Initial Public Offerings by Mark Pape

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Mark E. Pape is Chief Executive Officer of R.E.Technologies,a multi-family housing real estate data services company, providing resident lead generation, data management technology and management tools for the apartment industry.

He previously served as the CFO of, the leading Internet provider of residential mortgages to mortgage brokers. He has been VP of Strategic Planning for Torchmark Corporation, the CFO of United Dental Care, and CFO of American Income Holding. For United Dental and American Income he completed successful initial public offerings. He was previously an investment banker, associated with Bear, Stearns, Merrill Lynch, and First Boston. Mr. Pape received his MBA degree from the Harvard University Graduate School of Business Administration and his BA degree from Harvard College.

Q. Mark, are you going to be discussing initial public offerings, or all public offerings in general? Is there any difference?

My comments here will refer primarily to the initial public offering of a business. Prior to the IPO there was no public trading of the stock. An IPO is bit different than any other offering, since follow-on offerings mean you have already jumped the hurdle of problems with IPO. Of course you can always repeat problems but usually you have a new set.

Q. For American Income's IPO you selected Morgan Stanley for their so called institutional sales strength, and Prudential for their broker distribution. But very little stock was apparently made available to Pru, or its individual customers. Some junior people from MS hauled us around on the road show to 30 or more big funds who bought most of it, and then flipped it back into the market fairly quickly. It looked to me like there was a kind of symbiosis between the investment bankers and the funds. The bankers go over and over to the same funds, and the funds buy pretty much whatever the bankers bring them, for if they don’t, then the bankers stop cutting them in on the deals. This means the funds are the real conduit to the public, shaving a quick profit on the way, and the bankers actually don’t perform much of a function for what they get paid. And the stock doesn’t get widely distributed initially, and may take a dip while it is being flipped. Where have I got this wrong?

You will get investment bankers who argue strongly on this issue, especially those at "retail" firms like Merrill Lynch.

"there is no distribution to individual investors"

But I am absolutely confident that there is no distribution to individual investors. It is too hard to round them up, their orders are too small and they will flip as soon as it rises a little. (herding cats) The stock in any equity offering will never be widely distributed to "small investors". Recent sales to preferred well-connected individuals (like CEOs of prospective clients) have gotten the investment banks in trouble since it seems to be a payoff to "influence" future investment banking business (a practice known as "spinning').

The market for equity stock offerings is driven by the fact that the big mutual funds and pension funds are the buyers of most, if not all, of the stock in the IPO (and in the follow on offerings as well). Like the old bank robber said, when asked why he robbed banks: "It's where the money is". The institutional investors have analysts who are specialized by industry ("buyside analysts") and who maintain close contact with the industry analysts at the investment banks ("sellside analysts"). The buyside analysts advise the mutual fund portfolio managers on the investment prospects for any given offering. You are right, this is a "one hand washes the other" process: the institutional investors need a place

"the institutional investors need a place to invest ... the investment bankers need a customer to sell shares to...."

to invest money and the investment bankers need a customer to sell shares to. The big funds don't actually make a profit on the shares for themselves. They make their money off the management fees that the ultimate investor pays them to manage the portfolio or mutual fund.

The investment bankers are being paid for their relationships with the personnel at the big institutional investors, who won't talk to the IR staff of a company until after it is public, so I don't think it is fair to say that they "don't perform much of a function". Don't forget, they play a critical role not only in who buys the shares in the offering, but at what price and how many shares they buy. They are sales people and they try to push the price of the offered shares up by creating demand. Moreover, they keep track of the "book", which is a listing of potential order volume at various price levels. They can coordinate the indications of interest from many parties and parley the laggards into increased valuations. This helps them gauge the level of interest. In the actual offering, they cut back on institutional investors who want more, so that those investors will step into the aftermarket and buy up the shares sold by the flippers, thereby keeping the price up. The investment banks also buy and sell the stock in the immediate aftermarket to maintain the price and prevent a drop, acting as a buyer of last resort.

Q. Then what it means when there is no “window” to do public offerings is that the big funds can’t count on a generally rising market to profit quickly, so the conduit is “down”.

The window for public offerings is based on the willingness of the big institutional investors to look at new offerings, largely because they are comfortable that the new offerings will rise in the future. If they are gloomy about the overall market, they will not spend time on IPOs. They always have money, because they can sell existing ownership positions to get cash for the new investment, but that means they incur a capital gain/loss that they might not want to realize.

Q. The “road show” drags the top officers of a company all over the country for weeks, telling the company story to all those fund managers. I remember three weeks and 13 cities, or rather that is what my notes say. All I actually remember was this blur of getting on airplanes. I earned my Advantage Gold in that blur. But why is this necessary? If the buyers are already all set up by the sell side talking to the buy side, and the fund manager is going to buy anyway, is all this running around just to make sure the officers realize how hard it is, so as to justify the cost?

On the contrary, the road show is absolutely essential, even though it is also extremely irritating, time-consuming and

"...the road show is absolutely essential"

expensive. Believe me, if the investment bankers could get out of doing a road show, they would jump at the chance because they would rather be out soliciting the next client, a much more profitable use of their time. They get no benefit from the road show and, in fact must bear/assuage lots of grief from the management team suffering the indignities of the process, including missed flights, bad connections, offensive interviewers, and long days of repetitive presentations. Remember, the investment banks are probably going to get the same fee, with or without a road show, so they, too, would prefer to save all that cost, much which comes out of their fee. They pay their share of the cost and usually end up picking up most of the costs for the limos, meeting facilities, rubber chicken group meals, etc.

While the prospective institutional investors have been "pitched" the investment story by a sales representative from the investment bank, they generally will not buy shares of common stock (particularly in IPOs) unless they have had the chance to interview management. They want to look the management team in the eyes and see how they react to tough questions. They want to be able to ask penetrating questions that the sales representative could not begin to answer. After all, they are very clever individuals with penetrating insight, who can easily flush out a flawed business plan or weak management team (just ask them, if you don't believe me!).

They are used to being "pitched" by the sales representative, who, after all, is only a sales person and will tell them whatever it takes to get their order. So, the institutional investors have to protect themselves from "falling for the sales pitch". Part of that process is that the staff member recommending the investment generally must make a presentation to an internal "portfolio management committee" who will also have tough questions for the recommender. That recommending staff person must demonstrate a thorough understanding of the company and must indicate that management has been personally interviewed and found to be "credible/acceptable". In essence, the recommending staff person is acting as the representative of the management team, attempting to carve out a share of the institutional investor's portfolio for this particular investment. Remember, there are many things to invest in, and there must be some specific reason why the institutional investor puts money in this company rather than that company. The recommending staff person's career will depend on whether they can "pick winners" for the institutional investor so they cannot simply rely on a salesman's pitch.

Also, I believe that there is a measure of "obeisance" or "paying dues" involved, meaning that the institutional investors enjoy just this one opportunity of having the power to grill the overpaid and probably lazy (in their opinion)

"The institutional investors have the money and lots of other alternative places to invest it ...."

management team. The institutional investors have the money and lots of other alternative places to invest it, so they think managers must come crawling to them to "request the pleasure of their company" or "plead for their participation" in the deal. Taking the "mountain to Mohammed", so to speak. In the future, the institutional investors will have little influence on the management team, be begging the company for up-to-date information and be at the whim of the management's skill, but for this one time, they can make management do the pleading.

Q. Which individuals from the company should go on the road show? I know you are going to say that it is essential for the CEO to be there. And probably the CFO. But do you need anyone else? Like the public relations person, or the agency head? I remember in one city we were on the same schedule as a company that had about 8 people on the show, who would all traipse in in a line, led by the CEO, as we were leaving. I remember thinking about Snow White and the 7 dwarves. Doesn’t some number just become a negative?

Well, the simple answer is you need to have whoever the institutional investor wants to question. Generally, the CEO

"Generally the CEO and the CFO are adequate for IPOs"

and the CFO are adequate for IPOs, since the management team is pretty small anyway. However, when there is an offering for a public company, particularly a large one, other management team members may be necessary to represent their division/group/subsidiary since the investor wants to see "depth of management". In the future, the institutional investor may not get much chance to talk with the CEO but they will have detailed questions for the head of a division/group/subsidiary. For example, if GE were doing a large common stock offering, the heads of several major subsidiaries would be necessary, particularly the subsidiaries where significant future earnings will be derived or that are in the midst of crisis.

In some cases, where the Investor Relations person will be the primary interface for the institutional investor in the future, it might be worthwhile to bring him along to begin to establish the credibility and relationship with the staff at the institutional investor. This assumes that the IR person is high enough in stature within the company to be credible as the interface. When I was at Torchmark as VP of Strategic Planning, one of my principal functions was to go on road shows (not for stock offerings but for routine relationship maintenance). Sometimes with CEO and sometimes with IR Director. In effect, I was acting as a surrogate for the CFO in that situation.

When we saw the 8 people, I suspect that 4 of them were with the investment bank, including the bankers on the deal and a local sales representative. Often, investment banks send the junior bankers on the road, since senior bankers are more valuable calling on new accounts. But for the first few meetings the senior bankers may come along also, to be sure the client feels it is "getting attention". Then the senior bankers will discover some conflict and disappear, leaving the management team with the junior guys up until the last few meetings, when it is politic to re-appear with news of the "deal's progress" and the "book".

Q. The pricing of the deal, what the stock is sold at, is mysterious. There is the preliminary price sort of agreed upon at the outset, and then the price goes up or down depending on “demand”. But how is that demand expressed? A banker told me that many buyers say they will take so many shares at this price, so many more at that lower price, but so many less at that higher price. That sounds sort of artificial to me. Is that for real? And if that is the case, why wouldn’t the road show just go see a few more prospects to get a higher price. I got the impression that the visitation list was preset, and would not change no matter how the book was going.

Pricing of shares in an IPO is definitely an art. In the final analysis, it is actually set by the demand level for the shares. It is like any other investment that you are considering: if it very cheap, you might buy more of it. At a higher price, you still like it but your return potential goes down so you don't buy as much. At some price, you won't buy any because you do not see the return potential on that high price. The final pricing is done by the "syndicate desk" personnel at the "book-running" investment bank, not the investment bankers or the stock analyst, since the syndicate desk has all the data concerning demand for the new shares.

The mysterious "book" is what determines the ultimate sales price. The "book" is pretty much a listing of indications of interest from potential buyers at various price levels. The data is gathered from the sales representatives who talk

"The mysterious "book" is what determines the ultimate sales price."

with the institutional investors and from the syndicate desks at other "non-book-running" investment banks that are participating in the offering, including both co-managers and non-managers. Co-managers get their name on the cover of the prospectus and get a bigger cut of the fees on the offering. They also contribute a little to the project by contributing to the due diligence effort and the writing of the prospectus.

The road show DOES go to more prospects-in fact, the road show will go visit any prospective investor of any size that is willing to have the road show visit. The visitation list is not preset at all, although it might appear that way because all the big names are usually on it. That is why there is often a sudden change in the road show itinerary as the sales representatives get word that an important institutional investor is willing to see the show but can only see it at a certain time on a certain day. If the deal is "hot" some lesser institutions may get cut off as the road show ends early since they don't have the stroke to make the deal stronger. On the other hand, if the "book" is "weak" the road show may get extended to permit more visits to smaller, less significant prospective investors to try and build up more demand.

A key part of the road show is allowing management to demonstrate why a higher value is deserved and justifying the valuation to the prospective buyers.

The initial "talking price" is based on a comparison to existing public companies that are "similar" to the IPO company. The industry analyst at the investment bank and the investment bankers work on determining what is "similar" and try to refine the list to include only those companies that have the best valuation. This sometimes severely strains the

"The initial "talking price" is based on a comparison to existing public companies that are "similar" ...."

definition of "similar". The investment bank's sales representatives use the "similar" company data/analysis to talk to the institutional investors to get them interested in the deal and in hosting the road show. The institutional investors use the prospectus, the sales materials, the road show and their own analysis to determine their price levels. If there is too big a disparity or significant disagreement on what is "similar", the institutional investors will just pass on the offering.

Q. Many life companies, particularly the ones that are the most successful at putting on new business, are short of surplus. They believe they could write more business if they had the surplus to support it, or the improved Best rating that more surplus would justify. How does such a company know whether they could do a public offering? Are there rules of thumb that would help determine which ones should explore that option?

A public company can do an offering almost any time (assuming they like their current market price and don't want to raise too much money) and I would guess their investment bankers have already pushed them in that direction, so I will focus my comments on private companies considering going public.

Unfortunately, the only way to really know whether a company can do an IPO is to talk with an investment banker who specializes in insurance offerings. A "generalist" investment banker will always tend to give a positive answer and spend a lot of your time (because they do not know the right questions to ask), before his/her firm makes a decision on whether the firm will do an underwriting. More often than not, the answer will be "no, now is not the time" because the "window" for insurance stocks is more limited than the window for most industries.

A specialist investment banker who focuses on insurance stocks can easily give the company a quick and fairly reliable response without a lot of wasted time. They are fully up to date on the market for insurance stocks, know the comparable companies and understand the industry's actuarial/accounting issues . They will need to know some financial information from the company in order to make a quick evaluation. Much more data will be needed if they determine that it looks like there is a good possibility of market interest in an offering by the company.

A savvy management team can "guesstimate" whether an IPO is likely to be possible by looking at the current market valuation of public insurance companies that management of the company reasonably considers to be "comparable" to the company considering the offering. Applying the average Price/Earnings ratio of the group of comparable companies to the company's earnings for the latest twelve months will yield a price per share.

"(M)anagement can "guesstimate" whether an IPO is likely ... by looking at the current market valuation of public insurance companies ..."

Multiplying that price per share times the number of shares will generate a rough valuation for the company. But this is only a general rule so management should not expect to receive that valuation on the actual offering. In fact, the total valuation would usually be at a 10-15% discount from that value (assuming the ratio stayed the same all the way until the time of the offering, which is probably at least 4-6 months away).

Generally speaking, the total value of the company must exceed $30 million. This is because the investment banks usually want a minimum offering size of $15 million and they will sell no more than a third of the company at a maximum. So the post-offering valuation would be $45 million (the original $30 million plus the $15 million raised in the offering). All investment banks would prefer a bigger deal selling a smaller percentage of the company since their fees are based on the total dollar amount raised in the offering and they like to be associated with bigger companies. This is a broad generalization and depends on the particular investment bank evaluating the IPO. The Goldman Sachs and Morgan Stanley type investment banks would generally not be interested in an offering this small. But smaller regional firms may be willing to do a smaller deal if the market is strong and they wish to establish a relationship with the company. The company must have three years of audited financial statements.

"Very few insurance companies make it through the IPO process."

Very few insurance companies make it through the IPO process. It is demanding, time-consuming and heavily dependent on market conditions. It also is not a short term solution, even at best, because it takes so many months to complete and cannot be counted on to happen on a reliable time schedule. Companies are probably better served to consider selling a part of the company in a private offering to a knowledgeable investor.

Q. The reader is now thinking, “How do I do that, sell some stock to a private investor?” A venture capital firm won’t be interested unless they can foresee an exit strategy, which essentially means a public offering or the sale of the whole company to another company. Are there other reasonable options, and who would you talk to about that?

Selling stock to private investors is even more difficult than doing an IPO because there is no obvious place to begin looking. Venture capital firms are only interested in high growth companies with a clear exit strategy. If the company fits that profile, the management team should review the many available resources to determine which venture firms

"Venture capital firms are only interested in high growth companies with a clear exit strategy."

are interested in their industry. Raising venture capital is a subject all on its own, but it is difficult and time-consuming even at its easiest.

Some investment banks have private placement departments that are able to do large sized private placements of equity, but even the most active in this field can be hard to entice. They need to be "excited" about the deal, just as the investment bankers need to feel "excited" about an IPO in order to devote the time and energy to exploring the feasibility of the offering. Private placement experts are generally more oriented towards raising debt than equity, so the offering may need to be a "pseudo-equity" instrument like convertible debt or convertible preferred stock. Again, it makes sense to contact investment banks with a specialization in the company's industry to see if a meeting can be arranged with the private placement personnel and it is very helpful to have close relationship with one of the investment bankers who can facilitate that meeting.

It is very difficult to locate individual private investors. Often, a successful business person in the same town or the same industry might be interested in making an investment in a private company. The company's law firm, accounting firm or other business advisor can be helpful in introducing the company to potential investors. However, ultimately, the management team will be dependent upon networking with "friends and family"-type investors. Negotiating the valuation will always be a
stumbling block, unless the potential investor is a personal acquaintance of the CEO of the company and makes the investment based upon confidence in the CEO's capabilities and assurances.

Raising private equity is extremely time-consuming and more often than not fruitless. There are many individuals who hold themselves out as "money raisers" or "sources of capital" and there are probably a few who are really capable of helping the company raise private equity. But the majority of such service providers do not actually have access to capital and will want a large commission on any capital raised. These relationships are always doomed to acrimony, even when the service provider performs well and delivers some capital. Their fees seem perfectly reasonable when the company is desperate for funding, but seem unconsciously greedy once the money is actually found. There will be disputes on who made what introduction and who really raised the financing. If the company has no other way to raise private equity, then this is definitely a route to pursue, but the management team should have an excellent attorney drawing up the contract with the fund-raiser and the documents to be provided to prospective investors. A mistake in either of these areas may result in dangerous litigation in the future.

COMMENT: - Bob Manning,
I pretty much agree with Mark’s comments across the board and actually think his $30-45M minimum size for an IPO is probably on the low side. I would advise small life co’s seeking capital to hire a good boutique investment banker that knows the industry and do an institutional private placement. Firms like Green, Manning & Bunch can tell you up front how doable a deal is in current environment.

Note: Mark has not been very encouraging about the possibilities for raising capital for a company that is too small to do an offering or interest venture capital. For a life company the issue is always surplus, not cash. That is, of course, unless you are actually losing money. Sometimes a careful analysis of what is causing your surplus drain can get you out of the squeeze without raising outside capital. The problem is often agent advances, and financing may be available to convert these accounts receivable to admitted assets. See the first paragraph under Regulation.

Q. When a company hopes to do an IPO in the future, there are things they should be doing now to prepare. For example, apparently underwriters want 5 years of GAAP earnings for a life company. Most companies that are not public don’t bother with GAAP, relying solely on statutory earning reporting in their annual statement in the blue book. Is this a strict requirement, and are there ways to reconstruct GAAP for past years? Generally what records must you have to do that?

The things a company should be doing to prepare for an IPO are usually just good business procedures that are often neglected because they create additional administrative costs at a time when going public is not a consideration. The most common example is audited financial statements. Privately held companies often don't have annual audits, or use a cut-rate audit firm that is not qualified in the preparation of financial statements for the SEC. If the company subsequently decides to go public, the lack of historical audits is a huge hurdle. Going back to audit

"The lack of historical audits is a huge hurdle."

past years can be expensive and maybe impossible because some of the required information may not exist or be in an auditable form. Other statistics of an operational nature that show important facts about the company should also be preserved for use in an IPO document, such as number of customers or average purchase amount. The SEC requires the auditors to "vouch" every number in the prospectus so if there are statistics required to support management's "selling points" about the company's history and success, the basic data needs to be maintained in an "auditable" form that can be checked by the investment bankers doing their due diligence and the auditors.

Actually, underwriters will require for only 3 years of audited GAAP statements (or for as many years as the company has been in existence, if less than three years) but they would prefer 5 years to make a more comprehensive offering document. Generally speaking, the conversion of statutory to GAAP is not difficult and the data is available to make that conversion. The historical data used to produce statutory statements also has virtually all of the information required to recast/reconstruct the financial results into a GAAP statement. It will be necessary for the actuaries to recompute the reserves/costs based on GAAP requirements, but if they have saved their programs/data, this is not a major obstacle. The bigger issue is the audit mentioned above. Auditors have some mandatory procedures they must follow to certify financial statements. Even if the company has the GAAP data and can prepare the financial statements on a GAAP basis, the auditors may not be able to "form an opinion" because they cannot perform certain of those mandatory procedures on the old data. The footnote disclosures for SEC qualified financial statements are much more comprehensive than the simple notes that often accompany audited financials so the footnotes will have to be extensively modified, even if an audit exists.