Topic 3 Investment Banking

F232_Topic03 John Wei1

Topic 3Investment Banking(Updated: February 10, 2000)

I. INTRODUCTION

A. Two General Functions for Investment Bankers

1. raising funds for clients including corporations, federalgovernment agencies, state and local governments andforeign entities (Chinese Governments and state-ownenterprises) -- Corporate Finance, Underwriting, M&A

2. assisting clients (investors) in the sale or purchase ofsecurities -- Retail Brokerage

B. Definition of Investment Banking

1. Investment banks, merchant banks, and restricted licensedbanks

Traditional difference between investment bank and merchantbank is:

• Merchant banks actually risk their own capital; they takestakes. (Proprietary trading)

• Investment banks arrange thing and earn fees.

In Hong Kong, “restricted licensed banks” is used for either“investment banks” or “merchant banks”.


2. Investment bankers vs. commercial banks

• Most commercial banks perform at least some investmentbank functions, but investment banks do not do "typical"commercial bank things.

• In particular, merchant banks do not rely on smalldepositors.

• Disadvantage for investment bankers --just a few bigdepositors, including banks overseas, means that funds canbe lost quickly. Example, Drexel (Michael Milken),Peregrine (Andre Lee).

• In Hong Kong, deposits of MBs count about 20% of totalassets. Flows of funds still mostly come from individualsto firms.

• MBs largely provide advice to firms.

• Traditionally, firms got short-term financing fromcommercial banks and long-term financing from MBs.

3. Definition of investment bankers

• Investment banking covers all capital market activities,from underwriting and corporate finance, to mergers andacquisitions (M&A), to fund management and venturecapital.

Included are (1) merchant banking, when investment bankerswork and invest for their own account and (2) the nonretailtrading of blocks of securities for financial institutions.

stocks & bondsReselling stocks& bonds

Individual Investment Banks Firms


Excluded are the selling of securities to retail customers(brokerage or security firms), consumer real estate brokerage,mortgage banking, insurance products, and the like.

II. NATURE OF THE BUSINESS

A. Nature of the Business

• Investment bankers are highly leveraged.

• In addition to needing long-term sources of capital,investment bankers borrow on short-term basis to financetheir inventory of securities (repurchase agreement).

B. Capital Structure of Investment Bankers

Table 5-1Capital Structure of the Ten Largest Investment Banking Firms Rankedby Total Consolidated Capital (in millions, as of end of 1993)

FirmTotal Consolidated

CapitalEquityCapital

Long-TermDebt

Merrill Lynch

Salmon Inc.

Goldman, Sachs & Co.

Lehman Brothers

Morgan Stanley

Bear Stearns & Co.

CS First Boston

Paine Webber

Smith Barney Shearson

Prudential Securities

$18,954.8

17,023.0

15,249.0

11,951.0

8,208.8

4,665.3

4,649.0

3,131.0

2,742.0

1,842.0

$5,485.9

5,331.0

5,008.0

2,052.0

3,906.2

2,040.4

1,324.0

1,195.0

2,055.0

1,379.0

$13,468.9

11,692.0

10,241.0

9,899.0

4,302.6

2,624.9

3,325.0

1,936.0

687.0

463.0

Source : “Ranking America’s Biggest Brokers,” Institutional Investor (April 1994), p. 156.This copyrighted material is reprinted with permission from Institutional Investor,488 Madison Avenue, New York, NY 10022.


C. Revenue is Generated from:

• commission• fee income• spread• principal activities

III. ACTIVITIES OF INVESTMENT BANKERS

A. Underwriting (Public offering of securities)

• Helping firms raise funds thru stocks or bond issues.

• It is a traditional activity -- "sponsoring"

Underwriting involves:

1. Origination: advising the issuer on the terms (what typeand how much) and timing of the offering

In the U.S., firms sell new stock every 15-20 years and debtevery 2-3 years on average. For equity, it is more often in HongKong.

Investment bankers are in market all the time -- includingcreating new securities (innovations).

2. “Underwriting”: a kind of insurance

IBs buy securities from issuers and re-sell them to customers.

If demand is lower than expected, IBs take loss.

In practice, what IBs provide may be pre-selling rather thaninsurance. This is similar to “bridge financing.” (Peregrineprovided bridge loans to Indonesia taxi company Steady Safe)


Example of underwriting risk: IBM - October 1979

On October 3 (Wednesday), IBM agreed with Salmon Brothersand Merrill Lynch to have largest public offering in corporatehistory -- US$500 million in 7-year notes and US$500 millionin 25-year bonds.

Two lead underwriters, Salmon and Merrill Lynch wanted tohandle the top blue-chip firm's underwriting. Morgan Stanleyhad refused to be co-manager with Salmon or anyone.

Notes priced at 7 basis points above T-notes,

Bonds priced at 12 basis points above T-bonds.

Deal closed at 12:40p.m.

That afternoon, Treasury rates went up 5 basis points.

The next day (October 4), Treasury auctioned 4-year notes, atrate 17 basis points over IBM's notes.

Underwriting syndicate is committed to selling bonds at thesyndicate price.

On Friday (October 5), there was a rumor that Paul Volcker wasabout to resign; over weekend, Fed took major measures totighten credit [trying to curb inflation], interest rates leaptshooting up.

By Wednesday (October 10), Salmon Brothers had to disbandsyndicate [letting members sell at whatever price they couldget].

The loss -- the syndicate member would not say, but probablyUS$10-15 million.


3. Sales and distribution:

IBs have built up regular network to sell securities.

Often, a syndicate is often organized by the lead or co-leadunderwriters (or co-managers) to share the capital risk.

4. Making a market afterwards:

IBs may act as a dealer later, giving the issue extra liquidity.

Investors are more willing to buy the issue if they know therewill be a market later.

Types of underwriting:

a. firm commitment: When the IB agrees to buy thesecurities from the issuer at a set price.

b. best efforts: the underwriter agrees only to use its expertiseto sell securities == it does not buy the entire issue fromthe issuer.

c. standby: underwriting arrangement calls for theunderwriter to buy the unsubscribed shares. The issuerpays a standby fee to the IB. (uncommon in the U.S.)

The fee earned from underwriting is called:

Gross spread (or underwriter discount)

= the reoffering price - the price paid

= f(risk, size, type)


Table 5-2Typical Gross Spreads by Offering Size

Common Stock Offering* Initial Public OfferingSize (in Millions) Gross Spread Size (in Millions) Gross Spread

$1015203050

100150

6.0-8.0%5.0-7.55.0-7.03.5-5.02.0-5.02.0-4.52.0-4.0

$51015203050

200

8.0-10.0%7.5-9.07.0-8.06.5-7.05.5-7.05.0-7.02.0-4.0

Fixed-Income Offering**Size (in Millions) Gross Spread

$20253050

100150200

1.3%1.21.00.70.70.70.7

***

For industrial companies, not utilities.Typical offering of A-rated corporate debt with 10 years to maturity.

Source : Adapted from Figures 1,2, and 3 of G. Clyde Buck, “Spreads and Fees in InvestmentBanking,” Chapter 5 in Robert Lawrence Kuhn (Ed.), The Library of InvestmentBanking, Volume II (Homewood, IL: Dow Jones-Irwin, 1990).

Variations in the underwriting process:

a. "bought deal" for the underwriting of bonds

without a syndicate.

First used in Eurobond market in 1981: Credit Suisse FirstBoston purchased from General Motors AcceptanceCorporation a US$100 million.

b. auction process -- competitive bidding

c. rights offering

The firm can issue new common stock directly to existingshareholders via a preemptive rights offering.


Global offering:

The underwriting of securities is not limited to offerings in thedomestic market. Example: China Telecom.

Privatization:

Investment bankers have assisted in offering the securities ofgovernment-owned companies to private investors, a processreferred to as privatization.

B. Trading of Securities

The trading arm of an investment bank provides important inputfor the pricing of a security, the selling of the issue, and thesubsequent liquidity for the issue.

IBs must take a principal position in a transaction.

Revenue from trading is generated via

• bid-ask spread, and• appreciation of the price of the securities held in inventory.

To protect against a loss, investment banks engage hedging strategies.

1. riskless arbitrage:

A security trades at different prices in the different markets: sellhigh buy low.

Example:Payoff in Payoff in

Security Price State #1 State #2A $70 $50 $100B 60 30 120C 80 38 112


Is there any riskless arbitrage opportunity?

Yes: Long 4 shares of A and 6 shares of B, and short 10 sharesof C. ==> Guaranteed profit = $160.

The key point for a riskless arbitrage transaction is that the tradeis not exposed to any adverse movement in the market price ofsecurities in the transaction.

Speculation (betting on one direction) is different from risklessarbitrage.

Example: Baring’s trader Nick Leeson

2. risk arbitrage:

Two types:• exchange offers for securities of corporations coming out

of a bankruptcy proceeding.• a merger or acquisition is announced.

Example 1: Company A is being reorganized.

One of its bonds is selling for $500. The trader believes thatafter reorganization, its bond can exchange for 20 shares with anestimates value of $600.

Risk arbitrage profit = $600 - $500 = $100 per bond.

Two risks:(1) exchange will not take place on the term the trader

believes,(2) the value of the 20 shares is less than $500.

Example 2: Nam Pei Hong was a takeover target in 1994 at a price ofHK$ 1.00 when its share price was selling at HK$ 0.50.

After announcement, its share price jumped to HK$ 0.90.


HK$ 0.10 difference represents the risk the deal will not gothrough.

The offer was rejected by the majority shareholder and the pricefell back.

Example 3: UAL Corp.

In 1989, there was a $300 bid by pilots and management. ==>bid up the price to $296 ==> financing was denied ==> pricedropped 50%.

In January 1990, the union bid for $201. ==> financing for thetakeover could not obtained ==> share price plunge.

Estimated loss for arbitrageurs = US$ 1 billion

Example 4: Privatization of Kwong Sang Hong by Peregrine in 1997

Offered price valued at about HK$4.00,Price subsequently increased from around $ 3.20 to about $4.00The deal fell: Price dropped back to about $3.50

Example 5: Takeover by exchange of securities rather than cash.

Three risks involved:• takeover failed• a time delay• bidder's share price may decline

3. Speculation• bet on rising price• bet on falling price• bet on price movements on either up or down• bet on a stable (directionless) market

4. Execution of trades for clients• retail or institutions• block trades and program (or basket) trades


5. Research and trading

• give advice/research to clients: analyst reports• conflict of interest (IPOs and afterward recommendation)• “buy”, “hold”, very few “sell”

C. Private Placement of Securities

Private placement: investment banks assist the placement ofsecurities with a limited number of institutional or wealthy individualinvestors.

Fee for private placement:

Size (in million) Fee•••••••••••••••••••••••••••••••••

$ 5 - 10 1.5 - 4.0% 10 - 15 1.0 - 3.0% 25 - 50 0.7 - 2.0%over 50 0.5 - 1.5%

•••••••••••••••••••••••••••••••••

Rule 144A: eliminate the two year holding period for privately placedsecurities; allow institutions to trade among themselves.

D. Mergers and Acquisitions

Investment bankers role in M&A:

(1) find M&A candidates

reasons for M&A:• vertical merger• horizontal merger• use for excess cash/way to expand• find undervalued business (bad management?)• access to another market

Samsung buys AST Research, Chinese state


enterprises buy shell companies in HK

(2) advise acquiring firms or target firms with respect to priceand nonprice terms of an exchange or help target firmsfend off an unfriendly takeover attempt

(3) Assist acquiring firms in obtaining financing.

Mergers in the US come in waves"

• wave in the early 1960s but few IBs involved• wave in the 1980s - many takeovers were initiated by IBs

E. Merchant Banking

Merchant banking refers to a transaction in which an investmentbanking firm commits its own funds by either taking an equity interestor creditor position in companies.

An example is bridge financing wherein an investment bankingfirm loans funds to a client to consummate a takeover. Bridgefinancing is not only important for its potential source of interestincome, but also to attract clients who are considering an LBO.

Example: Risk of bridge financing

First Boston Corporation's bridge loan of US$450 million toOhio Mattress Co. to finance an LBO.

After the LBO was completed, Ohio Mattress could not getpermanent financing. First Boston was stuck with the bridgeloan.

Another example is project financing: Funding provides by asyndicate of merchant banks. Claim is only to the revenue from theproject itself, not to the rest of revenues and assets of firms taking onproject. Such as new airport project, MTR project.


HK MBs often lend directly to firms or hold their stocks. (SeePeregrine Investment). They are the major source of financing

F. Securitization of Assets

Securitization of assets refers to the issuance of securities thathave a pool of assets as collateral.

Example: Citibank and Cheung Kong Holding's Mortgage-backedsecurities.

Asset-backed securities: automobile loans andcredit card receivables.

Revenue from securitization:• the underwriting of an issue• price difference

G. Trading and Creation of Risk Control Instruments

Examples of contracts that can be used to control risk for bothinvestors and issuers include futures, options, interest rate swaps, andcustomized interest rate agreements.

Commissions are generated from the exchange-tradedinstruments that customers buy and sell through investment bankingfirms.

There are risk control instruments which an investment bankingfirm creates for its clients and in which it acts as a counterpart to theagreement.

==> These are called over-the-counter or dealer createdinstruments.

==> Today, any type of contract will be created for a client ifthe investment banking firm can hedge the associated risk(i.e., lay off the risk).


Risk control instruments are also used by investment bankingfirms to protect their own position in transactions.H. Money Management

Investment banking firms have created subsidiaries that managefunds for either individual investors or institutional investors such aspension funds.

Unit trust, mutual funds.Examples of Investment Revenue

Table 5-4Sources of Revenue in 1993 for Merrill Lynch

SourceRevenue

(in thousands)Percent of

total revenue

CommissionsInterest and DividendsPrincipal TransactionsInvestment BankingAsset Management andProfessional Service FeesOtherTotal revenues

$2,894,2287,099,1552,920,4391,831,253

1,577,778285,324

$16,588,177

17.5%42.817.611.0

9.41.7

100.0%Source 1993 Annual Report.

I. Ranking Measures Table 5-5 Global and Domestic (U.S.) Rankings of Underwriting Firms

Global RankingsFull Credit to Lead Manager

01/01/94-12/31/94 01/01/93-12/31/93Manager $Amount % Issues $Amount Rank

Merrill LynchCS First Boston/Credit SuisseLehman BrothersGoldman, SachsMorgan StanleySalmon BrothersPaine WebberJ.P. MorganBear, StearnsNomura SecuritiesDonaldson, Lufkin & JenretteUBSSwiss BankPrudential SecuritiesCiticorp

137,761.796,945.689,432.486,458.174,785.465,447.561,743.741,242.934,934.023,666.623,611.421,970.417,066.516,476.915,398.4

12.68.98.27.96.86.05.63.83.22.22.22.01.61.51.4

862648653512557542344271209151227163113141234

192,826.2113,418.7129,726.1151,344.489,482.0

104,180.0131,993.436,795.656,904.237,012.336,678.619,836.912,956.428,135.017,943.2

1542763

1089

1114211215

Top 15 Total 806,941.6 73.8 5,627 1,159,269.0 --


Industry Totals 1,093,627.8 100.0 9,009 1,500,877.6 --


IV. IPOs

A. IPOs in General

Typical procedure:

• MB gives issuers an idea of price range

• Issuer and underwriter put together a prospectus, describingfirms current condition and future plans; it includes results of anindependent audit.

• Underwriter does "road shows" and tries to "fill the book" -- i.e.,presell the issue with orders or indications of interest.

• Final price is set.

MBs did not follow this procedure for many B shares and Hshares. ==> may miss the market.

B. Why do Firms Use MBs?

• expertise: advise firms on what types, how much, what price,when.

• MBs know the current market and have customer base• certification: "due diligence", reputation• market-making service after issue• economies of scale in distribution• price support?

C. IPOs in Hong Kong

Procedure:1. Issuer and merchant bank write prospects and set price.2. Shares offered to public:

• must pay full amount in advance• “fairness” rule: all investors who place same size order

have same probability getting shares (but can favorsmall or large investors)


Example: Shanghai Hai Xing Shipping (New name: China ShippingDevelopment Co. Ltd.)

(1) Shares ordered (Last time for lodging application12:00 noon on Friday, November 4, 1994

(2) Checks cashed in the afternoon of Friday.(3) Shares allocated ["balloting"]: Tuesday, November 8.(4) Refund checks to be posted on or before: Wednesday,

November 9.(5) Certificates to be post on or before: Wednesday,

November 9.(6) Trading begins: Friday, November 11.

Key differences:No pre-selling; MBs has no discretion inallocation.

Multimarket IPO is allowed: Shanghai Petrochemical, CEPA,Chengdu Telecom

Over-allocations are allowed since Chengdu Telecom offering

D. Problems in HK's IPOs

Major problem: High oversubscription levels

During the hot market: Average = 50 times

Denway - Feb, 1993 - 658 times oversubscriptionwanted to raise $402.6 mn; it had $240 bn (5 time banknotes)

7 days of interest at 3% worth $138 mn

November 1992: China Travel: 412 times ==> $162 bn tied up

Guangzho Inv.: 230 times ==> $143 bn tied up

Kunming Machine (November 1993):627 times ==> $81.7 bn

Beijing Enterprises (May 1997): 1,276 times => 200 billion


Proposal:(1) 10% margin - can borrow only up to 90% of the total

(Actually must put up deposit = 10% as security)

(2) No investor can order more than 100% of total or

10% of shares to be outstanding [this often = 40% of total, sincethey have often been selling 25% of total]

Is it profitable using borrowed money to subscribe IPOs in HongKong? (See Wei, V.1, pp.161-167)

Example:Subscription price = $10; 10% own money plus 90% borrowedmoney; Number of days that interest is charged = 6; interest rate =6.5% versus 10%. Page 167 shows the break-even cost underdifferent over-subscription rates.

In Hong Kong, two methods are currently used: (1) pure publicofferings, and (2) book-building plus public offerings (some rulesapplied to protect retail investors)

E. IPOs in Taiwan

• process slower• price follows a formula set by SEC• investors did not put up cash• lottery (One ID can only subscript one specified lot)• investors can back out if price drops• two methods are used; (1) discriminatory auctions plus open

offers and (2) open offers.

F. IPOs in Singapore

• Issuer cannot cash check• process very fast• combination of auction/fixed price (fixed price first)


V. CURRENT INDUSTRY STRUCTURE

Depending on the activity area, there are several potentialmeasures of the relative ranking of an investment banking firm.

For underwriting activity:

1. Market share can be measured by the number of deals done in ayear or the total dollar volume of all deals done in a year.

2. It can be refined further by the level of participation (i. e., leadmanager, comanager or just part of the underwriting syndicate).

Classification of Firms

ο bulge-bracket firmsFirst Boston; Goldman Sachs; Merrill Lynch; Morgan Stanley;Salmon Brothers; and Lehman Brothers.

ο major bracket firmsBear Sterns; Smith Barney; Kidder Peabody; Paine Webber;Donaldson, Lukfin & Jenrette; Dean Witter; and Prudential-Bache Capital Funding.

ο submajor bracket firmsο regional firmsο specialized firmsο research firmsο merchant banks

M&As and fund-raising: Blackstonbe Group and Wasserstein,Perella & Co.


VI. COMPETITION AND CHALLENGES FOR INVESTMENT BANKING FIRMS

Investment banking firms are facing increased competitionwhich has forced them to reconsider their long-term businessstrategies.

A. Competition

Investment banking firms are facing competition from:

(1) commercial banks with the virtual elimination of Glass-Steagall

(2) new trading technology that is allowing institutionalinvestors to execute trades without employing investmentbanking firms as intermediaries

(3) direct purchase by institutional investors of publiclyregistered securities from issuers

(4) some of the more sophisticated corporations themselveswho are establishing in-house groups to perform some ofthe activities traditionally done by investment bankingfirms

B. Reassessing the Business

Investment banks are now reassessing the nature of the variousbusinesses that they are in.


VII. INVESTMENT BANKS IN HONG KONG

A. Hong Kong Major Merchant Banks

1992 Results of Hong Kong’s Major Merchant BanksMajor merchant banks are defined as merchant banks with total net worth of not less than US$25million or profit of not less than US$10 million.

Name 1992Profit/(Loss)

1991Profit/(Loss)

TotalNet

Worth

TotalAssets

ReturnOn Assets

Return OnEquity

1. Jardine Fleming Group Ltd2. Wardley Holdings Ltd3. Peregrine4. Sun Hung Kai & Co Ltd5. Schroders Asia Ltd6. Canadian Eastern Finance Ltd7. Nomura International (31/3/93)8. China Development Finance Co9. Chase Manhattan Asia Ltd10. BA Asia Ltd11. Citicorp International ltd12. Lehman Brothers Finance Ltd13. BT Asia Ltd

591.30542.20492.50310.00

92.8086.8081.7065.8039.6021.4017.30

6.90(5.00)

654.20473.60274.20206.60

88.30116.90185.80

33.9076.4030.5011.4014.70

(21.90)

1,730.902,157.403,268.101,581.00

301.10418.00

3,149.80320.00470.70552.10

250.8245.90206.80

15,828.8048,790.50

5,190.405,017.705,573.901,911.50

10,606.802,042.103,967.602,671.80

534.101,769.40

218.10

%3.741.119.496.181.674.540.773.221.000.803.240.39

--

%39.7225.5816.2521.9137.2421.49

2.6525.88

9.174.037.063.22

--

B. Top 20 International Investors in Asia-Pacific Equities

94 93 Score123456789

10=

12==

1516====

1362

11-

18--

11------

16---

Jardine Fleming Investment ManagementBaring International Asset ManagementFidelity Investment ManagementGT Management AsiaSchroder Asset ManagementCapital ResearchThornton ManagementTiger Management CorporationIndosuez Asset ManagementGlobal Asset ManagementAMP (Australia)Nomura Investment Management CoJohn Govett & CoWarburg Asset ManagementJP Morgan InvestmentAIA (Singapore)Bankers Trust (Australia)Morgan Grenfell Asset ManagementPerpetual Asset ManagementTempleton Investment Management

36282621151297666555544444

Topic 3 Investment Banking

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