Chapter 15

Investment Banking Public and Private Placements

By Md. Shahedur Rahaman Chowdhury

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Chapter Outline

• What is investment banking?• Functions of an investment banker• Dilution of earnings• Public versus private financing• Leveraged buyouts and debt for

restructuring of a corporation

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The Role of Investment Banking

• The investment banker is 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

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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

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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• Repealed the separation policy of the Depression-era laws– Which included separating banking, brokerage,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

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Investment Banking Competitors

• There is intense competition in the market– Being a leader in one sector helps a firm’s

overall reputation– It, however, does not ensure success in other

areas

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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 efforts” or commission,

basis

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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

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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

• Important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring are also offered

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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

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Distribution Process in Investment Banking

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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 the 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

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Allocation of Underwriting Spread

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Pricing the Security

• Investment Banker– Price of the stock is an important consideration– Conduct an in-depth analysis to determine a

firm’s value: • The company’s industry• Financial characteristics• Anticipated earnings• Dividend-paying capability

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Pricing the Security (cont’d)

• Based on a technique deemed appropriate by the underwriter:– A tentative price is assigned– This will be 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

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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

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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 or three days after

initial offering– Poor market environment - stabilization may be

very difficult to achieve– Underwriter price support – an exception to

market manipulation

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Aftermarket

• Research shows that the IPO generally tends to perform well in the immediate aftermarket– After the first day of trading, 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

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Shelf Registration (1982)

• Permits large companies to file one comprehensive registration statement– Should outline 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 issues, and

utilized minimally with the equity markets

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Public versus Private Financing

• Many companies, by choice or circumstance, prefer to remain private– They restrict their financial activities to direct

dealings

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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/her portfolio

– Stockholders of a private corporation can sell holdings if it decides to go public

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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 the 15-18% range

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Public Offerings - Examples

• A classic example of instant wealth – EDS goes public

• Internet Capital Group– Refer to the chapter for the complete story

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Public Offerings – Examples

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Internet Capital Group Price Chart (as of January 25, 2008)

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Private Placement

• Selling of securities not through the security market but directly:– Insurance companies– Pension funds– Wealthy individuals

• Device is employed by:– Firms that wish to avoid or defer an IPO offering– A publicly traded company wishing to merge

private funds into its financing package

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Advantages of Private Placement

• 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

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Disadvantages of Private Placement

• Interest rate on bonds is usually higher to compensate the investor for holding a less liquid obligation

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Going Private

• The trend:– 1970s, a number of small firms gave up their

public listings to be private– 1980s, 1990s, and mid-2000s, very large

companies began going private• Reason:

– Costs could be saved in annual report expenses, legal and auditing fees, and security analysts meetings

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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

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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

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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

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Privatization

• Privatization involves:– Investment bankers taking companies public– The companies sold have been previously

owned by governments

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End

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Q & A

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Thank You.

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