Investment Banking And The Public Sale Of Equity Securities Professor XXXXX Course Name / Number
Basic Choices In Securing External Financing A firm needing external capital faces three basic choices: Employ an investment bank to advise and handle offering Choice of public versus private capital market Choice of security and type of offer: equity or debt Focus of this chapter
Investment Banks Role in Equity Offerings Asset management Corporate finance Trading Investment banking lines of business Investment banks provide advice with structuring seasoned and unseasoned issues, actual sale and post-sale services. Seasoned offering <ul><li>Equity issues by firms that already have common stock outstanding </li></ul>seasoned Unseasoned offering <ul><li>Initial public offering (IPO): issue of securities that are not traded yet </li></ul>unseasoned
Investment Banks Role in Equity Offerings Public security issues can be: Best effort <ul><li>The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering. </li></ul>Firm commitment <ul><li>Underwritten offerings, bank guarantees certain proceeds. </li></ul><ul><li>Vast majority of US security offerings are underwritten this way. </li></ul>Direct negotiated offer Competitive bidding Firms can choose an investment bank through:
Global Investment Banking Rankings (2000), $ Billions $11,540 $6,032 $3,497 $1,785 Top 25 banks 484 48 120 295 8. Banc of America 511 47 88 44 7. ABN Amro 1,085 626 358 60 6. Credit Suisse Group 1,163 565 493 -- 5. Merrill Lynch 1,236 620 360 210 4. Citigroup 1,268 928 303 31 3. Goldman Sachs 1,283 907 344 14 2. Morgan Stanley $1,295 $426 $297 $487 1. JP Morgan Chase Total revenues M&A advisory Securities U/W and private placements Syndicated loans Rank & firm name Source: Roy C. Smith, “Strategic Directions in Investment Banking – A Retrospective Analysis”
Services Provided By Investment Bankers And Their Costs Investment banks provide services prior to security offering. <ul><ul><li>Primary pre-issue role: provide advice and help plan offer </li></ul></ul><ul><ul><li>Firm needing capital selects one or more lead underwriters. </li></ul></ul><ul><ul><li>Top firm the lead manager , others are co-managers </li></ul></ul><ul><ul><li>Offering syndicate organized early in process </li></ul></ul>Prior to offering, lead investment bank negotiates underwriting agreement: <ul><ul><li>Sets offer price and spread; details lock-up agreement </li></ul></ul><ul><ul><li>Bulge bracket underwriter’s spread usually 7.0% for IPOs </li></ul></ul><ul><ul><li>Initial offer price set as range; final price set day before offer. </li></ul></ul>
Legal Rules Governing U.S. Public Security Sales Two basic laws governing public issues: Securities act of 1933 Prescribed security issuance procedures, set basic principle of full disclosure. Securities and exchange commission act of 1934 Set up SEC, gave it broad regulatory, rule-making powers. Securities laws mandate disclosure of all relevant corporate information to potential investors. Investment banks play key disclosure role by performing due diligence.
Basic Disclosure Documents <ul><li>Actually a series of registration statements, beginning with the Preliminary Prospectus </li></ul><ul><ul><li>Called a Red Herring after title page disclaimer (in red ink) </li></ul></ul><ul><ul><li>Statements are submitted to SEC, which responds with changes needed. Firm makes changes and resubmits. </li></ul></ul><ul><ul><li>Offering only becomes effective with SEC’s final approval. </li></ul></ul><ul><li>After preliminary filing, firm and IB begin a road show. </li></ul><ul><ul><li>IB does book building during road show providing key pricing info. </li></ul></ul>Principal disclosure document: Registration Statement Prospectus Supplemental Disclosures
Material Covered In A Prospectus Title page summarizes offering and lists underwriters. First section presents offering details, discusses use of proceeds, describes firm, lists risk factors. Inner pages detail underwriting agreement, stock ownership and if offering is primary, secondary, or mixed offering. Final page presents cold comfort letter from auditors: states that firm’s books were prepared using GAAP. <ul><li>Always one or more lead underwriters </li></ul><ul><li>Sell newly issued shares </li></ul><ul><li>Raise new capital for the firm </li></ul><ul><li>Existing shareholders sell their shares </li></ul><ul><li>No new capital for the firm </li></ul>
Shelf Registration <ul><ul><li>Qualifying issuers (more than $150 million in outstanding stock) file a “master registration statement”, summarizing planned financing for the next two years. </li></ul></ul><ul><ul><li>The company can offer securities for sale ( off the shelf ) over subsequent two years. </li></ul></ul><ul><ul><li>Popular with issuers; very flexible </li></ul></ul>SEC introduced rule 415: shelf registration Most qualifying debt issues are shelf registered. Very few equity issues use shelf: IB certification needed.
Services Provided During And After A Security Offering Almost all IPOs and SEOs have a green shoe option: over-allotment option to cover excess demand. Lead underwriter is responsible for price stabilization after offering. After offering, lead underwriter serves as principal market maker. Lead underwriter sets each syndicate member’s percentage of participation. How many shares each member must sell and compensation.
The U.S. Initial Public Offering Market 1) US IPO market is larger than rest of world’s combined. IPOs account for 30-45% of all new equity raised each year. 2) NYSE and NASDAQ now compete for IPOs. 3) IPO market is highly cyclical: biggest IPO boom ever between 1991 and March 2000. 4) Market prone to industry “fads”: semiconductors, biotech mid-1980s; internet after 1995. 5) Institutions most important IPO investors: allocated 40-80% IPO shares.
Number of US IPO Offerings, Initial Returns and Gross Proceeds Initial returns were very high during internet boom: 69.0% in 1999 and 55.5% in 2000. $458,240 17.8% 7,054 Total 100,444 48.4 465 2000-01 294,076 20.9 4,129 1990-99 62,596 6.8 2,348 1980-89 $1,124 5.7% 112 1975-79 Gross proceeds ($ Millions) Average first day returns (%) Number of offerings Period Source: Jay R. Ritter, “Some Factoids about 2002 IPO Market”
Benefits Of An IPO 1) IPO can raise large amounts of new capital for growth. 2) Publicly traded stock is currency for acquisitions. 3) Listed stock (options) can be used to attract top managers. 4) Provides personal wealth and liquidity for entrepreneur 5) Serves as advertising for firm and its products/services
Costs Of IPO <ul><ul><li>Have to disclose operating and sensitive data publicly </li></ul></ul><ul><ul><li>Must follow public company governance rules set by SEC </li></ul></ul>1) High financial costs of IPOs, with no guarantee of success: cash expenses of IPO often approach $1 million. 2) Managerial costs of planning and executing IPO 3) Need to focus on stock price and deal with shareholders 4) Severe constraints on managerial discretion in public firm
Types Of Specialized IPOs Equity carve-out <ul><li>Parent sells minority stake in subsidiary to public through IPO. </li></ul><ul><li>Raises cash for parent, allows better monitoring of subsidiary. </li></ul>Spin-off <ul><li>Parent distributes all of a subsidiary’s stock to shareholders. </li></ul><ul><li>Full spin-off creates independent new company. </li></ul>Reverse LBO <ul><li>Company goes public again after LBO. </li></ul><ul><li>Successful LBOs create value, so high returns to second IPO. </li></ul>Tracking stock <ul><li>Stock mirrors performance of division, but not legally or operationally separate from parent. </li></ul>
Investment Performance Of IPOs <ul><ul><li>Positive initial returns for IPO investors </li></ul></ul><ul><ul><li>Large IPOs typically underpriced less than smaller offerings. </li></ul></ul><ul><ul><li>Initial returns are higher in “hot issue markets” than in cold markets. </li></ul></ul><ul><ul><li>Mean initial returns are much higher than median: a relative handful of severely underpriced offers drive results. </li></ul></ul><ul><ul><li>Mean return overstates actual profits for most investors; uninformed investors suffer from winner’s curse. </li></ul></ul><ul><ul><li>Venture-capital backing reduced initial returns during 1980s; increased after 1990. </li></ul></ul>Patterns observed in IPO offerings: IPOs seem to dramatically under-perform over 1-5 years.
Seasoned Equity Offerings (SEO) SEOs infrequent for most U.S. and non-U.S. firms Short-term and long-term performance of SEOs: prices fall on announcement, under-perform over 1,3 and 5 years. Reason Negative market reaction when SEOs are announced SEO announcements convey negative info: <ul><ul><li>Could be that managers consider stock over-valued </li></ul></ul><ul><ul><li>Could reveal that cash flows will be lower than expected </li></ul></ul>
Rights Offerings Existing shareholders have the right to buy new shares at a discount or can sell this right to other investors. Date of record <ul><li>Set by firm’s directors </li></ul><ul><li>Shareholders on firm’s books as of this date will receive rights. </li></ul><ul><li>Date when stock begins trading without right </li></ul><ul><li>Usually set a few days before record date </li></ul>Ex rights date <ul><li>Exercise price of stock being sold through offering </li></ul><ul><li>Right’s value depends on the number of rights needed to buy a share. </li></ul>Subscription price
Rights Offerings Theoretically, value of right ( R W ) is the same whether selling separately or still attached to share. Managers have three basic decision to make in rights offer: <ul><ul><li>Determining amount of capital firm needs to raise </li></ul></ul><ul><ul><li>Setting subscription price: set below current market price </li></ul></ul><ul><ul><li>Determining number of rights needed to buy share of stock </li></ul></ul><ul><ul><li>R W = value of right </li></ul></ul><ul><ul><li>M W = market value of stock with rights </li></ul></ul><ul><ul><li>S = subscription price of stock </li></ul></ul><ul><ul><li>N = number of rights needed to buy </li></ul></ul><ul><ul><li>one share </li></ul></ul>
Private Placements In The U.S. Sale of a security directly to one or a group of accredited investors Rule 144A has allowed limited trading of PP among “qualified institutional investors” Accredited investors in private placements are financially sophisticated. Corporations, institutional investors, wealthy individuals, pension and mutual funds, venture capitalists qualified institutional investors More than $100 million in assets
Private Placements In U.S. Capital Markets $86 345 Rule 144A, Foreign Issuers 83.7% 75.7% Rule 144A as % of Total PP $263 1,282 Rule 144A, U.S. Issuers $349 1,627 Rule 144A, All Issuers $29 149 Yankee Private Placements $127 699 Securitized Private Placements $59 362 Plain Vanilla Equity $52 214 High-Yield Debt $349 1,751 Straight Debt $417 2,148 Overall Private Placements Total Value US$ billions Number of Issues Type of Offering Source: Investment Dealers’ Digest, various 2002 issues
International Common Stock Offerings Total number of non-U.S. IPOs exceeds U.S. total, but total value (except privatizations) usually much smaller. All markets show significant IPO underpricing. Most markets show poor long-term returns for IPOs, SEOs. Most markets also seem prone to hot and cold markets. Two types Domestic stock offering International, or cross-border, issues
American Depositary Receipts (ADRs) Dollar-denominated claims issued by U.S. banks Represent ownership of shares of a foreign company’s stock held on deposit in the issuing firm’s home country Sponsored ADR <ul><li>The issuing foreign company pays all legal and financial costs of creating and trading the security. </li></ul><ul><li>Issuing firm is not involved with the issue of ADRs. </li></ul>Unsponsored ADR
Share Issue Privatizations SIPs have raised almost $1 trillion since 1980 SIPs are 10 largest (25 of 28 largest) offers ever 13,300 Deutsche Telekom Nov 96 14,760 Deutsche Telekom Jun 00 15,000 Nippon Telegraph & Telephone Nov 99 15,097 Nippon Telegraph & Telephone Feb 87 15,500 Telecom Italia Oct 97 18,000 NTT DoCoMo Oct 98 18,900 ENEL Nov 99 22,400 Nippon Telegraph & Telephone Oct 88 $40,260 Nippon Telegraph & Telephone Nov 87 Amount ($ in millions) Company Date Source: William L. Megginson and Jeffry M. Netter, “From State to Market: A Survey of Empirical Studies on Privatization”
Investment Banking And The Public Sale Of Equity Securities Companies that raise capital externally can issue debt or equity. Common stock can be sold through private placements or to the public. First public offerings is known as IPOs. Subsequent offerings are knows as SEOs. Investment banks assist companies in selling new securities.