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Can Investment Banks Ever Have Truly Independent Ratings Coverage?

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Sometimes, after bookrunners enthusiastically sell an IPO stock to investors, their research analysts initiate coverage of the stock with a neutral or hold recommendation, revealing an inherent contradiction.

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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?

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No positions in stocks mentioned.
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