Cover Me, I'm Going In!

Joseph W. Bartlett, Founder of VC

Wall Street analysts are under fire. They have been placed in the crosshairs both by investors who have suffered in the market downturn, as well as the media. But this war threatens to throw the baby out with the bath water.

There is, of course, a problem of conflict of interest when an analyst, employed by a major investment bank, is paid in accordance with the number of investment banking clients he or she is able to attract. But the notion that the analysts are to blame for the NASDAQ melt down is preposterous. Anybody in this business has known for years that analysts' reports are to be taken with a grain of salt, particularly if the underwriter of the security employed the analyst when it was initially offered. To be sure, the internet and television have drawn more public attention to certain analysts became celebrities during the late '90s, when everybody was getting rich. Thus, the disappointment of investors, who mistook celebrity for authority, is understandable. But analysts are not guarantors of the performance of a stock, or of market movements generally. Investors are supposed to make up their own minds, after taking into account all the relevant facts, including but not limited to the opinions of an analyst.

However, what concerns me more than the possibility that plaintiffs' counsel will get undeservedly rich is the fact that the popular outcry is missing the real problem. Conflict of interest is something one should take into account when reading analysts reports but the real problem is that are not enough analysts, and the ones we have do not cover a sufficient number of companies.

Thus, the venture capital business, historically the jewel in the crown of our economy, depends on reliable (if not omnipresent) exit opportunities. If there is no liquidity event on the horizon, then capital will not find its way into emerging growth companies. And, there are only (by and large) two liquidity events of sufficient importance to deserve notice: 1) the sale of the entire company to another company or 2) an IPO. In fact, IPO pricing has traditionally been higher than company sale pricing and, therefore, a robust IPO market tends to stimulate venture capital activity up and down the line. Therefore, it is of critical importance to the entire process that the IPO market comes back periodically. The window need not remain open continuously; but anything that compromises IPO opportunities on a long term basis is bad news for venture capital and thus bad for the economy as a whole.

The plain fact is that, in today's marketplace, the IPO opportunity has significant problems, in part due to the sparsity of analytical coverage. There are some 12,500 public companies in the United States, of which 7,500 have no analytical coverage whatsoever. Given the fact that asset managers (like other financial service companies) have been subjected to significant merger activity in recent years, someone that used to manage $1 billion or so now manages $10 billion. Accordingly, it is difficult for that individual to follow many companies below the "nifty fifty," a difficulty made even more marked if a professional analyst does not mediate the small cap company's results.

Improvements are required if the IPO process is to retain and resume its vitality. One part of that problem, stimulated by the absence of analysis, is that the 7,500 companies I mentioned are sinking into what is now called the "Orphanage," their stock languishing in an inefficient trading market because of the lack of readily useable information for investors.

The bunching of the entire analyst community at the top end of the market means that everybody else is struggling to obtain the benefits of public registration and trading. In fact, one reason why the analysts employed by the underwriters are so critical is that, if they don't cover the stock their employer underwrites in today's environment, who will? The insiders holding stock in an IPO candidate are not going to be trading for at least 180 days after the effective date. Initially, the stock may be well received, as a result of the promotional activities of the company and the underwriters, and handsomely priced in the public markets. But, without after market support, supplied in part by the ability of investors to track the company through the eyes of an analyst, the stock is necessarily going to trade off. Thus, a successful IPO requires that analysts employed by the underwriter continue to follow the stock and, naturally, their bias is in favor of the security. Otherwise why would the underwriter have agreed to bring the stock public in the first place? If you are an issuer, you are inexorably drawn to that underwriter whose analyst (and perhaps with perfect objectivity) believes in your company. If that is not the case, you have the wrong underwriter; and the underwriter, by the same token, has the wrong customer.

My view, in short, is that we should not beat up on the current crop of analysts. Indeed, it is important that we expand the same, perhaps finding a way to create an economic incentive for an analytical facility which is unaffiliated with any of the investment bankers and, more importantly, agrees to cover a much wider range of companies. The moat around the Orphanage these days is around $500 million in market capitalization. Any company with a smaller market cap is not covered, which cuts off any number of deserving companies from participating in the IPO process. It used to be that $100 million was the bar, but at $500 million a lot of good companies simply are not going to be able to go public and will have to sell out, which this is a bad omen for venture capital, and should be corrected.