Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
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.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
15-1
15
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.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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.
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
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)
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
15-8
