1. © 2007 Thomson South-Western Chapter 16 Investment Banking and the Public Sale of Equity Securities Professor XXX Course Name / #

2. 2 Companies that raise capital externally can issue debt or equity. Common stock can be sold through private placements or to the public. First public offerings is known as IPOs. Subsequent offerings are known as SEOs. Investment banks assist companies in selling new securities. Overview of Investment Banking

3. 3  Corporate finance  Trading  Asset management Key Investment Banking Activities

4. 4 Basic Choices In Securing External Financing A firm needing external capital faces three basic choices: Employ an investment bank to advise and handle offering Choice of public versus private capital market Choice of security and type of offer: equity or debt

5. 5 Investment Banks Role in Equity Offerings Asset management Corporate finance Trading Investment banking lines of business Investment banks provide advice with structuring seasoned and unseasoned issues, actual sale and post-sale services. Seasoned offering Equity issues by firms that already have common stock outstanding seasoned Unseasoned offering Initial public offering (IPO): issue of securities that are not traded yet unseasoned

6. 6 Investment Banks Role in Equity Offerings Public security issues can be: Best effort The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering. Firm commitment Underwritten offerings, bank guarantees certain proceeds. Vast majority of US security offerings are underwritten this way. Direct negotiated offerCompetitive bidding Firms can choose an investment bank through:

7. 7 Services Provided By Investment Bankers And Their Costs Investment banks provide services prior to security offering. Prior to offering, lead investment bank negotiates underwriting agreement: – Sets offer price and spread; details lock-up agreement – Bulge bracket underwriter’s spread usually 7.0% for IPOs – Initial offer price set as range; final price set day before offer.

8. 8 Legal Rules Governing U.S. Public Security Sales Two basic laws governing public issues: Securities act of 1933 Prescribed security issuance procedures, set basic principle of full disclosure. Securities and exchange commission act of 1934 Set up SEC, gave it broad regulatory, rule-making powers. Securities laws mandate disclosure of all relevant corporate information to potential investors. Investment banks play key disclosure role by performing due diligence.

9. 9 Key Steps in IPO Process  Initial Step  Registration Process  Marketing  Pricing and Allocation  Aftermarket Activities

10. 10 Basic Disclosure Documents Principal disclosure document: Registration Statement Prospectus Supplemental Disclosures  Actually a series of registration statements, beginning with the Preliminary Prospectus  Offering only becomes effective with SEC’s final approval.  After preliminary filing, firm and IB begin a road show.  IB does book building during road show providing key pricing info.

11. 11 Shelf Registration SEC introduced rule 415: shelf registration  Qualifying issuers (more than $150 million in outstanding stock) file a “master registration statement”, summarizing planned financing for the next two years.  The company can offer securities for sale (off the shelf) over subsequent two years.  Popular with issuers; very flexible Most qualifying debt issues are shelf registered. Very few equity issues use shelf: IB certification needed.

12. 12 Services Provided During And After A Security Offering Lead underwriter sets each syndicate member’s percentage of participation. How many shares each member must sell and compensation. Almost all IPOs and SEOs have a green shoe option: over- allotment option to cover excess demand. Lead underwriter is responsible for price stabilization after offering. After offering, lead underwriter serves as principal market maker.

13. 13 Number of US IPO Offerings, Initial Returns and Gross Proceeds $484,02913.5%7,322Total 126,23320.77332000-04 294,07620.94,1291990-99 62,5966.82,3481980-89 $1,1245.7%1121975-79 Gross proceeds ($ Millions) Average first day returns (%) Number of offerings Period Source: Jay R. Ritter, “Some Factoids about 2004 IPO Market” Initial returns were very high during internet boom: 69.0% in 1999 and 55.5% in 2000.

14. 14 Benefits Of An IPO 1) IPO can raise large amounts of new capital for growth. 2) Publicly traded stock is currency for acquisitions. 3) Listed stock (options) can be used to attract top managers. 4) Provides personal wealth and liquidity for entrepreneur 5) Serves as advertising for firm and its products/services

15. 15 Costs Of IPO 1) High financial costs of IPOs, with no guarantee of success: cash expenses of IPO often approach $1 million. 2) Managerial costs of planning and executing IPO 3) Need to focus on stock price and deal with shareholders 4) Severe constraints on managerial discretion in public firm

16. 16 Types Of Specialized IPOs Equity carve- out Parent sells minority stake in subsidiary to public through IPO. Raises cash for parent, allows better monitoring of subsidiary. Spin-off Parent distributes all of a subsidiary’s stock to shareholders. Full spin-off creates independent new company. Reverse LBO Company goes public again after LBO. Successful LBOs create value, so high returns to second IPO. Tracking stock Stock mirrors performance of division, but not legally or operationally separate from parent.

17. 17 Investment Performance Of IPOs Patterns observed in IPO offerings:  Positive initial returns for IPO investors  Large IPOs typically underpriced less than smaller offerings.  Initial returns are higher in “hot issue markets” than in cold markets.  Mean initial returns are much higher than median: a relative handful of severely underpriced offers drive results.  Mean return overstates actual profits for most investors; uninformed investors suffer from winner’s curse.  Venture-capital backing reduced initial returns during 1980s; increased after 1990. IPOs seem to dramatically under-perform over 1-5 years.

18. 18 Seasoned Equity Offerings (SEO) SEOs infrequent for most U.S. and non-U.S. firms Reason Negative market reaction when SEOs are announced SEO announcements convey negative info: Short-term and long-term performance of SEOs: prices fall on announcement, under-perform over 1,3 and 5 years.

19. 19 Rights Offerings  Existing shareholders have the right to buy new shares at a discount or can sell this right to other investors.

20. 20 Private Placements In The U.S. Sale of a security directly to one or a group of accredited investors Accredited investors in private placements are financially sophisticated. Corporations, institutional investors, wealthy individuals, pension and mutual funds, venture capitalists Rule 144A has allowed limited trading of PP among “qualified institutional investors”

21. 21 International Common Stock Offerings Two types Domestic stock offering International, or cross-border, issues Total number of non-U.S. IPOs exceeds U.S. total, but total value (except privatizations) usually much smaller. All markets show significant IPO underpricing. Most markets show poor long-term returns for IPOs, SEOs. Most markets also seem prone to hot and cold markets.

22. 22 Average First-Day IPO Returns, %, International Comparisons

23. 23 American Depositary Receipts (ADRs) Dollar-denominated claims issued by U.S. banks Represent ownership of shares of a foreign company’s stock held on deposit in the issuing firm’s home country Sponsored ADR The issuing foreign company pays all legal and financial costs of creating and trading the security. Issuing firm is not involved with the issue of ADRs. Unsponsored ADR

24. 24 Trading Volume in Public ADR Issues, 1990-2004

25. 25 Privatization’s Impact On Stock Market Development  10 largest share offerings in history are all share issue privatizations (SIPs)  30 Of 33 largest offerings SIPs  152 of 2004 Business Week Global 1000 are SIPs  SIPs 15% of total, 31% of non-US market cap  Most large emerging markets firms are SIPs  7 Of 9 largest capitalization firms are SIPs  Under-States True Importance Of SIPs  Play very important “bellweather” role  SIP usually a country’s largest cap firm  Also most actively traded--usually by wide margin

26. 26 The Largest Share Offerings In Financial History Are All SIPs