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Can Investment Banks Ever Have Truly Independent Ratings Coverage?

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Editor's note: This story was originally published by Minyanville on March 5, 2012. 

An initial public offering, or IPO, is an exhaustive process of hard selling. For issuing companies, CEOs and other top executives travel the country presenting their case to institutional investors through dog-and-pony road shows. IPO underwriters, too, are busy coordinating such road shows and engaging their own sales forces to make sales calls to institutional investors, fighting for allocations.
Given that IPO bookrunners have a duty to help their clients raise as much money as possible, investment banks unsurprisingly are very bullish when hyping the prospects of their clients’ stock in pitches to investors.
Usually, this enthusiasm about an issuer’s stock is also felt by the bookrunners’ research departments. This should be a logical expectation. After all, the sales forces that are out energetically selling IPO shares to institutions have undoubtedly been briefed by their equity research analysts through teach-ins as the IPO was being launched, and these briefings form the investment highlights for the sales force to pitch to potential investors.
This is why it is reasonable to expect that once the mandatory 40-day quiet period is over, research analysts at the bookrunners will initiate coverage with buy recommendations for those companies. Many investors indeed trade according to this assumption; in the few days leading up to the expiration of the quiet period, fresh IPO stocks generally enjoy a pop in their share price.,
This was the case with LinkedIn (LNKD). After its headline-grabbing IPO in May 2011, the company’s shares soared by 107% on the first day and then plunged steadily for a month to go from a high of $122.70 to a low of $60. Beginning June 28, a few days before the quiet period for its bookrunners expired, however, the stock shot up 12%. While there was an overall rally in the stock market at that time (In this same period, the S&P 500 rose by 4.5%),  a large part of LinkedIn’s rise was due to expectation of positive coverage, which it received, as all four lead underwriters -- UBS (UBS), Morgan Stanley (MS), JP Morgan (JPM), and Bank of America (BAC) -- initiated coverage of the Internet company with buy recommendations.
However, not every bookrunner will initiate coverage with a buy for its client. A 1999 academic study on IPOs issued between 1992 and 1993 by Roni Michaely and Kent Womack revealed that analysts affiliated with IPO companies issue 50% more buy recommendations than nonaffiliated analysts do, which means that sure, underwriters are more than likely to issue buy recommendations, but that is not guaranteed to happen. Yes, sometimes, after all the rah-rah stock selling to their investors, research analysts at bookrunners will launch coverage of IPO clients with contradicting hold ratings.
In the past couple of years, there have been a few such eyebrow-raising stock coverage initiations by IPO bookrunners. One of them was Groupon (GRPN), whose stock fluctuated a lot after its $20-a-share IPO. Six of Groupon’s underwriters assigned hold or neutral ratings initiations. Lead underwriter Morgan Stanley, which assigned an equal weight rating at the end of Groupon’s quiet period, said Groupon had “prime mover status and scale,” but also questioned the long-term viability of the company, pointing out that “Groupon’s competitive advantage might be eroded as merchants became more sophisticated on the Web and rivals attacked its market share,” noted the New York Times.
Another tech stock, Renren (RENN), which went public in May 2011, got an equal weight rating from underwriter JP Morgan, which said that the Chinese social network’s then 77 forward P/E  “appears demanding … versus online services leaders such as Alibaba, Baidu (BIDU), and Ctrip (CTRP),” as Barron’s noted.
Similarly, bookrunner Goldman Sachs (GS) gave Cobalt (CIE) a neutral initiation, saying in its report that though the energy company “is well positioned to benefit from our bullish crude oil view given its potential to show sizable oil resource growth,” the bank would “prefer to wait before becoming positive on the stock.” It should also be noted that Goldman Sachs is one of the private equity sponsors of Cobalt.
These surprising coverage initiations by bookrunners prompts one to wonder: Just what was the sales team spewing to investors before then, if their research analysts are less than convinced about the prospects of the stocks of their clients? What reason would make a fee-receiving underwriter recommend a rating less than a buy for a client?

“This is perhaps the most blatant form of misrepresentation imaginable,” says Andrew Schrage, co-owner of the website Money Crashers Personal Finance and a former portfolio analyst at Discovery Group. “Underwriters are appearing at road shows, racking up large sales of stocks, only to issue a less-than-stellar rating after the quiet period ends. This type of behavior happens in varying degrees on a consistent basis due to the built-in pressures surrounding IPOs and underwriters.”
In an email interview, Aswath Damodaran, a professor of finance at the Stern School of Business at New York University, agreed that it was a contradiction for lead underwriters to be out there selling IPOs to investors at road shows and then initiating coverage of their clients after the 40-day quiet period with a hold or a neutral.
However, he also says that this contradiction is “pretty transparent” and that “any investor who does not see this conflict and adjust for it accordingly deserves what he gets.”
Granted, these initiations occur 40 days after the IPO, so it is possible that that lead underwriters had observed a change in a company’s prospects that warrants a neutral rating even in spite of their efforts to sell their clients stock prior to pricing. Additionally, the price of a stock could have traded up to a level during the 40-day quiet period at which the analyst feels the stock is properly valued. Sometimes, too, simple ratings policy at the bank’s research department may require a lower rating. For example, research departments at some investment banks limit the amount of buy ratings each analyst can have outstanding at any given time in their respective coverage universes.
While it may appear to be a potential conflict that one department of a bank is touting the investment highlights of a stock to fill an order book as another department of the same bank issues a report that demonstrates reservations of the stock, other more egregious conflicts may also exist that can cast doubt on the independence of an analyst's price target or rating. Some investment banks, for example, have underwritten and provided research coverage for IPOs of companies that they own through their private equity arm. This should raise questions on many levels:
“If the firm underwriting the IPO also holds a private equity stake, it will be tempted to put forth excessively positive research and reports that will make a stock appear attractive to investors when it may, in fact, not be so rosy,” comments Schrage. But the conflict doesn’t end there:

While this aspect is to the benefit of the underlying company, there is another conflict that will disfavor that company. That is, if the PE arm is being pressured by its own investors to realize gains and return funds to them within a predetermined time frame, it may cloud the PE firm's advice to the underlying company such that it may recommend that it hold an IPO at a price that undervalues the company simply because that will allow the PE firm to profit. Doing so can severely cut IPO gains for the underlying company.
To Schrage, such a contradiction is ultimately built into the system. “One can argue that once hired, it is an underwriter's fiduciary duty to obtain as high a price as possible for the stock's IPO. Once the quiet period has come to an end, it is then the bank's fiduciary duty to provide the most accurate coverage reports and ratings for investors.”
Of course, conflicts of interest in research at investment banks are nothing new. Top Wall Street investment banks famously agreed 10 years ago to a historic $1.4 billion settlement for charges of providing biased research to investors during the heady days of the dot-com boom. One result of the settlement with the Securities and Exchange Commission and the investigation team led by then-New York Attorney General Eliot Spitzer was that investment banks had to set up ‘Chinese walls’ between their research and investment banking departments so that the two would remain independent of each other.
What advice does Damodaran have for investors then? “Don't buy the sales pitch at the time of the IPO they are selling or the recommendations of these companies by equity research analysts at these investment banks after the IPO.”

Twitter: @sterlingwong
POSITION:  No positions in stocks mentioned.