IPO Series #4B – Cast of Characters – Investors

KEY LESSON: It helps to understand investors’ individual time horizons, incentives and career perspectives. Or you should get help with your Investor Relations strategy.

Now we get to the meat of the process. A company’s investor base is a very important determinant of a company’s future stock prospects. This section took me several drafts to write.

In this series, I am looking at professional money managers, people who get paid to manage the investments of others. (Retail investors are a whole other topic that I will get to in a later chapter.) These money managers, often called Institutional Investors, are the people who manage the world’s retirement assets. At first, I tried to lay out all the types of investment funds there are:

  • Mutual funds or long-only
  • Hedge funds (i.e. funds that can short stocks)
  • Pension Funds
  • Investment Bank Proprietary Desks
  • Family Offices and High Net Worth advisers
  • Sovereign Funds
  • High Frequency Traders
  • Index, Quant and Exchange-Traded Funds

But this approach gets very blurry very quickly. For example, many investment managers run long-only funds for clients but also maintain internal hedge funds for themselves or a select group of clients.

Instead, I think management teams need to understand a few key facts about who their new business partners are.

First, fund managers each have their own time horizons. Typically, long-only investors can hold a position for years in a stock. While hedge funds hold for shorter periods, months or days. That being said, hedge funds may hold a stock for a short period, they can still follow it for years, repeatedly trading in and out of positions.

Second, holding periods are closely tied to incentive structures. This gets very complicated. The simple view is that many hedge funds get measured every month, while long-only funds get measured quarterly, annually and over multi-year horizons. But there is a lot of nuance to this.

Third, investors are individuals and they care about their personal career trajectories. Put simply, there are really two levels of investors – analysts and portfolio managers. Analysts are the more junior of the two, and hope to get promoted to portfolio mangers. They need to make smart investment recommendations over a long period. This is complicated by the fact that they also have to convince their portfolio managers to actually follow their recommendations. They typically look at a smaller number of investments than their bosses, but get much deeper into the details. Management teams often und up knowing many analysts well, seeing them many times over the years without ever meeting their portfolio manager bosses.

An analysts’s career path is hard to predict because often their immediate progress is determined by the very idiosyncratic relationships they have with their portfolio managers. I mention this, because companies will often find that a very receptive analyst, who meets with the company many times over the years, but never actually invests in that company. Often, this stems from the analyst’s portfolio manager not wanting to follow the investment advice. This can be frustrating for everyone involved.

Despite being the ‘boss’ Portfolio Managers (PM’s) have a very stressful job. They have to balance many risks and are constantly being measured by the markets and their own investors. Usually, the most important number for a PM’s career is his or her Assets Under Management (AUM). In one way or another, their compensation is tied pretty closely to the amount of money they manage. This is an incredibly competitive industry, so PM’s end up getting measured constantly. They get measured against some benchmark (for example, the S&P 500 for many mutual fund managers) or in terms of absolute return of their funds (more typical for hedge fund managers). Good results for their funds tend to attract more funds for them to manage. Mutual fund managers track fund flows into their funds on a daily basis. Hedge fund managers periodically raise new funds (similar to Venture Funds), and a good year means that raising the next fund can be much easier.

The one common theme throughout this is timing matters. The trading year has numerous key milestones which matter immensely to investors. Let me give an example to make this clear. Let’s say a newly public company has done a good job of attracting investors during its IPO roadshow. Everyone likes the management team and the stock. Then reality rears its head and the company misses its earnings numbers. If that miss takes place nine months after the IPO, and they announce the miss during the summer, there will be some grumbling, but probably no hard feelings. On the other hand, if the company announces the miss a month after the IPO, in the last week of December, then this will likely result in several investors having to report weaker annual returns to their own shareholders. And since investor compensation is heavily weighted to year-end bonuses, it is very likely that the company has just made a lot of enemies. As rational as the market is, it is still composed of individuals.

The most important thing for management teams to remember is that there is no such thing as the perfect investor. Many management teams express a distaste for dealing with hedge funds. “We only talk to long-only funds” is a common refrain I hear. This is a big mistake, especially for smaller companies (and by small, I mean market caps of less than $10 billion).

Management teams need to engage with almost all types of investors. First, this is a small industry, and investors talk to each other. A hedge fund analyst, may be playing squash with the mutual fund manager right after you meet her, or the day after that she may be running a giant long-only fund herself. More importantly, hedge funds trade a lot, than means they supply the liquidity which the long-only funds require to hold a position. There is a weird kind of symbiosis taking place here. Companies want long-only investors, but those investors want to see a lot of hedge fund activity before they take a sizable stake.

In the end, the best strategy is to preach where the choir appreciates the sermon. Management teams should court investors who show interest and who have done their homework. This is hard to determine during the IPO road show, because no one knows the story yet, it is new to everyone. But within a few months, it will be clear who the repeat visitors are. With time, companies need to develop a coherent investor relations (IR) strategy to make sure the company is reaching the right mix of investors. This takes some expertise (which is a not-so-subtle pitch for my consulting services).

Finally, keep in mind that any IR strategy will have two phases. One for the IPO process and one for the rest of the company’s life. We will return to the latter topic in a later post. As for the IPO IR strategy, that will in large part be determined for the company by its bankers, which we will address in the next post.

This is Chapter 4 of my series “A Practical Guide to IPOs”, you can find Chapter 1 here and the first part of Chapter 4 here, and the following Chapter 5 here.

2 responses to “IPO Series #4B – Cast of Characters – Investors

  1. Pingback: A Practical Guide to IPOs Chapter 8 – The Expectations Game – DIGITS to DOLLARS·

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