1. CHAPTER 18 INVESTMENT BANKING Copyright© 2012 John Wiley & Sons, Inc.

2. 2 Investment Banking Investment Banks (IB) are the most important participant in the direct financial markets Assist firms and governments in selling new securities in the primary market Make the market (dealer) or arrange the buying and selling (broker) in the secondary market Copyright© 2012 John Wiley & Sons, Inc.

3. 3 Investment And Commercial Banks Differ Commercial Banks (CB) accept deposits and make commercial loans as a financial intermediary. CB traditionally could underwrite only low- risk securities of governments under the Glass-Steagall Act. Many large firms now use the direct financial markets rather than bank loans to finance. Copyright© 2012 John Wiley & Sons, Inc.

4. 4 U.S. versus Other Developed Nations Until 1999, investment banks in the U.S. could not do commercial banking activities and vice versa. Outside of Japan, in most other developed nations, financial institutions are allowed to do both investment and commercial banking. They are called Universal Banks. Engage in deposit taking, making loans, brokerage, securities underwriting, and insurance. Copyright© 2012 John Wiley & Sons, Inc.

5. 5 Largest Investment Banks Copyright© 2012 John Wiley & Sons, Inc.

6. 6 Early History IBs trace their origins to European investment houses which branched to the U.S. Early U.S. CBs were chartered for note issue and business lending, Different from private IBs, organized as partnerships. IBs grew with the growth of security issuance and trading in the Civil War and later in the railroad and steel industries. CBs pressured for investment banking privileges from their regulators, and by the 1930s, they could provide full IB services. Copyright© 2012 John Wiley & Sons, Inc.

7. 7 Glass-Steagall Act Separated CB and IB in the U.S. The Glass-Steagall Act of 1933 (Banking Act) restricted the asset powers of commercial banks to low risk underwriting areas. In other countries, universal banks were able to combine commercial and investment banking functions. Copyright© 2012 John Wiley & Sons, Inc.

8. 8 The Glass-Steagall Act (continued) CB could not underwrite (buy and resell) risky business securities. CB were limited as to the risk assumed in their investment portfolio - no risky corporate securities. IB firms were prohibited from engaging in CB. Firms became either IB or CB. Copyright© 2012 John Wiley & Sons, Inc.

9. 9 The Objectives of the Glass-Steagall Act Discourage speculation in financial markets. Prevent conflict of interest and self-dealing. Restore confidence in the safety and soundness of the financial system. Copyright© 2012 John Wiley & Sons, Inc.

10. 10 Gramm-Leach-Bliley Act Financial Services Modernization Act of 1999 Repealed Glass-Steagall Permitted CB, IB, and insurance underwriting under a financial holding company Triggered by the merger of Citicorp and Travelers Group into Citigroup Copyright© 2012 John Wiley & Sons, Inc.

11. 11 Primary Services of an Investment Bank Bringing new securities to market Public Offering Private Placement New issues are called primary issues, first issued in the primary market. Initial public offering (IPO) – first sale of securities to the public. Seasoned offering - additional issue of securities already trading. Copyright© 2012 John Wiley & Sons, Inc.

12. Initial Public Offerings and Returns, Exhibit 18.3A 12 Copyright© 2012 John Wiley & Sons, Inc.

13. Initial Public Offerings and Returns, Exhibit 18.3B 13 Copyright© 2012 John Wiley & Sons, Inc.

14. 14 Bringing New Securities to Market (continued) Three steps of bringing a new issue to market: Origination - 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© 2012 John Wiley & Sons, Inc.

15. 15 Bringing New Securities to Market (concluded) Underwriting - IB buys the securities at a given price to resell them to the public at a higher price. Sales and distribution - selling quickly reduces inventory risk. Syndicates are formed to reduce inventory risk. Market price declines cut the IB's margin. Copyright© 2012 John Wiley & Sons, Inc.

16. 16 Front Page of a Final Prospectus Copyright© 2012 John Wiley & Sons, Inc.

17. 17 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© 2012 John Wiley & Sons, Inc.

18. 18 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© 2012 John Wiley & Sons, Inc.

19. 19 Private Placements The sale of securities directly to the ultimate investor (no public offering). The underwriting function/cost is avoided. A fee is earned for the origination/selling or uniting the supplier and user of funds. A private placement may reduce the total flotation costs for a business or government. Copyright© 2012 John Wiley & Sons, Inc.

20. 20 Private Placements, cont. Traditional two year trading delay with private placement securities SEC Rule 144A permits trading among institutional investors before the two year limit. Increased liquidity of investment  lower liquidity risk premium  lower financing cost for borrower Copyright© 2012 John Wiley & Sons, Inc.

21. 21 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© 2012 John Wiley & Sons, Inc.

22. 22 Trading and Brokerage The brokerage function is to bring a buyer and seller together. Dealer function - buying (bid) and selling (ask) from an inventory of securities owned by the seller. Providing loans to customers, who invest the margin proportion and borrow the rest. Dealer security inventories and customer credit are financed by bank call loans and repurchase agreements. Copyright© 2012 John Wiley & Sons, Inc.

23. 23 Trading and Brokerage (continued) Full service brokerages 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© 2012 John Wiley & Sons, Inc.

24. 24 Trading and Brokerage (concluded) Discount (Internet) brokerages offer fewer non- fee services than full service brokers, but charge lower commissions. Banks may act as a broker on behalf of their customers under the Glass-Steagall Act. Banks moved into this area in the 1980s and 1990s usually as a discount broker. Arbitrage activities involving the simultaneous buying/selling between two markets is another trading activity of IB. Proprietary trading entails an IB using its own capital to make bets. Copyright© 2012 John Wiley & Sons, Inc.

25. 25 Private Equity Can be broken down into two primary groups: Venture Capital Private Equity Buyout Private Equity Most have a fixed life. Usually set up as limited partnerships. Commitments, drawdowns. Fee structure consists of management fee and carried interest. Copyright© 2012 John Wiley & Sons, Inc.

26. 26 Venture Capitalists VC are private equity financing. Venture capital and managerial advice is provided to high-risk businesses with potential for high returns; for an equity stake in the company. VC often invest in high-tech based firms that require large amounts of capital. VC is usually the intermediate financing between founders' capital and the IPO. Copyright© 2012 John Wiley & Sons, Inc.

27. 27 Venture Capital Organizations Private independent funds - most common, usually limited partnerships of institutional investors. Corporate subsidiaries - provides higher risk investments for large corporations. Small Business Investment Companies - closed-end investment trusts authorized under the SBIC Act of 1958. Individuals and entrepreneurs may provide funds and advice for a “piece of the action”. Copyright© 2012 John Wiley & Sons, Inc.

28. 28 Stages of Venture Capital Investments Seed financing is at the “idea” stage. Start-up financing is capital used in product development. First-stage financing is capital to initiate manufacturing and sales. Second-stage financing is for initial expansion. Third-stage financing allows for major expansion. Mezzanine financing prepares the company to go public. Copyright© 2012 John Wiley & Sons, Inc.

29. 29 Structure of Venture Capital Investments Substantial control over management decisions, such as participating on the board of directors. Some protection against downside risk. A share of capital appreciation - convertible preferred stock is popular. Copyright© 2012 John Wiley & Sons, Inc.

30. 30 Venture Capital Rates of Return VC think of rates of returns in terms of multiple of the amount invested. E.g., a VC expects to receive ten times the amount invested over six years. This would be a 47% annual rate of return. A less risky third-stage investment might return five times the amount invested over five years (38% per year). Copyright© 2012 John Wiley & Sons, Inc.

31. 31 Valuation of Venture Capital Investments Companies are compared to “comparable” public companies for valuation: comparable revenues, earnings, P/E ratios. Multiple-scenarios valuation such as: optimistic, expected, pessimistic. Copyright© 2012 John Wiley & Sons, Inc.

32. Buyout Private Equity Taking public companies and making them private. A leveraged buyout (LBO) is when a buyout is leveraged with debt. The interest paid on the debt comes from the cash flow generated by the company. 32 Copyright© 2012 John Wiley & Sons, Inc.