What Do Banks Actually Do in an IPO?
Deciding if banks add value to the IPO process requires knowing what a bank actually does for a soon-to-be public company.
With the latest round of SPAC-mania, I’m finding a lot of explanations for why these new ways to go public are good, but not much on what the process currently looks like. I don’t know enough on SPACs and direct listings to choose to argue for or against, but I can offer a generalized account of how an IPO happens based on my time in the trenches after college in Equity Capital Markets (the part of the bank that takes companies public). I avoid specificity for the sake of clarity, which is to say there is much more nuance here.
Before diving in, I’d offer a question to help color the debates: are you considering all the 159 IPOs that happened last year, or just the few you’ve heard about?
Raising money through a traditional IPO is asking banks to sell your stock to investors around the world. You pick a certain bank or set of banks over others to lead it because they have convinced you that they can balance three things:
The amount you can raise
The quality of your long term investors
The proper liquidity on the first day.
The amount you can raise is dictated by the company and by the price investors will pay per IPO share offered.
Investor type matters because if you have all hedge funds as holders as opposed to Blackrock and Fidelity and Capital, the stock swings can be huge considering hedge funds move fast and the large institutions are meant to be there for the long haul.
That “move fast” mentality does mean that those same hedge funds allow for some IPO liquidity. You and I wanted to buy Airbnb shares the minute it opened? Someone needed to be selling their IPO shares for us to buy them. It popped massively as the bank’s traders waited for enough sellers to match with enough buyers before letting it go to the open market. Those sellers were gauging how much pop there could be.
One key aspect people miss here is that when a company “goes public”, us, as the public, isn’t necessarily buying shares from the company directly. We are buying shares from investors that have already bought them.
CEOs go into each bank two weeks before the actual IPO and give the pitch to all the bank's salespeople. Then the CEO flies around to all the best investors that the banks could line up to pitch them on why they should be a part of their company's public fundraise. Meanwhile the salespeople are pitching the IPO to all the thousands of other hedge funds, large asset managers, and pensions.
The thing to keep in mind here is this two week period is the CEO's biggest of their life. But it's just another IPO for the banks. While the banks are "building the book" of people that will be participating in the IPO (i.e. the people paying for the company's shares), the bank is balancing relationships and thinking about this IPO vs the hundred others they will be doing that year.
If it is a hot IPO and oversubscribed (more people want those IPO shares than is available at that price), they will fight like hell to get their best investor relationships as many shares as they can. They will also start to bump the price of the IPO up. But not too much, because those relationships are expecting a pop in the price to compensate them for coming in at the IPO as opposed to waiting for after and seeing how the market really values the company. People like Jim Cramer of Mad Money fame made a lot money back in his hedge fund days through relationships at banks that allowed him to get into IPOs, play the pops, and move on.
This is where the IPO investors make short-term money. They agreed to buy IPO shares at $10. Then when it goes “public” and everyone else, including retail investors and professional investors who couldn’t buy IPO shares, can now invest in the company, they buy it at $20 because there is so much demand and only so many shares available. That stock “popped” 100% on the first day.
But as I mentioned above, you can't only focus on the buzzy IPOs. There are 10+ IPOs a month that we never hear about. Exagen and PingIdentity happened last year. No front page WSJ article for them. They also follow the same process. If they hire a bank and the bank starts to see that there's just not enough demand, that bank desperately doesn't want to be associated with a failed deal. Banks actually track that and use it against each other. They call up that investor that got a great allocation of shares in that last hot IPO. They remind them of all they've done in the past and could they just take some of this IPO because it's unloved but has great prospects. And so another $100mm dollar IPO that we haven't heard of gets done. Do these middlemen need to exist for well-known companies with undeniably great prospects? Perhaps not. For now do they facilitate the fundraising for the other 90% of IPOs? They do.
Concepts not addressed here: when big IPOs go bad (Facebook), when big IPOs don’t happen (WeWork), bank financial incentives, how much the average IPO pop is, bank fees for an IPO, and what else a bank offers a company they take public etc etc etc.