978-0077861667 Chapter 16 Lecture Note Part 1

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1.1.1.1.1Chapter Sixteen

Securities Firms and Investment Banks

1.1.1.2 I. Chapter Outline

1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview

2. Size, Structure, and Composition of the Industry

3. Securities Firm and Investment Bank Activity Areas

a. Investment Banking

b. Venture Capital

c. Market Making

d. Trading

e. Cash Management

f. Mergers and Acquisitions

g. Other Service Functions

4. Recent Trends and Balance Sheets

a. Recent Trends

b. The Balance Sheet

5. Regulation

6. Global Issues

II. Learning Goals

1. Know the different types of securities firms and investment banks.

2. Understand the major activity areas in which securities firms and investment banks engage.

3. Differentiate among the major assets and liabilities held by securities firms.

4. Know the main regulators of securities firms and investment banks.

1.1.1.3 III. Chapter in Perspective

Investment bankers assist borrowers in raising capital in debt and equity markets and provide

advice about mergers and acquisitions, corporate restructuring and general assistance in finance.

Bankers also provide many creative over the counter derivative products. Securities firms

provide brokerage and market making services. The investment banking and securities industries

are complementary and many firms provide a broad range of services. Some specialized entities

with advantages in certain market niches remain less diversified. The industry underwent

tremendous consolidation in the last decade due to increasing scale and scope economies and the

need for greater capital. The face of the industry was changed forever during the financial crisis

of 2007-2008 with forced buyouts of Merrill-Lynch and Bear-Stearns, failure of Lehman

Brothers and Goldman-Sachs and Morgan Stanley becoming commercial banks. Nevertheless,

working for many of these firms is often considered the penultimate finance career, with prestige

and remuneration to match. With industry profits down, firms on the Street are having a difficult

time maintaining their large salaries and bonuses. A very significant portion of profits are paid

out in the form of remuneration to executives. The chapter presents an overview of the size of the

industry and the general strategies of the participants, major activities, primary assets and

liabilities on the balance sheet, recent in the news events concerning breaches of ethics and the

trend toward globalization. There is some overlap with Chapter 8, The Stock Market.

1.1.1.4

1.1.1.5 IV. Key Concepts and Definitions to Communicate to Students

Brokers and dealers Best efforts underwriting

Underwriting Firm commitment offering

Discount broker Cash management account

Private placement Shelf registration

Venture capital Block or Position Trading

Pure arbitrage Risk arbitrage

Program trading Cash management accounts

Mergers & Acquisitions SIPC

Sarbanes-Oxley Ethical problems on Wall Street

Tombstone ad Market making

Front running Price fixing

1.1.1.6

1.1.1.7 V. Teaching notes

1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview

Investment banking involves market analysis, advising, securities pricing, underwriting,

distribution of newly created securities and venture capital. Investment banks often create

formal or informal syndicates to assist in sharing risk and expertise. Some bankers are stronger

in distribution, such as Bank of America (via former Merrill Lynch), some are stronger in

corporate negotiations, such as Morgan Stanley, and some are stronger in certain industries or in

certain aspects of restructurings such as Goldman Sachs. Corporate finance activities such as

spin-offs, divestitures, mergers and acquisitions, tender offers, and other financial restructurings

are often undertaken with the advice and assistance of investment bankers. Securities firms

provide brokerage, research and advising services and trade securities for their own account.

Full line firms provide both investment banking and brokerage services. Specialized firms may

concentrate on firms in a given region, focus on a trading method, such as over the Internet, or

specialize in a particular type of financing such as providing capital for startups and small firms

(venture capital).

2. Size, Structure and Composition of the Industry

Total assets in 2012 comprised $4.77 trillion. Equity capital, the more traditional measure for

this industry, was $223 billion.1 The industry underwent shakeouts in the 1970s after “May Day”

and again after the 1987 crash.2 The number of firms fell from 9,515 in 1987 to 5,063 in 2010.

Ever larger firms have also been created via intra and inter industry mergers. The amount of

capital firms employ has also grown dramatically and probably now represents a valid entry

barrier.

The industry can be broken down into three major subdivisions and a group of smaller

specialized firms:

Commercial bank holding companies that operate diversified national full line firms

that serve both retail and corporate customers such as Bank of America and J.P. Morgan

Chase. These firms’ income comes primarily from brokerage, lending, and underwriting and

trading activities.

National full line firms specializing in corporate finance such as Goldman Sachs. Their

income is primarily from underwriting, placement, mergers and acquisitions other consulting

services and trading income.

Large investment banks such as Lazard Ltd and Greenhill and Company

Specialized firms such as

regional investment bankers (D.A. Davidson, Raymond James), (sometimes labeled

‘boutiques’)

discount brokers (Schwab),

Internet brokers (E-Trade),

venture capital firms (New Enterprise) &

exchange floor specialists (LaBranche & Co.)

dealers in off exchange trading (KCG or Knight Capital Group)

3. Securities Firm and Investment Bank Activity Areas

a. Investment Banking

Investment banking is underwriting and distributing new issues of debt and equity. The top 5

underwriters are listed in Text Table 16-3. The top firms represented about 32.9% of the total

underwriting volume. A key factor of success in the investment banking industry is reputation

and bankers guard their firm’s name jealously.

Teaching Tip: One can see the pecking order in the banking industry in a tombstone ad. The

lead or managing underwriter(s)’ names will appear at the top of the list of bankers involved in

the issue. Where the bankers’ name appears in this list is very important to the banker’s

reputation.

1The size of investment banking and securities trading is not properly measured by industry

assets because, unlike bank or insurance financing, investment bankers and securities firms need

not permanently hold securities. Their purpose is to turn them over quickly. Equity capital

measures a firm’s ability to turnover large issues since firms will only risk limited amounts of

their capital at one time. Underwriting volume is also used to measure activity.

2In May of 1975 brokerage commission rates were deregulated leading to reduced commission

revenue. Lower commission revenue translated into lower profitability and caused a major

industry shakeout of less competitive firms.

U.S. corporate underwriting activity for debt issues is almost always many times larger than the

volume of equity underwriting though equity deals usually dominate the headlines. Investment

banking strategy elements can be discussed with the help of Text Table 16-3 which contains the

top underwriters for different security types. In 2012 Morgan Stanley was tops for IPOs and

Goldman Sachs for equity, Bank of America for syndicated loans and J. P. Morgan for global

debt. After declining precipitously during the financial crisis, $6.19 trillion of debt and equity

was underwritten in 2012 and $4.76 trillion in the first nine months of 2013.

Placement methods:

Firm commitment: In a firm commitment the underwriter buys the issue from the issuer

at a set price called the bid price and then attempts to sell the issue to the final buyers at a

slightly higher amount called the offer price. The banker acts as a principle in this

transaction and the banker bears the risk of a failed issue if it does not sell. The banker

may not raise the offer price during the offer period once it is announced. In this sense

the banker has a profit profile similar to a written put option with limited upside gains

and unlimited downside loss potential. Bankers slightly underprice issues and charge

fees to offset the risk of underwriting. A significant amount of pre-selling activity occurs

(the so called “road show”) to limit the investment banker’s risk of selling the issue. An

excellent interactive CD-ROM on the mechanics of going public (and secondary market

mechanics) is available from NASDAQ (for free) titled Market MechanicsSM which you

can order from academic@nasdaq.com.

Best efforts: The investment banker agrees to market and distribute the issue and use

their ‘best efforts’ to sell the issue to the public, but the banker does not buy the issue

outright and is not at risk if buyers do not want the securities offered.

Private placements: Issues sold to a few large primarily institutional investors are

termed private placements and are exempt from SEC registration requirements. Private

placements can now be traded among institutional and high net worth investors.

b. Venture Capital

It can be difficult for small firms to obtain sufficient capital to grow. Many banks are not willing

to lend to small firms who do not have a sufficient record of profitability and may not have

sufficient collateral. An alternative source of financing is through venture capital (VC) or angel

investors. Venture capitalists are typically limited partnership organizations that specialize in

financing and assisting in the management of small startup entities. VC investors purchase an

equity stake in the enterprise and usually are actively involved in the business management of

the firm in which they invest. The VC firm will have a well defined exit strategy and an exit

timeline. The exit strategy is usually to take the firm public or to find a buyer for the firm,

usually within 10 years. VC firms usually invest money in stages to limit their capital at risk.

VC capital is not uniformly distributed among different industries. A VC investor is looking for

the ‘next big idea’ and is often concentrated in whatever industry is ‘hot’ at the time, often in

technology and bioengineering firms. The typical VC investor has traditionally been looking for

a 20% to 30% annualized return on invested capital although in recent years returns on the

NVCA index have been less than returns on major stock indices.

Many small investors obtain funding from angel investors. Angel investors can range from

wealthy individuals who are willing to put up capital without requiring such a high return on

investment nor providing active management to professional investment firms that specialize in

smaller deals than VC firms.

Private equity (PE) differs from VC in funds sources and in types of investments. PE firms raise

funds by selling securities rather than commingling private funds as many VC firms do. Second,

PE firms often acquire established existing firms rather than purchase start ups. During and after

the crisis however there have been fewer promising startups so VC firms have begun engaging in

PE type investments.

The federal government provides funding through the Small Business Administration (SBA) to

assist in venture financing. The SBA licenses privately organized Small Business Investment

Companies (SBICs) to help finance entrepreneurs. SBICs can obtain funds from the Treasury so

they have a cost advantage over private VC firms.

Some banks operate VC firms (financial VCs) and some corporations such as Intel operate VC

firms as well.

Implementation of the Volcker Rule in July 2014 continues to lead to reduced investment in all

forms of private equity by banks. Bank of America has eliminated its private equity fund and

Goldman Sachs and Citigroup are reducing their investments. This may reduce the supply of

funds available to VC and private equity, at least temporarily.

c. Market Making

Market making is creating a secondary market for securities or contracts. These involve both

agency (brokerage) and principle (dealer) functions. Brokerage is typically remunerated with

commissions and dealers profit from the bid-ask spread. Dealers buy at the bid (low) and sell at

the ask (high). Dealers incur the risk of price changes on the stock since they must maintain an

inventory and bear inventory financing costs. On the NYSE, specialists are designated market

makers that have an affirmative obligation to ensure ongoing market liquidity and price

continuity. If the majority of investors wish to sell the stock, the specialist is charged with

buying in order to provide market liquidity. In the event of a large market move the exchange’s

circuit breakers may halt trading, relieving specialists of their obligation. In addition specialists

may petition the exchange to halt trading in a given security.

Teaching Tip: The size of the spread is determined by the security’s volatility, inventory

financing costs, the amount of trading and competition between non-colluding dealers and

regulations. Decimalization reduced the minimum stock spread from about 6 cents (1/16) to 1

cent. To the extent that reduced spreads encourage more trading volume, specialists and other

brokers could see an increase in commission revenue. Increased competition from ECNs and

other markets have led to an erosion of specialist profits however.

Goldman Sachs managed $43 trillion in derivatives in 2013 (about 18% of the total held by FIs).

The profit for the first six months of 2013 was $392 million. This is a major source of income for

banks and illustrates why they don’t like the new restrictions in the Dodd-Frank bill. Losses

from subprimes and derivatives were over $1 trillion as of 2009 so these are risky investments.

Implementation of Dodd-Frank rules on OTC derivatives came were phased in in 2013. The

main changes are that OTC derivative positions such as swaps must be traded on an exchange

and cleared through a clearing agency. This change will probably reduce profits per deal and

may lead to increased capital commitments to meet margin requirements. However over the long

run, one would expect a pickup in trading activity and perhaps volume which may create

opportunities for banks to generate profits.

d. Trading

Trading activities include:

Position trading: Holing a position for weeks or months

Pure arbitrage; arbitrage is taking advantage of a mispricing between two markets by

simultaneously buying and selling the same commodity. Spot futures arbitrage is a

common example.

Risk arbitrage; taking advantage of a real or perceived mispricing based on some

information the trader possesses without perfectly covering or eliminating all the risk.

Program trading; defined as simultaneous buying and selling of a portfolio of at least 15

different stocks valued at more than $1 million in total using a computer program to

initiate the trade. Some forms of program trading are either pure or risk arbitrage, such as

stock index futures arbitrage trades. Portfolio insurance is another form of program

trading.

Stock brokerage; processing buy and sell orders from the public. Many firms either buy

or lease seats on the NYSE and/or are NASDAQ members.

Teaching Tip: Full service brokers offer research and advice about which stocks to buy,

discount brokers process public orders for a reduced fee.

Electronic brokerage offers investors direct access to the trading floor, bypassing normal

brokers and offering even lower fees than discount brokers. Examples include E-Trade

and Ameritrade. Most large firms now offer clients a choice of full service brokerage or

reduced cost electronic trading.

e. Cash Management

Securities firms have long offered accounts called Cash Management Accounts (CMAs) that

were similar to bank checking accounts. As of 1999 securities firms were allowed to offer

federally insured deposits. These accounts have normally been checking accounts written on

mutual fund investments. Many of these accounts now offer ATM and debit card services.

CMAs make it easier and cheaper for brokers to process payments for security buy and sell

orders. Note that since the FSMA securities firms can also offer loans, credit cards and other

banking type services to customers and banks can offer traditional brokerage services. New rules

that will soon be in place are likely to force these accounts to change. Currently money market

investments have a fixed $1 net asset value (NAV). As part of increased oversight from the

Dodd-Frank bill these accounts will soon be forced to trade at varying NAV so that investors can

understand the risks they face in these investments. It remains to be seen whether investors will

no longer consider these accounts as close substitutes for bank deposits.

f. Mergers and Acquisitions (M&A)

Investment bankers help find merger partners, underwrite new securities to be issued as a result

of a restructuring or acquisition, assess the value of a potential target, recommend takeover

terms, or assist in fighting off a hostile takeover.

U.S. and global M&A activity boomed in the late 1990s and through 2000 topping out at $1.83

trillion in 2000, but activity declined substantially after that. In 2001 U.S. M&A activity totaled

$819 billion, down 53% from the prior year, and declined again in 2002 to $458 billion. M&A

activity picked up slightly in 2003 to $465 billion, but grew rapidly again in 2004 when the total

value hit $748 billion, led by mergers of financial institutions. M&A activity in 2007 was $1.59

trillion. While M&A activity brings large fees to bankers, this type of business remains very

cyclical and it declined during the financial crisis, picking up in 2011. See below:

M&A activity by year

US Global

2008 $903 billion $2.90 trillion

2009 713 1.70

2010 687 1.80

2011 861 2.33

2012 882 2.04

2013* 594 1.45

* First nine months

Teaching Tip: According to a very interesting piece by Michael Jensen, “Agency Costs of

Overvalued Equity,” M. Jensen, Spring 2005, Financial Management, pp, 5-19, many if not most

of the large number of acquisitions in the late 1990s destroyed shareholder value. He argues that

overpriced equity led to too low cost of capital and encouraged managers to engage in poor

investments such as acquisitions in order to meet analysts’ earnings expectations. Given that a

high P/E ratio predicts rapid earnings growth and/or low risk, too high a stock price then predicts

an impossibly high growth rate (and/or an unrealistically low level of risk). The manager,

expected to hit ever growing earnings targets, faces an impossible task, because with overvalued

equity management cannot deliver the expected level of performance except by chance. Hence

firms look for ways to keep the fiction of improving performance alive, even resorting to illegal

accounting practices and poor acquisitions. This is a very interesting argument. It helps explain

why there were extreme pressures on managers to produce short term performance. It is not that

managers suddenly decided to ‘lie, cheat and steal.’ The pressure to perform has been very high,

and brought about in part by too close a tie between Wall Street analysts and corporate

executives, a conflict of interest. With overvalued equity, stock price signals are faulty and

cannot be relied upon as indicators of long term value of the firm. Trying to do so when those

signals are wrong must lead to suboptimal decisions for long term shareholder wealth. Several

firms enlisted their professional consultants in accounting and finance to help them find ways to

hit performance targets, which of course could not continue to occur without some form of

‘cheating’ such as accounting manipulations. This argument does not excuse managers. They

should have known better. We have seen a major breakdown of corporate governance at the

board level. Too many managers had ethical failures even though they were highly paid to act in

shareholders interests.

g. Other Service Functions

In addition to the above functions, investment bankers and securities firms also provide security

custodian services, clearance and settlement services, escrow services, research and advice on

divestitures and asset sales. Fees for these services are often bundled together and allocated for

different activities. Some of these ‘soft dollar’ allocations have come under scrutiny as alleged

conflicts of interest have arisen between the underwriting and security selling functions of

investment bankers (see the ethics discussion below).