Allocating Shares for an Initial Public Offering

In the last article, we went through the IPO process.  There are two major parties on the sellside that handle the deal:  equity sales and capital markets.  In the days leading up to the IPO effective date, salestraders are entering their indications of interest;  that is, the number of shares that their buyside clients want and any additional color that may help their clients get a larger allocation.  For a hot deal, buyside firms know that they will not get their number so they overbid i.e. I really want 100,000 shares but I'll order 200,000 to get it.  After the orders are placed, sales and capital markets management start allocating the IPO shares.  They will initially speak with the issuer company on some broad outlines.  The CEO may instruct the bankers to give minimal amounts of shares to hedge funds.  He may be afraid that they will "flip" the shares on the first day.  By "flipping", the fund makes a quick profit by selling the shares - providing that the IPO appreciates.  Or make sure that this fund gets a good allocation as they are a "friend of the firm".

Management will look at the following criteria (in no particular order) for the allocations:

• Amount of secondary commissions done with the bank
• For the last 3 months in the IPO's market (for example, for Netscape's IPO, management would look at US commissions)
• For the last 6 months in the IPO's market
• For the last year compared to the prior year in the IPO's market
• For the last year compared to the prior year global equity markets
• For the last year for derivative and convertible securities
• Amount of primary commissions done with the bank for the year compared to the prior year
• Amount of total commissions done with the bank (secondary and primary) for the year compared to the prior year
• Ranks for each of the commission categories above
• The fund promises to buy aftermarket shares
• The fund is a notorious flipper
• The fund's strategy is buy and hold

Primary commissions are equivalent to the selling concession from a deal.  Secondary commissions are from everyday trading of previously issued securities.  Note that the broker vote does not seem to hold much weight.

Studies in Client Profitability

We have reviewed the broker vote and the main factors that contribute to it.  The next logical step is to analyze them and determine if the investment bank is receiving a good return on its allocation in resources.  It's a simple revenues versus expenses calculation.  The art is in determining what the expenses are and how to weight them.  What services are the most important and bring the most value to the buy side?  How much does each service cost?

Within the financial services industry, the most expensive costs are people's time.  For the main roles that interact with the buy side, banks would measure:

Research Analyst - 1x1 meetings, group meetings, field trips, projects/special reports, 1x1 calls, conference calls, entertainment
Research Sales - calls/time spent on client, entertainment
Salestrader - calls/time spent on client, entertainment

For Corporate Access, the statistics would include 1x1 meetings, 2x1/3x1 meetings, group meetings, field trips, presentations, conference calls, special events and entertainment.

In addition to the basic profit/loss analysis, there are scenarios run to estimate revenues if the resource allocation changes.  If a fund is given more meetings, what is the upside in revenue?  What is the downside in revenue if resources are cut?  How should we approach a client who is not giving the firm enough revenues to merit the resources that are given to them?  Here is where senior management needs to make hard decisions.  This is usually the province of a relationship manager for large accounts and sales management for others.  We will discuss the role of the relationship manager at a later time.

Hedge Funds

The broker vote is not as reliable a forecaster of market share for hedge funds as for mutual and pension funds.  A hedge fund should have at least 2-3 prime brokers.  These brokers supply financial services such as custody services, securities lending and financing.  We will tackle these items at a later date.  The world of prime brokers used to be dominated by Goldman Sachs, Morgan Stanley and, to a lesser extent, Bear Stearns.  Since the financial crisis in 2008, the space has added Credit Suisse and Deutsche Bank.  JP Morgan has replaced Bear Stearns because of its acquisition.  Please reference this March 2010 article for a fuller understanding of the players.  These prime brokers are also sell side firms.  Since there are already strong existing relationships between hedge funds and their brokers, the market share for hedge fund commissions are skewed in favor of them and may not follow the results of the broker vote.

Anatomy of a Broker Vote

Sample Broker Vote:

We have maintained our #3 position with ABC Management Company in first half of 2010 (In the prior voting period, we were also #3).
Few highlights:

Our breadth of coverage with ABC Management Company is good...
There are 8 analysts who vote in New York, 4-5 in London (the number depends on the US-related projects). For the first half of 2010, only 2 analysts did not vote for us.  We are doing better than the competition.

...however our depth needs improvement.
Compared to the competitors, number of points we get from each analyst is low, according to the CIO i.e. we have fewer #1 rated analysts. As a benchmark, high single digit point is good, double-digit points are considered excellent (analysts and PM's allocate 100 points). We had 2 analysts who gave us double-digit points.

Overall ranking #3, but the upside to #1 is still big.
Top 3 gets roughly 40% of the commission market share. #1 broker gets in the high teens, while #3 gets 10%.  In absolute commissions, 8% difference is equal to around US $1m.  Biggest vote upside will come from the 2 analysts who did not vote for us.

Overall competitive landscape:
* Commission shares looks much like an S-curve. Top 3 gets roughly 40% of the commissions, while there is very little market share difference for #4-9.  1-2% difference between #4 and #9.  Top 10 gets close to 75%.  Broker universe has expanded as good analysts from big firms move to smaller houses or boutiques and ABC's analysts want access.  However, they are paid minimal amounts. Analysts usually vote for 10-15 brokers.

Overall updates on ABC Management Company:
* $7-8 B in assets under management
* Tougher 2Q, but July looking better overall.  Seeing stablilization of clients flow.
* Investment making process is a bottoms-up: each analyst talks to the portfolio manager when there are an actionable investment ideas and PM will make the final decisions on the stock.

ACTION POINTS:
* Introduction of credit analyst to John Smith
* Introduction of Thomas Jones to new technology analyst
* Establish solid relationship with Allan Edwards

Reasons the Sell Side Would Vote for an Analyst

Each sell side voter and firm has its own investing philosophy.  Naturally, during voting season, they have different reasons for giving an analyst a vote.  These may be:
1.  Making a good call for buying or selling a stock
2.  Having insights into their industry or stocks
3.  Taking the trouble to meet with them personally (This applies especially for clients not in New York, Boston, California or London.)
4.  Having an interesting/fresh investment thesis
5.  Sponsoring access with corporate management via a conference, field trip or roadshow

Effect of the Technology Bubble on the Broker Vote

In the previous article, there was a short summary on the analyst level detail of the broker vote.  During the technology bubble in the late 1990's, there was a distortion in the vote.  At that time, the analysts covering the technology (especially Internet) sector received an increased number of votes at the investment banks.  This was an attempt to curry favor with the analyst in hopes of getting an allocation to a hot/oversubscribed IPO.  As with many situations in investment banking, this was unspoken.  On the whole, an analyst of the lead underwriter of the IPO would have a favorable reputation and the comment would be:  "He/she gives valuable insights."

Broker Votes for Research Analysts

Investment Banks are ranked by buy side firms during the broker vote process.  There are additional levels of detail that emanate from this vote.  Some firms also rank coverage by geographic region or country, sector or industry and individual analyst.  One of the measurements for research analysts is the broker vote.  Here is where the subjective/objective line can be crossed.  The fund managers and buy side analysts, after the initial rank, are asked to give details of who has helped them during the voting period.  This may be because of a timely stock call (buy or sell) or special insights or historical relationship.  The analysts are ranked by how many firms have voted for them.  This is done twice a year.

There are about 150-200 votes collected from buy side firms at any given time.  The top analysts generally garner votes from about 120 firms as not all buy side firms are interested in all sectors/industries.  There are also firms that refuse to give any details about research analysts.

Personalized Information

Access to Intellectual Capital

Buy side firms are hungry for information as more recent and more accurate data give them an advantage when deciding on investments. There are two main sources: the research analyst at a sell side firm and corporate clients i.e. the companies that are covered.

Access to the research analyst through meetings or phone calls is coveted. These interactions with the analyst allow the buy side to understand the thought process behind their recommendations. It is not the actual buy/hold/sell opinion that interests the fund. The meeting would be held with the PM or buy side analyst. During the last two years, there have been staff reductions in the research departments of mutual fund firms. The trend has been towards more reliance on the sell side analyst's ideas since some sectors are no longer covered. Outside of the financial centers (New York and London), research analysts make trips to different regions to discuss their ideas. In the centers, there is a critical mass of firms and the analyst can just take a taxi or train for a meeting. In a regional trip, the analyst may have five meetings in three cities in a day. This is called Analyst Marketing.

Corporate access comes in the form of meetings with important officers of corporate clients such as the CEO or the CFO. There are many formats. Sell side firms sponsor conferences for different sectors and/or regions. Many corporate clients are invited to speak at them and, if they desire, to hold meetings with investors. Another venue is the Non-Deal Roadshow. This is when corporate officials travel to a region(s) to tell their company story to their current and potential investors. They may also set up a Field Trip to a third site. For example, an oil company may have the investors visit a refinery or off-shore drilling rig to experience the business firsthand. These events are allocated by the sell side firm. Here is where the research salespeople spring into action and try to get their clients approved for attending the limited amount of events.

Both types of meetings are very important for client service and, hence, the broker vote.

Serving the Buy Side

Research, Sales and Trading

The main elements of the broker vote revolve around research and best execution. To better understand this dynamic, look at the traditional roles on the sell and buy sides and their lines of communication. On the sell side, there are four main actors: research analysts, research salespeople, salestraders and position traders. Their counterparts at the buy side are research analysts, portfolio managers (PMs) and salestraders.

Sell side research analysts are the idea generators for an investment bank. They follow a sector or industry and get to know the companies intimately through analyzing financial statements, talking to the company's officers, following industry news and speaking to suppliers, clients and competitors of the firm. They compile all this information into opinions about the prospects for the company's business and stock price. This is known as the "Mosaic Theory". The analysts interface with the buy side's research analysts and PMs; giving them their talking points about different companies. Their recommendation is often boiled down to a buy, hold or sell in the press. The buy side is NOT solely interested in that. They are interested in the thinking process behind an analyst's stock recommendations.

Research salespeople are advocates for their buy side clients. It is their job to obtain the resources needed by them from within the investment bank. This may be a meeting with a sell side analyst or getting them into an industry conference. They market the bank's research capabilities by acting as filters - passing on the most impactful research to a client. For example, if a client has a large position in Microsoft, the salesperson will relay any important research reports regarding that stock to them. A better salesperson may relay news regarding Dell and Hewlett Packard as their sales affect the volume of Windows packages are sold.

Sell side salestraders communicate with the PMs and buy side salestraders. They execute trades and are trying to minimize the transaction prices for the buy side. The calculation of any investment return is dependent on the price of the security when bought. They also act as filters of the investment bank's research. Their ideas are more geared to day trading than any long term investing. Most of the orders are originated by the buy side. At times, they will ask the sell side to facilitate a trade by committing capital. This is something only the largest institutional clients are able to ask for and get.

Position traders interact with the exchanges and salestraders. They have a trading book which has a profit and loss (p/l) statement that is measured constantly. When an order comes from the buy side, the broker/dealer's salestrader will execute the trade through the position trader. Ideally, it will be in the book's current inventory. This is where some friction will appear between the sales and position traders. If the salestrader executes the trade at a good price, the customer will be happy and be more willing to allocate trades to the firm. However, a good price adversely affects the trading book and the p/l statement.

All four roles are large contributors to the broker vote. Whether research or trading is more important is firm specific although each side thinks that they contribute more to the vote than the other. Beyond the client service aspect, there are other items that influence commission allocation such as:

1. Is there is a prime broker relationship?
2. Corporate access
3. Does the investment bank sell the buy side firm's funds?

We will explore these factors later.

The Holy Grail - the Broker Vote

What is the broker vote and why is it important?

The Institutional Equities Business can be split into two main categories - the sell side and the buy side. The sell side is comprised of the Broker/Dealer arm of Investment Banks (IB's). The buy side is populated by money managers such as mutual funds, hedge funds, pensions and endowments. They are the consumers of the sell side's main products: mainly research, sales and trading. Secondary products may be access to corporate management, electronic trading systems and conferences run by the IB's.

The vote is a ranking of all the IB's and the services they provide to the buy side. This ranking provides the initial baseline for the amount of trading commissions that will be executed with the IB. Logically, better customer service leads to higher rankings and more trades. A large mutual fund company such as Fidelity may deal with 70-80 Broker/Dealers.

Vote information may be provided on a quarterly, semi-annual or annual basis. This may be done in a formal or informal manner. It can be a 30 page presentation, a back of the envelope note or a call saying, "You are in the top 5." Every client has their own methodology with different weights for services. Mutual funds may place more emphasis on research. Hedge funds may place a higher value on best execution. No two firms are exactly alike.

The ranking can be done as an absolute number i.e. 1 - Goldman Sachs, 2 - Morgan Stanley, 3 - Credit Suisse,... This is rarely done. The buy side is cannier than that. They usually tell firms that they are in the top 3 or 5 for 10 firms. Or they divide their brokers in Tiers and say, "You are in Tier 1. We have 5 firms in each Tier." This allows them to have some discretion in allocating their trading commissions.

The buy side can subdivide their vote into sectors or geographic regions/countries. Generally, there is a US/Americas, Europe and Asia vote. The International Markets have a more complicated vote since there is often a need to subdivide into different geographic regions/countries. For example, there might be a separate Scandinavia or Latin America vote. Canada may be included in the US or International vote. The Equity Divisions of most IB's are organized in this manner.

The main contributors to the broker vote are the portfolio managers, analysts and Chief Investment Officers of the buy side firms. Again, each firm weights the votes differently. On the whole, the portfolio managers have the greatest say.

This is an introduction to the broker vote. I have simplified it to give a baseline understanding.