3. Primary Services of an Investment
Bank
• Bringing New Securities to Market.
• Trading and brokerage.
• Mergers and acquisitions.
• Other business activities.
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4. Bringing New Securities to Market
• New issues are called primary offerings, first issued
in the primary market.
– Unseasoned offering or Initial public offering
(IPO) – first sale of securities to the public. One
problem with IPO is how to price them, therefore,
IPO suffers from underpricing.
– Seasoned offering - additional issue of securities
already trading.
Offering can be either:
– Public offering
– Private placement
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5. Bringing New Securities to Market
– Public offering: Corporation wishing to make a
public offering must decide whether to have:
- Underwriting: investment banker guarantees that
the issuer will receive a fixed amount of money
whether securities are sold or not.
- Best-efforts basis: investment banker makes no
guarantee and instead promises only to make its
best sales efforts.
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6. Bringing New Securities to Market
• Corporation wishing to make an underwriting
security can choose to solicit investment-
banking services through:
- Competitive bidding: the issuer publicly
announces a desire to sell securities and
solicits offers from several investment-banking
firms.
- Negotiated offering: direct negotiation with a
single investment banker.
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7. Bringing New Securities to Market
(continued)
• Three steps of bringing a new issue to market:
1. Origination- During the origination process,
investment bank helps the issuers to
– analyze the feasibility of the project, determine
the amount of money and type of financing.
– design of a security contract that is acceptable to
the market;
• Prepare SEC registration statements and a
summary prospectus,
• obtain a rating on the issue, obtain bond counsel, a
transfer agency and a trustee.
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8. Bringing New Securities to Market
(concluded)
2.Underwriting (price risk bearing) - the IB buys the
securities at a given price to resell them to the
public at a higher price.
3.Sales and distribution - selling quickly reduces
inventory risk.
• Syndicates are formed to reduce inventory risk.
• Market price declines cut the IB's margin.
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9. Underwriting Agreements
• In an underwritten offer, IB guarantees the
issuer a certain price
– The risk of not selling the issue at a price higher
than that promised to the issuer is borne by the
IB.
– The difference between the price at which the
issue is sold and that promised to the issuer is the
underwriting spread.
– This is the profit earned by the IB.
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10. 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 issuer, not the IB.
– Smaller and more risky issues resort to this type of
offering.
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11. Trading and Brokerage
• Besides underwriting, investment banks provide
services as brokers and dealers for existing
securities.
• The brokerage function is to bring a buyer and
seller together for a commission.
• Dealer (making market) function - buying (bid)
and selling (ask) from an inventory of securities
owned by the seller.
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12. Trading and Brokerage (continued)
• Brokers and dealers can also provide security credits
which represent loans to customers with margin account.
• Margin trading: means that the investor can buy
securities partly with borrowed money.
– Example: if a customer uses a 40% margin, it means
that 40% of the purchased securities is being financed
with the investor’s own money and the remaining 60%
is financed with money borrowed from the brokerage
house.
• Dealer security credits are financed by bank call loans and
repurchase agreements.
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13. Trading and Brokerage (continued)
• Full service brokerage firms offer a wide
range of services provided by licensed
stockbrokers or account executives:
– Storage or safekeeping of securities.
– Execution of trades.
– Investment research and advice.
– Cash management service.
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14. Trading and Brokerage (concluded)
• Discount (Internet) brokerage firms offer fewer non-fee
services than full-services brokers, but charge lower
commissions.
• Banks may act as a broker on behalf of its customers.
• Arbitrage activities involving the simultaneous
buying/selling of a security to take advantage of a price
that exists between two markets is another trading
activity of IB.
– Example: if GMC stock is trading for $35/share on New
York Stock Exchange (NYSE )and $34/share on the
NASDAQ, an arbitrageur would buy GMC stock on
NASDAQ and sell it on NYSE, so he will earn$1. this
process will continue until the price differential is
eliminated.
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15. Private Placements
• The sale of securities directly to the ultimate investor
(no public offering).
• The underwriting function/cost is avoided.
• The investment banker’s role is to:
– Bring buyer and seller together.
– Help determine a fair price for the securities.
– Execute the transaction.
• Investment banks earn a fee.
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16. Private Placements
• Advantages of private placement:
– Less costly in terms of time and money (i.e. 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.
– The terms of private placement are easier to renegotiate.
• Disadvantages of private placement:
– Securities have no readily available market price, they are
less liquid and there is a small group of investors.
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17. Mergers and Acquisitions
• Investment banks provide four categories of
M&A for which they can earn fees:
– Help firms indentify M&A candidates.
– Do the required analysis to price the deal.
– Provide advice and help the acquiring firm in negotiating.
– Help the acquiring firm in obtaining the funds to finance
the purchase.
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18. Mergers and Acquisitions
• Specialized IB departments provide the following
services.
– Arrange mergers which would produce economic
synergy or increase total value.
– Assist firms in fighting 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 M&A departments.
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19. Other business activities
• Investment-banking firms are very flexible
organizations and if they can earn a
satisfactory return, they can perform many
services:
– Financial consulting: e.g. assisting clients in
financial planning, determining the firm’s optimal
capital structure and dividend policy.
– Real estate investment and brokerage: purchasing
real estate for investment purposes.
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