Investment Banks Economics 71a Spring 2007 Mayo, Chapter 2 Lecture notes 2.2

Outline  What is an investment bank?  Role in financial markets  Investment banks and new securities IPO mechanics

What is an Investment Bank?  Not a bank!  Help firms sell securities to public Stocks/Equity Bonds/Debt  Transfers funds from public to firms Savings -> Investments  Example: Goldman/Sachs

Initial Public Offering (IPO)  First sale of stock by firm  Originating investment bank Key player in bringing the shares to market “Originating house” Handles most administrative details Reputation

Underwriting  A form of price guarantee  Agree to purchase shares from firm for a given amount  Then sell to the public  Example: Purchase stock from Yahoo ($10/share) Sell on the market ($11/share)

Risk of Underwriting  Market may not be willing to pay the price paid by investment bank ($10)  It would lose money  Investment banks often spread this risk over several investment banks “Underwriting Syndicate”  Also, try to reach more sellers “Selling group”

IPO Scandals  Most involve investment banks giving special deals to some favored customers (low prices)

Best Efforts Agreement  Risk shifted to issuing firm  It receives whatever price the market pays  No underwriting function by investment bank

IPO Timing  Private firm Negotiations between shareholders and other initial investors (Venture Capital) Find investment bank to handle IPO  Prospectus filed with Securities and Exchange Commission “Registration”  Red Herring : Version of prospectus for initial investors  Quiet period: filing to 1 month after IPO Restrictions on public information releases

IPO Pricing  How does the initial price get set by investment banks?  Difficult problem  Set price too high Can’t sell stock at this price Lose money now, or wait and see  Set price too low (more common) Bad for issuing firm Raises lower money than it could have Investment bank looks bad (reputation)

Dutch Auction IPO’s: Another Price Mechanism  The “Dutch auction” is another mechanism for an IPO  Not many do this  Most famous: Google, August 2004

Dutch Auction  Seller announces total shares to be auctioned (Qshares)  Potential buyers submit bids for (Shares, Price)  Auction moves price down until Shares demanded above this price = Qshares

Dutch Auction Example  Qhares = 10  Bids 2 at $10 1 at $9 3 at $8 4 at $7 2 at $6 4 at $5  Sell 10 to first 4 bidders at price = $7

Dutch Auction Picture Q Price Demand IPO Price Shares Offered

Dutch Auction Analysis  Benefits More transparent No need to guess price  Price is uncertain though  Why isn’t it used more often? Google price increases  Did they get a high enough price? Confusing mechanism  Not well designed  Qshares not specified  Many investment banks Patent (Hambrecht) Most firms not big enough to dictate these terms

Later Stock Offerings  “Seasoned equity”  Stock issued after IPO  Registered with SEC  Sold at current market prices  Firm often stores these shares “Shelf registration”  Google again: How to estimate shelf shares from web (public float and shares outstanding)

Private Placements  Shares sold to private investment groups Venture capital firms Private equity hedge funds  Usually, smaller, younger, riskier firms

Regulation  Securities and Exchange Commission Set up in the early 1930’s to oversee securities markets Oversees publicly traded firms Public investment companies (mutual funds)

SEC: Information and Regulation  Require timely release of information to public  10-K report: Annual information on firm  Firms required to report major information events to public

Insider Trading  Trading on private information  Illegal (why?)  Who’s an insider? Employees Associated  Lawyers  Investment bankers  Enforcement Trade reporting

Securities Investor Protection Corporation (SIPC)  Insures investors against failure in brokerage firms  Not insurance against price drops  Limited amounts $500,000 total $100,000 cash balances

Sarbanes-Oxley (2002)  Scandals of the 1990’s Accounting information shaky and deceptive (Enron, Worldcom,..)  Government response  Protect investors from fraud

Sarbanes-Oxley  Basic provisions Creates Public Company Accounting Oversight Board Strengthen the independence of auditors (accountants) Firm directors take responsibility for numbers

Conflict of Interest Problems  Many investment banks have brokerage sides  They will recommend stocks to investors: Analyst recommendations  What if same firm is doing IPO and writing recommendations?  There is supposed to be a “firewall”

Reponses to Sarbanes/Oxley  Board insurance  Privatization  Moving off shore  Still very much untested and controversial