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  1. 1. FINANCIAL MARKET & INSTITUTIONS LAN Yu Ping (Ricky), Associate Professor International Finance College Email:
  2. 2. Chapter 23 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms
  3. 3. Chapter Preview <ul><li>We examine the role played by investment banks (primary market), securities dealers and brokers (secondary market), and venture capital firm (pre-market). Topics include: </li></ul><ul><ul><li>Investment Banks </li></ul></ul><ul><ul><li>Security Brokers and Dealers </li></ul></ul><ul><ul><li>Regulation of Securities Firms </li></ul></ul>
  4. 4. Chapter Preview (cont.) <ul><ul><li>Relationship Between Securities Firms and Commercial Banks </li></ul></ul><ul><ul><li>Venture Capital Firms </li></ul></ul>
  5. 5. 23.1 Investment Banks <ul><li>Investment banks perform a variety of crucial functions in financial markets </li></ul><ul><ul><li>Underwrite the initial sale of stocks and bonds </li></ul></ul><ul><ul><li>Deal maker in mergers, acquisitions, and spin-offs ( 分拆 ) </li></ul></ul><ul><ul><li>Middleman in the purchase and sale of companies </li></ul></ul><ul><ul><li>Private broker to the very wealthy </li></ul></ul>
  6. 6. 23.1.1 Investment Banks <ul><li>Investment banks were essentially created in the U.S. by the passage of the Glass-Steagall Act. Prior to this, investment banking activities were part of large, money-center commercial banks. </li></ul><ul><li>The lines between investment banks and commercial banks again begins to blur (模糊) as legal separation between investment banks and commercial banks is no longer required. </li></ul>
  7. 7. 23.1.2 Investment Banks <ul><li>Investment banks play many roles in both the primary and secondary markets. We will focus on their role in three areas: </li></ul><ul><li>Underwriting Stocks and Bonds </li></ul><ul><li>Equity Sales </li></ul><ul><li>Mergers and Acquisitions </li></ul>
  8. 8. 23.1.3 Underwriting Stocks and Bonds <ul><li>The process of underwriting a stock or a bond issue requires that the investment banker purchase the entire offering at a predetermined price and then resell the offering (securities) in the market. The services provided during this process include: </li></ul><ul><ul><li>Giving Advice </li></ul></ul><ul><ul><li>Filing Documents </li></ul></ul><ul><ul><li>Underwriting, Best Efforts ( 代销 ), or Private Placement </li></ul></ul>
  9. 9. 23.1.4 Underwriting Stocks and Bonds <ul><li>Giving advice </li></ul><ul><ul><li>Explaining current market conditions in to help determine why type of security (equity, debt, etc.) to offer </li></ul></ul><ul><ul><li>Assisting in determining when to issue, how many, at what price (more important with IPOs than seasoned issues) </li></ul></ul>
  10. 10. 23.1.5 Underwriting Stocks and Bonds <ul><li>Filing Documents </li></ul><ul><ul><li>SEC registration (filing) is required for issues greater than $1.5 million and with a maturity greater than 270 days. </li></ul></ul><ul><ul><li>A portion of the registration statement known as the prospectus ( 募集说明书 ) is made available to the public. </li></ul></ul><ul><ul><li>Debt issues require several additional steps, including acquiring a credit rating, hire a bond counsel (法律顾问) , etc. </li></ul></ul><ul><ul><li>For equity issues, the investment banker may also arrange for the securities to appear on one of the exchanges. </li></ul></ul>
  11. 11. 23.1.6 Underwriting Stocks and Bonds <ul><li>Underwriting (firm commitment) </li></ul><ul><ul><li>The investment banker purchases the entire offering at a fixed price and then resells the offering to the market. </li></ul></ul><ul><ul><li>An underwriter may form an underwriting syndicate ( 承销团 ) to diffuse part of the underwriting risk. </li></ul></ul><ul><ul><li>Placement of a tombstone ( 发行通告 ) in, for instance, the Wall Street Journal (example on next slide). </li></ul></ul>
  12. 12. 23.1.7 Underwriting Stocks and Bonds
  13. 13. 23.1.8 Underwriting Stocks and Bonds <ul><li>The goal of underwriting is for all of the shares in an offering to be spoken for (订购) . However, this may not occur. </li></ul><ul><ul><li>Fully subscribed : all shares are spoken for </li></ul></ul><ul><ul><li>Undersubscribed : underwriting syndicate unable to generate interest in all of the available shares </li></ul></ul><ul><ul><li>Oversubscribed : interest in more shares than are available (may lead to rationing). </li></ul></ul>
  14. 14. 23.1.9 Underwriting Stocks and Bonds <ul><li>Figure 23.1 Using Investment Bankers to Distribute Securities to the Public </li></ul>
  15. 15. 23.1.10 Underwriting Stocks and Bonds <ul><li>Best Efforts ( 代销 ): An alternative to a firm commitment, the underwriter does not buy the issue, but rather makes its “best effort” to sell the entire issue. </li></ul><ul><li>Private Placements: The entire issue is sold to a small, select group of investors. This is rarely done with equity issues. </li></ul>
  16. 16. 23.1.11 Underwriting Stocks and Bonds <ul><li>Equity Sales: when a firm sells an entire division (or maybe the entire company), enlisting ( 寻求支持 ) the aid of an investment banker. </li></ul><ul><ul><li>Assists in determining the value of the division or firm and find potential buyers </li></ul></ul><ul><ul><li>Develop confidential financial statements for the division for prospective buyer ( confidential memorandum ) </li></ul></ul><ul><ul><li>Prepare a letter of intent to continue, assist with due diligence , and help reach a definitive agreement (正式协议) </li></ul></ul>
  17. 17. 23.1.12 Mergers and Acquisitions <ul><li>Investment bankers may assist both acquiring firms and potential targets (although not both in the same deal). </li></ul><ul><li>Deal may be a hostile takeover ( 敌意收购 ), where the target does not wish to be acquired. </li></ul><ul><li>Investment bankers will assist in all areas, including deal specifics, lining up financing, legal issues, etc. </li></ul>
  18. 18. 23.2 Securities Brokers and Dealers <ul><li>Securities firms with brokerage services offer several types of services: </li></ul><ul><li>Brokerage Service </li></ul><ul><li>Other services </li></ul><ul><li>Full-Service Brokers versus Discount Brokers </li></ul>
  19. 19. 23.2.1 Securities Brokers and Dealers <ul><li>Securities Orders: when you call a brokerage house to buy or sell a security, you essentially have three options: </li></ul><ul><ul><li>Market Order: buy or sell security at current price </li></ul></ul><ul><ul><li>Limit Order: you specify the most you are willing to pay (buy) or the least you are willing to accept (sell) for a security </li></ul></ul><ul><ul><li>Short Sales: sell a security you don’t own with the intent of buying it back at a later date (hopefully at a lower price) </li></ul></ul>
  20. 20. 23.2.3 Securities Brokers and Dealers <ul><li>Other Services </li></ul><ul><ul><li>Insurance against loss of actual security documents </li></ul></ul><ul><ul><li>Margin credit ( 保证金贷款, 孖展贷款 ) for purchasing equity with borrowed funds </li></ul></ul><ul><ul><li>Other services driven by market demand (e.g., the Merrill Lynch cash management account) </li></ul></ul>
  21. 21. 23.2.4 Securities Brokers and Dealers <ul><li>Full Service Brokers: offer clients research and investment advice, but usually charge a higher commission on trades. </li></ul><ul><li>Discount Broker( 減佣經紀;低收費經紀 ): provides facilities to buy/sell securities but offers no advice. Many on-line discount brokerage firms do have significant research available </li></ul>
  22. 22. 23.2.5 Securities Brokers and Dealers <ul><li>Securities Dealers ( 证券自营商 ) </li></ul><ul><ul><li>Hold inventories of securities on their own account </li></ul></ul><ul><ul><li>Provide liquidity to the market by standing by ready to buy or sell securities ( market maker ) </li></ul></ul><ul><ul><li>Especially important for thinly traded securities (交投淡静的证券) </li></ul></ul>
  23. 23. 23.3 Regulation of Securities Firms <ul><li>Two acts passed in 1933 and 1934 provide the primary basis of today’s markets. The major provisions include: </li></ul><ul><li>Establishment of the SEC </li></ul><ul><li>Registration requirement for new securities </li></ul><ul><li>Reporting requirements for companies and insiders </li></ul><ul><li>Prohibition of market manipulation </li></ul>
  24. 24. 23.3.1 Relationship Between Securities Firms and Commercial Banks <ul><li>Glass-Steagall stipulated that investment banking and commercial banking would be separated. </li></ul><ul><li>G-L-B Act removed some of these barriers. </li></ul><ul><li>Commercial banks are slowly gaining regulatory permission to engage in the full range of services offered by investment banks. </li></ul>
  25. 25. 23.4.1 Venture Capital Firms <ul><li>These firms provide funds for start-up companies </li></ul><ul><li>Often become very involved with firm management and provide expertise </li></ul>
  26. 26. 23.4.2 Venture Capital Firms <ul><li>Description of Industry </li></ul><ul><ul><li>Typically limited partnerships </li></ul></ul><ul><ul><li>Examples of venture-backed firms include Apple Computer, Cisco Systems, Starbucks, TCBY, etc. </li></ul></ul><ul><li>Table on next slide shows the level of venture involvement in companies over the last fourteen years. </li></ul>
  27. 27. 23.4.4 Venture Capital Investments
  28. 28. 23.4.5 Venture Capitalists Reduce Asymmetric Information <ul><li>Managers of start-ups may have objectives that differ significantly from profit maximization. </li></ul><ul><li>Venture capitalists can reduce this information problem in several ways </li></ul><ul><ul><li>Long-term motivation (don’t expect return in short term ) </li></ul></ul><ul><ul><li>Sit on the board of directors </li></ul></ul><ul><ul><li>Disburse ( 支付 ) funds in stages, based on required results </li></ul></ul><ul><ul><li>Invest in several firms, diversifying some risk </li></ul></ul>
  29. 29. 23.4.6 Origins of Venture Capital <ul><li>First U.S. venture capital firm was established in 1946. </li></ul><ul><li>Most venture capital firms in the 1950s and 1960s funded development in oil and real estate. </li></ul><ul><li>Funding has shifted from wealthy individuals to pension funds / corporations. This is one of the few risky investments pension funds are permitted. </li></ul>
  30. 30. 23.4.7 Structure of Venture Capital Firms <ul><li>Most are limited partnerships </li></ul><ul><li>Source of capital includes wealthy individuals, pension funds, and corporations </li></ul><ul><li>Investors must be willing to wait years before withdrawing money </li></ul>
  31. 31. 23.4.8 Life of Venture Capital Deal <ul><li>Fundraising </li></ul><ul><ul><li>Venture firm solicits ( 募集,恳求 ) commitments, usually less than 100 per deal </li></ul></ul><ul><li>Investment phase </li></ul><ul><ul><li>Seed investing </li></ul></ul><ul><ul><li>Early stage investing </li></ul></ul><ul><ul><li>Later stage investing </li></ul></ul><ul><li>Exit </li></ul><ul><ul><li>Usually IPO or merger </li></ul></ul>National Venture Capital Association (click on Industry Research) http://www. nvca .com
  32. 32. 23.4.9 Venture Profitability <ul><li>The 20-year average return is over 20%, with seed investing providing the highest average (24.5%) and later stage funding providing the lowest (18%). </li></ul><ul><li>Despite some phenomenal years (1999), venture capital has had negative returns in recent years. </li></ul>
  33. 33. Chapter Summary <ul><li>Investment Banks: the role of investment banks in issuing new securities and other important roles was discussed. </li></ul><ul><li>Security Brokers and Dealers: the importance of dealers and brokers in making markets and offering services to investors was presented. </li></ul>
  34. 34. Chapter Summary (cont.) <ul><li>Regulation of Securities Firms: the primary provisions of the two acts in 1933 and 1934 were summarized. </li></ul><ul><li>Relationship Between Securities Firms and Commercial Banks: with the changes in legislation, the blurring of these two industries was discussed. </li></ul>
  35. 35. Chapter Summary (cont.) <ul><li>Venture Capital Firms: the important roles that venture capital firms play in young, start-up companies was presented, as well as venture structure and performance over the last 20 years. </li></ul>
  36. 36. Terms <ul><li>Chapter 10 </li></ul><ul><li>Default risk </li></ul><ul><li>Call provisions </li></ul><ul><li>sinking fund </li></ul><ul><li>convertible bonds </li></ul><ul><li>current yield </li></ul><ul><li>chapter 11 </li></ul><ul><li>PE ratio </li></ul><ul><li>Gordon growth model </li></ul><ul><li>Chapter 12 </li></ul><ul><li>Down payments </li></ul><ul><li>Amortization </li></ul>
  37. 37. Terms <ul><li>Chapter 15 </li></ul><ul><li>Principal-agent Problem </li></ul><ul><li>Equity capital </li></ul><ul><li>Chapter 21 </li></ul><ul><li>Open-end fund </li></ul><ul><li>load fund </li></ul><ul><li>Free-rider Problem </li></ul><ul><li>Closed-end fund </li></ul><ul><li>Hedge fund </li></ul><ul><li>Chapter 23 </li></ul><ul><li>Private Placements </li></ul><ul><li>hostile takeovers </li></ul><ul><li>Market Order </li></ul><ul><li>Secondary market </li></ul>
  38. 38. Discussions <ul><li>Chapter 5 </li></ul><ul><li>Discuss what is shown by a yield curve. </li></ul><ul><li>Chapter 6 </li></ul><ul><li>What does the efficient market hypothesis tell? Does it make sense? </li></ul><ul><li>Chapter 17 </li></ul><ul><li>Distinguish between a bank’s reserves, required reserves, excess reserves, and secondary reserves. </li></ul><ul><li>Chapter 15 </li></ul><ul><li>What factors usually cause an increase in moral hazard and adverse selection? </li></ul>