The IPO market functions reasonably well (for issuers)
Nearly two-thirds (64 per cent) of companies that undergo an IPO award roles to banks which have not provided them with lending or other corporate banking services in two years prior to the transaction. But when it comes to debt markets, seven out of 10 roles are awarded to banks that already have some dealings with the issuer in that two-year window.
So there is a fair amount of competition here. The largest four banks in the market account for just 39 per cent of equity capital market transaction value, rising to 35 per cent of debt transactions and half of M&A deals. That looks like a veritable bar fight compared with retail banking, where the combined share of the four largest groups was just over 70 per cent in 2014. The majority of IPOs are awarded in a formal, competitive process starting with a request for proposal.
In terms of bad behaviour, most of the larger banks were found to use rather optimistic 'right of first refusal' or 'right to act' clauses regarding future transactions in their corporate broking and other service appointment letters. Banks have pleaded with the FCA that such clauses "are not enforced and not enforceable" - but the regulator may end up stamping out anything but a 'right to pitch' obligation.
Banks use loss leaders in the hope of transactional fees
'A Grand Don't Come For Free', rap artist The Streets reminded us in 2004. Investment banks have long known this. They will regularly offer services such as revolving credit facilities at a loss in order to keep clients onboard until the next big fee-making transaction comes along. One bank said it loses £1m-£2m per year per client on its lending business. Corporate broking is usually free for companies in the FTSE 350, and the fees charged to smaller businesses often do not cover the cost of the services provided.
But what is investment banking if not cross-selling? Apart from the use of restrictive contractual clauses, the FCA does not see grounds for "widespread intervention" to encourage competition. It concludes that the level of cross-subsidies have not created the barriers to entry (noting recent M&A entrants) that would ultimately harm the end client.
Banks' book-building bias is real
There is obviously a clash between a bank's obligation to construct an appropriate book of investors for an equity issuer, and the long-standing relationships they have with their larger buy-side clients. Banks in the FCA's IPO sample generated $37bn (£25bn) in broking, research, hedging and other revenues from investors each year, compared to the $750m they generate from IPOs. In the most sought-after public offerings, the majority of banks favour these clients when it comes to allocating equity. More attention should be paid to other book-building options, as this column has discussed previously, and it is likely this process will ultimately become digitised, as the Myners Report concluded in 2014.
It is, though, difficult to demonstrate that the current conflict is actually detrimental for the end client. Banks claim they favour 'long-term investors', but the data demonstrate book-builders have no ability to predict which investors will hold rather than flip the stock. But larger investors do provide help on pricing the IPO. They also make it easier to market to other investors, and are more likely as a group to top-up their allocations.
Berating the hand that feeds
Private and institutional investors will clearly welcome more transparency earlier in the IPO process. Allowing unconnected advisers to meet management and publishing the prospectus ahead of 'connected' analysts' research have been regular demands over the past couple of years, and investors are encouraged to give their views on the FCA's three proposed models of achieving this. We will return to this debate.
But it is worth noting that the main and alternative London equity markets managed 87 transactions between them in a turbulent 2015, down from 135 in 2014. More timely and independent disclosure would make for a smarter market that is harder to manipulate. But the FCA should carefully consider how changes might impact supply, with an investment lobby keen on biting the hand that feeds.
