1. Chapter 23 Investment Banks and Security Brokers and Dealers

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-2 Chapter Preview Everything from buying stock to raising money through a bond issuance typically requires an investment banking firm. The smooth functioning of securities markets requires many financial institutions, beyond the companies discussed to far. These investment banks, brokers, etc are the focus of chapter 23.

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-3 Chapter Preview We examine the role played by investment banks (primary market), securities dealers and brokers (secondary market), and venture capital firm (pre-market). Topics include: – Investment Banks – Security Brokers and Dealers – Regulation of Securities Firms

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-4 Chapter Preview (cont.) – Relationship Between Securities Firms and Commercial Banks – Private Equity Investments

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-5 Investment Banks Investment banks perform a variety of crucial functions in financial markets – Underwrite the initial sale of stocks and bonds – Deal maker in mergers, acquisitions, and spin-offs – Middleman in the purchase and sale of companies – Private broker to the very wealthy

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-6 Investment Banks Investment banks were essentially created in the U.S. by the passage of the Glass-Steagall Act. Prior to this, investment banking activities were part of large, money-center commercial banks. The lines between investment banks and commercial banks again begins to blur as legal separation between investment banks and commercial banks is no longer required.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-7 Investment Banks Investment banks play many roles in both the primary and secondary markets. We will focus on their role in three areas: Underwriting Stocks and Bonds Equity Sales Mergers and Acquisitions But first, let’s look at the largest U.S. underwriters.

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-8 Underwriting Stocks and Bonds The process of underwriting a stock or a bond issue requires that the investment banker purchase the entire offering at a predetermined price and then resell the offering (securities) in the market. The services provided during this process include: – Giving Advice – Filing Documents – Underwriting, Best Efforts, or Private Placement

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-9 Underwriting Stocks and Bonds Giving advice – Explaining current market conditions in to help determine what type of security (equity, debt, etc.) to offer – Assisting in determining when to issue, how many, at what price (more important with IPOs than SEOs)

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-10 Underwriting Stocks and Bonds Filing Documents – SEC registration (filing) is required for issues greater than $1.5 million and with a maturity greater than 270 days. – A portion of the registration statement known as the prospectus is made available to the public. – Debt issues require several additional steps, including acquiring a credit rating, hire a bond counsel, etc. – For equity issues, the investment banker may also arrange for the securities to appear on one of the exchanges.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-11 Underwriting Stocks and Bonds Underwriting (firm commitment) – The investment banker purchases the entire offering at a fixed price and then resells the offering to the market. – An underwriter may form an underwriting syndicate to diffuse part of the underwriting risk. – Placement of a tombstone in, for instance, the Wall Street Journal (example on next slide).

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-13 Underwriting Stocks and Bonds The goal of underwriting is for all of the shares in an offering to be spoken for. However, this may not occur. – Fully subscribed: all shares are spoken for – Undersubscribed: underwriting syndicate unable to generate interest in all of the available shares – Oversubscribed: interest in more shares than are available (may lead to rationing).

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-14 Underwriting Stocks and Bonds

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-15 Underwriting Stocks and Bonds Best Efforts: An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort” to sell the entire issue. Private Placements: The entire issue is sold to a small, selected group of investors. This is rarely done with equity issues.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-16 Underwriting Stocks and Bonds Equity Sales: when a firm sells an entire division (or maybe the entire company), enlisting the aid of an investment banker. – Assists in determining the value of the division or firm and find potential buyers – Develop confidential financial statements for the division for prospective buyer (confidential memorandum) – Prepare a letter of intent to continue, assist with due diligence, and help reach a definitive agreement

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-17 Mergers and Acquisitions Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal). Deal may be a hostile takeover, where the target does not wish to be acquired. Investment bankers will assist in all areas, including deal specifics, lining up financing, legal issues, etc.

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-18 Securities Brokers and Dealers Securities firms with brokerage services offer several types of services: Brokerage Service Other services Full-Service Brokers versus Discount Brokers

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-19 Securities Brokers and Dealers Securities Orders: when you call a brokerage house to buy or sell a security, you essentially have three options: – Market Order: buy or sell security at current price – Limit Order: you specify the most you are willing to pay (buy) or the least you are willing to accept (sell) for a security – Short Sales: sell a security you don’t own with the intent of buying it back at a later date (hopefully at a lower price)

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-20 Securities Brokers and Dealers Other Services – Insurance against loss of actual security documents – Margin credit for purchasing equity with borrowed funds – Other services driven by market demand (e.g., the Merrill Lynch cash management account)

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-21 Securities Brokers and Dealers Full Service Brokers: offer clients research and investment advice, but usually charge a higher commission on trades. Discount Broker: provides facilities to buy/sell securities but offers no advice. Many on-line discount brokerage firms do have significant research available

22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-22 Securities Brokers and Dealers Securities Dealers – Hold inventories of securities on their own account – Provide liquidity to the market by standing by ready to buy or sell securities (market maker) – Especially important for thinly traded securities

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 23-23 Regulation of Securities Firms Two acts passed in 1933 and 1934 provide the primary basis of today’s markets. The major provisions include: Establishment of the SEC Registration requirement for new securities Reporting requirements for companies and insiders Prohibition of market manipulation