1. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-1 Investment Banks Securities Firms Venture Capitalists Management and Ethical Issues Chapter 17

2. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-2 Securities Firms Structure of Industry Full service, full commission brokers E.g. Merrill Lynch, Salomon Smith Barney Reduced service, discount brokers E.g. Charles Schwab (originally) Internet only brokers E.g. E-trade Combinations of the above With each other With other financial institutions

3. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-3 Different Types of Firms National full-line firms Large investment banks Regional securities firms New York-City – based investment banks Discounter firms

4. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-4 Brief History of Securities Firms Sixteenth, seventeenth, and eighteenth centuries Merchant banking Family-run banking houses Nineteenth Century Investment banking firms grew due to ◦ Industrial revolution ◦ Civil war ◦ Industry consolidation due to 1893 recession ◦ Emergence of major U.S. initiated firms

5. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-5 Brief History of Securities Firms Early to Mid Twentieth Century Panic in 1907, creation of Federal Reserve System World War I Wall street primacy U.S. dollar became strongest currency New York surpassed London as financial capital Stock market crash of 1929 Legislative reforms of securities, banking industries World War II ◦ Fostered great economic growth in U.S. ◦ Devastated economies of Europe

6. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-6 Brief History of Securities Firms 1960s Internationalization Emergence of Eurobond and Eurodollar markets Increased competition Consolidation within industry 1970s Compensation became production-oriented Development of new services to gain clients Globalization continued into Japan May Day, May 1, 1975, brokerage fees became competitive

7. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-7 Brief History of Securities Firms 1980s Shelf registration Bull market Great merger & acquisition activity Emergence of high yield investment securities Innovations ◦ New types of securities ◦ Leveraged buyouts ◦ Securitization 1987 stock market crash

8. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-8 Brief History of Securities Firms 1990s Consolidation of firms continued Financial disasters ◦ Failure of Barings Bank in 1995 ◦ Orange County derivative trading losses European Economic Community emerged in 1992 Euro became new currency in 1999 Internet ◦ Online securities firms ◦ Delivery of services mechanism

9. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-9 Brief History of Securities Firms 2000s Mergers of securities firms with banks GLB of 1999 Low consumer confidence due to ◦ Accounting & financial fraud ◦ Ethical breaches by securities firms, corporations Sarbanes-Oxley Act Dot.com market Crash Increased internationalization Competition-induced reductions in customer fees

10. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-10 Key Area of Activities for Securities Firms Investment banking underwriting Principal transactions  Trading – profitable transactions  Investments – profitable return on portfolio Selling and dealing activities and trading for customers as an agent Investing activities as an agent Back office activities Other types of activities

11. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-11 Commissions 49.9% 15.4%13.77% Principal Transactions 15.6 17.112.94 Underwriting Revenues 13.3 9.08.03 Margin Interest 7.8 5.86.60 Mutual Fund Sales.6 3.83.25 Commodities 3.0 1.32.51 All Other 9.9 47.652.9 Total Revenues 100.0% 100.0% 100.0% 197519962001 Sources of Revenue

12. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-12 Performance Evaluation Ratios Based on the Income Statement Commissions/revenues (%) Principal transactions/revenues (%) Investment banking/revenues (%) Revenues/expenses (%) Growth rate in revenues - growth rate in expenses Portfolio revenue/investments (%) Revenue per employee Expenses per employee Compensation & benefits per employee Number of employees

13. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-13 Example of Financial Statements Income Statement Growth Rate in Expenses Relative to Growth Rate in Revenue over Time Analysis the Trends in Net Income Balance sheets Analyzing Trends in Asset and Liabilities Composition Overall Dupont Analysis

14. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-14 Overall DuPont Analysis 1996199519961995 Return on Equity20.04517.10%13.90% 9.94% Return on Assets 3.58% 2.70% 0.52% 0.42% Equity Multiplier 5.60 6.3326.5323.81 Net Profit Margin11.2410.46% 7.83% 6.58% Asset Utilization 0.318 0.259 0.067 0.063 Morgan Keegan Morgan Stanley

15. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-15 Risk Management in Securities Firms Trading risk can destroy institutions Barings Bank failed due to rogue trader Daiwa Bank had U.S. charter revoked for lying to the Federal Reserve about trading losses Underwriting Risks Negotiated offering basis Best efforts basis Bought Deal, Kamikaze Offer Hedging of Underwriting

16. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-16 Venture Capital and Private Equity Firms Venture Capital Firms Limited partnerships ◦ General partners manage firm ◦ Limited partners are only investors Types of VCs ◦ Private VC firms ◦ Venture capital networks (VCNs) ◦ Small business investment corporations (SBICs) ◦ Minority enterprise small business investment companies (MESBICs)

17. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-17 Non-Venture Private Equity Firms Private equity firms Invest and build strategy Leverages buyout base for some Work to build company value by Strengthening management Adding complementary companies Consolidating companies & company activities

18. Copyright © 2004 by Thomson Southwestern All rights reserved. 17-18 Ethical Considerations and SEC Proposed Code of Ethics in 2004 New Proposed Rule Requires investment firms to adopt ethics code States standards of conduct expected of personnel Safeguards non-public information about clients Addresses conflicts of interest by advisers Designed to Eliminate breaches of fiduciary duty Build confidence by clients Prohibit less than third-party-equivalent transactions