How Securities are Traded FIN 200 Investments CHAPTER 3 How Securities are Traded

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public.

How Firms Issue Securities Initial Public Offerings (IPOs) Investment Banking Shelf Registration Private Placements

How Firms Issue Securities IPO = Initial Public Offering Stocks issued by a company that has been privately owned until the sale of their shares. Why would a company sell shares of their company and go public? New issues of stocks or bonds marketed (sold) by investment bankers on Primary Markets.

Seasoned Equity Offerings (All Equities) Offerings of equity by companies that are already publicly owned. Why would a company that is already publicly owned, Sell more shares in their company? Expect that people will buy their shares?

Bond Markets Public Offering Sold to the general investing public that can be traded on secondary markets. Private Placement Sold to institutional investors and usually held to maturity.

The issuer (business firm) receives the proceeds (money) from the sale. Secondary Markets Existing owner sells to another person. Issuing firm doesn’t receive proceeds and is not directly involved

Secondary Markets Existing owner sells to another person. Issuing firm doesn’t receive proceeds and is not directly involved. What future relationship will the issuing firm have with the person who purchased the equity on the secondary market? Trading in the secondary market is the changing of ownership.

The role of Investment Banks UNDERWRITERS Public Offerings are marketed and sold by investment bankers. A team of investment bankers is usually needed to do the job.

Investment Bankers advise the issuer about how to best sell their securities Prospects for the resale values Complete the registration paperwork with the Securities exchange Commission (SEC) which promises that they will not attempt to sell until permission is granted. Known as a red herring and printed in red. When approved by the SEC, the approval is known as a Prospectus and information can be shared with the public.

Usual Practise The underwriter (investment bank) purchases the securities for one price and resells them to the pubic for a higher price. Their profit (commission). The profit to the underwriter is known as the firm commitment.

Shelf Registrations SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf Allows firms to register their securities and gradually sell them to the public for up to 2 years following initial registration. The benefits of shelf registration include Do not have to release all the equity at one time Only have to service the debt or commitment when the money is being used Minimal paperwork and low cost incurred when it is time to sell (float more securities

Concept Check 1 Why does it make sense for shelf registration to be limited in time? Limited time shelf registration was introduced because of its favorable trade-off of saving issue cost against mandated disclosure. Allowing unlimited shelf registration would circumvent “blue sky” laws that ensure proper disclosure as financial circumstances of the firm change over time.

Private Placements versus public offering Sale to a limited number of large institutional investors not requiring the protection of registration Less expensive because the fewer SEC registration requirements = lower cost = better value Private Placements do not trade on Secondary Markets Name an investor that would be willing to buy private placements. This reduces their liquidity (WHY?) Reduces the price that investors are willing to pay (WHY?)

Initial Public Offerings Process Road shows Bookbuilding Underpricing Post sale returns Cost to the issuing firm

IPO – The Process The SEC commented on the registration so that the public can see if there are any concerns. A Preliminary Prospectus is distributed. Prospectus = the companies prospects (the good things about the company, the challenges in their market, the economy, etc.) Investment bankers begin to tour the country (Road Show) to publicize (market) the offering. 1

The purpose of the Road Show Generate interest among potential investors and share information about the offering (pre-sell). Allows the Lead Underwriter to gather information from the people they meet and share it with the issuing firm partner underwriters

Underwriters collect the names of those interested in buying, in a book. The term Book or Bookbuilding refers to the list of people who will be called back when the security goes on sale. Institutional investors provide valuable information to investment bankers and underwriters, about Current market demand and value of the security. Competition from other firms in the same industry as the issuer.

It is common for the investment bankers to revise their original estimates of the offering price, and number of shares to be offered based on the road-show discussions with the investing community.

The success of relationships is based on trust Truth is the best policy The markets are built on trust Why do investors truthfully reveal their interest in an offering to an investment banker? If they pretend to be less interested, maybe the purchase price will be less. If the purchase price is less, maybe the profit will be less. 1

If they are a team and work together, they can create a win-win situation. When shares are sold, the decision on how many shares to issue is based on the information gathered from prospective investors. If the information is not good, they may issue to few shares. Therefore, if investors are optimistic, the security will be offered in the quantity that is most profitable for everyone involved.

Underwriters (investment bankers) therefore must offer the security at a lower price to their prospective investors who will have their name added to the book tell others about the offering IPOs are often underpriced to encourage investors to buy in early. Prices sometimes increase significantly when they are first publicly traded.

Textbook example. Page 56-57 VA Linux (software). Linux was priced at $30 per share in the IPO. At closing on the first day of public trading, the price was $239.25. Historically, IPO expenses are approximately 7% of the total funds raised. If the shares would have been priced at $239.25, the company would have raised 8X as much money. Within 1 year the share price was $9 and 2 years later was less than $1.

The difference between the $30 per share and the $239 per share is known as “the money left on the table”. This example is very uncommon. Reminder. Under-pricing is necessary, but requires careful evaluation.

Figure 3.2 Average Initial Returns for IPOs in Various Countries Why do you think that the five countries on the far right have much higher first day returns? Institutional investors purchase the bulk of newly issued stock, which some people consider unfair. If there were no discounts offered to the institutional investors, what would be their motivation for providing accurate information about a fair value and market competition? The discounts are their payment for the most reliable information available, which can lead to future profits by everybody.

Risks and Abuse Scandals in 2002 revealed that some IPOs were very underpriced. Known as “spinning”, and sold by investment bankers to other business people (like a kickback), with the promise of future investment banking services between the two. Not all IPOs are underpriced. Some stock is valued at less than the IPO price within days. Others can not be fully sold off and underwriters must sell them for a loss.

More slides to come