Today’s FT has a special supplement on equity capital markets, the part of an investment bank that helps companies to raise equity capital. One article mentions the well known fact that IPO fees remain very much unchanged for year after year. In the US the average is 6.7% – that means that if you raise $100m you pay $6.7m to the underwriting investment bank. That’s on top of legal fees (about $1m) and the time management spend on preparation. The US is supposedly the world’s most efficient capital market but these fees are more than double those in Europe and Asia.
In any market where there is persistently no price competition, there are two likely causes. One is a lack of competition and the US IPO market is, in effect, a tight oligopoly where few foreign banks have been able to break in. Secondly, competing on price may signal lower quality. Until recently all hedge funds charged 2% and 20% (a few charged more). Any that offered lower rates might have seemed to lack confidence in their investment ability. Many professional service firms barely compete on price for similar reasons.
So it’s hard to square the static IPO cost with a claim that this is a highly competitive industry. But how to get more competition? It’s very tough when people care about reputation and for many people the IPO is one of the most important events of their careers – so they’re not motivated to shop around for what might be an inferior service.
Which explains why, when volumes are high, equity capital markets is a very profitable business – but very hard work for the investment bank employees who are rushed off their feet.
If we agree free-market prices are the best mechanism to collect & disseminate information, then what manner of price discovery coordinates behavior most efficiently?
Whenever I talk to anyone about regulation, I start with Hayek. To me, the reason why we use free markets to allocate scarcity is that it’s really hard for a single, central actor to possess all information present in a complex system. In a decentralized economy, everybody’s unique knowledge and actions get sucked up into prices, which coordinate individuals like traffic lights at an intersection. When prices are at “true value”, capital is properly allocated and the economy grows. However, when prices are distorted, capital is misallocated and coordination fails.
I saw the latter many times on Wall St. There can be many reasons for distortions. Oligopolistic pricing by Banks in OTC markets may have reduced transparency & led to mispricing of assets. The raw size of firms leads to immense regulatory capture, which affects everything from interest rate setting to capital requirements (I admit a major problem with arguments for regulation is the assumption of a priori knowledge on risk & relevancy of targeted assets). Another reason for distortion may be structural misinterpretation of information – the propagation of bad info, stubborn rumors & stylized facts that clog functioning prices. My favorite phrase: gossip spreads quicker than calculus.
In a capitalistic society, regulation is supposed to identify & mitigate price distortions by improving market design. Anti-trust, fraud, externality-related taxation and transparency are all good ideas in abstract. However, I never hear anybody really talk about market microstructure. Who are the players; what is the step-by-step execution of transactions; what is the matching-mechanism and how does price discovery evolve; how do certain markets differ from each other (labor markets for lawyers vs firemen vs sorority bidding)?
Norms and repugnance also play their part in shaping matching mechanisms. Take liver shortages as example. American aversion to buying/selling of body parts severely constricts liver supply by replacing a continuous pricing mechanism and sufficient freedom to trade, with a discrete weighted lottery system and no trade. If we focus purely on quantity of asset, this system is inefficient. However, if norms & repugnance are constitutional agreements on which matching-mechanisms are created, the market may very well be appropriate for that society. The mere existence of black markets, while representing inefficiencies in legal markets, do not necessarily justify the trade. Human trafficking is a relevant example.
What we need to start flushing out, is how the market is actually organized. I don’t mean to suggest that regulators have perfect foresight, or even the ability to recognize clearly what Wall Street attempts to understand in the guesswork that is the art of valuation. However, if there is some feature within the financial structure that aggravates an obvious distortion in price signaling, then we need to have non-discretionary rules to make sure it gets corrected (I emphasize non-discretionary because I’m not convinced that 1) regulations will be implemented during good times if there was a choice 2) regulations wouldn’t be haphazardly directed at arbitrary firms, leaving the survivors the new oligarchs).
In it’s core, the Efficient Market Hypothesis deals head on with information. I just think that it assumes’ certain types of noise have no staying power, and certain pathways for the transmission of information are clear. To me, this would be like assuming the ocean around your boat isn’t full of fire coral, just because it isn’t jutting out.
i’m a finance student and really can’t imagine why the cost of IPO or M&A is so huge. For a specific case, the salaries of the group, the air-tickets for the roadshow, the access fee for database, maybe..etc., These operating expenses are less likely to pile up millions of dollars. If someone can establish a cost-efficient small investment bank to beat these big rivals, that will be great.
Very shorts, simple and easy to understand, bet some more comments from your side would be great
I didn’t understand the concluding part of your article, could you please explain it more?
ECM is, like M&A, a “fixed cost” and cyclical business ie you need to maintain a minimum number of people whether you have a lot of deals or a few. If there are few deals you make a loss. If there are lots of deals you make a good level of profit and everybody is very busy. In a real boom you make a great deal of profit but you don’t want to take on too many people in case you have too many for the inevitable subsequent downturn. So the people working there work very long hours to process all the deals but at least they get good bonuses. ECM doesn’t use much capital – banks do underwrite the offerings (usually) but very rarely do they actually lose from this so the capital allocation is not that high. So overall, if you’re one of the charmed circle of credible ECM players, you make a very good return on capital from this business, even allowing for the slow years of the cycle.
You have to express more your opinion to attract more readers, because just a video or plain text without any personal approach is not that valuable. But it is just form my point of view