Basking in the glow of a successful roadshow, counting valuation upticks and oversubscription multiples, it is easy for an IRO to lose sight of what is going on behind the scenes: the book-building process. For all the excitement of investor presentations and one-on-ones, the underwriter’s equity capital markets department is ground zero. An army of salespeople burn up the phone lines taking orders from investors, and at the end of the process they hand over a list of shareholders which forms the lines of battle in the IR department’s fight for investor attention.
At no time in the history of equity markets has this book-building terrain been so hotly contested. A soaring US stock market drove public equity sales to $40.9 bn in the second quarter of this year, destroying the old record of $26.4 bn set in fourth quarter 1995, according to Securities Data Corp.
IPOs alone nearly tripled to $18.6 bn from $6.7 bn in second quarter 1995, smashing the record of $12.2 bn recorded in the fourth quarter 1995. But bankers are starting to feel the tremors of a weakening market: ‘The issuance calendar is still extremely busy,’ notes Mark Loehr, head of equity capital markets at Smith Barney. ‘But buyers are getting more selective.’
Cracks in the new issuance market show in the growing number of offerings priced below their initial filing range: some 18 per cent in June against just 8 per cent in April and May, according to Securities Data. Meanwhile, only 26 per cent of IPOs were sold above their filing range in June compared to 29 per cent and 41 per cent in April and May respectively. Bear Stearns says that the third week in June had more deals priced under their filing range than above.
Aftermarket trading also sagged in June, with average post-issuance returns of just 3 per cent for the month’s 69 IPOs. This compares to a 13.1 per cent rise through the end of June for May’s 77 IPOs, according to Goldman Sachs statistics.
‘Usually it’s a bad sign for bankers when the stock price goes down in aftermarket trading, showing that the issue was overpriced,’ remarks William Buchanan, senior managing director and head of equity capital markets at Bear Stearns & Co. ‘Underpricing is indicated if the stock zooms up too much after the IPO – and that’s bad news for an issuing company that apparently should have had a higher valuation. It’s our job to strike a balance and aim for 10 per cent trade-up in the first week.’
Loehr and Buchanan agree that pricing is an art, requiring time and patience. Book-building is basically an auction that takes place over a period of a few weeks while the issuer is on a roadshow telling its story to groups of investors. This contrasts with a firm-underwritten bid where an investment bank buys the stock then sells it off again. ‘The idea behind book-building is to build momentum so that by the end of the process there is more demand than supply,’ explains Buchanan. Yet not just any investor will do. As IROs know, it’s important to find the right shareholder mix for any given stock.
Book-building is the role of the equity capital markets department of the lead underwriter. The group is responsible for originating and executing equity transactions, working on the trading floor as well as with investment banking clients. The firm’s sales force contacts clients for feedback on the offering and invites them to roadshow meetings. As interest builds, formal or informal orders are put on the ‘book’ which, to the practised eye, is a snapshot of investor enthusiasm. ‘Technology has not helped, except to keep track of the book,’ muses Buchanan. ‘Book-building is still done entirely by telephone.’
Targeting the right investors is key to the process, and critical to the reputation of the Street’s top underwriters. Buchanan notes that primary market buyers are almost always large institutions, and as a major underwriter Bear Stearns is in contact with the managers of some 80 per cent of American investment capital.
‘The sales force know their investor base well,’ Buchanan says. ‘There are different types of investor for different issues, from speculative early growth to blue-chip common stock players. Major investors like Fidelity or Dreyfus almost always have a natural buyer among their vast numbers of portfolio managers.’
At Smith Barney, the first step in targeted marketing is to look at fund charters to make sure the stock issuer fits the investment criteria. The company’s market capitalisation, growth rate and valuation should all be in line with other stocks in a targeted fund manager’s portfolio. The sales force also looks at the fund manager’s pattern of investing in previous IPOs. ‘It’s a matter of experience,’ Loehr explains. ‘The more deals we do, the more background we have on potential investors and their various investment styles.’
Loehr explains that his team does careful due diligence with all the potential buyers to determine if they have done their homework: ‘We need to know that they have taken the time to understand the story, and thoroughly investigated earnings models going forward. That tells us whether they’re serious in holding a position in the stock for a long time.’
A good example of Smith Barney’s targeted approach is Aviation Sales Co, a Miami company that began trading on the NYSE in late June. With investors getting picky, bankers built a list of ten critical institutions they were convinced were buying to hold the stock for the long term. ‘There were many interested buyers,’ says Loehr. ‘But these lead investors drove the valuation thinking. Their seriousness and long-term approach was awarded with a large proportion of the institutional pot.’ With a filing range of $18-$20, Aviation Sales was priced at $19 and opened at $20.5.
As the orders poured in for Aviation Sales, bankers combed through the book to weed out the ‘bad guys’ – profit-takers and momentum players – while keeping ‘good’ investors. In all cases, the opening price is decided by the equity capital markets team in conjunction with other bankers. At the end of the process, bankers tell the issuer who their buyers are and how much they are willing to pay. ‘IROs know who their shareholders are right from the opening bell,’ concludes Buchanan. ‘After that, they are on their own.’
