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CHAPTER 19 INVESTMENT BANKING
Primary Services of an Investment Bank Bringing New Securities to Market. Trading and brokerage. Mergers and acquisitions. Other business activities. Copyright© 2006 John Wiley & Sons, Inc.2
Bringing New Securities to Market New issues are called primary offerings, first issued in the primary market. – Unseasoned offering or Initial public offering (IPO) – first sale of securities to the public. One problem with IPO is how to price them, therefore, IPO suffers from underpricing. – Seasoned offering - additional issue of securities already trading. Offering can be either: – Public offering – Private placement Copyright© 2008 John Wiley & Sons, Inc. 3
Bringing New Securities to Market – Public offering: Corporation wishing to make a public offering must decide whether to have: -Underwriting: investment banker guarantees that the issuer will receive a fixed amount of money whether securities are sold or not. -Best-efforts basis: investment banker makes no guarantee and instead promises only to make its best sales efforts. Copyright© 2006 John Wiley & Sons, Inc.4
Bringing New Securities to Market Corporation wishing to make an underwriting security can choose to solicit investment- banking services through: -Competitive bidding: the issuer publicly announces a desire to sell securities and solicits offers from several investment-banking firms. -Negotiated offering: direct negotiation with a single investment banker. Copyright© 2006 John Wiley & Sons, Inc.5
Bringing New Securities to Market (continued) Three steps of bringing a new issue to market: 1. Origination- During the origination process, investment bank helps the issuers to – analyze the feasibility of the project, determine the amount of money and type of financing. – design of a security contract that is acceptable to the market; Prepare SEC registration statements and a summary prospectus, obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee. Copyright© 2008 John Wiley & Sons, Inc. 6
Bringing New Securities to Market (concluded) 2.Underwriting (price risk bearing) - the IB buys the securities at a given price to resell them to the public at a higher price. 3.Sales and distribution - selling quickly reduces inventory risk. Syndicates are formed to reduce inventory risk. Market price declines cut the IB's margin. Copyright© 2008 John Wiley & Sons, Inc. 7
Underwriting Agreements In an underwritten offer, IB guarantees the issuer a certain price – The risk of not selling the issue at a price higher than that promised to the issuer is borne by the IB. – The difference between the price at which the issue is sold and that promised to the issuer is the underwriting spread. – This is the profit earned by the IB. Copyright© 2008 John Wiley & Sons, Inc. 8
Underwriting Agreements In a best efforts offer, the investment bank does not guarantee a price or that the issue will be sold. – The investment bank is compensated based on the number of securities sold. – The risk of the securities not selling or not selling at a desired price is borne by the issuer, not the IB. – Smaller and more risky issues resort to this type of offering. Copyright© 2008 John Wiley & Sons, Inc. 9
Trading and Brokerage Besides underwriting, investment banks provide services as brokers and dealers for existing securities. The brokerage function is to bring a buyer and seller together for a commission. Dealer (making market) function - buying (bid) and selling (ask) from an inventory of securities owned by the seller. Copyright© 2008 John Wiley & Sons, Inc. 10
Trading and Brokerage (continued) Brokers and dealers can also provide security credits which represent loans to customers with margin account. Margin trading: means that the investor can buy securities partly with borrowed money. – Example: if a customer uses a 40% margin, it means that 40% of the purchased securities is being financed with the investor’s own money and the remaining 60% is financed with money borrowed from the brokerage house. Dealer security credits are financed by bank call loans and repurchase agreements. Copyright© 2006 John Wiley & Sons, Inc.11
Trading and Brokerage (continued) Full service brokerage firms offer a wide range of services provided by licensed stockbrokers or account executives: – Storage or safekeeping of securities. – Execution of trades. – Investment research and advice. – Cash management service. Copyright© 2008John Wiley & Sons, Inc. 12
Trading and Brokerage (concluded) Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions. Banks may act as a broker on behalf of its customers. Arbitrage activities involving the simultaneous buying/selling of a security to take advantage of a price that exists between two markets is another trading activity of IB. – Example: if GMC stock is trading for $35/share on New York Stock Exchange (NYSE )and $34/share on the NASDAQ, an arbitrageur would buy GMC stock on NASDAQ and sell it on NYSE, so he will earn$1. this process will continue until the price differential is eliminated. Copyright© 2008 John Wiley & Sons, Inc. 13
Private Placements The sale of securities directly to the ultimate investor (no public offering). The underwriting function/cost is avoided. The investment banker’s role is to: – Bring buyer and seller together. – Help determine a fair price for the securities. – Execute the transaction. Investment banks earn a fee. Copyright© 2008 John Wiley & Sons, Inc. 14
Private Placements Advantages of private placement: – Less costly in terms of time and money (i.e. reduce the total flotation costs for a business or government). – The extremes of high credit quality firms and low or unknown credit quality firms use private placements. – The terms of private placement are easier to renegotiate. Disadvantages of private placement: – Securities have no readily available market price, they are less liquid and there is a small group of investors. Copyright© 2006 John Wiley & Sons, Inc.15
Mergers and Acquisitions Investment banks provide four categories of M&A for which they can earn fees: – Help firms indentify M&A candidates. – Do the required analysis to price the deal. – Provide advice and help the acquiring firm in negotiating. – Help the acquiring firm in obtaining the funds to finance the purchase. Copyright© 2006 John Wiley & Sons, Inc.16
Mergers and Acquisitions Specialized IB departments provide the following services. – Arrange mergers which would produce economic synergy or increase total value. – Assist firms in fighting hostile takeovers. – Help establish the value of target firms. Mergers and acquisitions have been a profitable aspect of the IB business. CB have expanded their M&A departments. Copyright© 2008 John Wiley & Sons, Inc. 17
Other business activities Investment-banking firms are very flexible organizations and if they can earn a satisfactory return, they can perform many services: – Financial consulting: e.g. assisting clients in financial planning, determining the firm’s optimal capital structure and dividend policy. – Real estate investment and brokerage: purchasing real estate for investment purposes. Copyright© 2006 John Wiley & Sons, Inc.18
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