IPOs may often land new clients but they don’t bring in much money and can also fail altogether. Are they worth the bother?
This all points to a key question: how do firms without a lockstep manage to do IPO work? It would appear impossible for a partner in a firm with a merit-based remuneration system to take on an IPO mandate in the full knowledge that the deal is a loss-leader at best and cash-burner at worst. At lockstep firms, however, partners will know that they will not personally lose out if their IPO fails as their earnings are based on the success of the firm as a whole.
Is it a coincidence, then, that the ECM market is largely in the grasp of the magic circle, the last bastion of the lockstep?
“There’s no evidence that ‘eat what you kill’ firms aren’t aggressively touting for IPO,” contends one partner at a lockstep firm. “You still get points [at firms with merit-based systems] for bringing in new clients.”
But it surely cannot help at a partner’s annual remuneration review if his or her balance is in the red. And when even lockstep firms come around to slashing their equity, as many are now, a run of failed IPOs and loss-making deals hardly looks good.
Failure to launch
Scrapped IPOs are not necessarily a bad thing: radiator maker Nanning Baling’s pulled Shenzhen Stock Exchange listing last year, China’s first-ever failed IPO, was seen as a sign of the maturity of the country’s market. But nonetheless, the financial crisis has certainly hit the IPO industry, with potential issuers abandoning or shelving listing much more often.
Data from Perfect Information shows that none of the 32 London IPOs in 2008 or the 13 in 2009 were cancelled post-announcement. But in 2010, 10 out of 69 announced listings were called off, or just under 15 per cent: Travelport Holdings, New Look, UralChem, Long Bay Re, Ferrous Resources, Fairfield Energy, Scottish Resources, MDNX, Prime and Konkola Resources. Two of these – Long Bay Re and MDNX – were prospective Aim listings.
Dewey & LeBoeuf represented Long Bay Re and Latham & Watkins advised Konkola; none of the other issuers appear to have instructed outside lawyers for the deal, according to the data. No firms were hired as counsel to the investment bank on any of the cancelled deals.
Last year saw a squeeze on IPOs, with only 39 announced deals across the year, but a little over 28 per cent of these – 11 deals, in fact – never saw the light of day: Babson Capital, Bilt Paper, DME Limited, Edwards Group, Euroset, Kotak India Infrastructure Fund, Nord Gold, OAO KOKS, Russian Helicopters, Skrill and Topaz Energy and Marine.
This time around, all of them were eyeing the main market, and marginally more issuers had hired counsel. Babson, Kotak and Nord Gold turned to Herbert Smith, Norton Rose and Freshfields respectively. Linklaters had been brought in to act for the banks on Nord Gold, while LG won the bank roles on both Babson and Kotak.
The data only includes deals that reached the stage where documents were filed, but a number of additional listings were considered but never announced.
One partner with knowledge of the market claims Freshfields and Linklaters had been sitting on roughly 10 deals each through the downturn. Slaughter and May is thought to have been badly hit by the failure of a client’s deal a couple of years ago and absorbed the cost over time, while CMS Cameron McKenna also suffered from one.
Listings fail when economic conditions are tough, but the tougher thing still for lawyers is not that they fail, but that they limp along. Some deals that fell in 2007 were re-invigorated the following year, only for lawyers to down tools again and keep going with the same dance for years. And clients will have unpaid legal bills the whole time.
According to one corporate partner, this is partly down to the inherent inefficiency of banks. There are banks, the partner says, that have hoards of employees who are paid to mull clients’ IPOs and have nothing else to do all day. Hence listing processes go on and on, with no end in sight – while billable hours mushroom. And all of this is with the same fee cap agreed months earlier.
Playing it safe
You would think that lawyers would get wise to this and put pricing in writing. But the competitive nature of the legal market means they fear confrontation.
One partner says he might get a call on a Friday from a client asking for a fee quote for a deal by midday on Monday, after which the client may provide, say, eight facts about the deal, but nothing more. The firm may give a quote based on assumptions, start work and then find out that the company is in a mess, meaning the assumptions have to be entirely rethought. Rarely, however, does anything about the instruction appear in a written agreement until a much later stage.
Accountants involved in listings, on the other hand, appear far more circumspect.
They will emphasise that the quote was based on assumptions, get a letter of engagement signed and re-draft the agreement if the assumptions change. They will also put caps on liability, a rarer case for lawyers. Lawyers often will not ask their client to sign a letter of engagement until the deal is secured or scrapped.
At the heart of this are the different levels of competition in the two professions.
“Most IPO work is pitched for,” a magic circle partner comments. “It doesn’t come in the door with your name on it. Part of the pitching process is inevitably [dealing with] fee arrangements. How hard firms push, I don’t know.
“There are only four accountancy firms,” the partner quips. “That’s a very different market.”
The side of the deal the firm is on is also relevant. The issuer’s counsel role is strategically crucial but relatively straightforward from a relationship point of view.
The issuer hires a law firm and pays its fees – simple. It may get a great deal and be in a strong negotiating position when it comes to finalising fees, but there is little added complexity.
But when it comes to the investment bank’s advisers, things are not quite so easy. The bank is the firm’s client but the fees are paid by the issuer. The issuer is itself a client of the bank or syndicate, so it is in the bank’s interest to keep its legal fees down to maintain a strong relationship with the company up for listing.
This means an added layer of discussion when fee negotiations arise if an IPO fails. Sometimes the lawyers will negotiate fees with the banks, which will act as intermediaries between the firm and the issuer paying the bills. At other times, the bank’s law firm will find itself bartering with the issuer itself. At risk of damaging a relationship with both the client (the bank or banks) and the corporate, the bank’s counsel will be forceneive way even more. Banks have a poorer record of paying off failed IPO fees as a result.
Total fee write-offs are not unheard of, but perhaps more common are discretionary fees – where the client basically calls the shots – or the promise of the next mandates. But these vows, of course, are unwritten.
It all points to one thing: that lawyers should put fees in writing, get letters of engagement signed early and stand up to their clients – and, in the meantime, ensure their practice is not over-exposed to the success rate of clients’ IPOs.
“People just need to think it through. People don’t think of the downside scenario,” points out one corporate partner.
“To be honest, there’s no set process or procedure so it’s very difficult to comment on that,” says Norton Rose corporate head Martin Scott on his firm’s IPO acceptance scheme. “We have a new-client policy. We do that with all clients. We’re not as prescriptive in that way. We don’t say you can only do this, you can only do that.”
There are signs that firms are doing things to solve the problem. Freshfields, as well as introducing a mandate acceptance committee, tried to draw up a spreadsheet of ECM fees so that it could quote clients a reliable figure for a given deal type, but found that there were simply too many variables. Some firms are tightening up on engagement letters and liability, but this is not the norm – and can even push firms to the periphery in a competitive market.
Maybe they will just have to remain resigned to the fact that IPOs are great business, but dodgy earners.
IPOs use up between £2m and £4m in billable hours for a firm, depending on the size and complexity of the deal. But recovery rates are low, and lower still if the deal fails. Firms can recover anything from nothing to all of the agreed fee if the listing never happens, but assuming the worst-case scenario – where the firm puts £4m of work into an IPO and recovers nothing – the potential loss to the firm is huge.
On this rather extreme assumption, Linklaters’ and Freshfield Bruckhaus Deringer’s involvement in Russian gold miner Nord Gold’s failed IPO in early 2011 could have been costly. The nature of the company would point to it being towards the higher end of the complexity scale and the higher end of the fee spectrum, so the magic circle duo could have lost up to £8m between them. The true scale of the losses is probably much lower.
Both firms’ success rates, mind, are fairly strong: this was their only cancelled IPOs in our three-year data. LG, on other hand, managed to oversee two failed IPOs, compared with 11 successful IPOs, and made potentially the biggest loss in the market. A figure of £4m per deal is a harsh estimate, but a seven-figure loss would seem a fair guess. Dewey & LeBoeuf, meanwhile, was English law adviser on one failed IPO and not a single successful one.
The data only covers deals that failed after reaching the announcement stage. With many more listings dying before they even get this far, the further losses across the market could be significant. And with four London IPOs still pending – covering two Linklaters mandates and one each for Ashurst, Clifford Chance, Dickson Minto and Norton Rose – the nervousness is not over.
Law firms will typically earn between £750,000 and £1.5m from an IPO, although this can vary hugely depending on the importance of winning the client and the complexity of the deal.
Assuming an average of £1m in revenue per deal, Freshfields Bruckhaus Deringer probably raked in roughly £20m in fees from completed London IPOs between 2008 and 2011, or roughly £7m per year – a fraction of its overall corporate turnover in London.
Herbert Smith won as many roles on completed IPOs as Freshfields, 21, but fees are likely to be lower down the spectrum. Ashurst advised on 19 successful IPOs, probably turning over a figure slightly below the £20m mark (or in the region of £6m per year), while Linklaters and Norton Rose churned out 17 each.
LG advised on 11 IPOs, and assuming its fees are also further down the spectrum, might have made in the region of £8m on the deals. Simmons advised on nine IPOs, equating to three a year and an annual income of up to around £3m, while Clifford Chance won eight deals, which, assuming magic circle fees, probably means an annual IPO income slightly above that of Simmons’.
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