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  1. 1. Chapter 17 IPOs, Investment Banking Mini-Case Presentation (Randy’s Restaurants) Animesh Bhattacharya Alexander Kap
  2. 2. (1) Which Agencies Regulate? <ul><li>Issue is regulation of secondary markets </li></ul><ul><li>Securities & Exchange Commission ( SEC ) </li></ul><ul><ul><li>Interstate public offerings : >1 state (usually nationwide) </li></ul></ul><ul><ul><li>National stock exchanges: SEC regulates all of them </li></ul></ul><ul><ul><li>Insider trading: major stakeholders required to file monthly trading reports </li></ul></ul><ul><ul><li>Proxy Process : rules apply to method used to collect shareholder voting </li></ul></ul><ul><li>Federal Reserve Board </li></ul><ul><ul><li>Margin requirements : Fed specifies maximum percentage of purchase price that can be borrowed; if left unchecked, may trigger downward spiralling selloff </li></ul></ul>
  3. 3. (1) Which Agencies Regulate? (cont’d) <ul><li>States </li></ul><ul><ul><li>Control the issuance of securities within their boundaries </li></ul></ul><ul><ul><li>EG: New York State, atty gnrl Eliot Spitzer </li></ul></ul><ul><li>Securities Industry </li></ul><ul><ul><li>Exchanges (NYSE, AMEX, NASDAQ, etc) and National Association of Securities Dealers (NASD) </li></ul></ul><ul><ul><li>Duty is to maintain the integrity and credibility of overall trading system </li></ul></ul><ul><ul><li>EG: NYSE flap over fmr CEO Richard Grasso </li></ul></ul>
  4. 4. (2) How are startups usually financed? <ul><li>Founder’s resources </li></ul><ul><ul><li>Most businesses begin as proprietorships, partnerships </li></ul></ul><ul><ul><li>Usually financed by individuals involved </li></ul></ul><ul><li>“ Angels ”: hypothetical first round </li></ul><ul><ul><li>Provide some initial seed or growth money ($50 000 - $400 000) </li></ul></ul><ul><ul><li>Receive stock, seat on board in return for support </li></ul></ul><ul><ul><li>May influence decisions, should have knowledge of industry / experience </li></ul></ul><ul><li>Venture capital funds </li></ul><ul><ul><li>Funds usually set up as private limited partnerships; $30 - $80 million is typical pool </li></ul></ul><ul><ul><li>Institutional investors : have large sums to invest; eg, pension funds, endowments, corp’ns </li></ul></ul><ul><ul><li>Venture capitalists (VCs): managers of these funds, sit on boards of companies they fund </li></ul></ul><ul><ul><li>Portfolio companies: the companies a particular fund eventually comes to manage (avg 12) </li></ul></ul><ul><ul><li>Usually dissolved after pre-specified life elapses (usually 7-10 yrs) </li></ul></ul>
  5. 5. (3) Private Placements vs Public Offerings <ul><li>Private Placements </li></ul><ul><ul><li>Not required to be registered with SEC </li></ul></ul><ul><ul><li>Usually limited to angels / VCs / Institutional Investors </li></ul></ul><ul><ul><li>Unlimited for accredited investors (officers, directors, institutional investors), but limit of 35 to nonaccredited investors (anyone else) </li></ul></ul><ul><ul><li>(1) Offering Memorandum: 20-30pp data/information, lawyers prepare </li></ul></ul><ul><ul><li>(2) Buyers certified of requirements (net worth, income), promise not to sell to others who are unqualified </li></ul></ul><ul><li>Public Offerings </li></ul><ul><ul><li>Basically means allowing the sale of company stocks to outside investors, then letting these trade on secondary markets </li></ul></ul><ul><ul><li>Heavily regulated by SEC (gov’t), NYSE / NASDAQ / major world exchanges </li></ul></ul><ul><ul><li>There are many pros and cons to this…. </li></ul></ul>
  6. 6. (3) Pros / Cons of “Going Public” <ul><li>The Highlights </li></ul><ul><ul><li>Diversification : founders can spread out wealth among other investments </li></ul></ul><ul><ul><li>Liquidity : hard to raise cash with illiquid private stock; trading hassles eliminated </li></ul></ul><ul><ul><li>Raising Funds Easier : easier for investors to buy (liquidity), public disclosure boosts investor trust (SEC rules), firm can now raise capital w/o wasteful searching </li></ul></ul><ul><ul><li>Establishes Firm Value : can change hands without trouble, stock options </li></ul></ul><ul><ul><li>Merger Negotiations : can now pay for acquisitions with reliably-valued stock </li></ul></ul><ul><ul><li>Potential Markets : easier to sell products once “public” </li></ul></ul><ul><li>The Drawbacks </li></ul><ul><ul><li>Reporting Costs : SEC requires disclosure, may be large cost on smaller firms </li></ul></ul><ul><ul><li>Disclosure : data available to competitors, data about officers and company now open </li></ul></ul><ul><ul><li>Self-Dealings : harder to arrange semi-legal/illegal activities (nepotism, salaries, taxes) </li></ul></ul><ul><ul><li>Price Stagnation/Fall : few shares = low real liquidity, lack of coverage </li></ul></ul><ul><ul><li>Loss of Control : management may get ousted, pressure for earnings growth </li></ul></ul>
  7. 7. (4) Steps of an IPO (Overview) <ul><li>Selection of Primary Banker </li></ul><ul><li>Creation of Underwriting Syndicate </li></ul><ul><li>Compliance with Regulations </li></ul><ul><li>Roadshow / Bookbuilding </li></ul><ul><li>Day of IPO </li></ul><ul><li>Ongoing Costs </li></ul>
  8. 8. (4a) Selecting an Investment Banker <ul><li>Reputation and Experience </li></ul><ul><ul><li>Must convince investors that stock isn’t overpriced </li></ul></ul><ul><ul><li>If stock nosedives on opening, it will be a disaster for both bank and firm </li></ul></ul><ul><li>Must get right mix of investors </li></ul><ul><ul><li>Institutional </li></ul></ul><ul><ul><li>Retail (individuals) </li></ul></ul><ul><li>Secondary market “coverage” after IPO </li></ul><ul><ul><li>If well-reputed analysts give good ratings, will boost stock prices </li></ul></ul><ul><ul><li>Often, IBs have associated brokerage arms </li></ul></ul><ul><ul><li>Serious conflicts of interest may arise without ethical safeguards </li></ul></ul>
  9. 9. (4b) Sealing the Deal <ul><li>Methods of the Deal </li></ul><ul><ul><li>Best Efforts : no guarantee of sale at agreed price, IB “will do best” for fee; most risk is therefore on firm whose stock is being issued </li></ul></ul><ul><ul><ul><li>Usually not done unless deals are very risky, involve small firms </li></ul></ul></ul><ul><ul><li>Underwriting : banker guarantees purchase of stock at agreed price, then turns around and sells in secondary market next day (margin = profit) </li></ul></ul><ul><ul><ul><li>Bankers bear significant risks if stock tanks next day </li></ul></ul></ul><ul><ul><ul><li>Best method for firms: will get guaranteed amount of financing </li></ul></ul></ul><ul><ul><ul><li>IBs have high risk: oral commitments and investor interest carefully assessed before price set! </li></ul></ul></ul><ul><li>Negotiation vs Bidding </li></ul><ul><ul><li>Competitive bidding: only used for large issues by major firms; even for them, rarely used when dealing with stocks </li></ul></ul><ul><ul><li>Costs are too high for competitive bidding to be so widely used (huge costs involved learning about involved companies to make good guesses) </li></ul></ul>
  10. 10. (4b) Sealing the Deal (cont’d) <ul><li>Underwriting Syndicates </li></ul><ul><ul><li>Due to huge risks involved, bankers try to work together to minimise (10-15) </li></ul></ul><ul><ul><li>Lead Underwriter(s) : house setting up deal, working with firm </li></ul></ul><ul><ul><li>Selling Group : houses that handle distribution to individual investors; include syndicate members plus additional dealers </li></ul></ul><ul><li>Unsyndicated Offerings : just the opposite </li></ul><ul><ul><li>Lead underwriter sells entire issue to institutional investors alone </li></ul></ul><ul><ul><li>Make more money from deal (up to full percentage point in some cases) </li></ul></ul><ul><ul><li>Fee structure (ie, others involved) greatly reduced </li></ul></ul><ul><ul><li>Relatively new, growing in popularity </li></ul></ul>
  11. 11. (4c) The Regulators <ul><li>SEC is the main regulator </li></ul><ul><ul><li>Interstate Public Offerings : SEC handles everything over $1.5 million </li></ul></ul><ul><ul><li>Registration : at least 20 days before offering; reviewed before release </li></ul></ul><ul><ul><ul><li>Registration Statement (form S-1): financial, legal, technical information </li></ul></ul></ul><ul><ul><ul><li>Prospectus : summarizes such information for investors </li></ul></ul></ul><ul><ul><li>Red Herring Prospectus : solicitations must be accompanied by this, contains all information to be included in real offering except declared price </li></ul></ul><ul><ul><ul><li>If any misrepresentations or omissions on real info, all involved parties are liable </li></ul></ul></ul><ul><li>States </li></ul><ul><ul><li>Each state can regulate securities sales </li></ul></ul><ul><ul><li>More limited than SEC, however </li></ul></ul><ul><ul><li>Certain states (NY, NJ, CA, DE) are more important </li></ul></ul>
  12. 12. (4d) Road-show, Bookbuilding, Pricing <ul><li>“ Roadshow ”: making the sale to potential investors </li></ul><ul><ul><li>Management team often makes several presentations daily to promote new issue </li></ul></ul><ul><ul><li>Typically lasts 10-14 days, 10-20 cities (fairly gruelling!) </li></ul></ul><ul><ul><li>Quiet Period: certain questions cannot be answered until 25 days after trading starts </li></ul></ul><ul><ul><ul><li>Supposed to create level playing field for retail investors </li></ul></ul></ul><ul><ul><li>Violation of rules and/or ethical guidelines may force SEC to delay IPO </li></ul></ul><ul><li>“ Bookbuilding”: racking up interest on issue </li></ul><ul><ul><li>IBs records number of shares institutional investors willing to buy after roadshow </li></ul></ul><ul><ul><li>“ Book” shows how demand for offering is evolving, growing </li></ul></ul><ul><ul><li>Oversubsription can occur if investors wish to purchase more shares than are available </li></ul></ul><ul><ul><ul><li>High demand may mean that offer price is increased later on </li></ul></ul></ul><ul><ul><li>Important to time things correctly, as even good companies may lose out during downturns </li></ul></ul>
  13. 13. (4d) Road-show, Bookbuilding, Pricing <ul><li>Pricing: lots and lots of research!!! </li></ul><ul><ul><li>No established price, even if a privately placed company! </li></ul></ul><ul><ul><li>IB and firm must project future earnings and cash flows </li></ul></ul><ul><ul><li>Similar companies within industry can be used for fair comparisons </li></ul></ul><ul><li>Criteria for Pricing: “rules of thumb” used </li></ul><ul><ul><li>Key ratios (eg, Price/Earnings, Market/Book) are set in line with overall industry expectations </li></ul></ul><ul><ul><li>Ballpark Price : relevant factors can be used to establish a possible range of possible price (eg, “$10 - $12”); put on prospectus </li></ul></ul>
  14. 14. (4e) The Big Day: IPO Trading Begins <ul><li>First Day Trading: where the real money is </li></ul><ul><ul><li>“ Wild and Exciting,” even according to (otherwise dry) textbook </li></ul></ul><ul><ul><li>Some stocks appreciate to unimaginable (and usually unsustainable) levels </li></ul></ul><ul><ul><ul><li>Examples: eBay, Palm, JetBlue, </li></ul></ul></ul><ul><ul><ul><li>For 75% of IPOs, price goes up on first day. </li></ul></ul></ul><ul><ul><ul><li>Average first-day return is 14.1%. </li></ul></ul></ul><ul><ul><ul><li>About 10% of IPOs have first-day returns greater than 30%. </li></ul></ul></ul><ul><ul><ul><li>For some companies, the first-day return is well over 100%. </li></ul></ul></ul><ul><ul><li>Investment banks, institutional investors, insiders, and VCs all make a killing here </li></ul></ul><ul><ul><li>Many conflicts of interest centre around these gains </li></ul></ul><ul><li>IPO Underpricing: why does it happen? </li></ul><ul><ul><li>Strong incentive for IBs to do this, can ensure that they make a killing </li></ul></ul><ul><ul><ul><li>Increases chances of oversubscription </li></ul></ul></ul><ul><ul><ul><li>Commissions generated from brokerage arm </li></ul></ul></ul><ul><ul><ul><li>Way to ensure interest by investors </li></ul></ul></ul><ul><ul><li>Issuing Companies also don’t object </li></ul></ul><ul><ul><ul><li>Creates excitement around stock issue at very low cost to existing stockholders </li></ul></ul></ul><ul><ul><ul><li>Successful IPO generates momentum for future offerings </li></ul></ul></ul>
  15. 15. (5) Direct and Indirect Costs <ul><li>Direct Costs </li></ul><ul><ul><li>Spread (ie, between offer price and proceeds) of 7% spread usually charged by underwriters </li></ul></ul><ul><ul><li>Direct costs: lawyers, printers, accountants, etc; can be substantial (over half a million dollars) </li></ul></ul><ul><li>Indirect Costs </li></ul><ul><ul><li>Can be very time-consuming for management during months before </li></ul></ul><ul><ul><li>On average, raises $70 million, leaves $9 mil on table </li></ul></ul><ul><ul><li>“ Left on Table” = (# Issued Shares) * (Ending First Day Price – Offer Price) </li></ul></ul>
  16. 16. (5) Equity Carve-Outs <ul><li>What They Are </li></ul><ul><ul><li>Special kind of IPO: parent company creates a new public company by selling stock in a subsidiary to outside investors </li></ul></ul><ul><ul><li>Essentially the way companies are “spun off” from parents </li></ul></ul><ul><ul><li>Parent usually retains controlling interest in new public company . </li></ul></ul><ul><li>Certain Advantages </li></ul><ul><ul><li>Usually result in price increases for parent companies </li></ul></ul><ul><ul><li>May facilitate evaluation of growth opportunities on a line-of-business basis </li></ul></ul><ul><ul><li>Improve ability of corporation to offer incentive to subsidiary managers </li></ul></ul><ul><ul><li>Increase effectiveness of capital allocation (internal competition reduced) </li></ul></ul><ul><ul><li>Certain costs involved too (commission, time, filings, relationships) </li></ul></ul>
  17. 17. (6) Other IB Activities <ul><li>Shelf registration (SEC Rule 415) </li></ul><ul><ul><li>Issues are registered, but entire issue not sold </li></ul></ul><ul><ul><li>Partial sales allowed to occur over specified time period Public and private debt issues </li></ul></ul><ul><li>Debt Issues </li></ul><ul><ul><li>Public: bonds sold on global OTC bond markets; ratings (from agencies) apply </li></ul></ul><ul><ul><li>Private: bonds to large investors / money centre banks / corporations / etc </li></ul></ul><ul><li>Seasoned equity offerings </li></ul><ul><ul><li>Offerings by companies that are already “public”; public and private placements </li></ul></ul><ul><ul><li>Private placements: sold to a few investors, new trend is companies taking stock in suppliers, no need for SEC registration process; increasingly popular (40% all nonbank debt financing) </li></ul></ul><ul><li>Rights Offerings…. </li></ul>
  18. 18. (7) Rights Offerings <ul><li>Hierarchy of Purchasing Rights </li></ul><ul><ul><li>Common stockholders often have the right to purchase additional shares of firm before others </li></ul></ul><ul><ul><li>Must be specified in firm charter </li></ul></ul><ul><li>Shareholders have options </li></ul><ul><ul><li>Exercise rights: buy the shares now </li></ul></ul><ul><ul><li>Sell rights: to others who can then exercise </li></ul></ul><ul><ul><ul><li>Ex rights : old owner receives rights; usually after 2 days </li></ul></ul></ul><ul><ul><ul><li>Rights on : if stock is sold prior to ex-rights date </li></ul></ul></ul><ul><li>Shareholders have options </li></ul><ul><ul><li>Neither benefit nor lose by rights offering </li></ul></ul>
  19. 19. (7) Rights Offerings <ul><li>If Date is “Rights On,” P = Market Price bf Offering </li></ul><ul><ul><li>Formula: R = (M 0 – S) / (N + 1) </li></ul></ul><ul><ul><li>M0 = rights-on market price; R = value of one right; S = subscription price; N = rights for 1 share </li></ul></ul><ul><li>If Date is “Ex Rights,” then P changes (usu. lower) </li></ul><ul><ul><li>Formula: R = (M e – S) / N </li></ul></ul><ul><ul><li>Me = ex-rights market price; R = value of one right; S = subscription price; N = rights for 1 share </li></ul></ul><ul><li>Lesson of the story: R doesn’t change!! </li></ul>
  20. 20. (7) “Going Private” <ul><li>Reverse of Going Public </li></ul><ul><ul><li>Firm’s managers team up with a small group of outside investors and purchase all of the publicly held shares of the firm </li></ul></ul><ul><ul><li>Usually use large amounts of debt financing, so these transactions are classified as leveraged buyouts </li></ul></ul><ul><li>The Highlights </li></ul><ul><ul><li>Manager Flexibility : greater incentives to run company </li></ul></ul><ul><ul><li>Administrative Savings : saves on registration costs, filing costs, stockholder relations </li></ul></ul><ul><ul><li>Shareholder participation : small group of active investors with incentive to help firm succeed </li></ul></ul><ul><ul><li>Less pressure : eliminates need to maintain earnings growth, more long-term focus </li></ul></ul><ul><ul><li>Usually go public again : managers use time to make company more efficient, increase value </li></ul></ul><ul><li>The Drawbacks </li></ul><ul><ul><li>Difficult to raise new capital : creditors usually wary to give highly leveraged firms more money </li></ul></ul><ul><ul><li>Default Risk : even small shocks can cause bankruptcy due to high debt load </li></ul></ul>
  21. 21. (7) Managing Maturity Structure of Debt <ul><li>Maturity matching </li></ul><ul><ul><li>Match maturity of assets and debt </li></ul></ul><ul><ul><li>Dominates debt maturity decisions </li></ul></ul><ul><ul><li>EG: call provision on bonds (ability to lower costs at a premium), floating rate debt </li></ul></ul><ul><li>Information asymmetries </li></ul><ul><ul><li>Firms with strong future prospects will issue long-term debt (can lock in low rates now to protect against downturn later) </li></ul></ul><ul><ul><li>Firms that don’t do well have incentives to use short-term debt to finance long-term assets (expectation of replacing later with cheaper long-term debt) </li></ul></ul>