1. Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Investment Banking Public and Private Placement 15

2. 1-2 Chapter Outline What is investment banking? Functions of an investment banker Dilution of earnings Public versus private financing Leveraged buyouts and debt for restructuring of a corporation

3. 1-3 The Role of Investment Banking The investment banker is the link between the corporations in need of funds and the investor –Responsible for designing and packaging a security offering –Responsible for selling the securities to the public

4. 1-4 Concentration of Capital Allows large firms to take additional risks and satisfy the needs of an increasingly demanding capital market –Competition has propelled many businesses to the position they are at now –Raising capital has become an international proposition –Firms that are very large have the ability to compete –International consolidations with international buy-outs of banks have become common

5. 1-5 Gramm-Leach-Bliley Act (1999) Repealed the separation policy of the Depression-era laws –Which included separating banking, brokerage, insurance, and investment banking into separate entities Federal Reserve and Treasury: –Have the power to impose restrictions on the activities of the banks –Allows strong banks to participate in the venture capital market

6. 1-6 Investment Banking Competitors There is intense competition in the market –Being a leader in one sector helps a firm’s overall reputation –It, however, does not ensure success in other areas

7. 1-7 Functions of the Investment Dealer Underwriter: –buying the security and reselling it to the public (large companies). Takes a risk. –selling security on commission basis (unknown companies) Market Maker: –ensuring an available market by buying and selling the security Advisor: –on securities issues, mergers and acquisitions, leveraged buyouts, corporate restructuring Agent: –for private placements, mergers, acquisitions PPT 15-4

8. 1-8 Underwriter An investment banker underwrites any risk associated with a new issue: –By giving a ‘firm commitment’ to purchase the securities from the corporation Large investment houses assume risk of distribution Smaller investment houses may handle distributions for unknown corporations –This is done on a “best efforts” or commission, basis

9. 1-9 Market Maker Investment banker engaged in buying and selling of the security to ensure a liquid market –Provides research on the firm to encourage active investor interest

10. 1-10 Advisor Services offered include advising the client on a continuing basis about: –The types of securities to be sold –The number of shares or units for distribution –The timing of the sale Important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring are also offered

11. 1-11 Agency Functions An investment banker may act as an agent for a corporation –That wishes to place its securities privately with: An insurance company, A pension fund, or A wealthy individual –Involves in negotiation of the best possible deal for the corporation with potential investors

12. 1-12 Distribution Process in Investment Banking

13. 1-13 The Spread The underwriting spread represents the total compensation for all participating members –The lower a party falls in the distribution process, the higher the price for the shares –The farther down the line the securities are resold, the higher the potential profit –The larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price

14. 1-14 Allocation of Underwriting Spread

15. 1-15 Pricing the Security Investment Banker –Price of the stock is an important consideration –Conduct an in-depth analysis to determine a firm’s value: The company’s industry Financial characteristics Anticipated earnings Dividend-paying capability

16. 1-16 Pricing the Security (cont’d) Based on a technique deemed appropriate by the underwriter: –A tentative price is assigned –This will be compared to others in that given industry –Anticipated public demand also plays a major factor Underpricing –Setting the price slightly below the current market value Common during the issuance of additional shares

17. 1-17 Dilution Problem associated with the issuance of additional securities: –Actual or perceived dilution of earnings effect on shares currently outstanding –May be caused by the perceived time lag in the recovery of earning per share Resulting from increase in shares outstanding

18. 1-18 Market Stabilization An investment banker is responsible for stabilizing the offering during the distribution period: –Accomplished by repurchasing securities when market price is below initial public offering price –Stabilization lasts for two or three days after initial offering –Poor market environment - stabilization may be very difficult to achieve –Underwriter price support – an exception to market manipulation

19. 1-19 Aftermarket Research shows that the IPO generally tends to perform well in the immediate aftermarket –After the first day of trading, IPO returns are approximately 3.4% lower than returns for similar sized firms over the first full year of trading –The IPO appears to be a good deal for investors who purchase shares from the underwriter

20. 1-20 Shelf Registration (1982) Permits large companies to file one comprehensive registration statement –Should outline the firm’s financing plans for up to 2 years –The firm can issue securities without further SEC approval –This registration has become part of the underwriting process –Most frequently used with debt issues, and utilized minimally with the equity markets

21. 1-21 Public Vs. Private Financing for Companies Publicly financed company: –when shares of a company are offered to the public –anyone can buy shares of the stock Privately financed company: –privately owned or held by an individual or family –securities not available to the general public –additional funds may be raised by private placement PPT 15-9

22. 1-22 Advantages of Being Public To the Corporation: –Tap security markets for greater amounts of funds –Associated prestige – better relationships –Ability to purchase another firm using its own stock as currency To the Stockholders: –Ability to achieve a higher degree of liquidity and to diversify his/her portfolio –Stockholders of a private corporation can sell holdings if it decides to go public

23. 1-23 Disadvantages of Being Public All information must be made public through SEC and state filings Tremendous pressure for short-term performance by security analysts and large institutional investors For small firms, the underwriting spread and the out-of-pocket costs can run in the 15- 18% range

24. 1-24 Public Offerings - Examples A classic example of instant wealth – EDS goes public Internet Capital Group –Refer to the chapter for the complete story

25. 1-25 Public Offerings – Examples

26. 1-26 Internet Capital Group Price Chart (as of January 25, 2008)

27. 1-27 Private Placement Selling of securities not through the security market but directly: –Insurance companies –Pension funds –Wealthy individuals Device is employed by: –Firms that wish to avoid or defer an IPO offering –A publicly traded company wishing to merge private funds into its financing package

28. 1-28 Advantages of Private Placement No lengthy, expensive registration process with the SEC Firm has greater flexibility in negotiating than is possible in a public offering Initial costs of a private placement may be considerably lower than those of a public issue

29. 1-29 Disadvantages of Private Placement Interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation

30. 1-30 Going Private The trend: –1970s, a number of small firms gave up their public listings to be private –1980s, 1990s, and mid-2000s, very large companies began going private Reason: –Costs could be saved in annual report expenses, legal and auditing fees, and security analysts meetings

31. 1-31 Methods of Going Private Two ways of going private: –A publicly owned company is purchased by a private company or a private equity fund –To repurchase all publicly traded shares from stockholders

32. 1-32 Leveraged Buyout Either the management or some other investor group borrows the needed cash to repurchase all the shares of the company –The company exists with substantial debt and heavy interest cost –Management of the private company must sell assets to reduce the debt load –Corporate restructuring occurs: Divisions and products are sold Assets redeployed into new, higher-return areas

33. 1-33 Leveraged Buyout (cont’d) Investment bankers, as specialists in the valuation of assets, try to determine the ‘breakup value’ of a large company –This is its value if all divisions were divided up and sold separately

34. 1-34 Privatization Privatization involves: –Investment bankers taking companies public –The companies sold have been previously owned by governments