1. Investment Banking at a Crossroads Prof Ian Giddy New York University

2. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 2 Europe’s Future Banking l Banks vs. Markets l Relationships vs. Transactions l On Balance Sheet vs. Off l Domestic vs. Regional vs. Global l Debt vs. Equity l Bricks vs. Bytes

3. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 3 Banks vs. Markets l Where are investors going? l What do today’s shareholders expect? l Where are corporate clients going? l Where is your bank going? l Common theme: “The end of entitlement” (which implies the end of special responsibilities)

4. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 4 Relationships vs. Transactions l Lower barriers to entry – more price competition l Frequent re-calculation of benefits: “What will you do for me next?” l Shareholder pressure weakens traditional relationships, obligations l In business, the effect is toward alliances, contract manufacturing, out-sourcing l Stability requires “new communities,” the more broadly-based the better

5. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 5 Financial Innovation and the Shorter Product Life Cycle l More financial innovation l But most innovations fail l Fewer geographic barriers to entry l Fewer information barriers to entry Excess returns Time

6. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 6 Innovation as Value Creation l Innovations are costly to develop and produce, and easily copied, so l For an innovation to succeed, it must create differentiated value for issuer, investor, or risk manager, by:  Unbundling: create simple, more primitive instruments to isolate risks, or  Bundling: create tailor-made instruments to reduce costs, minimize taxes, or circumvent restrictions or imperfections.

7. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 7 On Balance Sheet vs. Off l “All my assets are for sale, all the time” l Maximize ROE by increasing capital turnover – become originators instead of lenders Asset-Backed Securities Asset-Backed Securities

8. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 8 Domestic, Regional or Global? l Which are more mobile?  Goods markets  Labor  Services  Financial services l Even domestic institutions must be able to compete in the world arena

9. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 9 Debt vs. Equity Index ($) $4,495.99 $33.73 $13.54 $8.85 $1,370.95 Small Company Stocks Large Company Stocks Long-Term Government Bonds Treasury Bills Inflation Year-End A $1 Investment in Different Types of Portfolios: 1926-1996

10. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 10 Passive vs. Active Investors l It’s an internet information age l Domestic shareholders want global returns – asset managers must beat benchmarks l Corporations or financial institutions which cling to underperforming assets will have lower ROE and share prices l Which makes them vulnerable to restructuring or takeover – Europe’s new market for corporate control

11. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 11 Passive vs. Active Investors  Investors expect results or sell their shares; “friendly holdings” become too costly, opportunity costs become explicit  Venture capital, private equity funds attract investors by offering higher returns  Market-based returns now expected by investors and lenders, and required of managers; local differences persist, but diminishing

12. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 12 Bricks vs. Bytes l It’s a Nasdaq world, and it’s moving at “internet time” l The old economy needs the new economy to meet shareholder expectations “To B2B, or not to be?” l E-business or m-business? l Equity, not debt, is financing the new economy Check your own bank’s online and mobile financial services Check your own bank’s online and mobile financial services

13. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 13 Whither European Financial Services? l The Anglo-Saxon model of transparent financial markets is coming, at internet speed l All assets must meet the test of the market – global shareholder return standards l Otherwise…

14. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 14 Example: Deutsche-Dresdner l What is Deutsche’s strategy? l Does the Dresdner acquisition advance that strategy? l What does it take to succeed in investment banking? Deutsche-Dresdner case study

15. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 15 The Commercial Banking Model AssetsLiabilities Loans n Net interest revenues Loans n Net interest revenues Deposits n Net interest costs Deposits n Net interest costs Goal: Add assets with positive net interest margin

16. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 16 The Investment Banking Model Sales Capital Markets Corporate Finance Customer-Driven Securities Goal: Originate deals and sell them in the capital market as quickly as possible

17. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 17 What Strategy? Client-Arena-Product Matrix Products offered Clients served Markets covered

18. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 18 Products l Credit products l Trading and positioning l Risk management products l Financial engineering and structured finance l Underwriting and distribution l Asset management l Retail and private client services l Transactions services

19. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 19 Range of Financial Services

20. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 20 NatWest Bank?

21. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 21 Product Profitability Cycle Excess returns Time n Do you want to be a Nescafe bank? n Or a Starbucks bank? n Do you want to be a Nescafe bank? n Or a Starbucks bank?

22. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 22 Client-Arena-Product Matrix Products offered Clients served Markets covered Build versus buy?

23. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 23 Client-Arena-Product Matrix Products offered Clients served Markets covered Deutsche Bank in USA

24. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 24 Client-Arena-Product Matrix Products offered Clients served Markets covered Sell?

25. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 25 To Succeed, Analyse the Industry Structure COMPETITIVE ADVANTAGE SUBSTITUTES CUSTOMERS BARRIERS TO ENTRY SUPPLIERS

26. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 26 Using Industry Structure Analysis COMPETITIVE ADVANTAGE SUBSTITUTES Questions: l Do substitutes exist? l What is their price/ performance? Potential Action: l Fund venture capital and joint venture to obtain key skills l Acquire position in new segment CUSTOMERS Questions: l Is the customer base concentrating? l Is value added to customer end product high,changing? Potential Actions: l Create differentiated product l Forward - integrate BARRIERS TO ENTRY Questions: l Do barriers to entry exist? l How large are the barriers? l Are they sustainable? Potential Actions: l Acquire to achieve scale in final product or critical component l Lock up supply of critical industry input SUPPLIERS Questions: l Is supplier industry concentrating? l Is supplier value/cost added to end product high, changing? Potential Actions: l Backward - integrate

27. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 27 Complementarity and Cross-Selling Wholesale Retail Insurance Asset Management Citigroup?

28. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 28 The Future of Banking: Where Do You Want To Go Today? l Banks vs. Markets l Relationships vs. Transactions l On Balance Sheet vs. Off l Domestic vs. Regional vs. Global l Debt vs. Equity l Bricks vs. Bytes

29. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 29 Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

30. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 30 The CFO Questions l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public? l How much (cheap) debt should we have? l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? l How should we manage our financial risks?

31. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 31 Financing X Inc

32. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 32 Financing X Inc

33. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 33 Financing X Inc

34. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 34 Corporate Financing Life-Cycle Growth companies Mature companies Leverage

35. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 35 Firm Characteristics as Growth Changes VariableHigh Growth Firms tend to Stable Growth Firms tend to Riskbe above-average riskbe average risk Dividend Payoutpay little or no dividendspay high dividends Net Cap Exhave high net cap exhave low net cap ex Return on Capitalearn high ROC (excess return)earn ROC closer to WACC Leveragehave little or no debthigher leverage Earnings Gearing 0

36. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 36 Financing Growth Companies: The Agenda l Where can we get the initial equity financing we need to grow? l Do we want money, management, or more? l When do we want to sell out, and how? l When is the right time for debt for a growth company? What kind?

37. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 37 First, Why Equity? l Benefits of Equity  Flexibility: cannot afford to have fixed obligations  Strategic partners  Interventionist partners l Disadvantages  No tax shield  Expensive!

38. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 38 What Kind of Equity? l Sources of Equity  Private investors  Strategic investors  Interventionist investors  Public market l And Kinds  Common stock  Stock with restricted voting rights  Hybrids, including convertibles

39. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 39.comfax l Started in September 1997,.comfax enables users to send faxes and receive faxes over the internet at a low cost. l By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day. l Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money. l What form of equity financing would be appropriate for.comfax?

40. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 40 Pre-IPO Equity Financing l Friends and family l Angel l Venture capital l Strategic partners

41. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 41 Pre-IPO Equity Financing l Friends and family l Angel l Venture capital l Strategic partners asiajack.com

42. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 42 Private Equity Funds l Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring. l The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.

43. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 43 Silipos Inc

44. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 44 Silipos Inc, 1999 Where do you want to go? Debt? Acquisition? IPO? Sell?

45. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 45 IntraLinks

46. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 46 IntraLinks’ Choices  Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.  Seek out one or more private equity investors, ones who believed in the company’s product and its management.  Do an initial public offering (IPO).  Find another corporation who would be willing to acquire IntraLinks.

47. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 47 Why Venture Capitalists Prefer Preferred l Senior status in bankruptcy l Does not put a value on the shares l Is convertible into common stock before the IPO l Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero)

48. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 48 Case Study: Photronics

49. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 49 Case Study: Photronics Photronics is the world's leading and fastest growing manufacturer of photomasks. Photomasks are high precision quartz plates that contain microscopic images of electronic circuits. A key element and enabling technology in the manufacture of semiconductors, photomasks are used to transfer circuit patterns onto semiconductor wafers during the fabrication of integrated circuits. They are produced in accordance with circuit designs provided by customers at strategically located manufacturing facilities in North America, Europe and Asia.

50. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 50 Case Study: Photronics Sales, 1994-99

51. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 51 The Company’s Debt

52. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 52 Should Photronics Have More Debt? l Benefits of Debt  Tax Benefits  Adds discipline to management l Costs of Debt  Bankruptcy Costs  Agency Costs  Loss of Future Flexibility

53. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 53 How Much Debt? Relative Analysis The “safest” place for any firm to be is close to the industry average l Subjective adjustments can be made to these averages to arrive at the right debt ratio.  Higher tax rates -> Higher debt ratios (Tax benefits)  Lower insider ownership -> Higher debt ratios (Greater discipline)  More stable income -> Higher debt ratios (Lower bankruptcy costs)  More intangible assets -> Lower debt ratios (More agency problems)

54. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 54 The CFO Questions l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public? l How much (cheap) debt should we have? l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? l How should we manage our financial risks?

55. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 55 Raising Equity: The Investment Banker’s Job l Market conditions l Corporate needs l Valuation l Information l Distribution Teleko m

56. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 56 Deutsche Telekom: The Sequence l See case Exhibit 2

57. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 57 What’s a Company Worth to Investors? l Required Returns l Types of Models  Balance sheet models  Dividend discount & corporate cash flow models  Price/Earnings ratios  Option models l Estimating Growth Rates Teleko m

58. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 58 Equity Valuation: From the Balance Sheet Value of Assets n Book n Liquidation n Replacement Value of Liabilities n Book n Market Value of Equity

59. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 59 Deutsche Telekom: Book Value l See case Exhibit 3

60. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 60 Relative Valuation l Do valuation ratios make sense? Price/Earnings (P/E) ratios q and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) Price/Book (P/BV) ratios q and variants (Tobin's Q) Price/Sales ratios l It depends on how they are used -- and what’s behind them!

61. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 61 Deutsche Telekom: Ratios and Comparables l See case page 9

62. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 62 Discounted Cashflow Valuation: Basis for Approach  where  n = Life of the asset  CF t = Cashflow in period t  r = Discount rate reflecting the riskiness of the estimated cashflows

63. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 63 Deutsche Telekom: Earnings l See case page 8

64. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 64 Valuing a Firm with DCF: An Illustration Historical financial results Adjust for nonrecurring aspects Gauge future growth Adjust for noncash items Projected sales and operating profits Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF Stable growth model or P/E comparable Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity … Discount to present using weighted average cost of capital (WACC)

66. n www.stern.nyu.edu

67. www.giddy.org

68. Copyright ©2000 Ian H. Giddy www.giddy.orgEuropean Banking 68 Ian H. Giddy Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332; Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org