Investment Banking And The Public Sale Of Equity Securities

1. Investment Banking And The Public Sale Of Equity Securities Professor XXXXX Course Name / Number

2. Focus of this chapter Basic Choices In Securing External Financing A firm needing external capital faces three basic choices: Choice of public versus private capital market Employ an investment bank to advise and handle offering Choice of security and type of offer: equity or debt

3. Trading Investment banking lines of business Asset management Corporate finance Investment banks provide advice with structuring seasoned and unseasoned issues, actual sale and post-sale services. seasoned unseasoned Seasoned offering • Equity issues by firms that already have common stock outstanding Unseasoned offering • Initial public offering (IPO): issue of securities that are not traded yet Investment Banks Role in Equity Offerings

4. Firms can choose an investment bank through: Direct negotiated offer Competitive bidding Best effort • The bank promises its best efforts to sell the firm’s securities. No guarantees though about the success of the offering. • Underwritten offerings, bank guarantees certain proceeds. • Vast majority of US security offerings are underwritten this way. Firm commitment Investment Banks Role in Equity Offerings Public security issues can be:

5. Investment banks provide services prior to security offering. • Primary pre-issue role: provide advice and help plan offer • Firm needing capital selects one or more lead underwriters. • Top firm the lead manager, others are co-managers • Offering syndicate organized early in process Prior to offering, lead investment bank negotiates underwriting agreement: • Sets offer price and spread; details lock-up agreement • Bulge bracket underwriter’s spread usually 7.0% for IPOs • Initial offer price set as range; final price set day before offer. Services Provided By Investment Bankers And Their Costs

6. Prescribed security issuance procedures, set basic principle of full disclosure. Securities act of 1933 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. Legal Rules Governing U.S. Public Security Sales Two basic laws governing public issues:

7. Principal disclosure document: Registration Statement Prospectus Supplemental Disclosures Basic Disclosure Documents • Actually a series of registration statements, beginning with the Preliminary Prospectus • Called a Red Herring after title page disclaimer (in red ink) • Statements are submitted to SEC, which responds with changes needed. Firm makes changes and resubmits. • Offering only becomes effective with SEC’s final approval. • After preliminary filing, firm and IB begin a road show. • IB does book building during road show providing key pricing info.

8. Always one or more lead underwriters • Existing shareholders sell their shares • No new capital for the firm • Sell newly issued shares • Raise new capital for the firm 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.

9. Shelf Registration SEC introduced rule 415: shelf registration • Qualifying issuers (more than $150 million in outstanding stock) file a “master registration statement”, summarizing planned financing for the next two years. • The company can offer securities for sale (off the shelf) over subsequent two years. • Popular with issuers; very flexible Most qualifying debt issues are shelf registered. Very few equity issues use shelf: IB certification needed.

10. Lead underwriter sets each syndicate member’s percentage of participation. How many shares each member must sell and compensation. 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.

11. 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.

12. 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

13. Costs Of IPO 1) High financial costs of IPOs, with no guarantee of success: cash expenses of IPO often approach $1 million. • Have to disclose operating and sensitive data publicly • Must follow public company governance rules set by SEC 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

14. Parent sells minority stake in subsidiary to public through IPO. • Raises cash for parent, allows better monitoring of subsidiary. Equity carve-out • Parent distributes all of a subsidiary’s stock to shareholders. • Full spin-off creates independent new company. Spin-off • Company goes public again after LBO. • Successful LBOs create value, so high returns to second IPO. Reverse LBO Tracking stock • Stock mirrors performance of division, but not legally or operationally separate from parent. Types Of Specialized IPOs

15. Investment Performance Of IPOs Patterns observed in IPO offerings: • Positive initial returns for IPO investors • Large IPOs typically underpriced less than smaller offerings. • Initial returns are higher in “hot issue markets” than in cold markets. • Mean initial returns are much higher than median: a relative handful of severely underpriced offers drive results. • Mean return overstates actual profits for most investors; uninformed investors suffer from winner’s curse. • Venture-capital backing reduced initial returns during 1980s; increased after 1990. IPOs seem to dramatically under-perform over 1-5 years.

16. Negative market reaction when SEOs are announced Reason SEO announcements convey negative info: • Could be that managers consider stock over-valued • Could reveal that cash flows will be lower than expected 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.

17. Set by firm’s directors • Shareholders on firm’s books as of this date will receive rights. Date of record Ex rights date • Date when stock begins trading without right • Usually set a few days before record date • Exercise price of stock being sold through offering • Right’s value depends on the number of rights needed to buy a share. Subscription price Rights Offerings Existing shareholders have the right to buy new shares at a discount or can sell this right to other investors.

18. Managers have three basic decision to make in rights offer: • Determining amount of capital firm needs to raise • Setting subscription price: set below current market price • Determining number of rights needed to buy share of stock • RW = value of right • MW = market value of stock with rights • S = subscription price of stock • N = number of rights needed to buy • one share Rights Offerings Theoretically, value of right (RW) is the same whether selling separately or still attached to share.

19. 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 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”

20. Type of Offering Number of Issues Total Value US$ billions Overall Private Placements 2,148 $417 Straight Debt 1,751 $349 High-Yield Debt 214 $52 Plain Vanilla Equity 362 $59 Securitized Private Placements 699 $127 Yankee Private Placements 149 $29 Rule 144A, All Issuers 1,627 $349 Rule 144A, U.S. Issuers 1,282 $263 Rule 144A, Foreign Issuers 345 $86 Rule 144A as % of Total PP 75.7% 83.7% Source:Investment Dealers’ Digest, various 2002 issues Private Placements In U.S. Capital Markets

21. Domestic stock offering Two types International, or cross-border, 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.

22. The issuing foreign company pays all legal and financial costs of creating and trading the security. Sponsored ADR Represent ownership of shares of a foreign company’s stock held on deposit in the issuing firm’s home country Unsponsored ADR • Issuing firm is not involved with the issue of ADRs. American Depositary Receipts (ADRs) Dollar-denominated claims issued by U.S. banks

23. Date Company Amount ($ in millions) Nov 87 Nippon Telegraph & Telephone $40,260 Oct 88 Nippon Telegraph & Telephone 22,400 Nov 99 ENEL 18,900 Oct 98 NTT DoCoMo 18,000 Oct 97 Telecom Italia 15,500 Feb 87 Nippon Telegraph & Telephone 15,097 Nov 99 Nippon Telegraph & Telephone 15,000 Jun 00 Deutsche Telekom 14,760 Nov 96 Deutsche Telekom 13,300 Source: William L. Megginson and Jeffry M. Netter, “From State to Market: A Survey of Empirical Studies on Privatization” Share Issue Privatizations SIPs have raised almost $1 trillion since 1980 SIPs are 10 largest (25 of 28 largest) offers ever

24. 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.