AAU

CAPITAL MARKET

Special Topic One-

Investment Banks (IBs)

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 Topics

• How Firms Issue Securities

• Primary Vs Secondary

• Publicly Vs Privately

• IPO Vs SEO

• Investment Banking

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 How Firms Issue Securities
• Primary vs. Secondary Market Security Sales
• Primary
• New issue created/sold
• Key factor: Issuer receives proceeds from sale
• Secondary
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds, is not
directly involved

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 Issue Methods
Public Issue –IPO &SEO

IPO

Initial Public Offering = Unseasoned new issue

Public offerings are marketed by investment bankers

or underwriters
 The issuing firm never actually meets the ultimate

purchaser of securities
Registration with SEC required

General cash offer = offered to general public 14-4

 Issue Methods
 SEO = Seasoned Equity Offering
A seasoned equity offering or secondary equity
offering or capital increase is a new equity issued by
an already publicly traded company.
 Seasoned offerings may involve shares sold by
existing shareholders, new shares or both.
 Rights offer = offered only to current shareholders
A rights offering occurs when current shareholders
get the first right to buy new shares.
Shareholders can either exercise the right and buy
new shares, or sell the right to someone else.

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 SEO
Stock prices tend to decline when new equity is issued

Signaling explanations:

Equity overvalued: If management believes equity is

overvalued, they would choose to issue stock shares
Debt usage: Issuing stock may indicate firm has too much debt

and can not issue more debt

Issue costs

Issue costs for equity – direct and indirect - are significantly

more than for debt

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 Issuing Method
Reasons for Seasoned Equity Offering
To procure additional finance in order to fund business operations.

To facilitate expansionary projects or projects

To finance the purchase of new business machinery and equipment

that would, in turn, help in revenue generation and improvement in

business efficiency.
 To pay-off existing high-cost debt or increase the levels of working

capital.

To pitch for mergers and acquisitions.

To buy new buildings or land for business purposes

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 Issuing Method
Features Seasoned Equity Offering
This is done to raise additional finance by issuing new
stocks or shares.
The proceeds materialized are generally employed to
fund existing debt.
They can also be used to fund any new projects that are
in pipelines.
Such issues can dilute the ownership of existing
stockholders.
By bringing in such issues causes the value of each
share to depreciate and the number of shares issued to
increase.
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 Issue Methods
Private Issue

The securities are offered and sold to a limited

number of investors
Issuing firms and buyers usually hammer out, face to

face, details of offerings

Sold to fewer than 35 investors

SEC registration not required

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 Reading assignment

Discuss the difference between

Dilutive and Non-Dilutive Offerings
IPO and Seasoned Equity Offering
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 Investment Banks (IBs)
Investment banking is a special segment of banking
operation that helps individuals or organisations raise
capital and provide financial consultancy services to them.
They act as intermediaries between security issuers and
investors and help new firms to go public.
• It renders extensive financial advisory service to client firms on

major transactions such as mergers,

• capital raising governments and financial institutions,

financial &
• risk management services & assistance to corporations

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 Key areas of Investment Banks (IBs)
• Investment Banking -IPO
• Market Making - involves the creation of secondary markets for an issue of securities
• Trading- the more frequent buying and selling of stock , or other instrument , with
the goal of generating returns.
• Investing-involves managing pools of assets such as closed- and open-end
mutual funds as agents and as principals
• Cash Management- involves deposit-like accounts such as money market
mutual funds that offer check writing privileges
• Merger and Acquisition-

• Venture Capital - is a professionally managed pool of money used to finance

new (i.e., start-up) and often high-risk firms for an equity investment in the
firm.
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 Investment Banks (IBs)
• In simple words, investment banking works with two

sides, that is “buy-side” and “sell-side”.

• Buy-side operations and functions include the
services like securities trading and portfolio
management.
• Sell-side operations and functions include
underwriting some stock lines, marketing financial
products and advertising financial research.
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 Investment Banks (IBs)
An IPO is the process by which a private company
transforms itself into a public company.

The company offers, for the first time, shares of its

equity (ownership) to the investing public.

These shares subsequently trade on a public stock

exchange

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 Investment Banks (IBs)
Why IPO?
 to raise cash to fund the growth
 cash out partially or entirely by selling ownership
 to diversify net worth or to gain liquidity
Concerns:
 Going Public is not a slum dunk
 Firms that are too small, too stagnant or have poor
growth prospects will - in general - fail to find an
investment bank willing to underwrite

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 Pros and Cons of an IPO

Stronger Capital Base Short-term growth pressure

Increases Financing Disclosure and

prospects Confidentiality
Better situated for Costs – initial and ongoing
acquisitions Restrictions on Management
Owner Diversification
Loss of personal benefits
Executive Compensation
Trading Restrictions
Increase company prestige

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Relationship among a Firm Issuing Securities, the
Underwriters, and the Public

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 Underwriters
Underwriting services:
Formulate method to issue securities
Price the securities
Sell the securities
Price stabilization by lead underwriter in the aftermarket

Syndicate = group of investment bankers that market the

securities and share the risk associated with selling the issue

Spread = difference between what the syndicate pays

the company and what the security sells for in the
market
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 Discussion Question

Investment vs. Commercial Bank

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 Types of underwriting
Firm commitment underwriting:

Best efforts underwriting:

Dutch or Uniform Price Auction

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 1. Firm Commitment Underwriting
Issuer sells entire issue to underwriting syndicate

Syndicate resells issue to the public

The underwriter buys the entire issue, assuming full financial

responsibility for any unsold shares

 Underwriter makes money on the spread between the price paid to the

issuer and the price received from investors when the stock is sold

Syndicate bears the risk of not being able to sell the entire

issue for more than the cost

 Commonly used

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 2. Best Efforts Underwriting
Underwriter makes “best effort” to sell the securities at an
agreed-upon offering price

Issuing company bears the risk of the issue not being sold

 The underwriter sells as much of the issue as possible, but can return
any unsold shares to the issuer without financial responsibility

Offer may be pulled if not enough interest at the offer price

 Company does not get the capital and they have still incurred
substantial flotation costs
Not as common as it used to be

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 3. Dutch or Uniform Price Auction
Buyers:
•Bid a price and number of shares
Seller:
• Work down the list of bidders

• Determine the highest price at which they can sell the desired
number of shares

• All successful bidders pay the same price per share.

• Encourages aggressive bidding

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 Dutch or Uniform Price Auction Example
The company wants to sell 1,500 shares of stock.

Bidder Quantity Bid

A 500 $20
B 400 18
C 250 16
D 350 15
E 200 12

The firm will sell 1,500 shares at $15 per share. Bidders A, B, C, and D will
get shares.

Bidder Quantity Bid Σ Qty

A 500 $20 500
B 400 18 900
C 250 16 1,150
D 350 15 1,500
E 200 12 1,700

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How an IPO Would be Priced

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 How an IPO Would be Priced
Since the firm is going public, there is no established price.

The banker would examine market data on similar

companies.

Price set to place the firm’s P/E and M/B ratios in line with
publicly traded firms in the same industry having similar risk
and growth prospects.

On the basis of all relevant factors, the investment banker

would determine a ballpark price, and specify a range (such
as $10 to $12) in the preliminary prospectus.
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 What is a Roadshow?
Senior management team, investment banker, and lawyer visit
potential institutional investors
Underwriters introduce the IPO to institutional investors,
analysts, fund managers, and hedge funds to interest them in the
security.
Management can’t say anything that is not in prospectus,
because company is in “quiet period.”
What is “Book Building?”
 Investment banker asks investors to indicate how many shares
they plan to buy, and records this in a “book”.
 Investment banker hopes for oversubscribed issue.
 Based on demand, investment banker sets final offer price on
evening before IPO.
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 IPO Underpricing
IPO pricing = very difficult

No current market price available

Dutch Auctions designed to eliminate first day IPO

price “pop”
Underpricing causes the issuer to “leave money on the

table”
Degree of underpricing varies over time

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 IPO Underpricing Reasons
Underwriters want offerings to sell out

Reputation for successful IPOs is critical

Underpricing = insurance for underwriters

Oversubscription & allotment

“Winner’s Curse”

Smaller, riskier IPOs underprice to attract investors

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 Underpricing: Solutions?
 Auction
Problem: will investors to gather the necessary
information?

 Unit IPOs
The company sells units of securities instead of
shares.
Puttable Common Stocks: a combination of
stocks and Put options.
The put options can be seen as a “money-back
warranty” that enable investors to sell back the
stock to the firm if the stock does not perform.
Put options protects the investor from the risk that
the share price will collapse 14-30
The Cost of Issuing Securities

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Direct Indirect Costs of an IPO

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 IPO Cost – Example
The ABC Co. has just gone public under a firm
commitment agreement. ABC received $32 for each of
the 4.1 million shares sold. The initial offering price was
$34.40 per share, and the stock rose to $41 per share in
the first few minutes of trading.
ABC paid $905,000 in legal and other direct costs and
$250,000 in indirect costs. What was the flotation cost as
a percentage of funds raised?
The net amount raised is the number of shares offered
times the price received by the company, minus the costs
associated with the offer, so:
Net amount raised = (4,100,000 shares)($32) – 905,000
– 250,000 = $130,045,000 14-33
 IPO Cost – Example
Next, we can calculate the direct costs. Part of the direct costs
are given in the problem, but the company also had to pay the
underwriters. The stock was offered at $34.40 per share, and
the company received $32 per share. The difference, which is
the underwriters’ spread, is also a direct cost.

Total direct costs = $905,000

+ ($34.40 – 32)(4,100,000 shares) = $10,745,000

We are given part of the indirect costs, but the underpricing is
another indirect cost.

Total indirect costs = $250,000

+ ($41 – 34.40)(4,100,000 shares) = $27,310,000 14-34
 IPO Cost – Example
Total costs = $10,745,000 + 27,310,000 = $38,055,000

The flotation costs as a percentage of the amount raised is

the total cost divided by the amount raised, or:

Flotation cost percentage =

$38,055,000 / $130,045,000

Flotation cost percentage = .2926, or 29.26%

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Additional Reading

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Differentiate Between a Private Placement and a Public
Offering
In a private placement securities are sold to a few
investors rather than to the public at large.

In a public offering, securities are offered to the public

and must be registered with SEC.

Privately placed stock is not registered, so sales must be

to “accredited” (high net worth) investors.

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 Why Would a Company Consider Going Public?
Advantages of going public
Current stockholders can diversify.

Liquidity is increased.

Easier to raise capital in the future.

Going public establishes firm value.

Makes it more feasible to use stock as employee

incentives.

Increases customer recognition.

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 Disadvantages of Going Public
Must file numerous reports.

Operating data must be disclosed.

Officers must disclose holdings.

Special “deals” to insiders will be more difficult to

undertake.
A small new issue may not be actively traded, so

market-determined price may not reflect true value.

Managing investor relations is time-consuming.
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 What Would the Sale be on an Underwritten or
Best Efforts Basis?

Most offerings are underwritten.

In very small, risky deals, the investment banker

may insist on a best efforts basis.

On an underwritten deal, the price is not set until

Investor interest is assessed.

Oral commitments are obtained.

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 What are equity carve-outs?
A special IPO in which a parent company creates a new
public company by selling stock in a subsidiary to outside
investors.

Parent usually retains controlling interest in new public

company.

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 What is meant by going private?
Going private is the reverse of going public.

Typically, the firm’s managers team up with a small

group of outside investors and purchase all of the
publicly held shares of the firm.

The new equity holders usually use a large amount of

debt financing, so such transactions are called
leveraged buyouts (LBOs).

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 Advantages of going private
Gives managers greater incentives and more flexibility in
running the company.
Removes pressure to report high earnings in the short run.
After several years as a private firm, owners typically go
public again. Firm is presumably operating more efficiently
and sells for more.

Disadvantages of going private

Firms that have recently gone private are normally leveraged
to the hilt, so it’s difficult to raise new capital.
A difficult period that normally could be weathered might
bankrupt the company.

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