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The Big Get Bigger

Banks are still your best option in underwriting.
Rob Garver, CFO Magazine
October 1, 2006

When Google went public in 2004, the initial public offering was conducted as an Internet-based Dutch auction, an approach widely seen as disempowering investment banks. A case before the U.S. Supreme Court in which the very existence of underwriting syndicates is alleged to violate antitrust law would seem to pose an even greater threat to the investment-banking status quo. And a recent survey by Financial Executives International revealed widespread dissatisfaction, with three out of four respondents complaining of a lack of competition in underwriting corporate securities.

But despite new technological options, legal challenges, and griping on the part of key stakeholders, the only notable change in the world of underwriting is that the big players are getting bigger. Through the end of the second quarter, a mere 10 firms accounted for fully 82.4 percent of market share for "book runners" (the banks that lead an offering). The top 5 firms controlled about half the market, and just 2 companies — Goldman Sachs, which did 14 deals worth $4.4 billion in the first half of the year, and Citigroup, which did 12 deals worth $3.6 billion — did more IPO business than the bottom 90 percent of the industry combined.

If that consolidation of power threatens competition, few CFOs seem bothered by the prospect. While most of the 261 senior finance executives who responded to a CFO survey on banking said they expect to see viable alternatives to traditional underwriters emerge in the next five years, only 14 percent have explored such alternatives during the past three years.

Indeed, there are few clues as to what such alternatives would even look like. Despite the success of Google's Dutch auction, few companies have followed that example. And even relatively small companies that have gone public recently report that their needs have been met — with a vengeance.

Hungrier Banks
"A few days after my initial S-1 filing in February," says Ed Morgan, CFO of Tennessee-based Delek US Holdings Inc., "I was inundated with calls and letters from firms that wanted to get involved in the offering. It was overwhelming."

Delek, which owns a Texas oil refinery as well as a string of nearly 400 convenience stores throughout the Southeast, generates about 60 percent of its revenue from its oil-and-gas business and 40 percent from its retail operations. Therefore it wanted a mix of investment banks that would give it solid representation among investors in both sectors, and says it had little trouble getting exactly that. The company was taken public in May by Lehman Brothers and Citigroup Global Markets, with William Blair, Credit Suisse Securities, HSBC Securities, Morgan Keegan, SunTrust Capital Markets, and Israel Discount Bank Capital acting as co-managers. "We had quite a few people who wanted a much larger role than they actually played, and we turned away another four or five banks, including some pretty large names," says Morgan.

Dave Smeltzer, CFO of Aqua America, a publicly traded utility firm based in Bryn Mawr, Pennsylvania, tells a similar story, noting that while his firm may not be large enough to attract the attention of the biggest investment banks, "that gives us more flexibility" to use companies including Edward Jones, A.G. Edwards, and Janney Montgomery Scott, which, as he notes, "are not in the top tier."

Smaller companies with less-certain prospects may have a harder time going public, according to Joseph Bartlett, of counsel to law firm Fish & Richardson and founder and chairman of market research firm VC Experts. But he says that has less to do with any issues posed by investment banks (such as high fees, for example) than with the costs of complying with the Sarbanes-Oxley Act or shareholder lawsuits. "I don't see it as a lack of competition," he says, so much as a regulatory climate that makes it difficult if not impossible for companies to go public if their anticipated market capitalization is less than $200 million.

No Next Big Thing
It doesn't help that most of the alternatives to traditional underwriting have failed to live up to their billing. Google's name recognition was sufficiently high that it could afford the Dutch auction route, experts say, but most small companies need a well-connected investment-banking firm to squire them around to potential investors.

Another alternative, in which the owners of a shell entity take it public as a special-purpose acquisition company (SPAC) and use the proceeds of the IPO to acquire a private company, isn't practical for most small companies. While a SPAC can specify which industries it will explore for deals, it cannot identify a specific acquisition candidate at the time of the IPO. That sort of constraint makes a SPAC "an interesting idea," says Achim Schwetlick, a manager and capital-markets expert in Boston Consulting Group's New York office, "but it's not the silver bullet for the general market."

What's more, the Securities and Exchange Commission has recently made it more costly to raise capital in this manner. For one thing, the SEC has increased the disclosure requirements of companies acquired in this way. Worse, the company must make a firm commitment to pay dividends on warrants that are typically offered in connection with such deals or they will be considered debt and thereby reduce shareholder equity (see "New Specs for SPACs" at the end of this article).

Over There
Small companies may have more ready access to capital outside United States borders, at least for now. Overseas capital markets charge much less in fees; while the typical rate in the States amounts to 7 percent of funds raised, for example, fees in the UK are about half that. Companies are taking notice. "Clearly, international capital markets are beginning to develop and are gaining traction as wealth begins to accumulate around the world," says Ken Goldmann, who chairs the SEC practice at accounting firm J.H. Cohn.

The higher fees charged in the United States, says Bartlett, are justified because underwriters here face significantly greater regulation and litigation risk than they do overseas, which drives their prices up. That burden can be a boon to clients: many investors find those stringent regulations and requirements reassuring, and will pay a premium for shares offered in the States that may more than offset the higher underwriting fees. That gap in fee structures may soon disappear if, as seems likely, other countries ratchet up the regulatory burden. But it's worth noting that 24 of the top 25 underwriting deals in 2005 took place overseas.

The London Stock Exchange's AIM, a market geared specifically to small businesses thanks to its light disclosure requirements and regulation, is only one of many markets worldwide that are "trying to take the game away from the U.S.," notes Bartlett. That suggests that some form of competition exists, but if the big players in underwriting are feeling the pressure, they certainly aren't showing it. And few of their clients seem overly interested in turning up the heat.

Rob Garver is a freelance writer based in Springfield, Virginia.

How Banks Stack Up on Underwriting*
1/1/2006–6/30/2006 1/1/2005–6/30/2005
Manager Inputed Fees (US$m) Rank Market Share Number of Deals Rank Market Share Change in Market Share
Goldman Sachs 771.4 1 8.6 127 5 6.1 2.5
Citigroup 711.0 2 7.9 256 1 8.0 -0.1
Morgan Stanley 572.7 3 6.4 125 4 6.3 0.1
UBS 557.3 4 6.2 170 3 6.8 -0.6
JP Morgan 502.5 5 5.6 147 6 5.9 -0.3
Merrill Lynch 468.7 6 5.2 144 2 6.9 -1.7
Credit Suisse 452.3 7 5.0 132 7 4.3 0.7
Deutsche Bank 401.8 8 4.5 137 8 4.1 0.4
Lehman Brothers 314.2 9 3.5 92 9 3.7 -0.2
Nomura 293.4 10 3.3 144 11 2.6 0.7
Top 10 Total 5,045.3 56.2 1,474 3,437.3 54.7 1.5
Industry Total 8,991.3 100.0 1,715 6,278.1 100.0
* Based on fees on global equity–related transactions
Source: Thomson Financial/Freeman & Co.

New Specs for SPACs

The extent of the Securities and Exchange Commission's crackdown on special-purpose acquisition companies became evident last October in a deal involving a SPAC formed by Sand Hill Partners that wanted to acquire St. Bernard Software, a computer-security firm.

Having formed a new unit devoted to reviewing SPAC deals, the SEC, according to St. Bernard CEO John Jones, "asked lots more questions than we expected." The commission did more than that: it also required St. Bernard to treat the warrants issued by the SPAC when it went public as St. Bernard's debt rather than equity. That requirement was designed to prevent shareholder equity from being inflated by such securities, which are frequently issued in connection with stock when a SPAC goes public.

The warrant requirement was especially surprising, according to St. Bernard CFO Alfred Riedler. "Among the accountants and attorneys we dealt with," he says, "no one was aware of the SEC not allowing a stock to be registered when it was in conjunction with a warrant already traded."

The added SEC scrutiny aimed at the kind of abuse that has plagued certain deals. In some cases, the private investors that sponsor the initial public offering of the SPAC ended up making no acquisition despite promising to do so within a specified period. Although the proceeds of the SPAC offering must then be returned to public investors, they enjoy no use of the funds during the interim, and only rarely do they recover the hefty investment-bank fees that are part and parcel of an IPO.

Despite the SEC's concern, the deal for St. Bernard eventually succeeded, providing the company with a $21.5 million infusion. And while the nine months the deal required was longer than anyone expected, Jones says that going the SPAC route required less time and energy than a traditional IPO would have. If the SEC is now satisfied with the way SPACs are operating, they may become a more viable alternative for companies, particularly those for which, like St. Bernard, neither venture-capital nor private-equity funding makes sense. — Ronald Fink

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