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  1. 1. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-1 Chapter 11 Investment Banks, Retail Securities Firms, and Venture Capitalists: Management and Ethical Issues
  2. 2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-2 Growth and Size of Securities Firm Industry  1990’s Data for the U.S. • About 8,000 securities firms. • Firms had more than $54 billion in equity capital. • Firms controlled more than $1.25 trillion in assets. • In 1997 debt underwriting exceeded $1 trillion and stock underwriting was greater than $150 billion.
  3. 3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-3  The growth and size of the industry, however, is very cyclical, with increases during bull stock markets, decreases during bear markets and periods of large trading losses.
  4. 4. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-4 Prior to Renaissance Renaissance 17th & 18th Centuries Specialization in money lending business by non-Catholics. Catholics adhered to dictums against lending; such church restrictions on commerce weaken in the Renaissance, and in the 17th and 18th centuries economic prosperity leads to the growth of public securities, banking, and merchant banking. Late 18th Century Growth of major European family-run international banking houses (Rothchilds, Baring brothers, Warburgs). Large European government needs to finance wartime activities brings rise of new merchant bankers. 19th Century Rise of London as financial capital; large financings for Industrial Revolution; large railroad financings; emergence of large U.S. investment banks, such as J.P. Morgan. Immigrants start securities firms, such as Joseph Seligman and Goldman and Sachs; Jay Cooke & Co. uses syndication process to sell bonds to public during the Civil War. In the later 1800s era of financing tycoons, such as J.P. Morgan and development of oligopolistic behavior by prestigious Wall Street firms. Brief Historic Overview of Securities Firms Emphasizing U.S. Securities Firms
  5. 5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-5 20th Century 1914-1950s New York becomes major financial center during World War I, U.S. security firms assist in foreign and U.S. financings; during 1920s broader public interest in securities. Modernization of securities issue origination and distribution process with growth of telephone and telegraph. 1929: Stock market crash followed by lawsuits and hearings against security firms; 1933: Glass Stegall breaks up banks and security firms; poorly capitalized security firms with severe underwriting losses remain; mergers and cutbacks during the depression. WWII: Securities firms assist in government financings; anti-Wall Street sentiment ends; English merchant banks facilitate first postwar hostile takeovers. Historic Overview (continued)
  6. 6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-6 1960s Dollar becomes principal currency of international trade. With deficits in the United States, a stable international climate, the 1963 Interest Equalization tax penalizing the sale of some foreign securities to American investors, and regulation Q preventing banks to offer market rates, banks and securities firms flock abroad, resulting in the development of the Eurodollar and Eurobond market; London is reestablished as a major financial market. First Eurobond issue for the Italian Autostrade in 1963. Greater trading activities; new breed of impersonal traders. Greater number of investment banks with international subsidiaries; high inflation; more active management of investments by institutional investors; securities firms develop services for institutional investors including block trading; this made firms like Salomon Brothers with large trading operations prominent. Historic Overview (Continued)
  7. 7. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-7 1970s Former hierarchy in underwriting of prestigious underwriters is challenged by full-service security firms, such as Merrill Lynch. Securities firms introduce production-oriented compensation to attract traders that creates new rivalries and tensions; entry of new type of “gunslinger;” development of research services area to attract investors. Dollar becomes a floating currency; 1972: Merrill Lynch receives first license to have a security branch in Japan. Largest Japanese security firms expand overseas; first yen-denominated bond (samurai bond) issued by non-Japanese issuer. May 1, 1975: Fixed brokerage commissions abolished, making commissions competitively based; a few discount brokerage firms spring up, and security firms merge. High inflation leads to innovations to offer market rates, including cash management funds in 1977 by Merrill Lynch; other money and mutual funds followed. 1980s March 16, 1982: Shelf Registration Rule (Rule 415) adopted by SEC, allowing corporations to register securities and issue them at any time over the next two years. SEC Rule 415 gives firms more flexibility to seek competitive bids for offerings, particularly debt offerings, which reduced underwriter gross spreads. Historic Overview (Continued)
  8. 8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-8 Mid-1980s Bull market; Go-Go Days; Great merger and acquisition activity; innovation of junk bonds by Drexel Lambert; leveraged buyouts; dramatic growth in underwriting; industry grows from 5,248 firms in 1980 to 9,515 in 1987. Securitization rises. 1986: “Big Bang” in London removes fixed commissions and other reforms, including development of a new international Stock Exchange Automated System (SEAQ), allowing 24-hour off-exchange trading. Later 1980s October 1987: Stock Market Crash resulting in lower underwriting and a loss of confidence by investors in equity markets. Insider trading and other scandals contribute to poor perceptions of security firms by the public. Profitability of securities industry declines with large drop in underwriting and brokerage commissions. Between 1987 and 1991, period of consolidation in the industry, mergers, and layoffs. Number of firms declines by about 20 percent. Movement into venture capital, real estate venture, mortgage-backed securities, and principal investing. Historic Overview (Continued)
  9. 9. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-9 1990s Greater competition from major commercial banks with section 20 subsidiaries. Recession; low profits; diversification into fixed income security and derivatives trading; securitization to offset decline in underwriting. 1992 on: Bull stock market and rise in profits but severe drop in underwriting and profits in 1994. Industry expands to about 8,000 firms. Mid and Later 1990s: Acquisitions by large banks and other financial institutions and mergers of wholesale retail firms. Trading scandals by rouge traders caused large losses, such as the 1995 Barings scandal and collapse. 1992: European Economic Community harmonized regulations and allowed financial institutions to sell services throughout the EC. Lawsuits by customers and employees; greater oversight by SEC and exchanges. Innovations; growth of Internet services; emergence of online brokerage firms and the first online investment bank. Historic Overview (Continued) Source: Samuel L. Hayes III and Philip M. Hubbard, Investment Banking (Boston: Harvard Business School Press, 1990), Anthony Saunders, Financial Institutions Management: A Modern Perspective, 2ed (Burr Ridge Ill: Irwin, 1997); and Ron Chernow, The House of Morgan (New York: Touchstone (Simon & Schuster), 1990)
  10. 10. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-10 Changes in the Culture of Investment Banking  In mid-1960’s, changed from white glove genteel culture to a competitive, cutthroat one. • Production-oriented compensation eroded collegiality and generated rivalries and tensions. • The adoption of a new fee-for-services mentality is directly related to the declining importance of underwriting and the greater importance of fees from M&A activity and trading.
  11. 11. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-11 Investment Banker Reputation  Firms that are being valued and taken public depend on a banker’s good judgement and honesty.  Short-term, unethical abuses ultimately hurt a firm and an individuals’ most valuable asset, reputation.  Examples of ethical breaches: • Salomon Brothers Treasury scandal (1990); and • Drexel, Burnham, and Lambert junk bond scandal (1988).
  12. 12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-12 Key Areas of Activities for Securities Firms  Investment banking underwriting for debt and equity securities, private placements, M&A  Principal transactions involving trading and investment activities  Selling and dealing activities for customers as an agent
  13. 13. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-13  Investing activities as an agent  Back office activities  Other activities such as merchant banking, real estate investment trust and real estate investment partnerships
  14. 14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-14 Changing Revenue Sources Commissions 49.9% 15.4% Principal Transactions 15.6 17.1 Underwriting Revenues 13.3 9.0 Margin Interest 7.8 5.8 Mutual Fund Sales .6 3.8 Commodities 3.0 1.3 All Other+ 9.9 47.6 Total Revenues 100.0% 100.0% 1975 1996 + Other activities include M&A fees, private placements, market making and global investment management.
  15. 15. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-15 Details on Revenue Sources  Fees for services to institutional investors have become a bigger source of revenue.  With globalization, U.S. gross activity in foreign securities and foreign gross activity in U.S. securities has grown dramatically.
  16. 16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-16  Between 1975 to 1996: • the mutual fund/asset management business grew at an annual rate of 30%; • interest income, private placement, M&A activities grew at an annual rate of 23%; • revenues grew at an annual compound rate of 43% ; and • earnings grew at a 13.5% annual rate.
  17. 17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-17 Financial Ratios Based on the Income Statement  Commissions/revenues(%)  Principal transactions/revenues(%)  Investment banking/revenues(%)  Revenues/expenses(%)  Portfolio revenue/investments(%)  Revenues per employee  Expenses per employee  Compensation and benefits per employee  Number of employees
  18. 18. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-18  Commissions/revenues will be larger for retail firms than for wholesale firms.  Wholesale investment banking firms typically have fewer employees and higher revenues, expenses, compensation, and benefits per employee than retail firms.
  19. 19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-19 Types of Assets for Securities Firms  Because of trading and broker/dealer activities, a large percentage of assets are securities.  Other assets are predominantly receivables from customers and broker/dealers.  Fixed assets are a small percentage of assets.  Large NYC investment banks will also hold derivative contracts, debt and currency swaps, and physical commodities as assets.
  20. 20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-20 Liabilities for Securities Firms  Liabilities are predominantly short-term and include: • short-term borrowing and repurchase agreements; • securities sold but not yet purchased; and • customer payables.  Security firms generally have high financial leverage. Equity-to-asset ratios are lower for wholesale firms than for retail firms.
  21. 21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-21 In managing trading risks securities firms have….  tried to collect better information on trading risks by using DEAR and VAR measures.  attempted to allocate greater capital and capital cost for potential losses associated with risky activities using RAROC approach.
  22. 22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-22  position limits for traders based on the market risk of traders’ portfolio.  devised compensation methods that consider traders’ returns along with the additional risk that riskier trades impose on the firm.
  23. 23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-23 Underwriting Risk  Underwriting risk is the risk of adverse price movements immediately after the issue of new securities.  Under negotiated offerings, investment bankers purchase securities at a given price and sell securities at a higher offering price to the public.
  24. 24. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-24  Underwriters have had greater risk with SEC 415 shelf registration deals. • In a bought deal, an investment bank has not had time to develop a syndicate or access market interest rates before submitting a bid. • A kamikaze offer is an offer by a prospective underwriter for a bought deal at such a low yield that other underwriters may decline to participate in the syndicate.
  25. 25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-25 To reduce underwriting risk investment bankers...  form syndicates of securities firms to take on a portion of the offering and reduce the underwriting and selling risk to the lead underwriter.  hedge their underwriting positions in futures markets.  use stabilization techniques during the first 30 days of a new stock issue, whereby they purchase or sell securities to stabilize the security’s price.
  26. 26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-26 Venture Capital (VC) Firms  VC firms are investment firms that provide seed capital to startup firms, start-up capital to firms beginning to operate or manufacture a product, and later stage capital and bridge financing.  VC firms’ goal is to make a large return, averaging about 50% per year, for investors who are willing to take the risk of investing in relatively new firms.
  27. 27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-27  VCs invest in a portfolio of firms with high growth potential, generally taking an equity stake in the firm.  Their objective is to take a firm public or sell it in a short time frame of five to seven years.  Firms must give up a portion of control of the business to the VC firm.
  28. 28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-28 Types of VC Firms  Private VC firms  Angels  Venture capital networks (VCNs)  Small business investment corporations (SBICs)  Minority enterprise small business investment companies (MESBICs)
  29. 29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-29 Steps in the IPO Process  Signing the letter of intent  Conducting a valuation of the company  Determining the share price and total number of shares to be sold  Performing an active due diligence of the firm to be taken public  Submitting the registration form to the SEC
  30. 30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-30  Marketing IPO through road shows and publishing a preliminary red herring prospectus  After SEC approval, the underwriting contract is executed and an effective date for the offering is set.  During the 30 days after the offering, the investment banker practices stabilization techniques if needed.