1. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-1 Chapter 11 Investment Banks, Retail Securities Firms, and Venture Capitalists: Management and Ethical Issues

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-2 Growth and Size of Securities Firm Industry 1990’s Data for the U.S. About 8,000 securities firms. Firms had more than $54 billion in equity capital. Firms controlled more than $1.25 trillion in assets. In 1997 debt underwriting exceeded $1 trillion and stock underwriting was greater than $150 billion.

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-3 The growth and size of the industry, however, is very cyclical, with increases during bull stock markets, decreases during bear markets and periods of large trading losses.

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-4 Brief Historic Overview of Securities Firms Emphasizing U.S. Securities Firms

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-5 Historic Overview (continued)

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-6 Historic Overview (Continued)

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-7 Historic Overview (Continued )

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-8 Historic Overview (Continued)

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-9 Historic Overview (Continued) Source: Samuel L. Hayes III and Philip M. Hubbard, Investment Banking (Boston: Harvard Business School Press, 1990), Anthony Saunders, Financial Institutions Management: A Modern Perspective, 2ed (Burr Ridge Ill: Irwin, 1997); and Ron Chernow, The House of Morgan (New York: Touchstone (Simon & Schuster), 1990)

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-10 Changes in the Culture of Investment Banking In mid-1960’s, changed from white glove genteel culture to a competitive, cutthroat one. Production-oriented compensation eroded collegiality and generated rivalries and tensions. The adoption of a new fee-for-services mentality is directly related to the declining importance of underwriting and the greater importance of fees from M&A activity and trading.

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-11 Investment Banker Reputation Firms that are being valued and taken public depend on a banker’s good judgement and honesty. Short-term, unethical abuses ultimately hurt a firm and an individuals’ most valuable asset, reputation. Examples of ethical breaches: Salomon Brothers Treasury scandal (1990); and Drexel, Burnham, and Lambert junk bond scandal (1988).

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-12 Key Areas of Activities for Securities Firms Investment banking underwriting for debt and equity securities, private placements, M&A Principal transactions involving trading and investment activities Selling and dealing activities for customers as an agent

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-13 Investing activities as an agent Back office activities Other activities such as merchant banking, real estate investment trust and real estate investment partnerships

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-14 Changing Revenue Sources Commissions 49.9% 15.4% Principal Transactions 15.6 17.1 Underwriting Revenues 13.3 9.0 Margin Interest 7.8 5.8 Mutual Fund Sales.6 3.8 Commodities 3.0 1.3 All Other + 9.9 47.6 Total Revenues100.0%100.0% 19751996 + Other activities include M&A fees, private placements, market making and global investment management.

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-15 Details on Revenue Sources Fees for services to institutional investors have become a bigger source of revenue. With globalization, U.S. gross activity in foreign securities and foreign gross activity in U.S. securities has grown dramatically.

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-16 Between 1975 to 1996: the mutual fund/asset management business grew at an annual rate of 30%; interest income, private placement, M&A activities grew at an annual rate of 23%; revenues grew at an annual compound rate of 43% ; and earnings grew at a 13.5% annual rate.

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-17 Financial Ratios Based on the Income Statement Commissions/revenues(%) Principal transactions/revenues(%) Investment banking/revenues(%) Revenues/expenses(%) Portfolio revenue/investments(%) Revenues per employee Expenses per employee Compensation and benefits per employee Number of employees

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-18 Commissions/revenues will be larger for retail firms than for wholesale firms. Wholesale investment banking firms typically have fewer employees and higher revenues, expenses, compensation, and benefits per employee than retail firms.

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-19 Types of Assets for Securities Firms Because of trading and broker/dealer activities, a large percentage of assets are securities. Other assets are predominantly receivables from customers and broker/dealers. Fixed assets are a small percentage of assets. Large NYC investment banks will also hold derivative contracts, debt and currency swaps, and physical commodities as assets.

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-20 Liabilities for Securities Firms Liabilities are predominantly short-term and include: short-term borrowing and repurchase agreements; securities sold but not yet purchased; and customer payables. Security firms generally have high financial leverage. Equity-to-asset ratios are lower for wholesale firms than for retail firms.

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-21 In managing trading risks securities firms have…. tried to collect better information on trading risks by using DEAR and VAR measures. attempted to allocate greater capital and capital cost for potential losses associated with risky activities using RAROC approach.

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-22 position limits for traders based on the market risk of traders’ portfolio. devised compensation methods that consider traders’ returns along with the additional risk that riskier trades impose on the firm.

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-23 Underwriting Risk Underwriting risk is the risk of adverse price movements immediately after the issue of new securities. Under negotiated offerings, investment bankers purchase securities at a given price and sell securities at a higher offering price to the public.

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-24 Underwriters have had greater risk with SEC 415 shelf registration deals. In a bought deal, an investment bank has not had time to develop a syndicate or access market interest rates before submitting a bid. A kamikaze offer is an offer by a prospective underwriter for a bought deal at such a low yield that other underwriters may decline to participate in the syndicate.

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-25 To reduce underwriting risk investment bankers... form syndicates of securities firms to take on a portion of the offering and reduce the underwriting and selling risk to the lead underwriter. hedge their underwriting positions in futures markets. use stabilization techniques during the first 30 days of a new stock issue, whereby they purchase or sell securities to stabilize the security’s price.

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-26 Venture Capital (VC) Firms VC firms are investment firms that provide seed capital to startup firms, start-up capital to firms beginning to operate or manufacture a product, and later stage capital and bridge financing. VC firms’ goal is to make a large return, averaging about 50% per year, for investors who are willing to take the risk of investing in relatively new firms.

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-27 VCs invest in a portfolio of firms with high growth potential, generally taking an equity stake in the firm. Their objective is to take a firm public or sell it in a short time frame of five to seven years. Firms must give up a portion of control of the business to the VC firm.

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-28 Types of VC Firms Private VC firms Angels Venture capital networks (VCNs) Small business investment corporations (SBICs) Minority enterprise small business investment companies (MESBICs)

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-29 Steps in the IPO Process Signing the letter of intent Conducting a valuation of the company Determining the share price and total number of shares to be sold Performing an active due diligence of the firm to be taken public Submitting the registration form to the SEC

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-30 Marketing IPO through road shows and publishing a preliminary red herring prospectus After SEC approval, the underwriting contract is executed and an effective date for the offering is set. During the 30 days after the offering, the investment banker practices stabilization techniques if needed.