Choosing the Right Investment Banker
from Summer 1999
by Randy Myers
Imagine: The high-tech startup company on whose board of directors you sit is finally ready to go public. Four prominent investment banks are bidding to underwrite the deal. Two tell you your company is worth $500 million. The other two peg its worth at nearly $1 billion. From which camp do you hire?
Venture capitalist Rick Frisbie was recently confronted with this exact question. The answer at which he and his fellow board members arrived might surprise you.
“Your first response might be to go with one of the banks that values your company at $1 billion,” says Frisbie, managing partner of Battery Ventures in Wellesley, Massachusetts. “But we went the other direction. We didn’t believe the investment banks that were tossing out the higher price. They weren’t as established in our sector of the market, and we felt they were trying to buy our business with an inflated estimate of the company’s value. We thought the two banks at the lower end had a better understanding of what companies like ours are worth.”
Across corporate America, board members wrestle with issues like these every day—especially in the high-tech sector, where Internet business models have thrown traditional valuation measures out the window. And while it’s the management team that’s usually on the front lines of any search for an investment bank, directors play an important part in the selection process. “Any transaction that requires an investment bank is going to be of large consequence to the company,” says Philip B. Livingston, president and chief executive officer of the Financial Executives Institute in Morristown, New Jersey. “Boards must be diligent in their effort to make sure that those transactions are done well.”
Easily said, but what about putting it into practice? How do you ensure that you’re getting the right investment bank? Is bigger always better? What if the bank you’re considering has done work for your competitors? And should you stick with the same firm for every deal or spread your business around? There is no universally correct answer to any of these questions, but talks with bankers, corporate directors, attorneys, chief executives, and CFOs do yield some helpful guidelines.
Bigger isn’t always better.
Sometimes, of course, there’s no substitute for size. “A huge M&A transaction or a major underwriting will need all the bodies that a large investment bank can throw at them,” says Jeffrey Hooke, formerly an investment banker with Lehman Brothers and now a partner at Emerging Markets Partnership, a $4 billion merchant banking firm in Washington, D.C. “If your transaction is international in scope, it also helps to have a firm with offices overseas.”
The cachet of a name-brand bank also can be valuable in its own right. Convince a bulge-bracket firm like Morgan Stanley Dean Witter, Merrill Lynch, or Goldman Sachs to underwrite your stock offering, and their strength and success will most likely reflect on your company. “It’s success by association,” says Fiona Ross, senior managing director and head of the finance practice for PR giant Hill & Knowlton in Los Angeles. “Who you go public with is very important for the first year or so after the deal.”
Before you succumb to the glitter of a golden name, though, make sure you’re not buying the banking equivalent of fool’s gold. If a big firm isn’t legitimately enthusiastic about your company and the prospect of future business from you, you’re not likely to get much of its attention once the deal is closed. That attention is especially important for an equity offering, when you’ll want ongoing research coverage from the bank to woo and keep institutional investors and trading-floor support for your stock.
“As a practical matter, you’d like to have as prestigious a bank as you can attract,” says Samuel L. Hayes, Harvard University professor of finance, “but only consistent with the level of service it’s willing to offer.” Adds James M.P. Feuille, head of investment banking and capital markets for Volpe Brown Whelan & Co., a San Francisco-based investment bank: “You have to be realistic and ask yourself how important your transaction will be to the bank and where your company would fit in its pecking order.”
Bear in mind, however, that if you’re not looking for underwriting muscle, a big bank may not necessarily be the best bank for you. “Certain bankers are good at certain things, and size in many cases is not an issue,” says Frisbie. “For example, there’s a very, very good investment banking firm a lot of people haven’t heard of—Broadview Int’l in Fort Lee, New Jersey—that is top-notch if you happen to have a software company you’re interested in selling. Small firms like this can often provide you with excellent service, especially in the mergers and acquisitions area.”
That’s what Mike Shultz, chairman, president, and chief executive officer of QuestLink Technology, found when he started shopping for an investment bank a year and a half ago. His goal was to find a buyer for his company, an online provider of technical information and products for engineers. “We set about to find an investment bank that was right for our organization, one that understood our business and had analysts and relationships within our industry,” Shultz says. “That brought us down to about half a dozen banks out of what must be 30 or 40 you could probably name. We assumed the big guys wouldn’t be interested in us—we figured our company would only sell for about $20 million—so we sliced those guys off the list right at the top.”
Ultimately, Shultz and his fellow board members narrowed down the choice to two banks with substantial experience in their industry. One was a small firm from the Midwest, and the other, which they eventually chose, was Needham & Company out of New York City. “We wound up not with big generalists, but with more boutique banks because of their industry expertise,” Shultz says. “These firms were recognized as being significant banks in this very narrow area where we compete. Needham was the one that was able to show us the greatest variety of options with the most likely positive outcomes. It took a great deal of interest in what we were doing. It flew in and did the due diligence with us, getting into the details of our business, understanding all the valuation propositions, all the marketing opportunities, and the unique things our company had—all the things you would think it should do to properly represent the company in a potential sale.”
People matter.
Whether the size of the investment bank you hire is important to you or not, experts say it’s often the people you’re working with who will determine the success of the engagement. “You should be interested in the person as opposed to the entity,” advises Dennis Block, co-chairman of the corporate and litigation departments of the New York City law firm Cadwalader, Wickersham & Taft. “Large investment banks tend to have people with great experience and talent, but if you’re the director of a smaller entity, you might not get the firm’s best people.”
Except when it’s trying to win your business, of course.“When an investment bank is trying to sell you its services,” warns Hooke, “it sends in the senior managing director to talk to your board. And everyone is impressed, because the senior managing director has a good resumé and talks a good game. Then, as soon as you sign the contract, he assigns a junior person three or four years out of Wharton to handle the deal. It’s a common problem.”
To avoid it, get a commitment from the bank about who will spearhead your assignment. “After making a commitment,” Block observes, “most people will stick by it.”
When QuestLink chose Needham for its M&A assignment, one of the reasons it did so was the ability to work directly with John J. Prior Jr., a Needham partner who, in Shultz’s words, “had 20 years of experience in the business, had done lots of deals, including a significant number of large deals, and who really dug in deep to understand the company.” How deep? When Prior came back to QuestLink, he advised the board not to sell the company at all but rather to go through another round of venture capital financing.
“I’m grateful I had the good judgment to hire them,” Shultz says now. “If we had sold the company at that time, I think we would have gotten a little more than $20 million. Since then we’ve had a recent market valuation, and we think we’d fetch well more than $100 million. And I wouldn’t sell the company for less than $250 million.”
The analyst could matter most of all.
If you’re asking a bank to negotiate a merger or acquisition, fend off a hostile takeover, or come up with a creative way to restructure your balance sheet, you’re going to be very interested in the banker who actually leads the team handling your account—just as QuestLink was interested in John Prior. You’ll want that banker to have done similar transactions for companies in similar industries and be somebody whose involvement can be counted upon.
If, on the other hand, you’re asking a bank to underwrite a stock offering for you—especially an initial public offering—that banker will take a back seat in the success of your deal to an even more influential player: the analyst who will be covering your stock once it’s been issued. “In today’s world, it’s critically important that you have an analyst who follows the industry in which you compete and who has substantial credibility,” says Mark N. Kaplan, until recently a partner in, and now of counsel to, Skadden, Arps, Slate, Meagher & Flom, a prominent New York City law firm that handles a big chunk of Wall Street’s corporate finance and M&A work. “Without that, it’s much harder to get a deal sold.”
“What makes an IPO successful today is the strength of the bank’s research department in your industry,” agrees Frisbie. “To cite one example, Salomon Smith Barney is probably the dominant firm in the telecommunications services market right now because of the research coverage it gets from Jack Grubman and the team of analysts he has working with him. If you get his stamp of approval, his institutional following will ensure the success of your deal. On the other hand, if you can’t get in to see Grubman, then you don’t want to use his firm—even if his corporate finance guys want to do your deal.”
The challenge today, of course, isn’t just finding the right analyst but landing one who stays on the job once you’ve found your bank. The best analysts jump from firm to firm these days almost as rapidly as professional baseball players change teams—especially in the red-hot Internet sector.
“It happens a lot,” says James Feuille. “If somebody chose a firm just for the analyst and that analyst leaves, the company usually doesn’t proceed with that firm. But if the analyst was only part of the equation, it often will proceed and give the bank an opportunity to replace the analyst with somebody equally capable. Of course, it also depends on how far into the process you are. If you’re already on the road show, you don’t have much choice; you stick with it. If it’s pre-road show, you can switch, but there are other considerations, too. How hot is the market? How much time are you going to lose if you bring in another banker? In a lot of situations, once you’ve started the process, your hands are tied for other than contractual reasons.”
The right banker should know your competitors—but not too well.
If you’re choosing a surgeon to do open-heart surgery, you want one who has already done open-heart surgery on lots of other people with your condition. The same logic holds if you’re choosing an investment bank—usually.
“If you’re asking the bank to do a valuation of your company, or part of it, you’ll see the business it’s doing with your competitors as directly assisting its valuation of you,” says Harvard’s Hayes, who sits on the board of Tiffany & Co. “If, on the other hand, you’re asking an investment bank to help you find an appropriate acquisition, you’ll want reassurance that you’re not taking second place to another client in the same industry. You don’t want to be wondering who it’s going to take the plums to first.
“Similarly, if you know this bank also has a long-standing relationship with one of your competitors, you’ll be cautious about using it for defense against a hostile takeover because of the possibility that it might somehow steer you into an alliance with its preferred client in the same industry, which may not be optimal from your point of view.
“Finally, if you’re doing a routine, investment-grade debt offering, you’re going to be looking for the best rate, and you don’t care about other stuff.”
Good things happen to good customers.
A few decades ago, ties between companies and their investment banks often reflected personal relationships between CEOs and investment bankers. While relationship banking hasn’t totally disappeared, Hayes says it’s secondary to business needs.
“In today’s market,” he says, “it would be admiration for the skills of a particular investment banker, rather than friendship, that might cause the company to steer business in one direction or another.”
Still, there’s no denying that, as with any business, repeat customers tend to get better service. The same is generally true of investment banking. If you want your bank to spend time and energy devising ways to help your company, says David Boris, director of investment banking for Ladenburg, Thalmann & Co. in New York City, it needs to know it will be rewarded for the effort.
“David Ogilvy [legendary founder of the Ogilvy & Mather advertising agency] said a client gets the advertising it deserves,” agrees Kaplan. “This is no different. If you let me in your life, I’ll do a better job for you, whether it’s as your lawyer or your investment banker. If you have the right service provider and make them part of your team, that reciprocal loyalty and attention you receive outweighs whatever benefit you get from having your door open to new banks. Yes, you keep your door open. But you have core relationships with your service providers that, in the end, will make your business better.”
Still, Boris concedes that it’s management’s job to enhance shareholder value and that, under certain circumstances, it might behoove a company and its board to consider working with a new bank. “There’s no monopoly on good ideas,” he says. “They may come from your bank or from somewhere else.” When they do come from somewhere else, and you choose to act on them, most investment banking experts agree that it’s only fair to let the originator lead the transaction.
An excellent case in point: Niagara Mohawk Power Corp.’s decision to hire Donaldson, Lufkin & Jenrette to lead its $3.45 billion junk bond offering last year. The deal allowed Niagara Mohawk to buy out onerous power-purchase contracts it had entered into with independent power producers and avert a potential Chapter 11 bankruptcy filing. Niagara Mohawk chose DLJ over its traditional banker, J.P. Morgan & Co., because DLJ had proposed the solution.
“To the extent that an idea is valuable and you want to adopt it, you typically will go with the bank that produced it,” concurs Kaplan. “At the very least, it gets co-managership of the transaction.”
The experts agree that the size of the fee falls very low on the list of criteria in choosing an investment bank. “Costs are not likely to vary much from firm to firm,” observes Frisbie. Indeed, the Justice Department recently launched an investigation into the possible fixing of underwriting fees at major investment firms. “As a director choosing an investment bank, what I’m looking to do is create long-term value and make the right decisions for my company. So a 1% difference in a banker’s commission doesn’t matter to me.”
You may find, though, that some major banks may insist on serving as the lead underwriter in a public offering, putting them in a position to reap more of the profits than a co-manager. When you hear such a bank say, “We’d like to alter the economics of the deal,” the standard translation is, “We want more of the pie.” The bank hopes to get it either by bumping up its fee or by reserving a greater number of shares for marketing by its firm rather than by the co-managers or other firms participating in the sales syndicate.
In the absence of any hard-and-fast rules for choosing an investment banker, Morton Pierce, chairman of the mergers and acquisitions group at the New York City law firm of Dewey Ballantine, advises board members to give serious attention to personal chemistry. “At the end of the day, when you’re talking about a service business, whether it’s law, banking or barbering, it boils down to who you’re working with and how comfortable you are with those people,” says Pierce, who sits on the board of NetCare Health Systems Inc., a Nashville-based hospital operator in registration to go public.
Of course, there’s no harm in trying to tilt the odds in your favor. Frisbie, for example, suggests that you “look at other companies a bank has handled over the last 12 to 24 months and try to find out if what it told those companies it would be able to do for them is what it, in fact, did.”
“You should also try to align the banker’s interests with yours,” says Michael E. Gibbons, senior managing director and founder of Brown, Gibbons, Lang & Co., a Cleveland-based investment banking firm that specializes in mergers and acquisitions work. “Set targets, and don’t be afraid to pay a little more for more performance. That will drive an investment banker to do better.”
Ultimately, your happiness with your investment bank is likely to be in close proportion to the time, energy, and effort you invest in choosing it.
Good hunting.
