Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
and
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 19
INVESTMENT
BANKING
Investment Banking
Investment Banks (IB) are the most
important participant in the direct financial
markets
Assist firms and governments in selling new
securities in the primary market.
Assist in making (dealer) or arranging the
buying and selling (broker) in the secondary
market.
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Investment And Commercial Banks Differ
Commercial Banks (CB) accept deposits and make
commercial loans as a financial intermediary.
CB traditionally could underwrite only low-risk
securities of governments per the Glass-Steagall
Act.
Many large firms now use the direct financial
markets to finance rather than bank loans.
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U. S. versus Other Developed Nations
Until 1999, investment banks in the U. S.
could not do commercial banking activities
and vice-versa.
Outside of Japan, in most other developed
nations, financial institutions are allowed to
do both investment and commercial banking
activities.
These institutions, called Universal banks,
engage in deposit taking, making loans,
brokerage activities, securities underwriting,
and offering insurance services.
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Largest Investment Banks
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Early History
Investment banks trace their origins to European
investment houses which branched to the U.S.
Early U.S. commercial banks were chartered for
note issue and business lending, separate from
private investment banks, organized as
partnerships.
Investment banks grew with the growth of security
issuance and trading in the Civil War and later in
the railroad and steel industries.
Commercial banks pressured for investment
banking privileges from their regulators, and by
the 1930s, commercial banks could provide full
investment banks services.
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Glass-Steagall Act
The legislated separation of CB and IB in
the United States is unique
The Glass-Steagall Act of 1933 (Banking
Act) restricted the asset powers of
commercial banks to low-risk underwriting
areas.
In other countries, universal banks were
able to combine commercial and investment
banking functions. United States, IB, and
CB had to compete with these firms.
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The Glass-Steagall Act (continued)
CB could not underwrite (buy and resell)
risky business securities.
CB were limited as to the risk assumed in
their investment portfolio-no risky corporate
securities.
IB firms were prohibited from engaging in
CB.
Firms became either IB or CB.
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The Objectives of the Glass-Steagall Act
Discourage speculation in financial markets.
Prevent conflict of interest and self-dealing.
Restore confidence in the safety and
soundness of the CB system.
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Commercial Banks & Securities Business >1980)
In 1988, courts ruled in favor of banks to allow
underwriting of securities in a limited fashion.
They could underwrite commercial paper,
municipal revenue bonds, and securities backed by
mortgage loan or consumer loans.
Business should be conducted by an independent
subsidiary of the bank holding company.
This business could not exceed 5% of the
subsidiary’s gross revenue.
In 1989, J. P. Morgan was allowed to underwrite
and deal in corporate debt within the U. S. through
its securities subsidiary, and in 1990 they were
allowed to underwrite domestic corporate equity.
Copyright© 2006 John Wiley & Sons, Inc.
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Repealing the Glass-Steagall Act
Relaxing the Glass-Steagall restrictions was one of
the major financial issues of the last twenty years.
CB increasingly had sought to be allowed to
engage in investment banking activities.
The Federal Reserve Board had increasingly
allowed CBs to engage in some investment
banking activities.
In the late 1990s, several commercial banks
purchased investment banking firms.
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Gramm-Leach-Bliley Act
Financial Services Modernization Act of
1999
Permitted commercial banking, investment
banking and insurance underwriting under a
financial holding company
Citigroup
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Bringing New Securities to Market
New issues are called primary issues, first
issued in the primary market.
If the issue is the first sold to the public, it is
called an unseasoned offering or an initial
public offering (IPO).
If securities are already trading, the new issue
of securities is called a seasoned offering.
Copyright© 2006 John Wiley & Sons, Inc.
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Bringing New Securities to Market (continued)
Three steps of bringing a new security issue
to market include:
Origination - design of a security contract that
is acceptable to the market;
• prepare the state and federal Securities and
Exchange Commission (SEC) registration
statements and a summary prospectus,
• obtain a rating on the issue, obtain bond
counsel, a transfer agency and a trustee, and
print the securities.
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Bringing New Securities to Market (concluded)
Underwriting - the risk-bearing function in
which the IB buys the securities at a given price
and turns to the market to sell them.
• Syndicates are formed to reduce the inventory risk.
• Market price declines cut the IB's margin.
Sales and distribution - selling quickly
reduces inventory risk. Firm members of the
syndicate and a wider selling group distribute
the securities over a wide retail and institutional
area.
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Front Page of a Final Prospectus
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Underwriting Agreements
When the investment bank guarantees the
issuing firm a certain price, it is called an
underwritten offer.
The risk of selling the issue at a price higher
than that promised to the issuer is borne by the
investment bank.
The difference between the price at which the
issue is sold and that promised to the issuer
represents the underwriting spread or the profit
earned by the investment bank.
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Underwriting Agreements
In a best efforts offer, the investment bank
does not guarantee a price or that the issue
will be sold.
The investment bank is compensated based on
the number of securities sold.
The risk of the securities not selling or not
selling at a desired price is borne by the issuing
firm, not the investment bank.
Typically, the smaller and more risky issues are
made to use this type of offering.
Copyright© 2006 John Wiley & Sons, Inc.
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Trading and Brokerage
The brokerage function is to bring a buyer and
seller together.
Dealer function - buying (bid) and selling (ask)
from an inventory of securities owned by the
seller.
Providing loans to customers, who invest the
margin proportion and borrow the rest.
Dealer security inventories and customer credit are
financed by bank call loans and repurchase
agreements, the sale and later repurchase of
securities held by the dealer.
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Balance Sheet of Security Broker & Dealers
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Trading and Brokerage (continued)
Full service brokerage firms offer a wide
range of financial services provided by
licensed stockbrokers or account executives
for commissions. Services include:
Storage or safekeeping of securities.
Execution of trades.
Investment research and advice.
Cash management service.
Copyright© 2006 John Wiley & Sons, Inc.
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Trading and Brokerage (concluded)
Discount (Internet) brokerage firms offer fewer
non-fee services than full-services brokers, but
charge lower commissions on security purchases
and sales.
Banks may act as a broker on behalf of its
customers under the Glass-Steagall Act. Banks
moved into this area in the 1980s and 1990s
usually as a discount broker.
Arbitrage activities involving the simultaneous
buying between two markets is another trading
activity of IB.
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Private Placements
The sale of securities directly to the ultimate
investor and not through a public offering.
The underwriting function/cost is avoided.
A fee is earned for the origination/selling or
uniting the supplier and user of funds.
A private placement may reduce the total flotation
costs for a business or government.
The extremes of high credit quality firms and low
or unknown credit quality firms use private
placements.
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Private Placement, cont.
Traditional two-year trading delay with
private placement securities
SEC Rule 144A permits trading among
institutional investors
Increased liquidity of investment; lower
liquidity risk premium; lower financing cost
for borrower.
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Mergers and Acquisitions
Specialized IB departments provide the following
services.
Arrange mergers which would produce economic
synergy or increased total value after merger.
Assist firms which have had unwanted merger offers
(hostile takeovers).
Help establish the value of target firms.
Mergers and acquisitions have been a profitable
aspect of the IB business.
CB have expanded their merger and acquisition
departments.
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Venture Capitalists
Venture capital is private equity financing.
Venture capital and managerial advice is
provided, usually for an equity interest in the
company involved, to higher risk businesses by
institutional investors hoping for high returns.
Venture capitalists typically invest in high-tech
based firms that require large amounts of
capital.
Venture capital is usually the intermediate
financing between founders' capital and the
IPO.
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Venture Capital Organizations
Private independent funds - most common,
usually limited partnerships of institutional
investors.
Corporate subsidiaries - provides higher
risk investments for large corporations.
Small Business Investment Companies closed-end investment trusts authorized
under the SBIC Act of 1958.
Individuals and entrepreneurs may provide
funds and advice for a "piece of the action."
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Areas of Venture Capital Investment
Venture capitalists invest in technologybased businesses such as:
electronics.
computer software.
biotechnology.
medical care.
industrial products.
Manufacturing business tend to be more
intense users of venture capital than service
businesses.
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Stages of Venture Capital Investments
Seed financing is capital provided at the “idea”
stage.
Start-up financing is capital used in product
development.
First-stage financing is capital provided to
initiate manufacturing and sales.
Second-stage financing is for initial expansion.
Third-stage financing allows for major
expansion.
Mezzanine financing prepares the company to
go public.
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Structure of Venture Capital Investments
Substantial control over management
decisions, such as participating on the board
of directors.
Some protections against downside risk.
A share of capital appreciation-convertible
preferred stock is popular.
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Venture Capital Rates of Return
Venture capitalists tend to think of rates of
returns in terms of multiple of the amount
invested.
For example, a venture capitalist might
expect to receive ten times the amount
invested in a start-up company over six
years. This would be a 47% annual rate of
return.
A less risky third-stage investment might
return five times the amount invested over
four years or 41% per year.
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Required Rate of Return for Venture Capitalists
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Valuation of Venture Capital Investments
Companies are compared to “comparable”
public companies for valuation.
comparable revenues, earnings, P/E ratios
bench marking with adjustments for varied
factors.
Multiple-scenarios valuation such as
optimistic
expected
pessimistic
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