© 2007 Thomson South-Western

Chapter 16Investment Banking and the

Public Sale of Equity Securities

Professor XXX Course Name / #

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Companies that raise capital externally can issue debt or equity.

Common stock can be sold through private placements or to the public.

First public offerings is known as IPOs. Subsequent offerings are known as SEOs.

Investment banks assist companies in selling new securities.

Overview of Investment Banking

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Corporate financeTradingAsset management

Key Investment Banking Activities

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Basic Choices In Securing External Financing

A firm needing external capital faces three basic choices:

Employ an investment bank to advise and handle offering

Choice of public versus private capital market

Choice of security and type of offer: equity or debt

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Investment Banks Role in Equity Offerings

Asset management

Corporate finance

Trading

Investment banking lines of

business

Investment banks provide advice with structuring seasoned and unseasoned issues, actual sale and

post-sale services.

Seasoned offering

• Equity issues by firms that already have common stock outstanding

seasoned

Unseasoned offering

• Initial public offering (IPO): issue of securities that are not traded yet

unseasoned

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Investment Banks Role in Equity Offerings

Public security issues can be:

Best effort

• The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering.

Firm

commitment

• Underwritten offerings, bank guarantees certain proceeds.

• Vast majority of US security offerings are underwritten this way.

Direct negotiated offer Competitive bidding

Firms can choose an investment bank through:

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Services Provided By Investment Bankers And Their Costs

Investment banks provide services prior to security offering.

Prior to offering, lead investment bank negotiates underwriting agreement:

– Sets offer price and spread; details lock-up agreement– Bulge bracket underwriter’s spread usually 7.0% for IPOs– Initial offer price set as range; final price set day before offer.

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Legal Rules Governing U.S. Public Security Sales

Two basic laws governing public issues:

Securities act of 1933Prescribed security issuance

procedures, set basic principle of full disclosure.

Securities and exchange commission

act of 1934

Set up SEC, gave it broad regulatory, rule-making

powers.

Securities laws mandate disclosure of all relevant corporate information to potential investors.

Investment banks play key disclosure role by performing due diligence.

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Key Steps in IPO Process

Initial StepRegistration ProcessMarketingPricing and AllocationAftermarket Activities

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Basic Disclosure Documents

Principal disclosure document: Registration Statement

ProspectusSupplemental Disclosures

Actually a series of registration statements, beginning with the Preliminary ProspectusOffering only becomes effective with SEC’s

final approval. After preliminary filing, firm and IB begin a

road show.IB does book building during road show

providing key pricing info.

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Shelf Registration

SEC introduced rule 415: shelf registration

Qualifying issuers (more than $150 million in outstanding stock) file a “master registration statement”, summarizing planned financing for the next two years.

The company can offer securities for sale (off the shelf) over subsequent two years.

Popular with issuers; very flexible

Most qualifying debt issues are shelf registered.Very few equity issues use shelf: IB certification

needed.

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Services Provided During And After A Security Offering

Lead underwriter sets each syndicate member’s percentage of participation.

How many shares each member must sell and compensation.

Almost all IPOs and SEOs have a green shoe option: over-allotment option to cover excess demand.

Lead underwriter is responsible for price stabilization after offering.

After offering, lead underwriter serves as principal market maker.

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Benefits Of An IPO

1) IPO can raise large amounts of new capital for growth.

2) Publicly traded stock is currency for acquisitions.

3) Listed stock (options) can be used to attract top managers.

4) Provides personal wealth and liquidity for entrepreneur

5) Serves as advertising for firm and its products/services

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Costs Of IPO

1) High financial costs of IPOs, with no guarantee of success: cash expenses of IPO often approach $1

million.

2) Managerial costs of planning and executing IPO

3) Need to focus on stock price and deal with shareholders

4) Severe constraints on managerial discretion in public firm

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Types Of Specialized IPOs

Equity carve-out

• Parent sells minority stake in subsidiary to public through IPO.

• Raises cash for parent, allows better monitoring of subsidiary.

Spin-off

• Parent distributes all of a subsidiary’s stock to shareholders.

• Full spin-off creates independent new company.

Reverse LBO• Company goes public again after

LBO.• Successful LBOs create value, so

high returns to second IPO.

Tracking stock

• Stock mirrors performance of division, but not legally or operationally separate from parent.

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Investment Performance Of IPOs

Patterns observed in IPO offerings:

Positive initial returns for IPO investors Large IPOs typically underpriced less than smaller offerings. Initial returns are higher in “hot issue markets” than in cold

markets. Mean initial returns are much higher than median: a relative

handful of severely underpriced offers drive results. Mean return overstates actual profits for most investors;

uninformed investors suffer from winner’s curse. Venture-capital backing reduced initial returns during 1980s;

increased after 1990.

IPOs seem to dramatically under-perform over 1-5 years.

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Seasoned Equity Offerings (SEO)

SEOs infrequent for most U.S. and non-U.S. firms

ReasonNegative market reaction when SEOs are announced

SEO announcements convey negative info:

Short-term and long-term performance of SEOs: prices fall on announcement, under-perform over 1,3 and 5 years.

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Rights Offerings

Existing shareholders have the right to buy new shares at a discount or can sell this right to other investors.

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Private Placements In The U.S.

Sale of a security directly to one or a group of accredited investors

Accredited investors in private placements are financially sophisticated.

Corporations, institutional investors, wealthy individuals, pension and mutual funds, venture

capitalists Rule 144A has allowed limited trading of PP among“qualified institutional

investors”

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International Common Stock Offerings

Two types

Domestic stock offering

International, or cross-border, issues

Total number of non-U.S. IPOs exceeds U.S. total, but total value (except privatizations) usually much

smaller.

All markets show significant IPO underpricing.

Most markets show poor long-term returns for IPOs, SEOs.

Most markets also seem prone to hot and cold markets.

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Average First-Day IPO Returns, %, International Comparisons

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American Depositary Receipts (ADRs)

Dollar-denominated claims issued by U.S. banks

Represent ownership of shares of a foreign company’s stock held on deposit in the issuing

firm’s home country

Sponsored ADR

• The issuing foreign company pays all legal and financial costs of creating and trading the security.

• Issuing firm is not involved with the issue of ADRs.

Unsponsored ADR

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Trading Volume in Public ADR Issues, 1990-2004

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Privatization’s Impact On Stock Market Development

10 largest share offerings in history are all share issue privatizations (SIPs)30 Of 33 largest offerings SIPs

152 of 2004 Business Week Global 1000 are SIPsSIPs 15% of total, 31% of non-US market cap

Most large emerging markets firms are SIPs7 Of 9 largest capitalization firms are SIPs

Under-States True Importance Of SIPs Play very important “bellweather” role

SIP usually a country’s largest cap firmAlso most actively traded--usually by wide margin

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The Largest Share Offerings In Financial History Are All SIPs

Nov 87 Nippon Tel & Tel $40.3 bn

Oct 88 Nippon Tel & Tel 22.4 Nov 99 ENEL 18.9

Oct 98 NTT DoCoMo * 18.4

Mar 03 France Telecom 15.8

Oct 97 Telecom Italia 15.5 Feb 87 Nippon Tel & Tel * 15.1

Nov 99 Nippon Tel & Tel 15.0

Jun 00 Deutsche Telekom 14.7

Nov 96 Deutsche Telekom * 13.3 Oct 87 British Petroleum 12.4

Nov 00 Nippon Tel & Tel 11.3