Investment Banking And The Public Sale Of Equity Securities

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Chapter 16
Investment Banking And The Public Sale Of Equity
Securities
Professor MegginsonFIN 5043/BAD 5283
Spring Semester 2007
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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
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Investment Banks Role in Equity Offerings
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Investment Banks Role in Equity Offerings
Public security issues can be
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Investment Banking League Table, 2006, Securities
Underwriting
Source Investment Dealers Digest, January 10,
2005
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Services Provided By Investment Bankers And Their
Costs
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Legal Rules Governing U.S. Public Security Sales
Two basic laws governing public issues
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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 SECs final
  approval.
  
• After preliminary filing, firm and IB begin a
  road show.
  
• IB does book building during road show providing
  key pricing info.

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Title Page From Googles IPO Prospectus (August
14, 2004)
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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 firms books were prepared
using GAAP.
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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.
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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.
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The U.S. Initial Public Offering Market
1) US IPO market is larger than rest of worlds
combined. IPOs account for 30-45 of all new equi
ty 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.
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Number of US IPO Offerings, Initial Returns and
Gross Proceeds
Initial returns were very high during internet
boom 69.0 in 1999 and 55.5 in 2000. Only
9.1-12.3 from 2002-06
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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
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Costs Of IPO
1) High financial costs of IPOs, with no
guarantee of success cash expenses of IPO often
approach 1 million.
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

• Have to disclose operating and sensitive data
  publicly
  
• Must follow public company governance rules set
  by SEC

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Types Of Specialized IPOs
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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
  winners curse.
  
• Venture-capital backing reduced initial returns
  during 1980s increased after 1990.

IPOs seem to dramatically under-perform over 1-5
years.
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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.
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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
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Private Placements In U.S. Capital Markets, 2002
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Services Provided By Investment Bankers--And
Their Costs

• IBs provide services before, during, after issue
• Services provided prior to security offering
• Primary pre-issue role provide advice
• Issuing firm selects lead underwriters
• Top firm the lead manager, others co-managers
• Lead IB negotiates U/W contract before issue
• Sets offer price underwriters (U/Ws) spread
• Bulge bracket U/Ws spread usually 7.0 for IPOs
  less for SEOs, prefd stock much less for debt
  
• Final price set offer day before offer
• IBs insist on lock-up agreements with issuer

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Underwriting Spreads For Different Security
Offerings, 2004
Source Corporate Edition Underwriting Fees,
Investment Dealers Digest (January 17, 2005),
pp. 36-37.
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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.
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Average First-Day IPO Returns, , International
Comparisons
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American Depositary Receipts (ADRs)
Dollar-denominated claims issued by U.S. banks
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Trading Volume in Public ADR Issues, 1990-2006
Sources The Bank of New York, Depositary
Receipt Market Review 2006 (http//adrbny.com).
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Example Of Creating An ADR Issue

• Assume Bayerische Motoren Werke (BMW) wants to
  create an ADR program for its shares on the NYSE.
  Data needed
  
• BMWs shares trade Deutsche Borse at 34.45/sh
• The U.S. dollar/Euro exchange rate is 1.3316/.
  
  
• BMW wishes to create a 100 mln ADR program
• BMW asks Bank of New York (BK), one of the two
  leading ADR issuers, to handle the issue
  
• BMW would pay BKs expenses U/W fee
• BK (a US bank) would actually create ADR issue
• Assume BK believes the ideal price for shares to
  trade on the NYSE is about 90 per share.

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Example Of Creating An ADR Issue (Cont)

• BK implements ADR program with these steps
• 1. Buy 2,200,000 BMW shares on Deutsche Borse at
  34.45/sh, paying 75,790,000. This investment
  worth 100,921,964 by BK (75,790,000 x
  1.3316/).
• 2. Create 1,100,000 ADRs for listing on the NYSE,
  with each ADR representing ownership of two BMW
  shares.
  
• 3. Sell the 1,100,000 ADRs to US investors for
  91.75/ADR. This is the price implied by BMWs
  price in , the current / rate, and that each
  ADR is worth two BMW shares (34.45/sh x 2
  shs/ADR x 1.3316/ 91.75/ADR).
• Total offering proceeds are 100,925,000, exactly
  (almost) what BK paid for the shares.
  
• ADR holders have a -denominated security, that
  perfectly reflects both BMWs share price and
  changes in the / exchange rate.

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Example Of Creating An ADR Issue (Cont)

• Show ADRs reflect BMWs stock price changes say
  shares rise 1.00/sh in German trading
  
• ADRs should rise 2.66/ADR (1.00/sh x 2 shs/ADR
  x 1.3316/) to 94.41/ADR when trading begins in
  New York
  
• Show ADRs reflect ER changes say BMWs price
  stays 34.45/sh, but appreciates from 1.3316/
  to 1.3702/ before NYSE opens
  
• ADRs should begin trading at NYSE 94.41/ADR
  (34.45/sh x 2 shs/ADR x 1.3702/) when the
  opens.
  
• So either a rise in BMWs stock price from 34.45
  to 35.45/sh, holding ER constant, or an
  appreciation of the Euro from 1.3316/ to
  1.3702/, holding stock price unchanged, can
  cause BMW ADR price to rise by 2.66, from 91.75
  to 94.41 per ADR.

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Investment Banking And The Public Sale Of Equity
Securities
Companies that raise capital externally can issue
debt or equity. Common stock can be sold throug
h private placements or to the public.
First public offerings is known as IPOs. Subse
quent offerings are knows as SEOs.
Investment banks assist companies in selling new
securities.