Initial Public Offerings, Part 2
The IPO market for HCIT continues to show some signs of life, or at least hoped-for life, as Accretive Health filed its IPO Prospectus (known as Form S1) with the SEC for a $200 million capital raise in late September, with part of the use of proceeds to pay back its private equity investors. Those who notice, track, or even care about such things observed that the company filed with four of Wall Street’s largest firms (known as Bulge Bracket banks) as lead managers — Goldman Sachs, Credit Suisse, JP Morgan, and Morgan Stanley.
These four Goliaths will take about 90% of the offering fees (known as economics), leaving the crumbs for one or two smaller firms that actually focus on HCIT to take or divide. An interesting choice to motivate those smaller banks and their analysts who will actually be paying long-term attention, but, clearly their prerogative. By the way, if this paragraph is meaningless to you, you probably missed my last post and might want to read it before proceeding (here).
Loyal readers will recall that when last we tuned in, our intrepid management team of HISTalkCo had just decided to go public and, after completing the ordeal of selecting underwriters (and, almost as bad, the economics negotiation) was getting ready to start the next phase of the process. After the dust settles on economics and cover order discussions, it’s time to begin the process in earnest. This starts with an “org meeting,” short for organizational.
The org meeting ritual sets the stage for the fun to follow. They generally start first thing in the morning in a location at or near the company issuing the stock (known as “the issuer”, or “the client”). Org books are handed out by the lead underwriters’ junior bankers and the meeting is called to order by the senior banker from the lead firm. The first 30-40 minutes are what I always refer to as “Mousketeer Roll Call”, aka introductions. This is where everyone in the room introduces themselves. Why so long? It’s a big crowd. For an org meeting, you’ll almost always see a few members of the management team (3-10, in my experience), three or four bankers from each firm (except for the lead, who brings a small army of bankers and capital market folks), two sets of lawyers (one set for the company, one set for the underwriters), and often some accountants. Before Elliot Spitzer changed the rules, you’d always have the equity analyst and usually their associate at the shindig as well, but those days are gone. It’s a big group, and usually a costly one.
Then the managing director of the lead firm re-takes control, reiterates their pleasure in being there, and then starts going through the rest of the agenda for the day and the subsequent weeks of the process. It always seems to be “a great story” that he or she “expects to have minimal issues with the SEC” and there’s always an “aggressive, but achievable” timeline. All agree to that, and it’s on to D&D — no multi-sided dice though, it’s time for diligence and drafting. The CEO, usually aided by the CFO and a few others, begins telling the story of the company in, of course, as glowing terms as possible, all with the goal of creating a prospectus that, in addition to having the required disclosure of risks and history, is as much of a marketing document as possible. This prospectus and the roadshow presentation delivered are the tools management and their bankers have to market the stock to potential investors.
Oftentimes these meetings start with a draft that’s been developed between company, lead underwriters and lawyers, making the process easier, but it’s primarily committee-driven, with all the fun and efficiency that suggests. From this point, there are multiple steps required to create the prospectus that will ultimately be submitted to the SEC for review.
First, the underwriters have a fiduciary responsibility to exercise “due diligence” to ensure that what’s being claimed is, in fact, the case. That means over the next few weeks, representatives of each bank will share conference calls with their clients’ clients, suppliers, and others who can verify that the system or product does what the prospectus and marketing materials claim. At the org meeting or subsequent drafting session, each member of the executive team will stand before the underwriting group (and lawyers) and discuss how they manage their department and discharge their other responsibilities. Sales pipelines and how they’re tracked will be discussed; product plans reviewed, and financial controls and forecasts are analyzed and “diligenced”.
It’s an important part of the process, and, in my experience, taken quite seriously. In addition, risk factors have to be discussed (and blessed by lawyers from both sides), though they are quite often cribbed from competitors’ SEC filings. Cover art is shown and discussed over and over again and the first few pages (known as the summary, or “the box” for the box it appears in) are virtually, and not inappropriately, obsessed over (“should the logo be that big?”).
Drafting a prospectus can generally take months and it can be painful. After the first diligence session, the herd of attendees is thinned dramatically, however. Senior bankers who aren’t at the lead firm rarely if ever show up after the first meeting. In many instances, I’ve been the most senior non-book-running banker in attendance, in part because my “pitch” to get my firm on the cover was that I’ll bring the research perspective to the process. Hopefully I always managed to.
While the diligence aspects of the meetings are often interesting (at least to me), it’s the drafting sessions that really drag and drag and drag. These are where the document actually gets written and rewritten and each mid-level banker (generally associates, but occasionally VPs, who should know better) tries to put a few fingerprints on the prospectus and show that their firm really and truly cares. There’s nothing quite like being in a room of 15 or more people, some of whom are paid by the hour (remember the lawyers present) arguing over whether something is a ‘strategy’ or a ‘tactic’, which SIC code to use, or how to punctuate a sentence to really get your blood running!
Possibly my favorite drafting session moment was underwriting a company that made blood glucose meters. The prospectus had a table that showed various parameters of each meter the company made, one of which was atmospheric tolerance (how many feet above sea level it could function). An associate from a co-managing firm asked (in her only speaking role of the day, I might add) if that meant they couldn’t be used on airplanes. The CEO took a breath, and patiently explained that no, it didn’t, because airplanes tend to be pressurized. I’m guessing said associate earned over $250,000 that year. The number of drafting sessions vary depending on the complexity of the story, whether any are done via conference call (where senior bankers are often on for the beginning and ends and have junior folk listen and throw in occasional comments for the vast middle) and how much the story needs prettying up for the investors.
Are these as bad as they sound? Yes, except for a few aspects, top of which can be the food! I had one Minnesota-based IPO client that had its meetings at its New York law firm, and, with apologies to Mr. HIStalk’s meeting comments, the spread they brought in was better than some weddings I’d been to. I remember commenting to my junior colleague that only in New York could you see sushi, corned beef sandwiches, and buffalo wraps (plus much, much more) at the same buffet. All that was missing was a bar.
How else could you pass the time? Like other corporate types, there was the ubiquitous BlackBerry usage. Recall that the BlackBerry was first popularized by bankers and you’ll have an idea of just how much your thumbs could hurt after a marathon drafting session. Clients, bosses, even friends and loved ones could be contacted during these meetings. Once in a while a banker would get caught, but for the most part, it was more or less ignored — though the CEO of Visicu imposed a strict no-BlackBerry rule in his sessions — at least for the ones he attended. Aiming for subtlety, I sometimes worked on other things, but on paper. My best use of time during an endless tangent was writing a poem for my wife, so it wasn’t a total waste.
Many, many circulated drafts later, hopefully close to the scheduled date, it’s time to “go to the printer”. Now, I’ve never been to the printer, as I became a banker at a senior level and my old firm never lead-managed a deal in HCIT, so much of this relies on colleagues’ stories. The printer, not surprisingly, prints the prospectus and oversees its transmittal to the SEC. Back before computerization, this relied on typesetting and other complex processes, but in the days of WYSIWYG (you young folks look up that term), it seems needlessly complex.
While at the printer, auditors sign off on the financial statements, the lawyers do their final bit of obsessive wordsmithing and editing — helped by junior bankers (analysts and associates) who’ve been instructed to find times to chime in to ensure the smaller firms are perceived by the management as “adding value”, final battles are fought over cover order (believe it or not) and the i’s are dotted and the t’s are crossed before the lead manager “pushes the button” and it’s off to the SEC. Printer sessions can last well into the wee hours and there’s a fair amount of idle time while these things happen, so I’m led to believe the place is stocked with an array of goodies (from snacks to beers) and toys (from pool tables to massage therapists) to occupy the oft-abused junior folk, where they’re finally treated the way many of them believe they should be. Sadly, the advent of WiFi and laptops makes the printer less fun than it used to be as they’re expected to keep working through the night on other projects. But, all good things come to an end and now the S1 is on file with the SEC.
I apologize if this is starting to sound like Schoolhouse Rock (I’m an S1, I am just an S1 and I’m telling you that drafting’s not fun…), but Bismarck must have forgotten this task when he said Laws are like sausages: it’s better not to see them being made.
Once the SEC has the first draft of the prospectus (and it’s simultaneously posted to www.edgar.sec.gov), a few things occur. First, HISTalkCo’s clients and competitors can all rush to read how profitable the business is (if at all), how it describes its business and, for the nosy friends, how much senior officers earn (“wow, I knew Inga had nice shoes, but always wondered how she could afford them”), and how much stock they have and what it will be worth at the time of the offering (“hmm, guess she’ll start shopping at Ferragamo”). Competitors can have a field day sharing the bad parts (like boilerplate risk factors or accounting details) with potential clients: “It says here if an asteroid hits their facility, they may experience service-related issues. Are you sure you want them as your vendor?”
Meanwhile, the issuer is assigned an SEC examiner who carefully reads the whole document and has approximately 30 days to send the company and its lawyers and underwriters a “comment letter.” These letters vary in length, but are usually at least a dozen pages and require the company to substantiate virtually every claim made, or at least tone them down. While at times these comments can get a bit silly, by and large, I think they do protect the investing public, which is, after all, the agency’s primary goal, we’re told. While the SEC doesn’t rule or opine on the veracity of prospectus statements, they do, in general, ensure that risks are disclosed and the worst hyperbole is eliminated. The company (and its underwriters and lawyers) amend and resubmit the draft and the process iterates until all the comments are “cleared” and the document ruled acceptable — kind of like a software QA process.
HISTalkCo now has an acceptable prospectus, it’s time for the Roadshow!
While the review process has been taking place, the lead (and occasionally the co-) managers have been working with the client on the presentation that the CEO and CFO (say, Mr. HIStalk and Inga) will give to institutional investors on the roadshow. With the help of the underwriters (and occasionally consultants or colleagues), Mr. HIStalk and Inga have rehearsed their presentation over and over again and also been prepared for any potential question that might be thrown at them. New suits (and perhaps shoes for Inga) are bought, hair is cut, and it’s time (cue the music).
Most firms have set itineraries that they like to use for roadshows and have it down to pretty much a science to ensure that the parts of the country that matter (to them) get covered as efficiently as possible. At the very least, this tour will include New York, Connecticut, Boston, Denver, San Francisco, San Diego, and Kansas City. Minneapolis, Chicago, Los Angeles, and even Europe, depending on the type of company and how much demand is forecast, are often added to the itinerary. The two fun-filled weeks go like this:
First, the management team delivers the 30 minute or so presentation to each of the underwriters’ sales forces (the people who call on the mutual funds, pension funds, and hedge funds that will buy the stock and pay all the underwriters’ commissions), then they hit the road along a pre-planned itinerary where they’ll repeat the presentation 50-100 times. Then it’s almost one of those scavenger hunts where management (accompanied by bankers of varying ranks) go from fund to fund in city to city in limos and often private planes (as schedules are tight).
The itinerary is constantly evolving as the sales people (perhaps mindful of the higher commissions inherent in an IPO) call their institutional clients and suggest they take a meeting with HISTalk Co (“as it seems to be a great play on the growth of HCIT in America”). Large funds get private meetings, smaller or less-active funds are relegated to group lunches or breakfasts where they hear the same story. When I was an underpaid associate research analyst, I’d sometimes go to these lunches, partly because hearing lots of stories was a good way to get trained (and hone my BS detector) and partly because the food was often better than I could afford for dinner, let alone lunch.
The quality of the meetings varies greatly and range from buy-side analysts who have no intention of recommending their firm buy, but are doing a favor to the sales person who took them to a game last month (it’s good to be at a big fund), to portfolio managers who’ve not even looked at the S1, but liked the sales pitch, to analysts who will grill the management team on even minute items and likely read the document more carefully than some of the bankers or even the company did. So, the meetings vary, as do the accommodations (but generally we’re talking Four Seasons level) and the amount of annoyance generated for both sides.
Management’s goal here is to convince the investor that HISTalkCo is a stock worth owning for the long haul. Simultaneously, the firms’ research analyst is fielding calls from potential investors, answering questions, sharing his or her estimates (which, incidentally, are never provided in writing), and trying to help sell the deal as well. They’ll have done separate diligence from their bankers to build their own models and (in theory) form their own opinions (thank you, Mr. Spitzer).
After the management meetings, the investors decide whether they want to own the stock and, if so, how much and at what price. As I mentioned last month, while the underwriters suggest a target price, it’s the investors who actually determine it, and it works as follows. Readers will recall from the last post that the underwriters (now, primarily the lead), have established the likely price of the stock as it relates to comparable companies and applying a 15% “IPO discount” to offset the risk inherent in buying a stock with no trading history. This range of values is what’s put on the cover of the prospectus a week or so before the road show so that investors will have an idea of what the company is worth, at least in theoretical terms.
Economics teaches us that prices are set by the intersection of supply and demand. The supply of stock is generally limited, so price depends on demand. Each fund that wants the stock will decide how much (up to a ten percent order) they want, and at times will say, we want none at $x/share, 5% at $y/share, but would take 10% if it’s priced at $z/share. Others and smaller funds will just say no, or how much they’d like to buy. Meanwhile, the lead underwriter’s capital markets department is keeping track of all this in a “book”, hence the term “book-runner”. The goal (and, in fact, some of their art) is to build a book that is over-subscribed (more demand than supply), so the stock will be priced within the hoped for range and, ideally, jump up after it opens on the market as funds buy more to build the amount of stock they want to hold (a position).
In some cases, demand within the range exceeds supply to an extent that the underwriters will “raise the range” and target a higher price, and/or the company will sell more stock. In less happy situations, issues price “below the range” and the price is lowered. Because companies want long-term shareholders, not funds that will sell the stock immediately to gain the 15% (or higher, in the case of a hot issue), the book runner primarily focuses on those funds that indicate they like the story or have a history of being loyal shareholders. I say primarily because, if an IPO is dramatically oversubscribed, the stock will rise immediately, and some funds will sell into that demand (a practice known as spinning) and make a very quick and easy profit. This can be a way for underwriters to reward loyal clients (saying, in effect, “sorry the last IPO you bought didn’t work, we’ll make it up to you with this one” or, “thanks for all that other commission business you’ve given us lately”.) Back in the dotcom days, banks did the same thing for CEOs of hoped-for clients as a way of currying favor (see “Friends of Frank” for details, or ask me in a follow-up post to discuss that phenomenon).
Once the calendar says the road show’s over (and hopefully it’s even close to the same date as we predicted at the org meeting), it’s time for “bring down diligence” and the pricing call. Bring down is simply checking in that nothing material has changed. In my experience, it rarely has. Then the lead banker and capital markets guys have a chat with Mr. HIStalk and his board or other advisors. The state of capital markets over the past few days is rehashed, the team congratulated on what a great road show they put on, the orders summarized, and the lead underwriter recommends a price of $x/share.
Assuming that’s acceptable to the company, the orders are then filled based on an amalgam of size, price, importance of fund to the investment bank, promises made by the funds to buy more the next day (known as the aftermarket), favors owed, and the best judgment of the capital markets group. The orders are thus filled in the morning, the Registration Statement is declared “Effective” by the SEC and HISTalkCo is now a public company (maybe Mr. HIStalk even gets to ring the opening Nasdaq bell). Depending on the state of the broader market that day or week, how strong the book is, and how good the allocations were, the stock than starts to move. Part of the art is to allocate and price it so that there are more buyers than sellers and the stock goes up and everyone is happy. That said, if it goes up too high, the company (and bankers) just left money on the table as they could have sold the stock at a higher price, but a big first day pop gives some bragging rights, so issuers don’t tend to complain too much when that happens.
From this point, all that management has to do is manage their business as before, but pay attention to investors, analysts, and the SEC, while ensuring they always hit the quarterly targets that investors are expecting. Miss a quarter, you can see your net worth plummet. Hit them consistently and it can skyrocket. It’s all just part of the fun that being a public company entails (well, that and Sarbanes-Oxley). I’m stunned, simply stunned that Ms. Faulkner continues to pass it up.
This was a long post, and I appreciate your patience in reading it. Please keep the questions coming, I’ll devote more of the next post to answering them.
Ben Rooks is the founder of ST Advisors, a strategic consultancy offering long-term and project-relationships to companies and financial sponsors. He earned an MBA in healthcare management from The Wharton School of the University of Pennsylvania, has done healthcare IT equity research, and has worked as an investment banker in over 25 successfully closed healthcare and medical technology transactions valued from $40 to $365 million.