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Lecture notes

  1. 1. Investment Banks Economics 71a Spring 2007 Mayo, Chapter 2 Lecture notes 2.2
  2. 2. Outline <ul><li>What is an investment bank? </li></ul><ul><li>Role in financial markets </li></ul><ul><li>Investment banks and new securities </li></ul><ul><ul><li>IPO mechanics </li></ul></ul>
  3. 3. What is an Investment Bank? <ul><li>Not a bank! </li></ul><ul><li>Help firms sell securities to public </li></ul><ul><ul><li>Stocks/Equity </li></ul></ul><ul><ul><li>Bonds/Debt </li></ul></ul><ul><li>Transfers funds from public to firms </li></ul><ul><ul><li>Savings -> Investments </li></ul></ul><ul><li>Example: Goldman/Sachs </li></ul>
  4. 4. Initial Public Offering (IPO) <ul><li>First sale of stock by firm </li></ul><ul><li>Originating investment bank </li></ul><ul><ul><li>Key player in bringing the shares to market </li></ul></ul><ul><ul><li>“ Originating house” </li></ul></ul><ul><ul><li>Handles most administrative details </li></ul></ul><ul><ul><li>Reputation </li></ul></ul>
  5. 5. Underwriting <ul><li>A form of price guarantee </li></ul><ul><li>Agree to purchase shares from firm for a given amount </li></ul><ul><li>Then sell to the public </li></ul><ul><li>Example: </li></ul><ul><ul><li>Purchase stock from Yahoo ($10/share) </li></ul></ul><ul><ul><li>Sell on the market ($11/share) </li></ul></ul>
  6. 6. Risk of Underwriting <ul><li>Market may not be willing to pay the price paid by investment bank ($10) </li></ul><ul><li>It would lose money </li></ul><ul><li>Investment banks often spread this risk over several investment banks </li></ul><ul><ul><li>“ Underwriting Syndicate” </li></ul></ul><ul><li>Also, try to reach more sellers </li></ul><ul><ul><li>“ Selling group” </li></ul></ul>
  7. 7. IPO Scandals <ul><li>Most involve investment banks giving special deals to some favored customers (low prices) </li></ul>
  8. 8. Best Efforts Agreement <ul><li>Risk shifted to issuing firm </li></ul><ul><li>It receives whatever price the market pays </li></ul><ul><li>No underwriting function by investment bank </li></ul>
  9. 9. IPO Timing <ul><li>Private firm </li></ul><ul><ul><li>Negotiations between shareholders and other initial investors (Venture Capital) </li></ul></ul><ul><ul><li>Find investment bank to handle IPO </li></ul></ul><ul><li>Prospectus filed with Securities and Exchange Commission </li></ul><ul><ul><li>“ Registration” </li></ul></ul><ul><li>Red Herring : Version of prospectus for initial investors </li></ul><ul><li>Quiet period: filing to 1 month after IPO </li></ul><ul><ul><li>Restrictions on public information releases </li></ul></ul>
  10. 10. IPO Pricing <ul><li>How does the initial price get set by investment banks? </li></ul><ul><li>Difficult problem </li></ul><ul><li>Set price too high </li></ul><ul><ul><li>Can’t sell stock at this price </li></ul></ul><ul><ul><li>Lose money now, or wait and see </li></ul></ul><ul><li>Set price too low (more common) </li></ul><ul><ul><li>Bad for issuing firm </li></ul></ul><ul><ul><li>Raises lower money than it could have </li></ul></ul><ul><ul><li>Investment bank looks bad (reputation) </li></ul></ul>
  11. 11. Dutch Auction IPO’s: Another Price Mechanism <ul><li>The “Dutch auction” is another mechanism for an IPO </li></ul><ul><li>Not many do this </li></ul><ul><li>Most famous: Google, August 2004 </li></ul>
  12. 12. Dutch Auction <ul><li>Seller announces total shares to be auctioned (Qshares) </li></ul><ul><li>Potential buyers submit bids for </li></ul><ul><ul><li>(Shares, Price) </li></ul></ul><ul><li>Auction moves price down until </li></ul><ul><ul><li>Shares demanded above this price = Qshares </li></ul></ul>
  13. 13. Dutch Auction Example <ul><li>Qhares = 10 </li></ul><ul><li>Bids </li></ul><ul><ul><li>2 at $10 </li></ul></ul><ul><ul><li>1 at $9 </li></ul></ul><ul><ul><li>3 at $8 </li></ul></ul><ul><ul><li>4 at $7 </li></ul></ul><ul><ul><li>2 at $6 </li></ul></ul><ul><ul><li>4 at $5 </li></ul></ul><ul><li>Sell 10 to first 4 bidders at price = $7 </li></ul>
  14. 14. Dutch Auction Picture Q Price Demand IPO Price Shares Offered
  15. 15. Dutch Auction Analysis <ul><li>Benefits </li></ul><ul><ul><li>More transparent </li></ul></ul><ul><ul><li>No need to guess price </li></ul></ul><ul><ul><ul><li>Price is uncertain though </li></ul></ul></ul><ul><li>Why isn’t it used more often? </li></ul><ul><ul><li>Google price increases </li></ul></ul><ul><ul><ul><li>Did they get a high enough price? </li></ul></ul></ul><ul><ul><li>Confusing mechanism </li></ul></ul><ul><ul><ul><li>Not well designed </li></ul></ul></ul><ul><ul><ul><li>Qshares not specified </li></ul></ul></ul><ul><ul><ul><li>Many investment banks </li></ul></ul></ul><ul><ul><li>Patent (Hambrecht) </li></ul></ul><ul><ul><li>Most firms not big enough to dictate these terms </li></ul></ul>
  16. 16. Later Stock Offerings <ul><li>“ Seasoned equity” </li></ul><ul><li>Stock issued after IPO </li></ul><ul><li>Registered with SEC </li></ul><ul><li>Sold at current market prices </li></ul><ul><li>Firm often stores these shares </li></ul><ul><ul><li>“ Shelf registration” </li></ul></ul><ul><li>Google again: How to estimate shelf shares from web (public float and shares outstanding) </li></ul>
  17. 17. Private Placements <ul><li>Shares sold to private investment groups </li></ul><ul><ul><li>Venture capital firms </li></ul></ul><ul><ul><li>Private equity hedge funds </li></ul></ul><ul><li>Usually, smaller, younger, riskier firms </li></ul>
  18. 18. Regulation <ul><li>Securities and Exchange Commission </li></ul><ul><ul><li>Set up in the early 1930’s to oversee securities markets </li></ul></ul><ul><ul><li>Oversees publicly traded firms </li></ul></ul><ul><ul><li>Public investment companies (mutual funds) </li></ul></ul>
  19. 19. SEC: Information and Regulation <ul><li>Require timely release of information to public </li></ul><ul><li>10-K report: Annual information on firm </li></ul><ul><li>Firms required to report major information events to public </li></ul>
  20. 20. Insider Trading <ul><li>Trading on private information </li></ul><ul><li>Illegal (why?) </li></ul><ul><li>Who’s an insider? </li></ul><ul><ul><li>Employees </li></ul></ul><ul><ul><li>Associated </li></ul></ul><ul><ul><ul><li>Lawyers </li></ul></ul></ul><ul><ul><ul><li>Investment bankers </li></ul></ul></ul><ul><li>Enforcement </li></ul><ul><ul><li>Trade reporting </li></ul></ul>
  21. 21. Securities Investor Protection Corporation (SIPC) <ul><li>Insures investors against failure in brokerage firms </li></ul><ul><li>Not insurance against price drops </li></ul><ul><li>Limited amounts </li></ul><ul><ul><li>$500,000 total </li></ul></ul><ul><ul><li>$100,000 cash balances </li></ul></ul>
  22. 22. Sarbanes-Oxley (2002) <ul><li>Scandals of the 1990’s </li></ul><ul><ul><li>Accounting information shaky and deceptive (Enron, Worldcom,..) </li></ul></ul><ul><li>Government response </li></ul><ul><li>Protect investors from fraud </li></ul>
  23. 23. Sarbanes-Oxley <ul><li>Basic provisions </li></ul><ul><ul><li>Creates Public Company Accounting Oversight Board </li></ul></ul><ul><ul><li>Strengthen the independence of auditors (accountants) </li></ul></ul><ul><ul><li>Firm directors take responsibility for numbers </li></ul></ul>
  24. 24. Conflict of Interest Problems <ul><li>Many investment banks have brokerage sides </li></ul><ul><li>They will recommend stocks to investors: Analyst recommendations </li></ul><ul><li>What if same firm is doing IPO and writing recommendations? </li></ul><ul><li>There is supposed to be a “firewall” </li></ul>
  25. 25. Reponses to Sarbanes/Oxley <ul><li>Board insurance </li></ul><ul><li>Privatization </li></ul><ul><li>Moving off shore </li></ul><ul><li>Still very much untested and controversial </li></ul>

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