The X-Men of e-finance

In the heartland of Gotham and the Bay Area of San Francisco, dwarfed by the high-rise headquarters of those they seek to challenge, lurk a select few individuals waiting to strike. These men are behind the mutant companies seeking to change the dynamics of equity capital-raising forever. They are much smaller than their prey, but less weighed down by legacy systems. The time has come for the internet-based new issue houses to show what they can do, reports Antony Currie

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New web-based securities Firms once evoked fear in their intended targets, but lack of immediate action has lessened the fear of the unknown. "Last year I was convinced that WR Hambrecht and Wit Capital were going seriously to threaten our way of doing business," says the head of investment banking at an incumbent bulge bracket Firm. "But now I just regard them as yet another small contender." Even one of the leading e-Finance analysts, Greg Smith at Chase Hambrecht and Quist, thinks that: "the era of the e-investment bank has faded somewhat".
The protagonists are hoping that their relative silence until now has lulled such people into a false sense of security, and look for inspiration to the success of their mutant cousins in the battle for secondary trading. Discount broker Charles Schwab led the way with on-line retail trading, followed by rival TD Waterhouse and start-ups such as Ameritrade and E*Trade. Archipelago, RediBook, Datek's Island and other ECNs (Electronic Commission Networks) have used newer, cheaper and more effective technology to improve access between investors and Nasdaq, where they have managed to snatch 35% of trading volume from traditional market makers in less than three years.
The battleground

But they face a much tougher challenge, for they are now focusing their attention on the biggest prize of all - the primary market. It is here that the most money is to be made, and here that the old-world way of conducting business is regarded by these e-Finance X-Men as especially outmoded, unsuitable for serving the rising influence of retail and smaller institutional investors. Equity capital markets, they reason, are ripe for new leadership.
However, equity underwriting is the part of the market where existing franchises, entrenched interests and long-standing relationships are at their Firmest.
As it stands, incumbent investment banks and asset managers have a near-total stranglehold on the IPO process. It is rare even for the issuer to have a say in which institutional investors should be allowed to take part, and the idea of making retail a more significant part of a deal is usually laughed off. Until recently, there was some logic to this. From the late 1970s onwards, the number of institutional money managers grew at a frenetic rate, so that there are now several vying to become the First ever $1 trillion manager. They began to dominate the stock allocation process, which in the 1970s had been largely a retail market, and investment banks developed their institutional equity coverage accordingly. Retail placement more often than not meant bringing in the full-service brokers such as Merrill Lynch or PaineWebber, where stock allocations were given to their best brokers to sell to their best clients - in practice those most willing to trade on the brokers' advice.
Retail was therefore relegated to second place, while the banks and the big institutional Firms developed a mutually beneficial, symbiotic relationship. The money manager pays a commission based on overall service during a year, not one linked to individual trades. So it is in the investment bank's interest to maximize its service, meaning that the more attractive IPOs it can get for its clients, the more chance it has of getting more of the manager's secondary trading business - and so more commission. The relationship with each of the big fund managers can be worth many tens of millions of dollars.
But now the equity market is changing. The number of individual investors is increasing rapidly, and more and more are opting for a more direct form of investment, where they make the decisions rather than leaving it to a full-service broker. Online brokers have been especially successful in this not just because of the cheap and easy method of trading they oVer, but also the distribution of research to help their clients make their decisions, which under the old system of mail or fax was prohibitively expensive.
Publications and other media covering the stock market have soared in popularity, from IPO.com, an on-line information service about IPOs, to CNBC's and CNN's all-day Financial programmes.
Figures for the destination of IPOs appear to confirm both that retail investors are growing, and that they are poorly served under the present primary market structure.
Institutional money managers account for up to 90% of an IPO placement, and rarely less than 70%. Yet within weeks - and in the recent hot IPO market for technology stocks within a day or two - that Figure can be turned on its head. In its own IPO prospectus last year, Wit Capital stated that 43% of all shares in the US are held by retail.
But the traditional investment banks largely ignored this development, and in some cases derided it. Some still seem keen to tar all retail with the day-trader's brush, arguing that retail investors are less sophisticated, and therefore less interested, and as a result more likely to be Flippers of a stock and thus not desirable investors for an IPO.
Nonsense, say the mutant e-underwriting companies, who believe the ancien regime is bankrupt. "Investment banks need to be doing more than simply covering the top 200 institutional accounts if they want to build a more accurate picture of market demand for an IPO," says Scott Ryles, CEO of Epoch Partners. "That was the optimal model Five years ago, when the likes of Merrill Lynch, Smith Barney and Dean Witter were the mainstay for retail distribution and when there were only 300 Firms managing assets of $1 billion or more. Now that number stands at 1000, and there are more retail distributors serving a more proactive client base."
Ron Readmond, formerly co-CEO of Wit Soundview until he retired in May, puts a more colourful spin on all these developments. "It's the death of the Wizard of Oz," he says. "Investment bankers and the top institutional investors have been keeping the book to themselves behind the curtain while the rest gaze on in awe. But they've been found out."
The near-impossible mission
The theory of a new primary market methodology is compelling, but transferring that into reality has not been easy. Issuing companies are being presented with two choices: stick with the known investment bank, with its franchise and its experienced bankers and relationships; or opt for a new organization which has great ideas, great technology, some great bankers, but no track record at all.
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The X-Men of e-finance

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