Investment Banking And The Public Sale Of Equity Securities

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2

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

Focus of this chapter

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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 CostsInvestment banks provide services prior to security

offering.

– Primary pre-issue role: provide advice and help plan offer– Firm needing capital selects one or more lead underwriters.– Top firm the lead manager, others are co-managers– Offering syndicate organized early in process

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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Basic Disclosure Documents

Principal disclosure document: Registration Statement

ProspectusSupplemental Disclosures

• Actually a series of registration statements, beginning with the Preliminary Prospectus– Called a Red Herring after title page disclaimer (in red ink)– Statements are submitted to SEC, which responds with

changes needed. Firm makes changes and resubmits.– Offering 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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Material Covered In A ProspectusTitle page summarizes offering and lists underwriters.

• Always one or more lead underwriters

First section presents offering details, discusses use of proceeds, describes firm, lists risk factors.

Inner pages detail underwriting agreement, stock ownership and if offering is primary, secondary, or

mixed offering.

• Sell newly issued shares• Raise new capital for the firm

• Existing shareholders sell their shares• No new capital for the firm

Final page presents cold comfort letter from auditors: states that firm’s books were prepared

using GAAP.

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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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The U.S. Initial Public Offering Market

1) US IPO market is larger than rest of world’s combined.

IPOs account for 30-45% of all new equity raised each year.

2) NYSE and NASDAQ now compete for IPOs.

3) IPO market is highly cyclical: biggest IPO boom ever between 1991 and March 2000.

4) Market prone to industry “fads”: semiconductors, biotech mid-1980s; internet after 1995.

5) Institutions most important IPO investors: allocated 40-80% IPO shares.

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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 IPO1) 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

– Have to disclose operating and sensitive data publicly– Must follow public company governance rules set by SEC

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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:

– Could be that managers consider stock over-valued– Could reveal that cash flows will be lower than expectedShort-term and long-term performance of SEOs: prices fall on

announcement, under-perform over 1,3 and 5 years.

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Rights OfferingsExisting shareholders have the right to buy new

shares at a discount or can sell this right to other investors.

Date of record

• Set by firm’s directors• Shareholders on firm’s books as of this

date will receive rights.

• Date when stock begins trading without right

• Usually set a few days before record date

Ex rights date

• Exercise price of stock being sold through offering

• Right’s value depends on the number of rights needed to buy a share.

Subscription price

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Rights Offerings

Managers have three basic decision to make in rights offer:

– Determining amount of capital firm needs to raise– Setting subscription price: set below current market price– Determining number of rights needed to buy share of stock

Theoretically, value of right (RW) is the same whether selling separately or still attached to share.

1N

SMR WW

RW = value of right

MW = market value of stock with rightsS = subscription price of stockN = number of rights needed to buy one share

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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”qualified institutional

investorsMore than $100 million in

assets

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Private Placements In U.S. Capital Markets

$86345Rule 144A, Foreign Issuers

83.7%75.7%Rule 144A as % of Total PP

$2631,282Rule 144A, U.S. Issuers

$3491,627Rule 144A, All Issuers

$29149Yankee Private Placements

$127699Securitized Private Placements

$59362Plain Vanilla Equity

$52214High-Yield Debt

$3491,751Straight Debt

$4172,148Overall Private Placements

Total Value

US$ billionsNumber of

IssuesType of Offering

Source: Investment Dealers’ Digest, various 2002 issues

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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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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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Share Issue Privatizations

SIPs have raised almost $1 trillion since 1980SIPs are 10 largest (25 of 28 largest) offers ever

13,300Deutsche TelekomNov 96

14,760Deutsche TelekomJun 00

15,000Nippon Telegraph & TelephoneNov 99

15,097Nippon Telegraph & TelephoneFeb 87

15,500Telecom ItaliaOct 97

18,000NTT DoCoMoOct 98

18,900ENELNov 99

22,400Nippon Telegraph & TelephoneOct 88

$40,260Nippon Telegraph & TelephoneNov 87

Amount ($ in millions)

CompanyDate

Source: William L. Megginson and Jeffry M. Netter, “From State to Market: A Survey of Empirical Studies on Privatization”

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 knows as SEOs.

Investment banks assist companies in selling new securities.

Investment Banking And The Public Sale Of Equity Securities