investors are presented with pages of legalese, allotted a scant hour with the company whose shares are being sold and are then contacted by sales forces from a number of different banks, none of whom is aware of what the others are doing.

“Some large institutions are contacted by six to 10 sales teams and it becomes very irritating. To make matters worse, other investors are then completely missed off the list,” says one observer.

When markets are benign, practices such as these may be overlooked. Investors know they are in a sellers’ market and they forgive lack of syndicate co-ordination. They are prepared to buy into deals on the basis of little information, because the downside risk is limited. In the current environment, however, the investment community is more cautious and less tolerant.

“Many investors lack inflows and so they need to sell existing holdings to buy something new. They need a good reason to swap an investment they may have held for a considerable length of time for something completely new,” says Craig Coben, head of Europe, Middle East and Africa (EMEA) equity capital markets (ECM) at Bank of America Merrill Lynch.

Guiding principles

The ECM team at Bank of America Merrill Lynch has become so concerned about the atmosphere of mistrust pervading the sector that it has published a paper entitled 'A Set of Guiding Principles for IPOs'.

The paper makes eight suggestions. Some of these are relatively uncontroversial – there should be more and earlier meetings between investors and company management; more attention should be paid to corporate governance; and syndicates should be smaller or at least well-managed "to ensure clear leadership and involvement in the running of the IPO and bookbuilding process from global coordinators/bookrunners".

Issues such as these are broadly accepted by most market participants. “Syndicate structures are important. They set the basis for the framework within which the roles and responsibilities of each bank are set. Too many banks at the top line can dilute the sense of ownership and responsibility," says Sam Dean, co-head of global ECM at Barclays Capital.

The Bank of America Merrill Lynch principles also make the point that bookbuilding is "an exercise in price discovery" – in other words, the whole point of the process is to work out the best price at which a company should be floated. In a bull market, this can come down to ensuring shares are sold at the highest possible price that investors will accept. In current conditions, it is far more complex.

“Equity markets are uncertain, chief executives’ confidence in the future is uncertain and the macroeconomic and political environment is highly volatile,” says Mark Aedy, head of EMEA investment banking at boutique investment bank Moelis.

Market volatility 

In the first six months of this year, for example, markets have witnessed the Arab Spring, the Japanese tsunami, the credit downgrade for the US and continuing turmoil across the eurozone. These events have, at times, had a devastating effect on markets. Indices have tumbled and investors have gone into temporary hibernation. Any flotation caught in the middle of such periods has either had to withdraw completely or reduce the IPO price.

“Investors are risk averse. Market volatility and macro factors all combine to make it much more difficult to predict what the market will be like even three to four weeks ahead. Before the financial crisis, markets were much more robust. Now it is hard to know at the beginning of the process where you will be at the end,” says Georg Hansel, chairman of ECM for the EMEA region at Deutsche Bank.

Equity markets are uncertain, chief executives’ confidence in the future is uncertain and the macroeconomic and political environment is highly volatile.

Mark Aedy

Barclays’ Mr Dean suggests that there may be lessons to be learned from US market practices. “The US IPO process has the timetable advantage that the gap from formally launching the deal to pricing is much shorter. When markets are volatile, this difference can be material. The big difference is that in the US the prospectus is on file earlier, which many European investors would like to see, but there is no pre-deal research which investors in Europe are used to receiving,” he says.

The value of research

Some market participants suggest pre-deal research is of dubious value. Larger institutions tend to have their own research teams and the pre-deal research on offer is currently provided only by the equity analysts of firms in the syndicate, prompting a certain amount of investor scepticism, despite the Chinese walls between ECM and research teams. Smaller institutions can find external research helpful however, so a number of investors are pushing for independent research from banks and brokers that are not part of the syndicate

Deutsche’s Mr Hansel suggests institutions take a worldly approach to the current system. “Investors use the information in the research notes. They largely ignore the valuation,” he says. 

But research is not the only bone of contention. Some bankers believe investors do not help the process by failing to provide consistent feedback.“Sometimes it is obvious an investor is trying to talk down the value of a company. Sometimes, they say they are going to come into a deal and then withdraw at the last minute. And sometimes, investors say they will only come into a deal once the book is ‘covered’,” says one ECM banker.

In other words, investors are hedging their bets. Understandable perhaps, but banks are particularly frustrated by the practice of refusing to come into a deal until others have said they will, a situation that can create a vicious circle, or “death spiral”, according to one adviser. Some bankers believe the most effective way around this is simply to stop giving guidance about the state of the book during the bookbuild.

“I know that arguing for no coverage updates sounds like less transparency but actually these updates can be misleading even if true. If I tell you that the bucket is full, that could be true whether the bucket is full of gold or manure. If one cannot easily comment on the quality of a book, then its probably better not to talk about quantity either,” says Mr Dean.

Critics of ECM bankers say this is one of the key problems in today’s market – that low-quality institutions are being invited into bookbuilds - investors who are likely to pull out at any time or sell their shares immediately after flotation.

“How do you stop deals trading down? You have to be careful about who you allocate shares to, focus on those institutions that are likely to buy and hold rather than those that will flip it,” says Adam Young, global co-head of equity advisory at Rothschild.

Achieving balance

This is one of the areas in which independent advisers, such as Rothschild, believe they have a role to play. Appointed by the issuer, they are there to provide objective guidance to help management teams or even private equity partners that are inexperienced in the ways of ECM. Advisers maintain they have an important role to play because banks have two sets of conflicting clients – the issuer, who wants to achieve as high an IPO price as possible, and investors, who want as low a price as possible.

Bankers, meanwhile, are careful to say some independent advice is beneficial but they resent intrusive practices, such as being told what the IPO timetable is.

Craig Coben, head of EMEA ECM at Bank of America Merrill Lynch

Craig Coben, head of EMEA ECM at Bank of America Merrill Lynch

Criticism has also been directed at advisory fees, some of which encourage advisors to push for the maximum flotation price rather than the optimal price. Many in the ECM community believe the best way around this issue is to publish exactly what fees are being paid to whom in the IPO prospectus. Bank of America Merrill Lynch says: "In particular, there should be full transparency on discretionary fees paid for performance or as an incentive."

This practice, developed over recent years, is designed to encourage banks and advisers to give of their best. Some suggest it has the opposite effect, however. “Issuers need to be careful with incentive fees. What exactly are they trying to incentivise? They should want to encourage good advice and banks working hard towards the common goal of a successful deal for both the issuer and for investors. That isn’t always the case,” says Mr Dean.

Equal blame

Perhaps it is not surprising that, when times are tough, disagreements emerge. Bankers are blamed for sloppy work and greedy valuations, advisers are blamed for excessive interference, institutions are blamed for inconsistency. As Mr Hansel says: “2010 was a very good year for IPOs. Investors made good returns and were satisfied with their investments. This year the reverse is true overall.”

Against that backdrop, there is a growing realisation that every participant in the market needs to up their game, especially as the IPO market can be exceptionally lucrative. Fees on the Glencore deal, for example, were $435m, in return for which issuers expect hard work from bankers and advisers and, of course, a successful outcome.

Sensible players in the market believe the situation requires two basic solutions: high-quality issuers and slick execution.

“For institutions to be excited by companies coming to market, they have to offer good growth or a generous yield. If they offer neither, institutions are justifiably frustrated,” says Mr Aedy.

Execution has to be watertight too, on the part of every participant. “Execution needs to be really tight. Real thought and precision needs to go into the planning, structuring, placing, pricing and allocation of each IPO,” says Rothschild's Mr Young.

In a year’s time, if markets recover, the IPO scrap of 2011 may come to be seen as a temporary reaction to a temporary problem. Right now, however, it seems there may need to be real and lasting changes, with enhanced transparency, smaller syndicates, more thoughtful pricing and greater co-operation from every side.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter