Investment Banking & the Capital Acquisition Process

1. Corporate Finance includes the study of the optimal financing mix of a corporation. Increasingly, the question of optimal mix is intertwined with the dynamic effects and costs associated with offering different types of securities. One of the largest types of cost is thought to be informational effects. Investment Banking & the Capital Acquisition Process

2. Value Effects of Offerings Smith starts his survey with a look at the announcement effects of different security offerings. These results are robust, and have been obtained on more recent data, as well. For non-regulated corporations, the stock price drops by an average 3.14% when an announcement of a new equity offering is made.

3. Value Effects of Offerings 2 Smith also reports that the stock price is unaffected by a straight bond offering – although we will be looking at this effect in more detail later in the course. Summarizing his table 1, the more equity-like a security, the more negative is the announcement effect. Lending added credence to this result is the observation that the offering effects for regulated utilities are close to 0.

4. Value Effects of Offerings 3 A natural interpretation of the above results is that firms raising equity are, in effect, announcing that they need more cash. Smith highlights this notion by demonstrating in Table 2 that events associated with increased cash flow – share tender offers, repurchases, dividend increases, etc., when announced induce a positive stock market reaction. Whereas events which may tip the market that the company needs cash induce a negative stock market reaction.

5. Value Effects of Offerings 4 Smith also notes (Table 3) that transactions which increase leverage are associated with a positive stock market reaction, whereas leverage-reducing transactions are associated with a negative stock market reaction. This seems counterintuitive to many MBA students. But remember the tax effects and equity-as-an-option effect – all suggest that more debt is better. (Agency cost effects are apt to depend on the type of firm.)

6. Value Effects of Offerings 5 Given choice of what security to offer is made, as smith notes, the next question is how. Choices: • Rights offering vs. Underwritten sale to public. • Negotiated terms vs. Internally structured – put to bid. (Archaic) • Firm commitment vs. Best efforts. • Registered offering vs. Shelf filing. • Private placement. (Recall some of the largest equity offerings are targeted placements in takeovers.)

7. Structuring the Offering A puzzle in American finance is the lack of rights offerings. (Although Dividend Reinvestment Plans are popular forms of doing this on a small scale.) It has been found that rights offerings are most commonly used by firms with concentrated ownership. A major motivation for a secondary offering is often to increase the shareholder base, analyst following, and liquidity. The road show is a chance for good publicity. Such benefits do not accrue to a rights offering.

8. Shelf Registration In 1982 the SEC allowed shelf registration with Rule 415. Since then, it has expanded this program. In SEC documents, the motivation for shelf filing is to allow companies to “take advantage of perceived ‘market windows.’”

9. Private Equity Placement Studies have found a positive 4.5% stock price reaction to the announcement of a private placement of equity. In more than half of these cases, this entails a large unregistered block sold at a discount (13.5% below market). Also, in general the buyer commits to holding the stock for 2-3 years. (In general, large block holders mitigate a variety of agency problems.)

10. IPOs Why?: • Firm gets access to large pool of capital (lowering cost of capital). • Current shareholders’ claims made more liquid (hence more valuable). • Easier to attract employees (offer stock options). • Market provides continuous barometer of performance.

11. Equilibrium Underpricing Although I disagree, many experts look at the bookbuilding process as an optimal way to do IPOs. Smith refers to an important body of work that relies on the same information structure as in the market making game. There are informed traders and liquidity traders. Because IPOs are quantity-rationed, the only way you can entice uniformed traders to participate is to offer an 0-expected return – conditional on winning.

12. Bookbuilding Another aspect of bookbuilding that proponents stress is that it provides valuable information (about market perceptions, the economic climate, etc.) to the issuing firm’s management. The only way to get the investors to reveal the truth is through a system that underprices on average and allows for punishment.

13. Investment Banks and Publicity In general an IPO is considered successful if it is followed up with a seasoned equity offering (SEO). Laurie Krigman did a survey of CFOs of firms doing a SEO with a different underwriter than the IPO. She found that a major reason for switching is to garner more analyst following.

14. SEOs Announcement Effect: A company doing an SEO already has publicly traded stock. As Smith shows, on average when a company announces a new equity offering its stock price falls by over 3% on average. The classic argument for this effect is that management issues stock strategically – like the market for lemons. In general, the gross spread on a SEO in the US is 5%. There is a road show – much like an IPO. An offering date is specified, and the offering price is set at a random time on this date.

15. SEOs Cont’d. An interesting question in the impact of the SEO on the stock’s trading activity. Anecdotal evidence suggests that the road show does generate activity. This also reflects the fact that many institutions realize that the allotment from the SEO will be less than they want. As in an IPO the offering is usually oversubscribed, with shares allocated to bidders by the Investment Banker.

16. SEOs Cont’d. The pricing of the SEO is such that often it is thought that the offer price is subject to manipulation. The SEC adopted Rule 10b-21 on August 25, 1988 which prohibits the use of shares purchased at the offer price to cover short positions established after the filing of the registration statement. (This essentially prevents the public from acting like an investment banker with the Green Shoe Option.)