Direct Listing’s Potential Effect on Investment Banks
The fundamental definition of capitalism provides opportunity in the form of wealth to those who make certain investments. Despite some of their practices coming under scrutiny, investment banks have long played a crucial part to the US economy, and especially to capitalism. Investment banks have provided capital raising services to companies in search of capital to expand by acting as a middleman between entrepreneurship and public investors. One drawback to investment banks engaging in capital raising is that they pertain large fees, and at times high risk to their clients. Recently, a new form of capital raising called “direct listing” will eliminate the need for underwriters and allow firms to go immediately to the New York Stock Exchange, receiving capital from the public directly. But, this newly added capital raising program poses a major threat to many investment banks.
Direct listing on the New York Stock exchange means that companies will have the ability to go directly into the secondary market and become publicly traded. This eliminates the traditional step for an initial public offering (IPO), where companies that wished to trade openly in the secondary market would hire an investment bank to perform services. Many smaller companies that needed capital to expand their business could hire an investment bank, for a high cost, and receive both capital and liquidity if original investors were seeking cash.
The major advantage of direct listing is that it provides companies an easy way to trade publicly at a much cheaper cost. Fees for investment banking services regarding initial public offerings range from 3-7% The dollar figure of these fees can range from a few million to over a hundred million. IPOs present a large risk for corporations and IPO failures can be catastrophic for many corporations. Underwriters are responsible for a large portion of the success of the company given it is their task to survey demand and create valuations. One publication described:
“Underwriter prestige plays a certification role at the time that a company goes public. Prior evidence suggests that IPO firms with higher prestige underwriters earn lower first day returns, consistent with there being a lower level of risk and information asymmetry associated with these offerings (Carter and Manaster [1990], Megginson and Weiss [1991]). In a more comparable analysis to our setting, Schultz [1993] finds that the probability of firm failure within either two or three years of IPO is negatively associated with underwriter prestige.” (E. Demers and P. Joos)
Essentially, this means that a large portion of the success of an IPO is left up to an investment bank. This poses a huge threat to companies that are not going public through large names like JP Morgan, Evercore, or other banks that have a successful reputation based on past performance. As detailed above, though higher prestige underwriters earn lower first day returns, a firm is less likely to fail on a public exchange if they were underwritten by a well-known firm. Direct listing eliminates this large risk for companies, more specifically companies with smaller EBITDA and size multiples who are less likely to be underwritten by a prestigious firm. This will have a domino effect on the less prestigious investment banks. Many firms that would not have had access to a notable investment bank are more likely to choose to use a direct listing, thus putting a massive hit in revenue for boutique and middle market investment banks.
Direct listing poses a threat to investment banks that derive a large portion of their revenue from capital raising. At the senior levels of these banks, bankers’ jobs are to find companies to take public. Should eliminating the middleman become popular, investment banks are sure to suffer. According to FactSet, investment banking activities (capital markets, mergers, etc.) account for 33% of JP Morgan Chase’s revenue and most of their assets. Other elite boutiques and middle market banks, such as Evercore and Jefferies, would likely take a greater hit should this form of capital raising become popular. Investment banking services account for 97% and 80% of their revenue, respectively.
Capital raising is arguably the most important function of the US economy. Without capital raising, the United States would likely be decades behind with respect to innovation relative to its current state. There are many attractive factors to capital raising without investment banks acting as the broker, especially for smaller firms. Some small firms seeking fast liquidity for initial investors will likely choose to use direct listing, in order to avoid "lockup periods"which bind traditional IPOs. Conversely, some investment banks, specifically elite boutique and middle market firms will see a large portion of their revenue seek the cheaper alternative.
Works Cited:
Demers, Elizabeth, and Philip Joos. “IPO Failure Risk”. Journal of Accounting Research, vol. 45, no. 2, 2007, pp. 333â371. JSTOR, www.jstor.org/stable/4622034.
