The Anatomy of New Issues

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Ever wonder why your financial advisor calls you with a recommendation to purchase the latest financial product? And whether it really is good for your investment portfolio?

Here is an attempt to explain some of the activities that precede the urgent call from your advisor alerting you to the opportunity to participate in the latest stock, bond, or mutual fund. In particular, we will focus on financing known as a “bought deal.”

Back in the dark ages, before online trading, discount brokerage firms and bank-owned investment dealers, many blue chip companies had executives from investment dealers on their boards of directors. Once a corporation decided it needed to raise more capital, it used its contacts at brokerage firms and entered into an underwriting agreement to issue new shares of the company. Large issues required the use of a syndicate of dealers and a fair price was established and stock was marketed and sold on a best-efforts basis to institutional and retail investors. A “best-efforts basis” meant the dealers would do their best to raise the capital but would not guarantee the success or timing of the issue.

Corporate presentations were made to investment advisors (nicknamed “dog and pony shows”) informing them of the latest activities of “XYZ Corporation” and advisors sometimes had several days to consult with their clients on the suitability of an upcoming issue. Internal information, known as “green sheets,” highlighted key points to ensure investment advisors had sufficient information to make recommendations. Investors buying stocks received a discount to the current trading price and were exempt from paying commissions because newly issued stock is issued as a principal transaction.

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Don’t fret: the advisor received commission directly from the issuing corporation, and the investment dealer received a corporate finance or underwriting fee to compensate for their time and advice. In addition, most firms gave advisors a reasonable period of time to market as many shares as suitable for their clientele. Any excess stock was returned to the syndicate, either to be placed by other advisors or not issued. The laws of supply and demand created an equilibrium of price and volume, and it was usually a win-win scenario for everyone. The syndicate of underwriters charged a fee to the corporate issuer and it behooved the individual investment dealers to hire analysts to provide ongoing advice and coverage of said issues.

However, in a capitalistic society, all good things come to an end. After 26 years in the investment industry, historical events sometimes get hazy, but to my recollection, it wasn’t long after the Canadian banks started buying investment dealers that the old-fashioned way of doing business evolved into a newer, faster method of raising capital. Companies rarely use the old method of taking days or weeks to raise capital. Instead, deals are done overnight and sometimes a virtual bidding war develops to see which firm will write the biggest cheque and keep the lion’s share of the underwriting fee.

Advisors now have anywhere from 15 minutes to a couple of hours to express an interest in the latest stock offering. This puts many investment advisors wishing to participate in stock underwritings someplace between the fire and the frying pan. They have little opportunity to assess the merits of the issue and discuss the benefits with their clients but, instead, have to estimate how many shares their collective clientele would be willing to buy and then place an order with their branch manager or syndication department. Once the books close, actual allotments are given out to advisors. The advisor then spends the remaining part of his day calling clients and obtaining orders. But wait — the story gets better.

The departments at an investment firm involved in the distribution of a financing have different names at different firms. Corporate finance, investment banking, and syndication are three areas that work closely with the institutional department (these advisors deal with the large pension funds and mutual fund companies) and the retail department to divide up the allotted supply with the indicated demand. There are special rules (exemptions) for institutional accounts and, due to their importance to an investment dealer’s profitability, they generally get the lion’s share of most stock offerings. As a result, most retail advisors only get a portion of their indicated interest when a stock has been given a large discount and is well priced, but they get a full allotment if the institutional accounts turn their nose up at the deal.

The corporate finance department almost always wins. They receive compensation regardless of how the future price of the issue performs. For the retail advisor, it’s a different story. Under a bought deal arrangement, the investment dealer has prearranged to pay the issuer the full amount of the funds raised, so a retail advisor is usually financially responsible for any unsold stock he has been allocated.

There are eight questions to ask your advisor when you receive a call concerning a financing. Is this a bought deal or best efforts basis? What percentage of the deal did your firm underwrite? How many shares did you ask for? How many shares were you allocated? How much dilution will result from this financing? What is the discount to the last traded price? What is the use of proceeds? How much compensation are you getting?

These questions are designed to determine the future performance of bought deal financing. If your advisor hasn’t started stuttering uncontrollably, you should take some comfort on the success of the issue, but you can also ask him to research the price performance of the last three issues his firm has underwritten. If the line gets disconnected, chances are it might be better to avoid this share issue.

Everything you want to know about an issue is available at www.sedar.com. Unfortunately, much of the information may not show up until after an issue closes. However, you can ask your advisor for the names of some recent financings; go to www.sedar.com, and review the documentation regarding the fees and expenses of each issue.

In a future article, I will describe my favourite type of deal: the order books open at 4:30 a.m. Pacific time and close at 5:00 a.m. Pacific time. Anyone awake can participate, but how many people do you know working those hours?  Also on the future article list is an Initial Public Offering, plus market stabilization activities like “greenshoe and broker warrants.” Many of the same procedures apply, but investors have a chance to review a preliminary prospectus and advisors are provided with green sheets and, in many cases, a corporate presentation. You will have days or weeks to make a decision.

Finally, if a financial advisor only markets mutual funds or segregated funds, you might want to ask why most managed funds under-perform the market as a whole. And shouldn’t the underlying fund company spend more time improving their existing stable of funds rather than bringing out another flavour-of-the-month fund? There are thousands of mutual funds and it can be a full-time job making sure the hot new fund isn’t just a mediocre fund with a slightly different twist.