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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 “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
aftermarket 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 15-7 to highlight the investment banking
process with real firms and the concentration and competition within the investment banking market.
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.
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.
LO5. Leveraged buyouts rely heavily on debt in the restructuring of a corporation.
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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
PPT Examples of Equity IPOs 2014–2018 (Table 15-1)
While the IPO markets are exciting for the big winners, we 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 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 investment bankers controlled 49.0 percent of the global market in
2017, up from 47.1 percent in 2016.
PPT Global Ranking of Investment Bankers, 2017 v. 2016 (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 non–risk-bearing “best–efforts” basis only.
D. Agency functions: As an agent, the investment banker assists in the private placement
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of security issues and in the negotiating process of merger and acquisition
transactions.
E. Note in Tables 15-3 and 15-4 the diverse areas where investment bankers make their
money. Competition is keen among investment bankers and many limit themselves to
PPT Banking Leaders Based on Fees for the Year Ended December 26,
2017 (Table 15-3)
PPT Underwriting Fees and Number of Deals by Quarter and Product
(Table 15-4)
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
2. Usually, the larger the dollar value of an issue, the smaller the spread is as a
percentage of the offering price.
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PPT Allocation of Underwriting Spread (Figure 15-2)
PPT Underwriting Compensation as a Percentage of Proceeds (Table 15-5)
PPT Total Costs to Issue Stock (Percentage of Total Proceeds) (Table 15-6)
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.
3. Expected earnings and dividends.
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 as well as warrants to buy an additional $5 billion of
Perspective 15-2: Investment bankers take price risks 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
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of new funds.
D. 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
PPT Facebook Share Price on the First Day of Trading (Figure 15-3)
PPT Facebook Closing Quotes on May 18, 2012 (Figure 15-4)
Perspective 15-3: The stabilization process for the Facebook IPO is highlighted by Figures
15-3 and 15-4.
E. Aftermarket: Research has indicated that initial public offerings often do well in the
1. Large companies are permitted to file one comprehensive registration
statement and then wait (hold securities on a shelf) until market conditions
2. A greater concentration of business among the stronger firms in the
investment banking industry has resulted from the shelf registration process.
G. In 1999 Congress passed the Gramm-Leach-Bliley Act that repealed the Glass-
Steagall Act. The Glass-Steagall Act required that commercial banks and investment
VI. Public versus Private Financing
A. Advantages of being public
1. Greater availability of funds
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3. Higher liquidity for stockholders
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
4. Embarrassment from public failure
6. Sarbanes-Oxley requirements have added additional burdens
VII. Public Offerings
A. A classic example: Rosetta Stone goes public
1. Table 15-8 shows the costs of issuance including the following fees: SEC
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.
PPT Rosetta Stone’s Prospectus (Figure 15-5)
PPT Out-of-Pocket Costs for Rosetta Stone IPO (Table 15-8)
PPT 2009 Stock Returns for Rosetta Stone and S&P 500 Index (Figure 15-6)
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
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1. Advantages
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 Managerial: 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
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 1980s, 1990s, and mid-
2. Many firms have gone private through leveraged buyouts. Management or
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
IX. International Investment Banking Deals
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
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 23, Glazer Drug Co. (Initial Public Offering)