Power Point Slides for:  <ul><li>Financial Institutions, Markets, and Money, 9th Edition </li></ul><ul><li>Authors: Kidwel...
CHAPTER 19 INVESTMENT BANKING
Investment Banking <ul><li>Investment Banks (IB) are the most important participant in the direct financial markets </li><...
Investment And Commercial Banks Differ <ul><li>Commercial Banks (CB) accept deposits and make commercial loans as a financ...
U. S. versus Other Developed Nations  <ul><li>Until 1999, investment banks in the U. S. could not do commercial banking ac...
Largest Investment Banks
Early History  <ul><li>Investment banks trace their origins to European investment houses which branched to the U.S. </li>...
Glass-Steagall Act  <ul><li>The legislated separation of CB and IB in the United States is unique </li></ul><ul><li>The  G...
The Glass-Steagall Act (continued) <ul><li>CB could not underwrite (buy and resell) risky business securities. </li></ul><...
The Objectives of the Glass-Steagall Act <ul><li>Discourage speculation in financial markets. </li></ul><ul><li>Prevent co...
Commercial Banks & Securities Business >1980) <ul><li>In 1988, courts ruled in favor of banks to allow underwriting of sec...
Repealing the Glass-Steagall Act <ul><li>Relaxing the Glass-Steagall restrictions was one of the major financial issues of...
Gramm-Leach-Bliley Act <ul><li>Financial Services Modernization Act of 1999 </li></ul><ul><li>Permitted commercial banking...
Bringing New Securities to Market <ul><li>New issues are called primary issues, first issued in the primary market. </li><...
Bringing New Securities to Market  (continued) <ul><li>Three steps of bringing a new security issue to market include: </l...
Bringing New Securities to Market  (concluded) <ul><ul><li>Underwriting  - the risk-bearing function in which the IB buys ...
Front Page of a Final Prospectus
Underwriting Agreements <ul><li>When the investment bank guarantees the issuing firm a certain price, it is called an  und...
Underwriting Agreements <ul><li>In a  best efforts  offer, the investment bank does not guarantee a price or that the issu...
Trading and Brokerage <ul><li>The  brokerage function  is to bring a buyer and seller together. </li></ul><ul><li>Dealer f...
Balance Sheet of Security Broker & Dealers
Trading and Brokerage  (continued) <ul><li>Full service brokerage  firms offer a wide range of financial services provided...
Trading and Brokerage  (concluded) <ul><li>Discount (Internet) brokerage  firms offer fewer non-fee services than full-ser...
Private Placements <ul><li>The sale of securities directly to the ultimate investor and not through a public offering. </l...
Private Placement, cont. <ul><li>Traditional two-year trading delay with private placement securities </li></ul><ul><li>SE...
Mergers and Acquisitions <ul><li>Specialized IB departments provide the following services. </li></ul><ul><ul><li>Arrange ...
Venture Capitalists <ul><li>Venture capital is private equity financing. </li></ul><ul><li>Venture capital and managerial ...
Venture Capital Organizations <ul><li>Private independent funds   - most common, usually limited partnerships of instituti...
Areas of Venture Capital Investment <ul><li>Venture capitalists invest in technology-based businesses such as: </li></ul><...
Stages of Venture Capital Investments <ul><li>Seed financing  is capital provided at the “idea” stage. </li></ul><ul><li>S...
Structure of Venture Capital Investments <ul><li>Substantial control over management decisions, such as participating on t...
Venture Capital Rates of Return <ul><li>Venture capitalists tend to think of rates of returns in terms of multiple of the ...
Required Rate of Return for Venture Capitalists
Valuation of Venture Capital Investments  <ul><li>Companies are compared to “comparable” public companies for valuation. <...
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  1. 1. Power Point Slides for: <ul><li>Financial Institutions, Markets, and Money, 9th Edition </li></ul><ul><li>Authors: Kidwell, Blackwell, Whidbee & Peterson </li></ul><ul><li>Prepared by: Babu G. Baradwaj, Towson University </li></ul><ul><ul><ul><ul><ul><li>and </li></ul></ul></ul></ul></ul><ul><ul><li> Lanny R. Martindale, Texas A&M University </li></ul></ul>
  2. 2. CHAPTER 19 INVESTMENT BANKING
  3. 3. Investment Banking <ul><li>Investment Banks (IB) are the most important participant in the direct financial markets </li></ul><ul><li>Assist firms and governments in selling new securities in the primary market. </li></ul><ul><li>Assist in making (dealer) or arranging the buying and selling (broker) in the secondary market. </li></ul>
  4. 4. Investment And Commercial Banks Differ <ul><li>Commercial Banks (CB) accept deposits and make commercial loans as a financial intermediary. </li></ul><ul><li>CB traditionally could underwrite only low-risk securities of governments per the Glass-Steagall Act. </li></ul><ul><li>Many large firms now use the direct financial markets to finance rather than bank loans. </li></ul>
  5. 5. U. S. versus Other Developed Nations <ul><li>Until 1999, investment banks in the U. S. could not do commercial banking activities and vice-versa. </li></ul><ul><li>Outside of Japan, in most other developed nations, financial institutions are allowed to do both investment and commercial banking activities. </li></ul><ul><ul><li>These institutions, called Universal banks , engage in deposit taking, making loans, brokerage activities, securities underwriting, and offering insurance services. </li></ul></ul>
  6. 6. Largest Investment Banks
  7. 7. Early History <ul><li>Investment banks trace their origins to European investment houses which branched to the U.S. </li></ul><ul><li>Early U.S. commercial banks were chartered for note issue and business lending, separate from private investment banks, organized as partnerships. </li></ul><ul><li>Investment banks grew with the growth of security issuance and trading in the Civil War and later in the railroad and steel industries. </li></ul><ul><li>Commercial banks pressured for investment banking privileges from their regulators, and by the 1930s, commercial banks could provide full investment banks services. </li></ul>
  8. 8. Glass-Steagall Act <ul><li>The legislated separation of CB and IB in the United States is unique </li></ul><ul><li>The Glass-Steagall Act of 1933 (Banking Act) restricted the asset powers of commercial banks to low-risk underwriting areas. </li></ul><ul><li>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. </li></ul>
  9. 9. The Glass-Steagall Act (continued) <ul><li>CB could not underwrite (buy and resell) risky business securities. </li></ul><ul><li>CB were limited as to the risk assumed in their investment portfolio-no risky corporate securities. </li></ul><ul><li>IB firms were prohibited from engaging in CB. </li></ul><ul><li>Firms became either IB or CB. </li></ul>
  10. 10. The Objectives of the Glass-Steagall Act <ul><li>Discourage speculation in financial markets. </li></ul><ul><li>Prevent conflict of interest and self-dealing. </li></ul><ul><li>Restore confidence in the safety and soundness of the CB system. </li></ul>
  11. 11. Commercial Banks & Securities Business >1980) <ul><li>In 1988, courts ruled in favor of banks to allow underwriting of securities in a limited fashion. </li></ul><ul><li>They could underwrite commercial paper, municipal revenue bonds, and securities backed by mortgage loan or consumer loans. </li></ul><ul><li>Business should be conducted by an independent subsidiary of the bank holding company. </li></ul><ul><li>This business could not exceed 5% of the subsidiary’s gross revenue. </li></ul><ul><li>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. </li></ul>
  12. 12. Repealing the Glass-Steagall Act <ul><li>Relaxing the Glass-Steagall restrictions was one of the major financial issues of the last twenty years. </li></ul><ul><li>CB increasingly had sought to be allowed to engage in investment banking activities. </li></ul><ul><li>The Federal Reserve Board had increasingly allowed CBs to engage in some investment banking activities. </li></ul><ul><li>In the late 1990s, several commercial banks purchased investment banking firms. </li></ul>
  13. 13. Gramm-Leach-Bliley Act <ul><li>Financial Services Modernization Act of 1999 </li></ul><ul><li>Permitted commercial banking, investment banking and insurance underwriting under a financial holding company </li></ul><ul><li>Citigroup </li></ul>
  14. 14. Bringing New Securities to Market <ul><li>New issues are called primary issues, first issued in the primary market. </li></ul><ul><ul><li>If the issue is the first sold to the public, it is called an unseasoned offering or an initial public offering (IPO). </li></ul></ul><ul><ul><li>If securities are already trading, the new issue of securities is called a seasoned offering . </li></ul></ul>
  15. 15. Bringing New Securities to Market (continued) <ul><li>Three steps of bringing a new security issue to market include: </li></ul><ul><ul><li>Origination - design of a security contract that is acceptable to the market; </li></ul></ul><ul><ul><ul><li>prepare the state and federal Securities and Exchange Commission (SEC) registration statements and a summary prospectus, </li></ul></ul></ul><ul><ul><ul><li>obtain a rating on the issue, obtain bond counsel, a transfer agency and a trustee, and print the securities. </li></ul></ul></ul>
  16. 16. Bringing New Securities to Market (concluded) <ul><ul><li>Underwriting - the risk-bearing function in which the IB buys the securities at a given price and turns to the market to sell them . </li></ul></ul><ul><ul><ul><li>Syndicates are formed to reduce the inventory risk. </li></ul></ul></ul><ul><ul><ul><li>Market price declines cut the IB's margin. </li></ul></ul></ul><ul><ul><li>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. </li></ul></ul>
  17. 17. Front Page of a Final Prospectus
  18. 18. Underwriting Agreements <ul><li>When the investment bank guarantees the issuing firm a certain price, it is called an underwritten offer. </li></ul><ul><ul><li>The risk of selling the issue at a price higher than that promised to the issuer is borne by the investment bank. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  19. 19. Underwriting Agreements <ul><li>In a best efforts offer, the investment bank does not guarantee a price or that the issue will be sold. </li></ul><ul><ul><li>The investment bank is compensated based on the number of securities sold. </li></ul></ul><ul><ul><li>The risk of the securities not selling or not selling at a desired price is borne by the issuing firm, not the investment bank. </li></ul></ul><ul><ul><li>Typically, the smaller and more risky issues are made to use this type of offering. </li></ul></ul>
  20. 20. Trading and Brokerage <ul><li>The brokerage function is to bring a buyer and seller together. </li></ul><ul><li>Dealer function - buying (bid) and selling (ask) from an inventory of securities owned by the seller. </li></ul><ul><li>Providing loans to customers, who invest the margin proportion and borrow the rest. </li></ul><ul><li>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. </li></ul>
  21. 21. Balance Sheet of Security Broker & Dealers
  22. 22. Trading and Brokerage (continued) <ul><li>Full service brokerage firms offer a wide range of financial services provided by licensed stockbrokers or account executives for commissions. Services include: </li></ul><ul><ul><li>Storage or safekeeping of securities. </li></ul></ul><ul><ul><li>Execution of trades. </li></ul></ul><ul><ul><li>Investment research and advice. </li></ul></ul><ul><ul><li>Cash management service. </li></ul></ul>
  23. 23. Trading and Brokerage (concluded) <ul><li>Discount (Internet) brokerage firms offer fewer non-fee services than full-services brokers, but charge lower commissions on security purchases and sales. </li></ul><ul><li>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. </li></ul><ul><li>Arbitrage activities involving the simultaneous buying between two markets is another trading activity of IB. </li></ul>
  24. 24. Private Placements <ul><li>The sale of securities directly to the ultimate investor and not through a public offering. </li></ul><ul><li>The underwriting function/cost is avoided. </li></ul><ul><li>A fee is earned for the origination/selling or uniting the supplier and user of funds. </li></ul><ul><li>A private placement may reduce the total flotation costs for a business or government. </li></ul><ul><li>The extremes of high credit quality firms and low or unknown credit quality firms use private placements. </li></ul>
  25. 25. Private Placement, cont. <ul><li>Traditional two-year trading delay with private placement securities </li></ul><ul><li>SEC Rule 144A permits trading among institutional investors </li></ul><ul><li>Increased liquidity of investment; lower liquidity risk premium; lower financing cost for borrower. </li></ul>
  26. 26. Mergers and Acquisitions <ul><li>Specialized IB departments provide the following services. </li></ul><ul><ul><li>Arrange mergers which would produce economic synergy or increased total value after merger. </li></ul></ul><ul><ul><li>Assist firms which have had unwanted merger offers (hostile takeovers). </li></ul></ul><ul><ul><li>Help establish the value of target firms. </li></ul></ul><ul><li>Mergers and acquisitions have been a profitable aspect of the IB business. </li></ul><ul><li>CB have expanded their merger and acquisition departments. </li></ul>
  27. 27. Venture Capitalists <ul><li>Venture capital is private equity financing. </li></ul><ul><li>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. </li></ul><ul><li>Venture capitalists typically invest in high-tech based firms that require large amounts of capital. </li></ul><ul><li>Venture capital is usually the intermediate financing between founders' capital and the IPO. </li></ul>
  28. 28. Venture Capital Organizations <ul><li>Private independent funds - most common, usually limited partnerships of institutional investors. </li></ul><ul><li>Corporate subsidiaries - provides higher risk investments for large corporations. </li></ul><ul><li>Small Business Investment Companies - closed-end investment trusts authorized under the SBIC Act of 1958. </li></ul><ul><li>Individuals and entrepreneurs may provide funds and advice for a &quot;piece of the action.&quot; </li></ul>
  29. 29. Areas of Venture Capital Investment <ul><li>Venture capitalists invest in technology-based businesses such as: </li></ul><ul><ul><li>electronics. </li></ul></ul><ul><ul><li>computer software. </li></ul></ul><ul><ul><li>biotechnology. </li></ul></ul><ul><ul><li>medical care. </li></ul></ul><ul><ul><li>industrial products. </li></ul></ul><ul><li>Manufacturing business tend to be more intense users of venture capital than service businesses. </li></ul>
  30. 30. Stages of Venture Capital Investments <ul><li>Seed financing is capital provided at the “idea” stage. </li></ul><ul><li>Start-up financing is capital used in product development. </li></ul><ul><li>First-stage financing is capital provided to initiate manufacturing and sales. </li></ul><ul><li>Second-stage financing is for initial expansion. </li></ul><ul><li>Third-stage financing allows for major expansion. </li></ul><ul><li>Mezzanine financing prepares the company to go public. </li></ul>
  31. 31. Structure of Venture Capital Investments <ul><li>Substantial control over management decisions, such as participating on the board of directors. </li></ul><ul><li>Some protections against downside risk. </li></ul><ul><li>A share of capital appreciation-convertible preferred stock is popular. </li></ul>
  32. 32. Venture Capital Rates of Return <ul><li>Venture capitalists tend to think of rates of returns in terms of multiple of the amount invested. </li></ul><ul><li>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. </li></ul><ul><li>A less risky third-stage investment might return five times the amount invested over four years or 41% per year. </li></ul>
  33. 33. Required Rate of Return for Venture Capitalists
  34. 34. Valuation of Venture Capital Investments <ul><li>Companies are compared to “comparable” public companies for valuation. </li></ul><ul><ul><li>comparable revenues, earnings, P/E ratios </li></ul></ul><ul><ul><li>bench marking with adjustments for varied factors. </li></ul></ul><ul><li>Multiple-scenarios valuation such as </li></ul><ul><ul><li>optimistic </li></ul></ul><ul><ul><li>expected </li></ul></ul><ul><ul><li>pessimistic </li></ul></ul>
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