We are most likely starting the second leg of a bull market, even though it seems as though we are slogging sideways (http://finance.fortune.cnn.com/2010/10/01/wall-street-bulls-pull-in-their-horns/). If that is so, we should be preparing for a shift next year when the larger-cap stocks are fully valued and investors turn their focus to smaller stocks, which have a history of outperforming big stocks in bull markets. For investors, that may mean picking favorite segments (healthcare is always the biggest, but network/telcom, entertainment/media/games, and greentech/alt-energy are looking strong).
Small companies and entrepreneurs should be preparing for a time when capital may be available on better terms and shorter leadtimes. This article is directed at CFOs and CEOs of small companies who may need financing over the next 12 months (and one of the immutable truths of small companies is that almost all of them need financing). Or to those who simply want to strike while the iron is hot.
Not long ago you could almost put all the hot small-cap investment banks on single-digit speed-dial because there were not very many. But many of the old guard (H&Q, Montgomery, Robertson Stephens) are merged into megabanks now and chasing after larger targets. The range of good new firms is fairly broad, but most are not even trying to be dominant across the board, picking their segments and sticking to them. That means there are more banks to talk to, but they will tend to be narrower in their focus.
They basically fall into 4 categories: (1) small boutiques; (2) smaller broker/dealers with investment banking operations; (3) musclebound get-it-done banks, and (4) larger investment banks with a real interest in smaller companies.
Small boutique investment banks tend to be formed by experienced investment bankers who either get fed up with red tape, or who find themselves standing on the wrong side of the door in an economic downturn such as the one that we have beenn living through for the last 2+ years. They tend to be composed of a small number of professionals with impressive resumes and lots of hands-on knowledge, but very little in the way of extended organizational capabilities. These firms can be very strong in the conceptual side of financing, and they frequently have good connections formed over years of bigger-bank experience. But their ability to put together deals is often restricted to private deals (PIPEs, private placements, etc), and many have no ability to provide support in the aftermarket.
The best part of the small-boutique experience for most entrepreneurs is that they provide one-stop shopping, and the same bankers can often work on equity, warrants, commercial debt, M&A. They may have no formal internal committees to clear, and they may be able to offer engagement terms very quickly. The client almost always ends up dealing with an experienced banker with “gray hair” (whether it actually is or not — it’s a way of speaking). Their ability to canvass large groups of potential investors may, however, be fairly narrow, and they may be averse to sharing an assignment with another bank.
There are many small boutiques that offer a startling amount of expertise, but there are also many that will take a fee and have trouble delivering. Referrals and references are super-important in finding and choosing a boutique. Boutiques tend to form and re-form, change names and partnerships, and it would be a fool’s errand to try to list the best ones because there are too many. A good IR firm can direct you to a bunch.
On the side of caution, boutiques may lack research analysts, or if they have analysts, they may lack effective distribution (meaning nobody reads the reports). They may not have brokerage licenses, which means they may not have the ability to trade shares or to affect market-making. Usually their deals are put together with relatively few players who can become uncomfortably big shareholders when the deals are done. They may create “overhangs” as they restrict the sale of common stock sold in private placements for 6 months, a year, or longer. These overhangs can make overall gains in stock value more difficult to achieve, and since the boutique probably does not have a trading desk, the overhanging stock may well fall like hail on the market when the restrictions expire.
Middle Market Brokers with investment banking groups
Most free-standing broker-dealers have investment banking departments. The very large broker-dealers have very large investment banking groups, and they tend to do deals for very large clients.
Smaller companies who are looking for investment banks may want to keep in mind that the “younger” broker-dealers may be the most aggressive ones, and they may be willing to work on smaller deals. I put “younger” in quotes meaning broker-dealers whose investment banking groups are comparatively recently formed (or re-formed, given the number of mergers and de-acquisitions/spin-outs). With the churn of Wall Street companies being bought, sold and spun out over the last 10 years, some of these “younger” firms may well have older names on the door: Cowen, Piper Jaffray, Morgan Joseph, Stephens, Morgan Keegan, Wedbush, Janney, RW Baird, Stifel Nicolaus.
Some may have fairly unknown names: some may have been formed by alumni of other banks. Many entrepreneurs may not recognize Signal Hill, Revolution Partners, Think Equity, Merriman & Company, Madison Williams, JMP Securities, Roth Capital, Stonegate Securities, or Leerink Swann. But they are doing deals every day and gaining strength and top-of-head awareness.
The investment banks in this category tend to have higher admission threshholds than the boutiques do. Although there are no “magic numbers” in this group, you might assume that if you do not have a bona fide use of proceeds for $30 million or more, these banks may not be able to get their machinery in gear for you. Sex appeal changes everything, of course. If you have a property that they can’t resist (an AIDS vaccine, demonstrable cold fusion, carbon-free fuel, etc), you may be able to name your own terms. Because they are club members (FINRA, SIPC et al) most of them have the ability to do your deal publicly or privately, and to help you through the aftermarket quagmires, possibly providing research, nondeal roadshows, etc.
Getting a commitment from these banks is likely to take a good bit longer than getting a commitment from a boutique, simply due to internal committee structures.
Smaller Middle Market Investment Banks
There is a hard-to-define category of smaller investment banks that are more concentrated on corporate finance than they are on standard broker-dealer trading and accounts. These hard-edged investment banks survive on the deals that other banks either don’t want or can’t do, and many of them are not well-known names. They typically have a sales force that is part institutional and part retail (sometimes largely retail), but concentrated in a few offices, often concentrating on New York.
These banks can get deals done, but their flexibility in designing deals may often be limited to what their financing sources like. So an entrepreneur or small company may find that one talks about equity credit lines, while another shakes his head and says something about deep discounts to the market price.
In fairness, if the deals were easy to do, someone up the food chain would do them. Fees at these investment banks may tend to be higher — but basically they belong to the same “club” as the bigger investment banks, are SIPC, FINRA members, watchdogged by all kinds of regulators. The ones that survive for a long while are tough — and they can slam home deals that other firms might well not be able to do. For the best in this category, a commitment to do a deal may not be as good as cash in the bank, but it can be pretty close, and that, as the man says, ain’t all bad.
Investment banks in this category might include Maxim Group, B Riley, Midtown Partners, Mid-Market Securities, Dinosaur Securities, CK Cooper and lots of others. Some, like Brooks Houghton or Ascendiant, may have their own capital available to invest. Many have research departments that are somewhat pared-down compared to the larger banks, but their research is real and updated regularly. Deal sizes vary, and the range of deal sizes may go from single-digits to upwards of $30 million or so, depending on the use of proceeds and the general market enthusiasm for the sector.
Muscle Banks with an Interest in Smaller Companies
This is the smallest category as to the number of players. Mostly like goes with like — and larger investment banks like to do large deals. But there are large and/or muscle banks that have a cultural bias toward newer, smaller companies, and there are some investment banks with enough sheer power to whack deals out of the park on a daily basis.
These firms generally have a full range of services, and enough tombstones to cover the walls of many conference rooms. Based on its quite extraordinary dominance of the small PIPE market in general (and increasingly of the small IPO market as well), one of the first names that comes to mind is Rodman & Renshaw. Some might put the smallcap side of JP Morgan into this group, especially in healthcare. And, although it is less clearcut, Jefferies could be in this group. Other names here would include Canaccord Genuity, UBS and Deutsche Bank. Oh, and Lazard Freres.
What to do?
The task is to sift through the banks, deciding which ones might be interested and which ones have the right combination of expertise and experience for a specific small company in a specific industry segment.
Many companies opt for what Wall Street calls, alternatively, either a “beauty pageant” or a “bake-off.” When a company chooses this path, a knowledgeable consultant or IR firm will canvass the investment banks, provide a list of candidates, and then make appointments for the company to present to a list of 5 to 10 banks, usually within the space of a week or so, and always using the same presentation materials. Shortly thereafter, the company or the consultant will request draft engagement letters from the banks in the pageant, and the company can either elect to look further, or to accept one of the letters proferred to it after the pageant process.
Our firm, Allen & Caron, has been doing such pageants for the last 30 years, but law firms, management consultants and accountancies are sometimes willing to manage a process like this. It is best to embark on the process at least 6 months before you will “need” the financing, because if you begin to run low on cash, terms stiffen up, buyers become more gnarly and difficult, and bankers begin offering less attractive terms.
In the next installment of this series, we’ll tell you about some things to keep in mind, some things to avoid, and some things to be super-careful about when you set out to raise money. — JA