Investment Banks and IPOs: Selecting a Bookrunner

The investment bank (“bookrunner” or “lead underwriter”) you select to take your company through the IPO process can play a large role in the success of your offering. Because your underwriter will be the face of your offering to national and potentially global investors, the process of filling this position deserves a lot of planning and thought. This article will focus on two main topics; it will first briefly address the role that an investment bank plays in the IPO process, and will then cover in greater depth the key factors to consider when selecting your bookrunner.

The Role of an Investment Bank in an IPO

Your engagement with an investment bank will likely begin with their analysis of your business plan, during which they will scrutinize most aspects of your business to determine if they are willing to work with you. If the bank believes your IPO is feasible, they will likely want to be involved. If one investment bank believes your IPO to be feasible, many other banks will want to be involved as well. This leads to what is known as a “bake-off,” wherein multiple banks will pitch their services to your company. Unless your company is exceptionally large, it is likely that you will need only one lead underwriter, but there are circumstances in which you will need to select joint-bookrunners—more than one lead underwriter. Once a bank has decided to work with you, a negotiation process will ensue, during which you will need to agree upon many issues including the details of your offering, the amount and type of assistance the bank will provide pre- and post-IPO, and the compensation they will receive in exchange.

Depending on the terms of your negotiations, the investment bank may fulfill any of the following tasks:

• Create a letter of intent
• Form a banking syndicate
• Provide financial advice
• Act as lead financial advisor
• Develop a listing execution plan
• Refine the offer structure and strategy
• Aid in the shaping of your equity story—also referred to as an “investment thesis¹”—that will be used to market the offering.
• Develop marketing materials
• Create the registration statement
• Manage the roadshow
• Develop a valuation framework
• Price the offering
• Buy the entire offering and then sell it to investors, or simply make their best effort to sell the entire offering with no obligation to buy remaining shares
• Advise on proposed mergers and acquisitions or manage a dual process
• Provide analysts to publish research on your firm, positioning you for your offering

Key Considerations

In addition to understanding the role an investment bank will play in your IPO, it is beneficial to understand some of the important factors to consider when choosing a lead underwriter. The remainder of this article will cover those considerations.

As with all areas of business, the relationships you develop will likely play a role in which investment bank you select, and in turn the success of your IPO. If your company reaches a certain level of credibility and strength, it is likely you will be faced with choosing between the many investment banks that will want to be your underwriter, and will do their best to sell their services to you.

If your company isn’t as well established, and you aren’t experiencing the level of interest described above, you may need to more actively seek out an underwriter. Once you have identified several potential lead underwriters, the same process described above remains true; if your potential banks believe your IPO is feasible, they will want to be involved in the deal and negotiations will ensue. Whether you are being sought out, or are the one doing the seeking, it is equally important that you find and select an investment bank that is right for you. In addition to considering your professional network, there are many other factors that should be accounted for when selecting your underwriter. The most obvious item to consider is cost. However, as this topic has already been covered in depth in our article titled The Costs of Going Public, it will not be discussed in this article. Instead, this article will focus on 7 key issues that encompass many of the topics commonly relevant when making this important decision. The key issues addressed in this article are as follows:

1. Fit
2. Track Record
3. Independence
4. Research Department
5. Distribution Capability
6. Aftermarket Performance
7. Continuing Services

Each of these considerations will be addressed in greater detail below.

1. Fit

Fit refers to how well a particular investment bank will align with your company, both at present and in the future. A bank’s fit is determined by several factors; four especially important factors are (a) investor relations, (b) the bank’s knowledge of your industry, (c) the bank’s knowledge has of your company and its history, and (d) the bank’s vision for the future of your company.

Investor Relations – As we will reiterate throughout this article, the relationships your investment bank has with investors and other banks are some of the most valuable things they can offer you. Therefore, it is important to choose a firm that matches your company’s target market. If you plan on serving a small market, a local boutique firm may be the best choice for your company because they will have relationships within that market. Likewise, if you plan to market to national audiences, it may be wiser to choose a larger firm with a broader range of experience and more extensive network.

Knowledge of your industry – Many investment banks specialize in specific industries, so selecting a bank that has knowledge and experience in your industry is important. Your chosen bank will help structure your IPO and will introduce you to potential investors; their understanding of your industry can be a valuable asset during this process. In their Guide to Going Public article, KPMG suggests that “If you plan to diversify…consider using an investment dealer that also has experience in that new industry.” Choosing an underwriter than can “fill both your current and anticipated needs,” as KPMG states, can alleviate the need to go through the entire selection process again.

Knowledge of your company – One of the more important things your bookrunner will do during your IPO is pitch your company to investors during the road show². The more they know about your company and its history, the better job they will do when presenting you to potential investors. An investment bank can also play the role of the lead financial advisor to your firm during your IPO, adding further weight to the importance of their knowledge of your company.

Vision for the future – The investment bank you choose as your lead underwriter will likely be the long-term financial advisor for your company. Therefore, it is important that you share a common vision for the future of your company. Do you see eye-to-eye on the way value will be created in the future? Do you have complementary strengths? Do you work well together on a personal level? Do you both see your company competing in the same industry 5, 10, and 20 years down the road? Just as important as your shared view of the future of your company, is your vision of the way the industry will evolve and how your company will fit within that industry. The answers to these questions will aid you in determining whether a bank is the right fit for your company.

2. Track Record

Investors want to see consistency in a bank’s track record, and they will look for patterns that demonstrate it. This means that investors in IPOs want to see a bank with a track record that not only demonstrates general credibility, experience, and a positive reputation, but one that demonstrates those qualities in situations with companies similar to yours—in size, industry, subsector, and growth story.

When an investment bank is making a pitch to win a deal with a company, they will often cover four main areas: (1) qualifications, (2) standings, (3) brand and reputation, and (4) testimonials. They do so, because they know that a bookrunner’s track record plays a large role in a company’s decision when selecting a bank to take them public. The remainder of this section will provide some guidance on how to obtain information independent of the information the bank will give you, in these four areas.

An investment bank’s credibility, experience and reputation can be determined by speaking with companies they have worked with in the past. If you don’t already have relationships with these companies, speaking with other professional firms you employ may help you to make these needed connections. Auditors, consultants, and investors will likely have relationships with your potential lead underwriter, allowing you to gain valuable insight into their track record.

As you speak with these companies, consider asking the following questions, or questions similar to them:

• Did the underwriters satisfy the promises they made to you?
• Did the underwriters plan wisely and act accordingly, eliminating last minute crisis?
• Were the underwriters and their syndicate able to provide the placement you desired?
• How satisfied have you been with the post-IPO attention and service you have received from your underwriters?
• How satisfied were you with the price of your offering and the subsequent reaction of the market in the days and weeks after your IPO?
• Did the underwriters offer or provide you with any other services during your IPO?
• Would you hire the same underwriters in the future?

Yet another way to determine the credibility of an underwriter is by looking at their ranking using one—or the combination of several—of the ranking systems created by academics over the years. There are three ranking tools that are commonly used. They are as follows:

1. The Ritter Rank: This ranking system is based on the Carter-Manaster rank, modified by Jay Ritter.
2. The Megginson-Weiss Rank: This ranking is determined by the market share of offer proceeds an underwriter has generated, calculated as the total offer proceeds generated when acting as lead underwriter in an IPO, divided by total offer proceeds generated by all underwriters in the market.
3. The Underwriting Rank: This ranking is similar to the Megginson-Weiss rank, with credit given to all underwriters, not just lead underwriters. The calculation is made using the offerings reported in the prospectus, providing each underwriter in an IPO with credit for the portion of the offerings they underwrote.

In addition to these three tools, companies can also turn to one or more of the many investment banking league tables available online to determine the current standing of the bank, as measured by the investment bank’s ongoing deals.

By comparing an underwriter’s ranking across all of these ranking tools, you will be better equipped with quantifiable data to select a credible firm.

It is worth noting that in addition to the track record of the bank as whole, you should also consider the track record of individual bankers, as it is possible to select a well-qualified, experienced bank and still end up with a banker that has a poor track record or simply doesn’t meet the standard you had expected from the bank you selected.

3. Independence

It is critical that your chosen investment bank meets the necessary requirements to qualify as an independent underwriter. Determine which self-regulatory organization (SRO) your potential investment bank is regulated by, and verify their independence according to the organization’s requirements. Many banks are regulated by the Financial Industry Regulation Authority (FINRA), whose independence requirements for parties participating in a public offering can be found in rule 5121. Rule 5121 defines an independent underwriter as an one that meets the following qualifications:

4. Research Department

When hiring an investment bank, you will be hiring analysts in addition to the actual underwriters. In making your decision for whom to hire, it is very important that you consider the required independence of your underwriters and analysts. As a result of the 2003 Global Analyst Research Settlement, several regulations were put in place regarding the relationship between underwriters and analysts. The more important reforms (as identified in a report put out by the SEC) are summarized below:

• The firms will physically separate their research and investment banking departments to prevent the flow of information between the two groups.
• The firms’ senior management will determine the research department's budget without input from investment banking and without regard to specific revenues derived from investment banking.
• Research analysts' compensation may not be based, directly or indirectly, on investment banking revenues or input from investment banking personnel, and investment bankers will have no role in evaluating analysts' job performance.
• Research management will make all company-specific decisions to terminate coverage, and investment bankers will have no role in company-specific coverage decisions.
• Research analysts will be prohibited from participating in efforts to solicit investment banking business, including pitches and roadshows. During the offering period for an investment banking transaction, research analysts may not participate in roadshows or other efforts to market the transaction.
• The firms will create and enforce firewalls restricting interaction between investment banking and research except in specifically designated circumstances.

In addition to their independence, you should research the analyst’s reputation and capabilities. Analysts lead the way for your companies positioning, as they will be the ones who turn your numbers into a narrative to attract investors. Analysts should help investors see the value in your company that may not be obvious or initially visible. Thus, you should get to know the analysts on both the buy and sell sides of the transaction. Make sure that you understand the implications of both sides of the transaction, as this understanding will help as you evaluate the analysts.

Though you will not be influencing what analysts write about your company, a thorough understanding of their experience, skill, and style will give you confidence in their ability to help position your company in a satisfactory way.

5. Distribution Capability

One of the roles of an investment bank is to buy shares from the filing firm and then sell them to investors–normally institutional investors rather than individuals. For a bank to be successful in their efforts to sell your shares, the strength of their syndicate³ —which directly correlates to their distribution capabilities—is paramount. Make sure the bank you select can put together a strong syndicate that will provide a distribution channel that is both the right type and size for your company. For some this may mean access to specific, large hedge funds, while for others it may mean access to a niche endowment fund. Ask your prospective bank which banks they would likely form a syndicate with, and what their distribution capabilities and distribution strategy would be. Just as with the size of your distribution channel, who you are distributing to will play an important role in the success of your offering.

6. Aftermarket Performance

In considering which investment bank to hire, it is wise to evaluate the aftermarket performance of their past underwriting engagements. Aftermarket performance is a measure of the movement of an IPO’s shares after being introduced on an exchange. Two specific aspects of aftermarket performance that you should consider are the ability of an investment bank and its syndicate to provide aftermarket analyst coverage, and their ability to act as market makers⁴ post-IPO. The term aftermarket analyst coverage refers to the amount of attention a company receives from analysts in the form of published opinions regarding the company’s position and potential, after the initial public offering. This coverage is an important contributor to keeping market interest in your securities high. Poor coverage can result in a lack of investor interest and a drop in share price. An investment bank and its syndicate’s ability to facilitate the trading of a company’s stock as market makers is important because they can directly influence the liquidity of your company’s shares and provide price stability in the post-issuance trading of your shares.

Though similar to the measures discussed above, another important measure of aftermarket performance is the movement of share price immediately after the shares are available to be traded in the secondary market. If a company’s shares experience a significant price change in either direction, this is a strong indication that the offering was not priced correctly. Evaluate your prospective bookrunner’s past offerings for these price movements to determine how appropriately they price the offerings they broker.

Though there are many factors outside of an investment bank’s control that can determine an offering’s aftermarket success, an overall view of a bank’s prior underwriting efforts and its aftermarket success provides a useful gauge for evaluating an investment bank and their syndicate.

7. Continuing Services

An investment bank should be capable of helping with your future financing and growth needs. The following list offers a few ways that an investment bank should be able and willing to provide services to your company after completing your offering.

• Supporting you in your additional capital raising needs
• Assisting with mergers and acquisitions
• Providing timely and relevant coverage
• Any other services requiring an investment bank’s expertise

As you search for a bank that will fit your needs, be sure to research their ability and willingness to provide additional services after completing your offering.

Conclusion

It is important to have a basic understanding of the services that are commonly provided by an investment bank. The information provided in this article should help to establish this basic understanding, and should be used as a starting point for deeper investigation into areas you are less familiar with. An understanding of these services will help you negotiate the terms of your engagement with your chosen investment bank.

As is true with many decisions that are made during an IPO, choosing the right investment bank to fill your IPO and post-IPO needs will take time and money, but with the proper care and effort, may pay off in rich returns. PwC has stated that “…the value added by an underwriter should be the assurance that an IPO will be properly managed and successfully marketed and supported, both before and after going public.” Research and evaluate the seven considerations discussed in this article as you begin your search for the right investment bank to guide you through your IPO.

Resources Consulted

• KPMG, A Guide to Going Public
• PwC, Roadmap for an IPO: A guide to going public
• NYSE, IPO Guide
• EY, EY’s guide to going public
• EY, 5 Things to Consider When Choosing Your IPO Banker
• FINRA, 5121. Public Offerings of Securities With Conflicts of Interest
• SEC, Joint Press Release April 28, 2003
• Journal of Finance – When the Underwriter Is the Market Maker: An Examination of Trading in the IPO Aftermarket. Journal of Finance, Vol. LV, No. 3, June 2000