the friends and business partners of the underwriting firms. For instance, large institutions that use the investment bank’s other services are often given access to IPOs, as are wealthy individuals that may be clients of the investment banks.After the deal is priced, these initial investors are free to sell on the open market, in what’s called aftermarket trading. And it’s during the first day of regular trading when regular investors, customers of brokerages like TD Ameritrade and Charles Schwab of the world, are able to buy the stock.
What matters in an IPO
Underwriters stay involved in the process during this tenuous first day of trading. Investment banks want to do whatever they can to make sure the shares of the newly public company don’t break (close below the initial price). A broken deal is often looked at negatively by investors; plus, a broken deal makes it look like the investment bank didn’t set the initial price correctly.
Investment bankers try to balance the needs and wants of the buyers and sellers. If the price of the IPO zooms upward, the investors who sold their shares may feel like they were shortchanged and missed out on gains. However, if the price drops after the stock starts trading, the buyers may feel cheated and avoid that investment banking firm’s deal in the future. There’s also a risk that if an investment bank prices shares too high, it might need to step in and buy the shares to stop them from falling too much. On the first day of trading of Internet stock Facebook in May 2012, for instance, underwriters had to step up and buy to hold the stock from closing below the $38-per-share offering price.
Lastly, several months after the IPO has been trading, the investment bank’s research unit will initiate coverage on the new stock. A research analyst at the bank will write a report describing the company and the stocks, advising the investment bank’s clients on whether to invest in the new stock. This investment research capability of investment banks is covered in the next section as well as in Chapter 3 in greater detail.
Helping Investors Decide Whether to Buy or Sell
Investment banks make most of their money helping companies and governments raise money by selling securities. But most important, the investment bankers act as middlemen between buyers and sellers. Investment bankers not only help the sellers prepare securities to be sold, but also interact with potential investors. One of the great values offered by investment bankers to their customers selling securities is their ability to find buyers.
The importance of research
Even if there were thousands of companies lined up to sell securities, that wouldn’t necessarily translate into big profits for investment banks. The fees, generated by underwriting securities, only materialize if there are ample buyers to soak up the stock being offered. And that’s the role of the research unit of investment banks. By tasking research analysts with closely following developments in industries or by individual companies, the investment bank can assist investors on deciding whether to buy into securities. Chapter 3 describes this process in more detail, but here you can find out why research is so important.
Sell-side and buy-side analysts
Most large investment banks have entire research divisions that employ armies of research analysts. These research analysts pick apart the prospects of a company and tell investors whether to buy the stock. These analysts are called sell-side analysts because it’s their job to highlight stocks they say are worthy of investment, but they don’t actually invest in the stocks themselves. Sell-side analysts typically are creating research to be used by investors actually doing the buying, called buy-side analysts. These research reports are also often provided to individual investors who are clients of the firm for free, or sometimes made available through discount brokerage firms or for purchase.
Buy-side analysts are the ones who will be actually plunking down cash if they decide to purchase a security. These analysts consider the demands of the investors who have given them money to invest, be it mutual fund investors or pensioners with money in the pension plan. Buy-side analysts typically work for large mutual funds, which have pooled money from smaller investors to build a diversified portfolio. Buy-side analysts rely primarily on their own in-house research, which is not typically available to individual investors. Buy-side analysts, though, also use sell-side research to bolster their own insights about potential investments.
How an analyst’s research can make money for investors
Investment bankers, looking to sell shares of a security they’re pitching for a client raising money, will often seek out buy-side analysts to stoke demand. The buy-side analysts are the ones who decide whether the risk of a particular investment is worthwhile given the potential returns. There are massive potential conflicts of interest here, because there’s the danger that the buy-side analysts at an investment bank may issue positive reports on IPOs sold by that investment bank. For that reason, sell-side analysts at investment banks that did an IPO must wait 40 days before issuing a research report on that company.
What do the analysts do?
Sell-side analysts are billed as industry experts who follow companies closely and provide insights. These professionals typically build financial models that tell them how much a stock is worth and what investors should be willing to pay. These financial models aren’t made with plastic parts and model glue; instead, they’re made from spreadsheets and quantitative analysis.
What recommendations are and why they are important
Typically, sell-side analysts provide a recommendation on a stock, on whether investors should buy, sell, or hold the shares. Most sell-side analysts also put a price target on the shares, putting their best guess on what the shares may be worth a year from now. Some sell-side analysts also do channel checks from time to time. In channel checks, the analysts find out how much demand for products there is by examining orders from end-users and customers.
How the sell side interacts with the buy side
Sell-side analysts are also often given the role of providing buy-side analysts access to the management teams of a company. Most large investment banks put on conferences or presentations that allow potential investors to hear CEOs of companies talk about the prospects of their firms.
How sell-side analysts make money for the investment bank
Research continues to be one area in which making money can be somewhat problematic. With the money-raising functions of investment baking, the ways investment banks generate fees is pretty straightforward. A company pays the investment bank a charge for handling an IPO, for instance.
Getting paid for research is a bit more elusive, though. There are some instances where buy-side investors pay an investment bank to access the research from its sell-side research team. But more often than not, research is paid for in less direct methods.
One of the most common ways that investment banking operations are paid for research is through trading commissions. Sell-side analysts try to pitch investment ideas to buy-side analysts. Instead of paying for the research reports, the buy-side analysts may instead place trades for
