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  • Power Point Slides for:
    • Financial Institutions, Markets, and Money, 9th Edition
    • Authors: Kidwell, Blackwell, Whidbee & Peterson
    • Prepared by: Babu G. Baradwaj, Towson University
            • and
      • Lanny R. Martindale, Texas A&M University
  • 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.
    • Assist in making (dealer) or arranging the buying and selling (broker) in the secondary market.
    View slide
  • Investment And Commercial Banks Differ
    • Commercial Banks (CB) accept deposits and make commercial loans as a financial intermediary.
    • CB traditionally could underwrite only low-risk securities of governments per the Glass-Steagall Act.
    • Many large firms now use the direct financial markets to finance rather than bank loans.
    View slide
  • U. S. versus Other Developed Nations
    • Until 1999, investment banks in the U. S. could not do commercial banking activities and vice-versa.
    • Outside of Japan, in most other developed nations, financial institutions are allowed to do both investment and commercial banking activities.
      • These institutions, called Universal banks , engage in deposit taking, making loans, brokerage activities, securities underwriting, and offering insurance services.
  • Largest Investment Banks
  • Early History
    • Investment banks trace their origins to European investment houses which branched to the U.S.
    • Early U.S. commercial banks were chartered for note issue and business lending, separate from private investment banks, organized as partnerships.
    • Investment banks grew with the growth of security issuance and trading in the Civil War and later in the railroad and steel industries.
    • Commercial banks pressured for investment banking privileges from their regulators, and by the 1930s, commercial banks could provide full investment banks services.
  • Glass-Steagall Act
    • The legislated separation of CB and IB in the United States is unique
    • The Glass-Steagall Act of 1933 (Banking Act) restricted the asset powers of commercial banks to low-risk underwriting areas.
    • In other countries, universal banks were able to combine commercial and investment banking functions. United States, IB, and CB had to compete with these firms.
  • The Glass-Steagall Act (continued)
    • CB could not underwrite (buy and resell) risky business securities.
    • CB were limited as to the risk assumed in their investment portfolio-no risky corporate securities.
    • IB firms were prohibited from engaging in CB.
    • Firms became either IB or CB.
  • The Objectives of the Glass-Steagall Act
    • Discourage speculation in financial markets.
    • Prevent conflict of interest and self-dealing.
    • Restore confidence in the safety and soundness of the CB system.
  • Commercial Banks & Securities Business >1980)
    • In 1988, courts ruled in favor of banks to allow underwriting of securities in a limited fashion.
    • They could underwrite commercial paper, municipal revenue bonds, and securities backed by mortgage loan or consumer loans.
    • Business should be conducted by an independent subsidiary of the bank holding company.
    • This business could not exceed 5% of the subsidiary’s gross revenue.
    • In 1989, J. P. Morgan was allowed to underwrite and deal in corporate debt within the U. S. through its securities subsidiary, and in 1990 they were allowed to underwrite domestic corporate equity.
  • Repealing the Glass-Steagall Act
    • Relaxing the Glass-Steagall restrictions was one of the major financial issues of the last twenty years.
    • CB increasingly had sought to be allowed to engage in investment banking activities.
    • The Federal Reserve Board had increasingly allowed CBs to engage in some investment banking activities.
    • In the late 1990s, several commercial banks purchased investment banking firms.
  • Gramm-Leach-Bliley Act
    • Financial Services Modernization Act of 1999
    • Permitted commercial banking, investment banking and insurance underwriting under a financial holding company
    • Citigroup
  • Bringing New Securities to Market
    • New issues are called primary issues, first issued in the primary market.
      • If the issue is the first sold to the public, it is called an unseasoned offering or an initial public offering (IPO).
      • If securities are already trading, the new issue of securities is called a seasoned offering .
  • Bringing New Securities to Market (continued)
    • Three steps of bringing a new security issue to market include:
      • Origination - design of a security contract that is acceptable to the market;
        • prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus,
        • obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee, and print the securities.
  • Bringing New Securities to Market (concluded)
      • Underwriting - the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them .
        • Syndicates are formed to reduce the inventory risk.
        • Market price declines cut the IB's margin.
      • Sales and distribution - selling quickly reduces inventory risk. Firm members of the syndicate and a wider selling group distribute the securities over a wide retail and institutional area.
  • Front Page of a Final Prospectus
  • Underwriting Agreements
    • When the investment bank guarantees the issuing firm a certain price, it is called an underwritten offer.
      • The risk of selling the issue at a price higher than that promised to the issuer is borne by the investment bank.
      • The difference between the price at which the issue is sold and that promised to the issuer represents the underwriting spread or the profit earned by the investment bank.
  • 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 issuing firm, not the investment bank.
      • Typically, the smaller and more risky issues are made to use this type of offering.
  • Trading and Brokerage
    • 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.
    • Providing loans to customers, who invest the margin proportion and borrow the rest.
    • Dealer security inventories and customer credit are financed by bank call loans and repurchase agreements, the sale and later repurchase of securities held by the dealer.
  • Balance Sheet of Security Broker & Dealers
  • Trading and Brokerage (continued)
    • Full service brokerage firms offer a wide range of financial services provided by licensed stockbrokers or account executives for commissions. Services include:
      • Storage or safekeeping of securities.
      • Execution of trades.
      • Investment research and advice.
      • Cash management service.
  • Trading and Brokerage (concluded)
    • Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions on security purchases and sales.
    • Banks may act as a broker on behalf of its customers under the Glass-Steagall Act. Banks moved into this area in the 1980s and 1990s usually as a discount broker.
    • Arbitrage activities involving the simultaneous buying between two markets is another trading activity of IB.
  • Private Placements
    • The sale of securities directly to the ultimate investor and not through a public offering.
    • The underwriting function/cost is avoided.
    • A fee is earned for the origination/selling or uniting the supplier and user of funds.
    • A private placement may reduce the total flotation costs for a business or government.
    • The extremes of high credit quality firms and low or unknown credit quality firms use private placements.
  • Private Placement, cont.
    • Traditional two-year trading delay with private placement securities
    • SEC Rule 144A permits trading among institutional investors
    • Increased liquidity of investment; lower liquidity risk premium; lower financing cost for borrower.
  • Mergers and Acquisitions
    • Specialized IB departments provide the following services.
      • Arrange mergers which would produce economic synergy or increased total value after merger.
      • Assist firms which have had unwanted merger offers (hostile takeovers).
      • Help establish the value of target firms.
    • Mergers and acquisitions have been a profitable aspect of the IB business.
    • CB have expanded their merger and acquisition departments.
  • Venture Capitalists
    • Venture capital is private equity financing.
    • Venture capital and managerial advice is provided, usually for an equity interest in the company involved, to higher risk businesses by institutional investors hoping for high returns.
    • Venture capitalists typically invest in high-tech based firms that require large amounts of capital.
    • Venture capital is usually the intermediate financing between founders' capital and the IPO.
  • Venture Capital Organizations
    • Private independent funds - most common, usually limited partnerships of institutional investors.
    • Corporate subsidiaries - provides higher risk investments for large corporations.
    • Small Business Investment Companies - closed-end investment trusts authorized under the SBIC Act of 1958.
    • Individuals and entrepreneurs may provide funds and advice for a "piece of the action."
  • Areas of Venture Capital Investment
    • Venture capitalists invest in technology-based businesses such as:
      • electronics.
      • computer software.
      • biotechnology.
      • medical care.
      • industrial products.
    • Manufacturing business tend to be more intense users of venture capital than service businesses.
  • Stages of Venture Capital Investments
    • Seed financing is capital provided at the “idea” stage.
    • Start-up financing is capital used in product development.
    • First-stage financing is capital provided to initiate manufacturing and sales.
    • Second-stage financing is for initial expansion.
    • Third-stage financing allows for major expansion.
    • Mezzanine financing prepares the company to go public.
  • Structure of Venture Capital Investments
    • Substantial control over management decisions, such as participating on the board of directors.
    • Some protections against downside risk.
    • A share of capital appreciation-convertible preferred stock is popular.
  • Venture Capital Rates of Return
    • Venture capitalists tend to think of rates of returns in terms of multiple of the amount invested.
    • For example, a venture capitalist might expect to receive ten times the amount invested in a start-up company over six years. This would be a 47% annual rate of return.
    • A less risky third-stage investment might return five times the amount invested over four years or 41% per year.
  • Required Rate of Return for Venture Capitalists
  • Valuation of Venture Capital Investments
    • Companies are compared to “comparable” public companies for valuation.
      • comparable revenues, earnings, P/E ratios
      • bench marking with adjustments for varied factors.
    • Multiple-scenarios valuation such as
      • optimistic
      • expected
      • pessimistic