Can someone explain what role investment banks play in putting together an IPO?

First, a firm decides to go public. Generally to raise capital, but sometimes for legal reasons (e.g. it has too many different private owners, which is illegal).

Once the firm has decided to go public, they hire a bank. The bank essentially does 4 things. The first is valuation. In other words, the bank decides how much the company is worth. This is an important calculation because it determines how to price the shares (company worth = number of shares multiplied by the price of a share).

The second thing the bank does is underwrite the shares. This means that the bank literally buys the portion of the company that is going to go public and then slice up that ownership into individual contracts (shares).

The third thing the bank does is take the shares of the IPO that it owns and goes on a "roadshow". The bank visits all of the big asset management firms (e.g. pension funds, hedge funds, traditional asset managers) and pitches the stock at the price they've determined. The bank will generally wind up selling all of the shares it plans to on the road show. The asset managers will become owners of the company once it starts trading...and they can choose to sell the shares they purchased on the first day of public trading. This is often very lucrative for the asset management firms who have the connections needed to have access to the IPO before it goes public.

The fourth thing the bank does is keep some of the shares for itself. The bank that IPOs the stock become a market maker for the stock. It needs to keep the stock liquid, so the IPO bank will trade its inventory of shares on the exchange and in off-exchange venues (like dark pools). It may also use the shares to structure other instruments like equity derivatives or ETFs. But, the main thing is that the IPO bank needs to be able to trade its inventory to keep the stock price stable. (This last part can be tricky...often, the stock pops a lot on the first day of trading and the IPO bank makes a lot of money. Other times, like the case with FB, Morgan Stanley had to throw a lot of money at the stock to keep the price stable for the first week of trading. Then the price fell considerably).

Also worth mentioning is that the bank will work with the lawyers on the legal side of things so that the client doesn't have to be as involved. But this is more of a support function than the primary activity of the bank during an IPO.

thanks for that write-up, it explained alot things. So it sounds like the asset management bank and its clients are in a way better position to make money than the average joe stock investor does.

When you say the IPO bank tries to keep the stock price stable, are you saying that they try to float the price of the stock or generate a pop as you say by artificial means?

sugar cane wrote:

thanks for that write-up, it explained alot things. So it sounds like the asset management bank and its clients are in a way better position to make money than the average joe stock investor does.

You are correct, and this is a scummy, scummy business with the somewhat open secret that IPOs are rigged by collusion between investment banks and instutional buyers at the expense of the offering company and retail investors.

Lawsuit discovery has revealed some very bad behavior by investment bankers where the company will be undervalued at the opening bell and sold in large chunks to institutional buyers who can reap outstanding profits at the start of trading due to hyped demand. Part of the profit is then kicked back to the investment bank through commissions on trades with the implicit tit-for-tat that otherwise they won't get allotments of future hot IPOs. One trader involved in the infamous eToys IPO, which gained 300% on the first day of trading, said that his desk existed essentially for the sole purpose of making pointless trades to generate kickback commission.

The incentives are very clear: the investment bank can make a few percent in fees on the overall value of the IPO if they play straight, or they can make much, much more by playing on the same team with the instutitional buyers to steal from the offering company.

dumb wrote:

sugar cane wrote:

thanks for that write-up, it explained alot things. So it sounds like the asset management bank and its clients are in a way better position to make money than the average joe stock investor does.

You are correct, and this is a scummy, scummy business with the somewhat open secret that IPOs are rigged by collusion between investment banks and instutional buyers at the expense of the offering company and retail investors.

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But the clients of the institutional investors are just avg people. Do you have a 401k, a pension, etc? Then your fund manager is one of these asset managers ...

This is a great description. I've been through three IPO's. The investment bankers are the interface with the SEC on top of everything else. A company can't just choose to go public without meeting SEC requirements.

The bankers and legal folks will insure that you do this based on relevant laws.

This is right from a 50,000 foot level but has a lot of details wrong. TO go through them point by point:It's not "illegal" to have too many private shareholders. But once a company gets too many (500...double-check the Securities Exchange Act of 1934 and related rules if you're interested), it is subject to the Act's public reporting requirements such as quarterly 10Qs and annual 10K. Google was in this predicament and rushed to complete its IPO (technically under the Securities Act of 1933) ahead of the '34 Act deadline since it was going to have to start the public reporting anyway. Apparently same situation for Facebook.In any IPO underwritten by the top-tier investment banks, they don't buy the shares until the very last minute so that they don't take on any meaningful risk of ownership. In other words, the purchase effectively isn't done until the buyers are all lined up. The roadshow is in advance of the actual sale to the underwriters and is happening while the underwriters are lining up buyers. It's also usually a syndicate of underwriters as the underwriters only want to underwrite as much as they can place with their buyers. For them, the issue is reputational: they don't want be the bank that can't get deals done since they would potentially lose future business.I've been on the buy side too: we "indicate interest" of a certain amount of shares but there's no pre-selling by the underwriter (firm commitment to sell/buy) since that can't happen until the deal is effective (i.e. SEC approval).Valuation is set / negotiated between the company and the bank and can be a big tug-of-war. The Company wants the highest price possible (obviously), while the bank wants to be sure to be able to sell the entire deal and doesn't mind seeing a big pop on the 1st day price (reputational, etc). Price can also change during roadshow based on how much interest they're getting. There are probably some market theorists who can explain better than I can, but the 4 things the banks deliver are: (1) reputation (companies like having a Goldman or a Morgan Stanley as lead underwriter), (2) ability to complete the deal and ideally sell to good buyers (think Fidelity), (3) provide analyst coverage, and (4) serve as a market-maker. I'm least experienced with the technical details of the last one, but banks don't usually hold for themselves very much of the offering because they don't want the risk of ownership. They can get more shares via the underwriters' overallotment option ("green shoe") that is standard in deals. The green shoe is the right of the underwriter to buy more shares at the IPO price for a certain time period post-IPO.