The development of information technologies in the banking industry has caused a proliferation of investment platforms which help companies find their investor. Such services soon occurred to be a worthy alternative to the bank’s capital search service. Meanwhile, numerous startups have begun to postpone their IPO acquisition, while some of them have even decided to remain private and continue to develop projects with the capital received from venture funds.
However, this has dealt a blow to another key source of income for investment banks.
According to a study conducted by the consulting company Ernst & Young, the number of U.S. public companies decreased from 290 in 2014 to 112 in 2016. Further, according to Seeking Alpha, the profits of investment banks, gained by holding IPOs over the same period, declined by 10%, from 25% to 15%.
According to Vlad Miller, CEO of Ethereum Express, such decline is natural given that more companies launch the market independently. He said:
“Today, many elements of the traditional financial system, not only investment banks, are losing their former importance in the market. This is a natural process we have seen before. For example, you do not need many buttons on the phone; one can perform multiple functions. You do not need investment banks to conduct IPO; you need a strong brand. Real products with a large community successfully enter the market without resorting too much to financial institutions as it was before.”
The usefulness of investment banks for the companies that hold IPO is the special relationship they share with institutional investors and their ability to pitch a company for which the bank acts as the organizer of the issuance of securities. However, if there is a “selling” name, such special services are no longer needed. For instance, companies such as Slack (NYSE:WORK) or Spotify (NYSE:SPOT) went public without any assistance from investment banks. At the same time, they feel quite confident in the market.
In addition to the IPO, the preparation and conduct of M&A take a significant share in the profits of investment banks. Profit from this type of activity decreased, according to KPMG studies, from 43% in 2015 to 34% in 2018. This is partly because of the emergence of numerous boutique companies specializing in M&A in the SME industry (up to $100 million worth of business), where the average transaction size — $20-30 million.
Some small and medium-sized enterprises do not involve a boutique company or a bank in the purchase of the target company, preferring to negotiate directly with the owners and hire external lawyers for a specific transaction. Thus, the company significantly reduces the cost of consulting services and negotiation. With the availability of direct lending funds, the number of which is increasing every year, it becomes much easier to find additional financing for the M&A transaction, which also works against investment banks.
Vivid examples of conducting transactions directly in the higher price segment are the purchase of WhatsApp by Facebook (NASDAQ:FB) and the purchase of Beats by Apple (NASDAQ:AAPL). With an average bank commission of 3-4%, the amount of savings is impressive.
Another key source of investment bank profits is money management. In this type of activity, hedge funds and private companies specializing in asset management compete to provide customers with more favourable trading conditions. The situation is also aggravated by the difference in the yield of ten-year and two-year U.S. Treasury bonds, namely: the yield of short-term bonds is higher than long-term ones, which signals an impending recession. The current situation as a whole reduces the risk appetite of companies, postpones investments for an indefinite period and encourages them to enter protective assets.
What does it mean for banks?
What should banks do in the face of declining profits and increasing competition? Adapt and transform or leave the market. The introduction of automated trading platforms allows for withstanding competition and lower rates for trade, which attracts investors with a large number of trading operations.
Banks can also automate that part of the IPO that they are massively hiring entry-level analysts for, or replace non-profitable activities such as IPOs or M&A while focusing on money management. Individual banks, like Citigroup (NYSE:C) or Deutsche Bank (NYSE:DB), remain full-cycle banks, no matter what.
Over the next 10 years, we will see how successful the changes in the models of individual banks will be and what the automation of simple banking operations will lead to, as well as which of the players will leave the industry if the recession becomes obvious.
What does it mean for IPO investors?
The refusal of some companies to resort to banks, and others — to hold IPO, cannot but affect investors. Especially when the market witnesses signs of a bubble that may soon burst. Among these signs is the failure of some IPOs in 2019 and the fall in the price of their shares after the stock exchange listing.
Thus, for example, on November 1, Pinterest (NYSE:PINS) stock prices fell for the first time below the IPO price after the company reported a sharp increase in losses. The fall in PINT reached 24% on the New York Stock Exchange.
Data by YCharts
The IPO of the automotive giant — Uber — has not gone smoothly as well. Back in 2018, Goldman Sachs Group (NYSE:GS) and Morgan Stanley (NYSE:MS) suggested a $120 billion valuation of the aggregator’s business, but before the stock exchange listing, in April of this year, Uber (NYSE:UBER) reduced the valuation to $80.5–91.5 billion. In May, one day after its stock exchange listing at a price of $45 per share, UBER dropped to $42 with the record-breaking downfall to $25.58 in early November.
Data by YCharts
Mining equipment manufacturer Canaan (NASDAQ:CAN) raised $90 million at its IPO, instead of the planned $400 million. Many attribute this to the exit of Credit Suisse (SIX:CSGN) Group (NYSE:CS), Canaan’s leading underwriter, just before the start of the IPO.
As a rule, the main reason for the IPO failure is that investors ignore companies' growing debts. Take, for example, electric vehicle manufacturer Tesla (NASDAQ:TSLA) and Snap, the developer of Snapchat's social network. Since their successful debut in the past decade, both companies are still burning a huge amount of money and are far from the threshold of profitability.
However, there are also winners in this game. Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOGL), and Facebook have made their long-term investors profitable, and their stock remains an attractive investment. At the same time, it is important to note that not all IPOs are successful, especially if the value of their shares is due solely to hype.
Beyond Meat (NASDAQ:BYND) is one of such example — its shares have grown more than 500% since the company entered the stock exchange market in May. However, while the company has enormous potential and may soon become profitable, the rapid growth makes its shares vulnerable to a significant correction.
Data by YCharts
Although it is almost impossible to predict which of these companies will be successful and which will create problems for their investors, history teaches us that even a successful IPO is not a guarantee of the long-term viability of the company. Bloomberg has recently conducted an analysis of companies that made their debut after the financial crisis and surged more than 100% on the first day of trading: most of their stocks have since fallen.
Participation in an IPO may be a good solution in the short term, especially given that much money is spent by hunters for new ideas. However, this euphoria cannot last forever. Investors should consider these offers with a healthy share of scepticism. Stocks cannot continue to grow at such a pace, and companies still have a long and difficult path to stability and profitability.