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

2. 15-2 Chapter Outline What is investment banking? Functions of an investment banker. Advocacy on matters of mergers and acquisitions. Public versus private financing. Leveraged buyouts and debt for restructuring of a corporation.

3. 15-3 The Role of Investment Banking 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. 15-4 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. 15-5 Underwriters, Markets, and Rankings

6. 15-6 Gramm-Leach-Bliley Act (1999) Repealed the separation policy of the Depression-era laws.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.

7. 15-7 Investment Banking Competitors There is intense competition the market. –Being a leader in one sector helps a firms overall reputation. –It however does not ensure success in other areas.

8. 15-8 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 effort” basis or commission basis.

9. 15-9 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. 15-10 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 are some of the services offered. Important advisory services in the area of mergers, leveraged buyouts and corporate restructuring are also offered.

11. 15-11 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. 15-12 Distribution Process in Investment Banking

13. 15-13 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 of 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. 15-14 Allocation of Underwriting Spread

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

16. 15-16 Pricing the Security (cont’d) Based on a technique deemed appropriate by the underwriter: –A tentative price is assigned. –This will 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. 15-17 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. 15-18 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 to three days after initial offering. –Poor market environment - stabilization may be very difficult to achieve. –Underwriter price support – an exception to market manipulation.

19. 15-19 Aftermarket Research shows that the IPO generally tends to perform well in the immediate aftermarket. –After the first day of trading, an 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. 15-20 Shelf Registration (1982) Permits large companies to file one comprehensive registration statement. –Should outlines 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 issue, and utilized minimally with the equity markets.

21. 15-21 Public versus Private Financing Many companies, by choice or circumstance, prefer to remain private. –They restrict their financial activities to direct dealings.

22. 15-22 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 or her portfolio. –Stockholders of a private corporation can sell holdings if it decides to go public.

23. 15-23 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 to the 15- 18% range.

24. 15-24 Public Offerings - Examples A classical example of instant wealth – EDS goes public Internet Capital Group –Refer to the chapters for the complete story.

25. 15-25 Public Offerings – Examples

26. 15-26 Internet Capital Group Stock Price (as of January 13, 2006)

27. 15-27 Private Placements Selling of securities not through the security market but directly: –Insurance companies. –Pension funds. –Wealthy individuals. Device is employed by: –Firms who wish to avoid or defer an IPO offering. –A publicly traded company wishing to merge private funds into its financing package.

28. 15-28 Advantages of Private Placements 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. 15-29 Disadvantages of Private Placements Interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation.

30. 15-30 Going Private The trend: –1970s, a number of small firms gave up their public listings to be private. –1980s and 1990s, very large companies began going private. Reason: –Costs could be saved in annual report expenses, legal and auditing fees, and security analyst meetings.

31. 15-31 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. 15-32 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. 15-33 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. 15-34 Privatization Privatization involves: –Investment bankers taking companies public. –The companies sold have been previously owned by governments.