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Investment in the future: procurement and investment banking

Guy Strafford
Jul 14, 2011 5:49:00 PM

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Guy-New

While investment banking has been somewhat off limits to purchasing professionals, applying procurement disciplines to this area can add significant value to a business.

An ex-FTSE 250 finance director recently recounted how he had been told by his chairman that their company was going to use an investment bank for a transaction. No competition, no tender, the 40-page, close-type contract simply turned up. The terms were that the investment bank was going to be paid whatever it deemed appropriate for the fee, that is, the bank set their own remuneration. When the CFO complained to his chairman, he was told: “"we are going to use this bank".” That was that.

Indirect/enabling procurement has made great progress breaking into professional services and marketing, but investment banking has been off-limits. Our belief is that procurement disciplines can bring significant benefit. However '‘tread with care'’ was never more apt.

Investment banking is an umbrella term covering a host of different services, including treasury; forex; equity trading; derivatives; fixed income; commodity trading; corporate; merger & acquisitions (M&A); borrowing - loans and bonds; hedging; futures; rights issues; and advice, for example on financial engineering. Many of these are highly competitive markets. This article takes a look at corporate finance, M&A and advisory-type services, where there are varying levels of competition.

There is opportunity

The recent Institutional Investor Council and ABI reports pointed out the lack of sophistication of pricing and buying of banking services for rights issues, but the problem is broader than this. Many companies buying investment banking services are not as commercial as they could be in their approach to procuring them and it is made worse by lack of market fluidity.

The consolidation of the investment banking marketplace since 2008 has reduced the level of actual competition. When seeking finance and advisory services, there are now fewer choices. If you do not want financing from a competitor’s bank, the options are even more limited.

Limited competition is further constrained by pre-existing relationships. Investment banks typically have an inside track to the chairperson and employ world-class salespeople to exploit this. The scale of the monies and the importance of the financial transaction to the client is played on by the salespeople. They disconnect the value-add of the service or the cost of providing it from the fee. 

The Evidence

The Office of Fair Trading has recently launched a market study into equity underwriting fees. The ABI and other investors have complained that, whereas pre-banking crisis typical fees were 2 per cent of funds raised, this is now routinely up to 4 per cent with the banks taking less risk, as the discounts on share prices they want are up from typically 15 per cent to 30 per cent.

As with other industries, bundling services together is a common ploy. Corporate broking (representing a company to investors) and capital raising is a common example. Extending credit in return for a promise of future '‘large'’ fees is another less well-publicised tactic.

CFOs must often choose between debt and equity for major funding. You would expect their well-paid advisors to push debt as this is much cheaper to raise. However, the incentives are skewed towards equity. One banker we spoke to pointed out: “"we earn more fees from raising equity (5-10 per cent v 2-3 per cent). It also gives us the opportunity to get a slice of the company and participate in the upside.”"

Investment banks will often ask companies to agree financing terms prior to sourcing capital, the justification being to accelerate the process. The company’'s expectations are captured in a ‘'term sheet'’, a key part of the business plan presented to potential lenders. The investment banks will argue this speeds up the process. However, having named your '‘price'’, it doesn'’t take much to guess the likely outcome – inferior terms. Lenders can also place very different valuations on companies, particularly high-growth ones.

Surely allowing the market to set the price would be more beneficial? But that would mean more work for the bankers earning those big fees, and a low valuation will provide more upside to a bank being paid equity. Finders'’ fees and commissions may also be paid by lenders to the bank brokering the deal, but this is not always transparent or rebated to the customer.

The devil, as always, is in the detail when it comes to the terms and conditions of doing business. However, in the chairperson’'s rush to engage a bank, this is often overlooked. For example, investment banks routinely try to obtain long exclusivity periods on transactions.

A transaction may take six months to close; one to two-year exclusivity periods allow them to be compensated on the same terms if any capital is raised during this period. The bank’s argument is that it has invested significant resources in the outcome and needs to protect this. However, if the bank can’t deliver what the company requires, then seeking alternatives means it will either need to pay twice, renegotiate terms, or pay the ‘'break-fee'’ spelled out in the agreement: win, win.

So you want to get involved - Where to start?

The chairperson is key. Building his or her trust is the single most important thing you can do. Reliable previous delivery is the precursor to starting to advise the chairperson on a very sensitive area to them as they often have close relationships with –- some may even have been placed in role on the recommendation of –- the bank.

The second element is knowing the tactics to take by service as there are boundaries to competition given confidentiality. Certain services are competitive; other services such as M&A are either time critical or confidential so competition is not practical. This needs deep consideration and planning to anticipate the scenarios you may face. In particular, you want to be in the banking presentations being made at board/senior executive level to anticipate commitments.

In common with most areas of external spend, applying procurement disciplines to investment banking can add significant value to a business, despite the differences and complexities, if we are prepared – and have the right internal relationships.

5 key actions

  1. Become known as a trusted adviser. Confidentiality is key to being involved with strategic deals. Often, just a handful of people know –- your objective is to be one of them.
  2. Build close relations with your chairperson, CFO and strategy director. Find opportunities to discuss the company’'s strategic direction and develop an understanding of potential targets and deals. The sooner you hear of potential deals, the greater your opportunity to influence them.
  3. Get to know the market and the individuals concerned, and their key drivers –- research their specific areas of expertise and the deals they’'ve worked on for other clients.
  4. Understand what your competitors are doing and with whom. Who are the movers and shakers? What deals do they have on the cards? How might your organisation respond?  Which investment banks are they using?
  5. Develop a clear message of the benefits of procurement’s involvement, such as ensuring clarity and comparability of costs and providing objectivity in the selection process. ensuring management against clearly-articulated objectives, consistency of approach or risk mitigation through better influencing the terms of engagement.

We [Proxima] will be holding a workshop in mid-October for senior procurement professionals interested in this area, to share more of the research that we have undertaken in this field. For more information, contact Guy Strafford here.

 

* This article was first published in Supply Management
** Other contributors include Harbir Sidhu and Richard James

Guy Strafford

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