The Cross-Border Biotech Blog

Biotechnology, Health and Business in Canada, the United States and Worldwide

Biotech Capital Markets – Who are the players? Part 20 of Valuation and Other Biotech Mysteries

[Ed. This is the twentieth part in Wayne's series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]

I am starting the final part of this blog series with a description of the main players in the capital market – what do they do, who do they interact with and how do they generate revenue. These blogs will be written for the person who has little or no knowledge of capital markets. For simplicity, I am only going to deal with equities (stocks) in the public market.

The sell side, as expected from its name, is comprised of those players working for investment dealers who are involved in selling stocks, including investment bankers, institutional sales, institutional trading and analysts. At each investment dealer, these players will all interact with each other, subject to securities regulations and individual dealer policies.

Investment bankers (I-bankers for short) are primarily involved in structuring stock offerings, providing capital markets advice to companies, and mergers & acquisitions. I-bankers usually have a sector responsibility and develop relationships with companies in that sector for both information and deal flow. They are usually subject to non-disclosure agreements when working on a deal as they will need to have access to confidential material in order to provide the best advice. There is a ‘Chinese wall’ between I-bankers and the rest of their firm, who do their jobs with only public information.

In deals where a company is selling stock from treasury to the market, the group of firms selling the deal (syndicate) is usually compensated with a percentage of the gross proceeds (up to 10% for small deals), certain expense coverage (subject to negotiation) and sometimes broker warrants (to purchase company shares at a specified price for a certain period of time). In most cases, an I-banker will would like their firm to lead the deal, with its higher revenue and the ability to use that lead position to pursue future business. Fees for mergers & acquisitions are also usually a percentage of the deal size. Capital markets advice is usually provided on a monthly retainer basis.

Institutional sales are usually generalists unless they are with a sector-specific investment dealer. Their key relationships are with the institutional fund managers, to whom they pitch deals in which their firm is a syndicate member, and investment ideas often based on the recommendations of their stock analysts. They will develop relationships with companies during both deal and non-deal marketing. They will also market their analysts to the fund managers, where both sector and company ideas are presented.

Institutional traders primarily interact with the traders at both institutional funds and other investment dealers. Their key information is where various stocks are owned, what was the purchase price and at what price might all or a portion of that stock be sold. If a firm has been involved in stock offerings by a specific company, the traders should have better information. On a daily basis, they are trying to find buyers or sellers for the stocks which are on their block list (price/volume specific orders which they have received from funds). Trading fees used to be a percentage of the value of the transaction but are usually now only pennies per share.

Stock analysts write research reports on individual companies which contain information, analysis, recommendations and target prices. Some analysts are valued for their information and analysis, others for their market sense, and a few analysts combine both skills. Analysts must have excellent relationships with companies in order to have access to management and information, and with fund managers both directly and indirectly through institutional sales.

The revenue for an investment dealer can be highly variable. There are some market conditions over which none of these players have any control, such as sovereign debt crises which decrease risk tolerance and market activity. I-bankers can only compete for deals which can get completed under current market conditions. Institutional sales and trading can only compete for a share of the daily market volume. Investment dealers are currently fighting for a share of a smaller pie than has existed over much of the last decade.

One question which sometimes gets asked is ‘who is the more important client for an investment dealer – the company doing a deal or the fund manager buying that deal’. Consider the following two points.

  • An investment dealer will probably only do one deal annually with each company.
  • An investment dealer will annually pitch hundreds of deals and investment ideas to each fund manager.

The buy side can be divided into the institutional and retail components. While the institutional fund managers are the key people, larger institutional funds may also have their own traders and analysts. Smaller institutional funds often rely on their manager’s personal analysis plus sell-side research reports, and contract out trading. Most fund managers would be compensated on the basis of a salary and a corporate/personal performance bonus.

In the retail area, the key people are the investment advisors (IAs), also known as retail brokers. IAs can work for investment dealers or for independent firms. Their compensation can take two general forms. In one case, they receive a share of the fee for each purchase or trade, with the share varying with the investment dealer. For money management, an alternative compensation scheme is an annual fee which is a percentage of the funds under management.

The revenue for the buy side can also be highly variable. Numerous factors have impacted revenue in recent year, including reduced market volume, discount brokerage firms with online trading and ETFs (exchange-traded funds).

There are rules and regulators for this complex marketplace. Each of them has a web site – three Canadian ones are listed below.

In the next post, we will take a closer look at the role of biotech stock analysts.

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