Investment Banking Public and Private Placement Chapter 15 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Who are investment bankers Costs and risk involved in distribution of new securities Distribution of new securities and dilution of earnings per share Public versus private financing Leveraged buyouts and restructuring of a corporation

The Role of Investment Banking The investment banker is the link between the corporations in need of funds and the investor Investment bankers are responsible for designing and packaging a security, offering and selling the securities to the public

Concentration of Capital Allows large firms to take additional risks and satisfy the needs of an increasingly demanding capital market Raising capital has become an international proposition International consolidations and buy-outs of banks have become common

Investment Banking Competitors Intense competition in the market and there are various dimensions of competition such as fees, pricing accuracy, analyst recommendations and debt offering abilities. Being a leader in one sector helps a firm’s overall reputation but does not ensure success in all areas.

Functions of Investment Bankers As a middleman in the distribution of securities, the investment banker has a key role of: Underwriter Market maker Client advisor Agency services to corporations

Underwriter Contracting to buy securities from a corporation and re-selling them to security dealers and the public Underwriting Giving a “firm commitment” to purchase securities from the corporation Assuming any risks associated with the new issue Best-efforts Undertaking to do the very best in selling a security issue to the public, on commission basis, without committing any quantity

Market Maker Buying and selling of securities issued to ensure a liquid market Providing research on the firm to encourage active investor interest

Advisor Advising clients on a continuing basis about: Types of securities to be sold Number of shares or units to be distributed Timing of such sale Offering other advisory services in the areas of M&A, leveraged buyouts, and corporate restructuring

Agency Functions Acting as an agent to a corporation to place its securities privately with: An insurance company A pension fund A wealthy individual Negotiating for a best possible deal with the potential investors

The Distribution Process in Investment Banking

The Distribution Process in Investment Banking (cont’d) Principal investment banker calls on other investment houses to share burden of risk and aid in distribution Underwriting syndicate is formed comprising many investment houses Syndicate members act as wholesalers in distributing the shares to brokers and dealers Brokers and dealers sell the shares to the public

Underwriting Spread Represents the total compensation for all participants in the distribution process

The Underwriting Spread(con’d) The lower a party falls in the distribution process, the higher is the price for shares The farther down the line the securities are resold, the higher is the potential profit The larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price

Pricing the Security The managing investment banker determines the price by conducting an in-depth analysis on the following: Company’s industry Financial characteristics Anticipated earnings Dividend-paying capability

Pricing the Security (cont’d) Based on a technique deemed appropriate by the underwriter: A tentative price is assigned Price is compared to industry peers 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

Dilution Issuance of additional securities result in: Actual or perceived dilution of earnings for shares currently outstanding Current profit distributable to more number of outstanding shares A perceived time lag in the recovery of earning per share Resulting from increase in shares outstanding Temporary weakness in price The proceeds from additional issue may be expected to provide additional earnings

Market Stabilization An investment banker stabilizes the offering during distribution period by: Repurchasing securities when market price goes below the initial public offering price Period of stabilization lasts for two or three days after initial offering, but may extend up to 30 days Stabilization may be virtually impossible in case of poor market environment Price manipulation in security markets is illegal An exception to this is underwriter price support

Aftermarket Research shows IPOs generally perform well in immediate aftermarket Over the first three years of trading, IPO returns (excluding the first-day price jump), are approximately 6.5% lower than returns for similar sized firms The IPO is a good deal for investors who purchase shares from the underwriter at the offering price After the first day of trading most companies underperform the market for several years

Shelf Registration Large firms filing one comprehensive registration statement: Outlines the firm’s financing plans for up to two years Allowed to issue securities without further SEC approval when market conditions are appropriate Mostly use with debt issues, and utilize minimally with equity markets

Public versus Private Financing Many companies prefer to remain private Restricting their financial activities to direct dealings and negotiations with bankers, insurance companies etc.

Advantages of Being Public To corporations: Corporations can have access to greater amounts of funds A public traded security helps in bank negotiations A company can use its own stock as currency for the purchase of another firm A company can issue marketable securities for the purchase of another firm

Advantages of Being Public (cont’d) To stockholders: Ability to achieve a higher degree of liquidity Ability to diversify his/her portfolio Holding a publicly traded stock helps in estate planning

Disadvantages of Being Public Important corporate information on profit margins and product lines will be divulged through SEC and state filings These filings are tedious, time-consuming, and expensive Tremendous pressure from security analysts and large institutional Investors for short-term performance Shift in management interest for short term performance against long-term stewardship Relatively high cost for smaller firms going public Underwriting spread and out-of-pocket costs can run in the 15% - 18% range

Public Offerings The act of issuing shares to the public The issuing company has to file a registration statement with the SEC Statement includes prospectus containing details about the company offering

Public Offerings – Classic Example A classic example of recent IPO – Rosetta Stone Refer to the chapter for the complete story [Pages 476-79]

Public Offerings – Example (cont’d)

2009 Stock Returns For Rosetta Stone and S&P 500 Index

Private Placement Selling of securities not through the security market but directly to: Insurance companies Pension funds Wealthy individuals Such device employed to: Avoid or defer an IPO offering Incorporate private funds into the financing package More than 50% of long-term corporate debt outstanding is privately placed

Advantages and Disadvantages of Private Placement No lengthy, expensive registration process with the SEC Greater flexibility in negotiating than is possible in a public offering Lower initial costs in a private placement than those of a public issue Disadvantage: Interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation

Going Private and Leveraged Buy-outs The trend: 1970s, a number of small firms gave up their public listings to be private 1980s, 1990s, and mid-2000s, very large companies began to go private Reason: Significant cost savings in annual report expenses, legal and auditing fees, and security analysts meetings

Going Private Absence of a public float Two methods of going private: A publicly owned company purchased by a private company or a private equity fund Repurchasing all publicly traded shares from stockholders Leveraged buyout an easy way to go private

Leveraged Buyout The management or some investor group borrows the needed cash to repurchase all shares of the company The company exists with substantial debt and heavy interest cost Management of the private company sells assets to reduce excess debt load Corporate restructuring occurs: Divisions and products are sold Assets redeployed into new, higher-return areas

Leveraged Buyout (cont’d) Investment bankers try to determine the ‘breakup value’ of a large company This implies the value if all divisions are divided up and sold separately

International Investment Banking Deals Privatization efforts across globe Fraction of wealth owned by the state is higher Much needed cash to build public services Key companies owned by government in many countries Privatization involves: Investment bankers taking such companies public The companies sold are formerly owned by governments rather individuals