CHAPTER 19 INVESTMENT BANKING. Investment Banking Investment Banks (IB) are the most important...

CHAPTER 19

INVESTMENT BANKING

Investment Banking• Investment Banks (IB) are the most

important participant in the direct financial markets

• Assist firms and governments in selling new securities in the primary market.

• They also can make the market (dealer) or arrange the buying and selling (broker) in the secondary market.

Copyright© 2008 John Wiley & Sons, Inc. 2

Primary Services of an Investment Bank

Bringing new securities to Market: one of the basic services offered by an Investment Bank.•New issues are called primary issues, which are first issued in the primary market.– Initial public offering (IPO) or unseasoned

offering – company has never offered securities to public (first sale of securities to the public).

– Seasoned offering - additional issue of securities already trading.


An offering can be either public offering or private placement

• In Public offering, the company has to decide whether to have underwritten issue (using firm commitment) or best-efforts basis. In best-efforts, the investment bank does not guarantee fixed amount of money but instead promises only to make its best sales effort.

• In underwritten issue the company has to decide whether to solicit(ask) investment banking services through competitive bidding or negotiated offering.


Underwriting Agreements

• In an underwritten offer, IB guarantees the issuer a certain price – The risk of not selling the issue at a price higher

than that promised to the issuer is borne by the IB.

– The difference between the price at which the issue is sold and that promised to the issuer is the underwriting spread.

– This is the profit earned by the IB.


Underwriting Agreements

• In a best efforts offer, the investment bank does not guarantee a price or that the issue will be sold.– The investment bank is compensated based on the

number of securities sold.– The risk of the securities not selling or not selling at

a desired price is borne by the issuer, not the IB.– Smaller and more risky issues falls in this type of

offering.


• One of the main problems that investment bankers face is how to price the securities so that they are not under-priced or over-priced. If the price is too low, more shares are sold than necessary to raise the needed funds, which dilutes the firm’s earning. If the price is too high, the underwriter can not sell the issue at the proposed price and the investment banker suffers loss.


Bringing New Securities to Market (continued)

• Three steps of bringing a new issue to market:1. Origination – analyze feasibility of the project, determine amount of money to raise, decide on type of financing, characteristics of the securities issued and the advice on the best sale date.–Once the decision to issue the securities is made, the investment banker can help in preparation of official sale documents such as registration statement and prospectus (details of issuer’s financial condition, business activities, industry competition, management experience, the project, characteristics and risk of securities issued).


Bringing New Securities to Market (concluded)

2. Underwriting – is the process whereby an investment banker helps a firm sell its new security issue.–Inventory risk is the risk that securities are sold at less than purchase price. To reduce risk Underwriting syndicate is formed which is group of investment banks, each will be responsible for its pro rata share of securities and receive portion of underwriter fees. Selling group is investment banks that bear no underwriting responsibility but receive commission on whatever securities they sell.


3. Sales and distribution :Once the investment banker purchases the securities, they must be resold to investors. The sales function is divided into institutional sales(sales to institutions e.g. pension funds, insurance companies etc.) and retail sales(sales to individuals).


Trading and Brokerage• Investment banks can also do brokers and

dealers services.• The brokerage function is to bring a buyer and

seller together.• Dealer function - buying (bid) and selling (ask)

from an inventory of securities owned by the seller.

• Margin trading means that the investor can buy securities partly from borrowed money(borrowed from brokerage firms).40% margin means 40% is investor money and 60% is borrowed money.


• The largest source of funds for dealers and brokers is customer credit balance (funds owed by brokers and dealers to their customers after sales transaction).

• Other sources are bank call loans(short term loans from banks) and repurchase agreements.


Trading and Brokerage (continued)

• Full service brokerage firms offer a wide range of services such as:– Storage or safekeeping of securities.– Execution of trades.– Investment research and advice.– Margin Credit– Cash management service.(e.g.allows customers

to write checks against their credit balance available with broker).

Copyright© 2008John Wiley & Sons, Inc. 13

Trading and Brokerage (concluded)

• Discount (Internet) brokerages fims offer fewer than full-services brokers. They do not have highly paid research staff who gives recommendations to buy and sell, instead they hire telephone clerks to take customer’s orders of buying and selling, thus charging lower commissions.

• Banks may act as a broker on behalf of its customers. Banks moved into this area in the 1980s and 1990s usually as a discount broker.

• Arbitrage activities involving the simultaneous buying/selling between two markets to take advantage of price anomaly between the two markets. This is another trading activity of IB.


Private Placements• The sale of securities directly to the ultimate

investor accredited wealthy investors (no public offering).

• The underwriting function/cost is avoided.• A fee is earned by investment bank for helping in

bringing the buyer and seller, determining the fair price of securities and executing the transaction.


Private Placements

• Advantages over public offering: less costly and easier to negotiate because only few people.

• Disadvantages: securities of private placements has no readily available market price, less liquid and small group of potential investors.

• The extremes of high credit quality firms and low or unknown credit quality firms use private placements.


Mergers and Acquisitions (M &A)• Investment banks provide four categories of M&A

services for which they earn fees (usually percentage of selling price).

1. Help firms to identify M&A candidates that match the acquiring firm’s needs.

2. Investment bank does all the analysis to price the deal.

3. Investment bank works with the acquiring firm management to provide advice and help them to negotiate the deal.

4. Finally, investment bank assist the acquiring firm to obtain the necessary funds to finance the purchase.


Other services of IB• Other services of Investment banks could

be real estate investment and financial consulting (e.g. providing feasibility studies for major capital projects).


CHAPTER 19 INVESTMENT BANKING. Investment Banking Investment Banks (IB) are the most important...

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