Goldman Picked a Good Time to Like Tesla's Stock
Just after 4 p.m. yesterday, Tesla Motors Inc. announced a $2 billion stock offering, of which about $1.4 billion will fund a production expansion, and the rest will pay taxes on an option exercise by Chief Executive Officer Elon Musk. The deal will be led by Morgan Stanley and Goldman Sachs. Awkwardly, another thing that happened yesterday -- in the wee hours of the morning, some 16 hours before the deal launched -- is that the equity research analysts at Goldman Sachs raised their rating on Tesla from "Neutral" to "Buy."
Obviously if Goldman is selling Tesla shares to its customers, it is helpful -- though oddly not essential -- that Goldman's research analysts think that the customers should buy those shares. But the timing is weird: Goldman research was officially meh on Tesla shares until yesterday morning, and then became enthusiastic just before Goldman's bankers were officially mandated on the deal. Is that ... suspicious?
I mean, no, not really, but let's work through why.
First some disclosure. Not only did I once work at Goldman Sachs, but I worked in Equity Capital Markets, with the beautiful people, doing deals not entirely unlike this one. And in that job I interacted with research analysts. But: not much! And only in very carefully monitored circumstances. If I had ever asked a research analyst to change his recommendation to help me win a deal mandate ... I mean, "fired" is too soft a word for what would happen to me. Blank incredulity. Astonishment at my daring and ability to scale the thousand-foot ice wall separating the research and banking floors. Bankers can't even e-mail analysts. Not, like, it's not allowed; like, the e-mails just won't go through. A research analyst once asked me for advice on applying to law school; he had to call me on his cell phone and meet me outside of the office. On their first day of work, bankers and analysts are fitted with powerful magnets so that the one will always repel the other. One does not simply talk to a research analyst.
The purpose of all of this mutual repulsion is to prevent precisely the scenario where a banker asks a research analyst to upgrade a company's stock in order to win investment banking business. First of all, because that would be gross and dishonest, but more immediately because it would be super illegal under the global research settlement that all the big banks signed in 2003 to settle accusations that they ... well, did that, over and over again, in the most straightforwardly cynical ways imaginable, with lots of e-mail evidence. So now they have stopped doing that, and have put in place procedures to prevent even the whisper of a possibility that an analyst might upgrade a company to win investment banking business.
The awkward thing about those procedures is that, if bankers never talk to analysts, you will occasionally get a situation where the analysts are upgrading a company at the same time that the bankers are finalizing an investment banking mandate, and the near-simultaneous announcements are embarrassing all around. But that's proof of good behavior, not bad behavior. If they were doing evil collusion, they'd at least have the sense to wait a few days between the upgrade and the deal.
Now there are a couple of caveats to that. First of all, while I am reasonably confident that no one in investment banking called up the research analysts to say that a deal was coming, the analysts could have figured it out. Or rather, they did figure it out. It's right in the first paragraph of their report:
We upgrade shares of Tesla to Buy from Neutral with 22% upside to our 6-month price target of $250. While we believe the volume targets are ambitious, Street and investor expectations seem more grounded and following a 23% decline in the share price post the Model 3 unveil, we do not believe Tesla shares are fully capturing the company’s disruptive potential. This combined with a more stable macro backdrop (relative to January/February) and increased confidence in Model 3 demand (from orders and our competitive benchmarking) drives attractive risk/reward. The company has publicly stated it might look to raise capital, and our detailed capex analysis points to capital needs of $1bn.
Off by $400 million, but still pretty good. That's not based on illicit communications from the bankers; it's based on the analysts' own modeling of Tesla's capital needs for expansion, and on the company's public statements, including Musk talking about a capital raise on the earnings call earlier this month. And the timing makes sense: A couple of weeks after earnings is a good time to do an equity offering, because all of the company's nonpublic information has recently been made public.
So the analysts could, and did, figure out that a big deal was coming. If you are conspiracy-minded, you might think that alone -- without any communication from banking -- would be enough to influence the analysts. A deal is coming. Morgan Stanley has a "Buy" (well, "Overweight") on the stock. Goldman has a "Neutral." Moving that to a "Buy" might make Tesla more inclined to hire Goldman. The analysts could figure that out without any prompting from banking.
And that is true. But why would they care? The research settlement also prohibits banks from paying research analysts "based directly or indirectly on Investment Banking revenues or results," or considering input from investment banking in analyst compensation decisions. So the analysts won't get paid extra because Goldman got this mandate. Nor will they get any hearty back-slaps and high-fives from the bankers, because any banker who walked onto a research floor would be vaporized by powerful lasers long before he could raise his hand for a high-five. There just isn't much incentive for an analyst to upgrade a company that he doesn't believe in to win a deal. (While there is an incentive for him to upgrade a company if and only if he thinks the stock will go up, because he is compensated based on accuracy and investing client feedback.) And people at investment banks respond to incentives. That's why they're at investment banks.
The other caveat is that Goldman's bankers probably did tell the analysts about the deal before it launched. Not a whole 16 hours before -- certainly not before the upgrade went out -- but it is customary to "wall-cross" the research analysts shortly before launching the deal. The bankers get on the phone with the analysts and the research chaperones and explain that the deal is coming. But once the analysts have gotten this material nonpublic information about a pending but un-announced equity offering, they can't do anything about it until it's announced. They have to sit very quietly, not put out research about the company, not tell investors about the deal, etc.
That is annoying for the analysts -- particularly analysts who have just published a big upgrade research report! -- so you don't want to do it too much before the deal. For a 4:01 p.m. deal launch, I doubt the analysts were wall-crossed much before 3:30.
Why wall-cross them at all? Because the analysts do have some role in selling the deal. If an equity offering is announced at 4:01 p.m., a research analyst is going to start getting calls from clients at 4:02 p.m. asking him if it's a good deal. If it's his bank's deal, and he found out about it at the same time as the client, that's a little awkward. So he is given a little time to get up to speed. And, having gotten up to speed, the analyst will typically participate on the sales call where the bankers brief the sales force on the deal, and will chime in with his own opinion so the salespeople know what he thinks.
At this point, though, the incentives have shifted subtly. The analysts don't care about the bankers and have no incentives to work on their behalf. But they do care about the salespeople, and have incentives to work on their behalf. The salespeople are allowed to talk to the analysts. The bank is allowed to take into account sales feedback in paying analysts. And, just, fundamentally, research is a form of sales. The reason banks have research departments is the same reason they have sales departments: to get institutional customers to trade with them. One generally effective way to do that is to publish good smart research that clients trust. But the ultimate goal is to get more trading done, not to obtain objective truth.
And the salespeople have an incentive to sell stock. Again, this isn't their only interest. In the dynamics of an equity offering, loosely speaking, the bankers are sort of loyal to the issuer, and the salespeople are sort of loyal to the investors. The salespeople deal with their investor clients every day; they're not going to hear from Tesla again for a while. So they want to make sure that their investing clients get a good deal. But they also want to sell stock, because that is what they are paid to do. Their job is to sell stock. And, at the most basic level, the analysts' job is to help them sell stock. Not every stock, not all the time, but generally speaking selling more stock is good for everyone.
So in practice, if an analyst has a "Sell" rating on a company's stock, and his bank nonetheless wins a mandate to underwrite that company's offering -- it happens! -- then he will get on the sales call and talk to the sales force about the offering and be polite. He won't say "this stock is a screaming buy." (That would be a bad look, of the sort that regulators would find out about.) But he might say, I don't know, "this equity raise addresses some of my concerns about how this company is about to run out of money from being so terrible." And while he might not make a lot of outgoing calls, if investors call him to ask about the deal, he will try to restrain himself from launching into a fearsome tirade about how bad the company is. His research can speak for itself; he doesn't need to undermine his colleagues' work any more than he already has with his "Sell" rating.
An analyst with a "Buy" might be more effusive in his conversations with investors.
Perhaps all of this sounds a bit nefarious. If so, I urge you to abandon the view that sell-side equity research is about the pursuit of objective truth for its own sake, and reconcile yourself to the possibility that it is basically about selling stock and helping institutional investors get access to corporate management. But you don't need to be too cynical. The selling stuff, the corporate-access stuff: Most of that happens outside of the analysts' formal research reports, as they talk to clients and set up meetings and conferences. The written reports and price targets and "Buy" recommendations are where research gets closest to the pursuit of truth and unbiased opinion. It's just lucky for Goldman, and Tesla, how the timing worked out.
The research note is dated May 18, and the first Bloomberg report of the upgrade is timestamped 4:37 GMT (12:37 a.m. Eastern) yesterday. The offering press release is timestamped 4:01 p.m. Eastern.
Morgan Stanley rates the shares "overweight," with a $333 price target, and has had Tesla at "overweight" for years. Goldman's price target is $250.
Which is "the fifth-largest equity-capital markets transaction in the US in 2016," though there are five bookrunners -- Deutsche Bank, Citigroup and Bank of America Merrill Lynch, along with Goldman and Morgan Stanley -- reducing the per-bank economics a bit.
A bit unlike this one -- my deals were convertible and equity-linked deals, not straight stock -- though we sometimes did them alongside common stock deals too, and the rules are pretty similar anyway.
Also further disclosure: I have a GSBank savings account with, now, a nonzero number of dollars in it. At a 1.05 percent interest rate, that means that Goldman is paying me a few dollars a year. (I hope.)
I should perhaps make clear that my GSBank disclosures are three-quarters-joking and will soon stop. I have a Chase checking account too. It's just a bank account, you know?
Here is Goldman's research settlement; section 10 covers the limited circumstances in which bankers are allowed to talk to research analysts, and the procedures to make sure that those conversations never involve the bankers asking the analysts for help winning a mandate.
Also, I suppose this should be obvious, but neither a research upgrade nor an equity offering is an instantaneous thing. Presumably both the analysts and the bankers were working on their respective projects for days before their awkwardly near-simultaneous announcements.
From the Bloomberg transcript of the May 4 call:
<Q - John J. Murphy>: Good afternoon. Just a first question on the capital needs. I mean, it looks like there's a little over $400 million left on the ABL, and given the preorders or the reservations for the Model 3, it seems like you'll have at least another $400 million flowing in in the second quarter. So just curious, I mean as you look at that kind of cash potential or liquidity and potential inflow, do you really think you need to do a capital raise this year, or could you get by with those sources of cash?
<A - Elon Reeve Musk>: Well, I don't think we want to rely too much on customer reservation money as a source of capital. Maybe there is a buffer or something, but it's not as a primary source of capital. So yeah, I mean, I think it's going to make sense for us to raise some amount of money, some combination of equity and debt and make sure the company has a good buffer of cash on hand. I think it's important for de-risking the company.
See section 5 of Goldman's settlement.
I mean this is not literally how the research settlement works. The ice wall and magnets stuff, above, were also perhaps exaggerated. (The law-school applicant guy was real, as was the thing about e-mails not going through.) But really, analysts and bankers just do not bro down together much.
A real thing! Remember, bankers can't just call up analysts. Their phones would explode.
There's another, much more important reason not to wall-cross early. What if the deal didn't launch? What if the bankers told the analyst about the deal at 3, and then at 3:30 the market tanked and Tesla decided not to raise capital that day? It wouldn't put out a press release saying "hey we thought about selling stock, but then didn't." It would just quietly tell its bankers to go home.
This is a problem for the analyst! He knows that Tesla was going to sell stock, which is material nonpublic information. (Probably! I mean, Elon Musk already said it on the conference call, but the specific size and timing and so forth are probably material and still nonpublic.) But then when he gets in the next day, he still has material nonpublic information that he can't act on. He's restricted in the stock until either the deal happens or compliance people decide that the information is "stale," a subjective and awkward determination. It is a bad situation.
So you wait until the last minute to bring him over the wall, to minimize this risk.
Similarly, the bankers deal with Tesla a lot, and don't spend a lot of time hanging out with Fidelity and T. Rowe Price. (And the bankers' bonuses are paid by investment banking fees from Tesla, while the salespeople's bonuses are paid by commissions from Fidelity and T. Rowe.) So as a generic stereotype, the bankers will want to get a high price for their issuer client, the salespeople will want to get a low price for their investor customers, and ECM will intermediate between them.
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