978-1259277160 Chapter 15 Lecture Note

Unlock access to all the studying documents.

View Full Document

Investment Banking: Public and

Private Placement

Author’s Overview

This chapter presents a detailed account of the functions of the investment banker. By making

maximum use of material covered under the “distribution process,” the instructor can present a

good picture of the marketing channels and pricing mechanisms that are frequently utilized in a

public distribution. Such topics as the underwriter spread, pricing of the security, market

stabilization, and after-market considerations are usually interesting to the student. We

highlight the Facebook IPO and its subsequent price collapse and rebound.

You may want to focus on Tables 15-1, 15-2, 15-3 and 15-6 to highlight the investment banking

process with real firms and the concentration and competition within the investment banking

market.

The advantages and disadvantages of going public is an area worthy of consideration. While it

seems that the ultimate goal of every small firm is to grow large enough to one day be public,

there are some very sound reasons to challenge this objective.

The continuing importance of private placement and its impact on traditional investment

banking can be considered. Also, the instructor should cover the phenomenon of the leveraged

buy-out, a significant development of the 1980s that has continued to this day.

Chapter Concepts

LO1. Investment bankers are intermediaries between corporations in need of funds and the

investing public. They also provide important advice.

LO2. Investment bankers, rather than corporations, normally take the risk of successfully

distributing corporate securities and for this there are costs involved.

LO3. Distribution of new securities may involve dilution of earnings.

LO4. Corporations turn to investment bankers and others in making the critical decision about

whether to go public (distribute their securities in the public markets) or stay private.

Education.

15-1

LO5. Leveraged buy-outs rely heavily on debt in the restructuring of a corporation.

Annotated Outline and Strategy

I. Introduction: The late 1990s may well be called the dot.com era for investment

banking, as record numbers of companies from Amazon.com to eBay went public.

Emphasis on this phenomenon is a great way to make this chapter interesting from

the start. Table 15-1 shows the international nature of the initial public offering

markets from Hong Kong, to Saudi Arabia, New York, Amsterdam, Tokyo and

Australia. The largest IPO of 2014 was Alibaba, a Chinese company that came

public on the New York Stock Exchange.

PPT Top Equity IPO in 2014 (Table 15-1)

While the IPO markets are exciting for the big winners, we point out some of the

biggest winners but also emphasize that buying IPOs is no guaranteed way to make

a profit for investors. Additionally the IPO by Google featured in the last Finance in

Action Box and the IPO by Facebook highlighted later can create some interest in

this chapter.

II. The Role of Investment Banking

A. The role of investment banking has been to act as the middleman between

investors with money and companies in need of capital.

B. Investment bankers have been merging and the industry has consolidated to the

point where the top 10 underwriters controlled 51.9 percent of the global market

in 2014 down from 54.2% in 2013.

PPT Global Ranking of Investment Bankers 2014 (Table 15-2)

III. Enumeration of Functions

A. Underwriter: The risk-taking function. The underwriter bears the risk of

fluctuations in the selling price of the security issue. The investment banker may

handle the issues of unknown corporations on a nonrisk-bearing “best efforts”

basis only.

Education.

15-2

B. Market maker: The investment banker may engage in buying and selling of a

security to ensure an available market.

C. Advising: Corporations may seek an investment banker’s advice on the size,

timing, and marketability of security issues. Advice is also rendered pertaining

to merger and acquisition decisions, leveraged buyouts, and corporate

restructuring.

D. Agency functions: As an agent, the investment banker assists in the private

placement of security issues and in the negotiating process of merger and

acquisition transactions.

E. Note in Table 15-3 the diverse areas where investment bankers make their

money. Competition is keen among investment bankers and many limit

themselves to specific segments where their reputation and expertise is highest.

Table 15-3 indicates that Morgan Stanley, JPMorgan and Goldman Sachs

dominate the categories.

PPT Top Investment Bankers by Product 2014 (Table 15-3)

Perspective 15-1: Further explain that these Wall Street firms are financial conglomerates

providing a variety of services such as those listed in the table as well as brokerage, mutual

fund management, wealth management for individuals and pension funds and more.

IV. The Distribution Process

A. The managing investment banker forms an underwriting syndicate of investment

bankers to increase marketability of the issue and spread the risk.

B. Syndicate members, acting as wholesalers, sell the securities to brokers and

dealers who eventually sell the securities to the public.

PPT Distribution Process in Investment Banking (Figure 15-1)

C. The spread is the difference in the price of a security to the public and the

amount paid to the issuing firm and represents the compensation of those

participating in the distribution.

1. The spread is divided among the distribution participants. The lower a

party falls in the distribution hierarchy, the lower the portion of the

Education.

15-3

spread received.

2. Usually, the larger the dollar value of an issue, the smaller the spread.

3. The spread on equity issues is greater than on debt issues because of the

greater price uncertainty.

PPT Allocation of Underwriting Spread (Figure 15-2)

V. Pricing the Security

A. Several factors must be considered by the managing investment banker when

negotiating the issue price of a security of a first-time issuer.

1. Experience of the firm in the market.

2. Financial position of the issuing firm.

3. Expected earnings and dividends.

4. P/E multiples of firms in the same industry.

5. Anticipated public demand.

Finance in Action: Warren Buffett’s Bailout of Goldman Sachs

At the peak of the financial crises of 2008, Berkshire Hathaway stepped in to rescue Goldman

Sachs by buying $5 Billion worth of preferred stock and warrants to buy $5 billion of common

stock at $115 per share. The influx of cash not only helped Goldman Sachs avoid financial

collapse but actually increased the stock price from $113 to $176; a healthy benefit for both

parties. Buffett actually traded in his warrants for 13.06 million shares of stock in 2013. Have

your students research the transaction on Google.

Perspective 15-2: Investment bankers take price risk and are motivated to price issues

conservatively to sell out the issue. Corporations want the highest price possible. This

potential conflict may create interesting situations and is worthy of discussion.

B. The issue price of securities of firms with existing securities outstanding is

usually determined by “underpricing.”

1. Price is set slightly below current market value.

2. Underpricing is partially a result of the dilutive effect of spreading

earnings over a greater number of shares of stock.

C. Table 15-6 shows that debt offerings dominate new issues of common stock by

more than 6 to 1 in 2014. This is always a surprise to student who often think of

bonds as boring markets. The fact that debt has a maturity date and needs to be

Education.

15-4

refinanced and common stock has no maturity date is the key to this dichotomy.

PPT Global Debt and Equity Capital Markets Bookrunner Rankings

(Table 15-6)

D. Dilution: When new common stock is sold, the new shares issued immediately

cause earnings per share to decline until the earnings can be increased from the

investment of new funds.

E. Market Stabilization. The managing investment banker seeks to stabilize the

market (keep the sales price up) by repurchasing securities while at the same

time selling them. Note that the SEC recognizes that underwriter price support is

a form of market manipulation, but the practice is allowed as a justifiable

element of smoothly functioning IPO markets.

Perspective 15-3: The stabilization process for the Facebook IPO is highlighted by Figures

15-3 and 15-4.

F. Aftermarket: Research has indicated that initial public offerings often do well in

the immediate aftermarket. However, average long-run returns for IPOs appear

to be relatively poor.

G. Shelf Registration

1. Large companies are permitted to file one comprehensive registration

statement and then wait (hold securities on a shelf) until market

conditions are favorable before issuing securities without further SEC

approval. Previously, a registration statement had to be filed for each

security issue. Shelf registration has been used primarily for debt issues.

2. A greater concentration of business among the stronger firms in the

investment banking industry has resulted from the shelf registration

process.

H. In 1999 Congress passed the Gramm-Leach-Bliley Act that repealed the

Glass-Stegal Act. The Glass-Stegal Act required that commercial banks and

investment banks operate independently of each other. While the investment

banking market was already competitive, Gramm-Leach-Bliley allows

combinations between investment banks and commercial banks. Note that

Citigroup and JP Morgan, two of the leading security underwriters, also own two

of the three largest U.S. commercial banks, Citibank and Chase, respectively.

Education.

15-5

VI. Public versus Private Financing

A. Advantages of being public

1. Greater availability of funds

2. Prestige

3. Higher liquidity for stockholders

4. Established price of public issues aids a stockholder’s estate planning

5. Enables a firm to engage in merger activities more readily

B. Disadvantages of being public

1. Company information must be made public through SEC and state filings

2. Accumulating and disclosing information is expensive in terms of dollars

and time

3. Short-term pressure from security analysts and investors

4. Embarrassment from public failure

5. High cost of going public

6. Sarbanes-Oxley requirements have added additional burdens

VII. Public Offerings

A. A classic example: Rosetta Stone goes public

1. Table 15-7 shows the costs of issuance including the following fees: SEC

registration fee, FINRA filing fee, initial NYSE listing fee, legal fees and

expenses, accounting fees and expenses, printing expenses, transfer agent

and registrar fees and expenses, and miscellaneous expenses.

2. Figure 15-6 demonstrates what often happens after an IPO. Large

shareholders decide to sell more shares after the IPO. The increased

supply of shares and the negative signal that large shareholders are

exiting the stock sends the price down.

VIII. Private Placement. Private placement refers to selling securities directly to insurance

companies, pension funds, and others rather than going through security markets.

Private placement is used more for debt than equity issues.

A. Advantages and disadvantages of private placements

1. Advantages

Education.

15-6

a. Eliminates the lengthy, expensive registration process with the

SEC

b. Greater flexibility in negotiating terms of issue

c. Costs of issue are less

2. The usually higher interest cost on a privately placed debt instrument is a

disadvantage.

Perspective 15-4: Discuss the consequences for public markets if the trend to utilize private

placement increases.

Finance in Action: Tulip Auctions and the Google IPO

This box describes how Google went public using a Dutch auction rather than the standard

methods discussed in this chapter. Google’s decision was driven, at least in part, by a desire to

avoid under pricing its stock in the offering. Dutch auctions are used extensively for Treasury

auctions, but IPOs are rarely priced in this manner. Google’s IPO was underpriced anyway.

However, underwriter fees were only 2.8%, which is certainly less than a traditional IPO would

have cost the firm. Also, Dutch auctions appear to remove at least some to the disadvantages

faced by small investors in the traditional IPO process.

B. Going Private and Leveraged Buyouts

1. Firms that elect to go private are usually small companies that are

seeking to avoid large auditing and reporting expenses. In the 1980’s,

however, large firms have been going private to avoid the pressure of

pleasing analysts in the short term. There are two basic ways to go

private. The public firm can be purchased by a private firm or the

company can repurchase all publicly traded shares from the stockholders.

2. Many firms have gone private through leveraged buyouts. Management

or some external group borrows the needed cash to repurchase all the

shares of the company. Frequently the management of the private firm

must sell off assets in order to reduce the heavy debt load.

3. Several firms that have gone private during the 1980s have restructured

and returned to the public market at an increased market value. In some

cases the firm was divided and the divisions were sold separately. The

“breakup value” of some firms such as Beatrice and Uniroyal was

substantially higher than the market value of the unified entity.

IX. International Investment Banking Deals

Education.

15-7

A. Privatization: Beginning in the 1980s and continuing today, many governments

around the world are selling state-owned companies to individual and

institutional investors. China is probably the current leader in this activity as the

communist country tries to create large publicly-owned companies that can

become more efficient through the pressure of being compared to other publicly

traded companies in its competitive industry. Markets do have a way of

rewarding successful companies and penalizing underperforming ones.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 22, Robert Boyle & Associates, Inc. (Going Public and Investment Banking)

Case 23, Glazer Drug Co. (Initial Public Offering)

Education.

15-8