Online Investment Banks Grab a Bigger Piece of the IPO Pie

Mainline investment banks are having to cozy up to their Internet rivals as issuers increasingly demand an online component to their deals.
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When

Interliant

(INIT)

, an Internet service and Web-hosting company, decided to go public last summer, it picked

Merrill Lynch

(MER)

to lead the offering. But Interliant made it clear it needed more than mighty Merrill to make its IPO a success.

It dictated that online investment banks

Wit Capital

(WITC)

and

E*Offering

would join in to sell shares online to individual investors.

Interliant's push to have some of its shares distributed to investors over the Internet is yet another example of the pressure on traditional investment banks to include their online rivals in offerings. Once a sideshow attraction, online investment banks now command up to 10% of offerings. And a

new investment bank being formed by

Schwab

(SCH)

and two other online brokers is expected to gun for up to 50% of the shares in new offerings.

But much of the power these banks have is coming from the issuers, which are insisting the online banks be included in public offerings. After all, many of these issuers do business on the Internet and want to show support for their medium. And then there's the little fact that online investment banks cater to individual investors, who in turn play a big role in jacking up first-day prices, giving issuers invaluable publicity and often making company insiders rich.

William Wilson, Interliant's chief financial officer, says it was Interliant's decision -- not Merrill's -- to include the online banks. "We're an Internet company. We have to play in our own field," says Wilson. "Besides, we're just big believers in the Internet."

And the traditional investment banks? "I hate hearing that these guys

online banks have gotten in on one of our deals," says one Merrill Lynch banker, who requested anonymity and wasn't speaking about Interliant. "I try telling the clients that they don't want these guys in, that they can play havoc with the stock price. But they don't care. They want the online distribution."

The traditional banks have little choice but to play along. "As issuers are becoming more aware of the story, they are demanding online distribution on their deals," says Walter Cruttenden, E*Offering's founder and chief executive.

Cruttenden says 50% of IPOs and secondary offerings have an online component, according to numbers his firm compiled. That's an increase from just 20% in 1998, and a long way from 1997, when just three offerings were available online. While obviously biased, he figures that 50% figure will climb to 80% in short order and that online banks will grab increasingly larger portions of deals.

Some scoff at estimates like that. "The perception is that these issuers are forcing the investment banks to let these online banks in on their deals. The reality is that Wall Street is giving these online banks very little in these deals," says Steve Eisman, an analyst at

CIBC World Markets

. Although the number of shares may be increasing, it is still small compared to what the mainstream underwriters handle, Eisman says. More importantly, the profits these online banks are seeing when involved on a bulge bracket deal is minimal, he adds.

Still, with fee pressures and profit squeezes rampant in the underwriting game, any sliver of fees going to the online crowd means that much less for the traditional banks, and over time those slivers can cause quite a sting. "Sure, the online banks take one or two meals out of our mouth over time, maybe," says the Merrill banker.

Despite this, mainline Wall Street is grinning through its gritted teeth and chumming up with the online banks. Over the past year, Wall Street firms have been striking agreements with existing online investment banks or building their own systems to meet client demands.

For example,

Credit Suisse First Boston

recently aligned itself with E*Offering, reaching an agreement that will give the online bank's customers access to First Boston's deals. Earlier this year,

Goldman Sachs

(GS) - Get Report

bought a portion of Wit Capital, and

increasingly has been getting its new charge in on coveted Goldman-underwritten offerings. Others, such as

Morgan Stanley Dean Witter

(MWD)

and

Donaldson Lufkin & Jenrette

(DLJ)

, have sharpened their own online banking operations. And Merrill expects to quit having the likes of Wit and E*Offering tagging along on its deals when it expands its online trading capability, says the Merrill banker. Merrill already offers online trading to customers willing to pay a set asset-based fee, and is expected to roll out a fee-based online trading system to a much larger number of customers by Dec. 1.

Yet all this hoopla could die down if the IPO market quieted down, says Dick Smith, a veteran of the underwriting wars and former head of

Banc of America Securities'

equity syndicate desk. And then traditional Wall Street banks would have the upper hand again.

"All this attention to online distribution is a marketing ploy by Wall Street," says Smith. "In order to get underwriting assignments, they have to pander to the issuers and pretend online is important. But they don't really believe it."