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15 Investment Banking Public and Private Placement Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline • What is investment banking? • Functions of an investment banker. • Advocacy on matters of mergers and acquisitions. • Public versus private financing. • Leveraged buyouts and debt for restructuring of a corporation. 15-2 The Role of Investment Banking • The link between the corporations in need of funds and the investor. – Responsible for designing and packaging a security offering. – Responsible for selling the securities to the public. 15-3 Concentration of Capital • Allows large firms to take additional risks and satisfy the needs of an increasingly demanding capital market – Competition has propelled many businesses to the position they are at now. – Raising capital has become an international proposition. – Firms that are very large have the ability to compete. – International consolidations with international buy-outs of banks have become common. 15-4 Underwriters, Markets, and Rankings 15-5 Gramm-Leach-Bliley Act (1999) • Repealed the separation policy of the Depression-era laws. – Which included separating banking, brokerage, insurance and investment banking into separate entities. • Federal Reserve and Treasury: – Have the power to impose restrictions on the activities of the banks. – Allows strong banks to participate in the venture capital market. 15-6 Investment Banking Competitors • There is intense competition the market. – Being a leader in one sector helps a firms overall reputation. – It however does not ensure success in other areas. 15-7 Underwriter • An investment banker underwrites any risk associated with a new issue: – By giving a ‘firm commitment’ to purchase the securities from the corporation. • Large investment houses assume risk of distribution. • Smaller investment houses may handle distributions for unknown corporations. – This is done on a “best effort” basis or commission basis. 15-8 Market Maker • Investment banker engaged in buying and selling of the security to ensure a liquid market. – Provides research on the firm to encourage active investor interest. 15-9 Advisor • Services offered include advising the client on a continuing basis about: – The types of securities to be sold. – The number of shares or units for distribution. – The timing of the sale are some of the services offered. • Important advisory services in the area of mergers, leveraged buyouts and corporate restructuring are also offered. 15-10 Agency Functions • An investment banker may act as an agent for a corporation. – That wishes to place its securities privately with: • An insurance company, • A pension fund, or • A wealthy individual. – Involves in negotiation of the best possible deal for the corporation with potential investors. 15-11 Distribution Process in Investment Banking 15-12 The Spread • The underwriting spread represents the total compensation for all participating members. – The lower a party falls in the distribution process, the higher the price for the shares. – The farther down the line of securities are resold, the higher the potential profit. – The larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price. 15-13 Allocation of Underwriting Spread 15-14 Pricing the Security • Investment Banker – Price of the stock is an important consideration – Conduct an in-depth analysis to determine a firms value: • • • • The company’s industry. Financial characteristics. Anticipated earnings. Dividend-paying capability. 15-15 Pricing the Security (cont’d) • Based on a technique deemed appropriate by the underwriter: – A tentative price is assigned. – This will compared to others in that given industry. – Anticipated public demand also plays a major factor. • Underpricing – Setting the price slightly below the current market value. • Common during the issuance of additional shares. 15-16 Dilution • Problem associated with the issuance of additional securities: – Actual or perceived dilution of earnings effect on shares currently outstanding. – May be caused by the perceived time lag in the recovery of earning per share. • Resulting from increase in shares outstanding. 15-17 Market Stabilization • An investment banker is responsible for stabilizing the offering during the distribution period: – Accomplished by repurchasing securities when market price is below initial public offering price. – Stabilization lasts for two to three days after initial offering. – Poor market environment - stabilization may be very difficult to achieve. – Underwriter price support – an exception to market manipulation. 15-18 Aftermarket • Research shows that the IPO generally tends to perform well in the immediate aftermarket. – After the first day of trading, an IPO returns are approximately 3.4% lower than returns for similar sized firms over the first full year of trading. – The IPO appears to be a good deal for investors who purchase shares from the underwriter. 15-19 Shelf Registration (1982) • Permits large companies to file one comprehensive registration statement. – Should outlines the firm’s financing plans for up to 2 years. – The firm can issue securities without further SEC approval. – This registration has become part of the underwriting process. – Most frequently used with debt issue, and utilized minimally with the equity markets. 15-20 Public versus Private Financing • Many companies, by choice or circumstance, prefer to remain private. – They restrict their financial activities to direct dealings. 15-21 Advantages of Being Public • To the Corporation: – Tap security markets for greater amounts of funds. – Associated prestige – better relationships. – Ability to purchase another firm using its own stock as currency. • To the Stockholders: – Ability to achieve a higher degree of liquidity and to diversify his or her portfolio. – Stockholders of a private corporation can sell holdings if it decides to go public. 15-22 Disadvantages of Being Public • All information must be made public through SEC and state filings. • Tremendous pressure for short-term performance by security analysts and large institutional investors. • For small firms, the underwriting spread and the out-of-pocket costs can run in to the 1518% range. 15-23 Public Offerings - Examples • A classical example of instant wealth – EDS goes public • Internet Capital Group – Refer to the chapters for the complete story. 15-24 Public Offerings – Examples 15-25 Internet Capital Group Stock Price (as of January 13, 2006) 15-26 Private Placements • Selling of securities not through the security market but directly: – Insurance companies. – Pension funds. – Wealthy individuals. • Device is employed by: – Firms who wish to avoid or defer an IPO offering. – A publicly traded company wishing to merge private funds into its financing package. 15-27 Advantages of Private Placements • No lengthy, expensive registration process with the SEC. • Firm has greater flexibility in negotiating than is possible in a public offering. • Initial costs of a private placement may be considerably lower than those of a public issue. 15-28 Disadvantages of Private Placements • Interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation. 15-29 Going Private • The trend: – 1970s, a number of small firms gave up their public listings to be private. – 1980s and 1990s, very large companies began going private. • Reason: – Costs could be saved in annual report expenses, legal and auditing fees, and security analyst meetings. 15-30 Methods of Going Private • Two ways of going private: – A publicly owned company is purchased by a private company or a private equity fund. – To repurchase all publicly traded shares from stockholders. 15-31 Leveraged Buyout • Either the management, or some other investor group borrows the needed cash to repurchase all the shares of the company. – The company exists with substantial debt and heavy interest cost. – Management of the private company must sell assets to reduce the debt load. – Corporate restructuring occurs: • Divisions and products are sold. • Assets redeployed into new, higher-return areas. 15-32 Leveraged Buyout (cont’d) • Investment bankers, as specialists in the valuation of assets, try to determine the ‘breakup value’ of a large company. – This is its value if all divisions were divided up and sold separately. 15-33 Privatization • Privatization involves: – Investment bankers taking companies public. – The companies sold have been previously owned by governments. 15-34