Chapter 2
Investment
Banking
Investment Banking
A.
Primary Market
1.
2.
3.
4.
B.
The initial sale of a security
Assistant of investment bankers
Initial sale only occurs once
Process by which securities come into existence
Secondary Market
1.
2.
3.
4.
Buy and sell securities once they have been issued
NYSE
NASDAQ
American Stock Exchange
The Transfer of Funds to Business
A. Indirect Transfer
1. Buying or selling securities through a
financial intermediary
a)
Commercial bank
B. Direct Transfer
1. Investing money directly in a firm or
business
2. Firms raise money by selling securities
directly to the general public
The Role of Investment Bankers
A. Investment Bankers
1. Middleman who brings together investors and
firms (and governments) issuing new securities
2. Channel money from investors to firms that need
money
3. Often are not bankers
4. Generally do not invest
5. Division of a brokerage firm
a) Goldman, Sacks & Co.
b) Donaldson
c) Montgomery Securities
The Role of Investment Bankers
B. Initial Public Offering
1. First sale of common stock to the
general public
The Role of Investment Bankers
– Firm Commitment
• Investment bankers guarantee the sale and
make a firm commitment to raise a specified
amount of money
– Underwriting
• Purchase of an issue of new securities for
subsequent sale by investment bankers
• The guaranteeing of the sale of a new issue of
securities
The Role of Investment Bankers
– Underwriters
• Buy securities with the intention to sell them
to the general public
• By agreeing to buy the securities, the
underwriters guarantee the sale and bear all
risk
• If the underwriters cannot sell the securities to
the general public, they must still pay the
agreed-on sum to the issuing firm
The Mechanics of Underwriting
– Syndicate
• A group of brokerage houses that joins
together to underwrite and market a specific
sale of securities
• The firms that manage the sale are the lead
underwriters
• Advantages
– More potential buyers
– Reduced amount of securities that each firm must
sell
– Increased probability that the entire issue will be
sold
The Mechanics of Underwriting
– Best Efforts Agreement
• The investment bankers that do not want to
guarantee the sale or underwrite the sale
• Instead, the investment bankers agree to make
their best efforts to sell the securities, but the
risk of the sale is borne by the issuing firm
• Most Sales are through underwriting, small
issues of risky securities are often best efforts
sales
Pricing an IPO
If the price is set too high…
– The syndicate will be unable to sell the
securities
– The syndicate has two options:
• Maintain the offer price and hold the securities
in inventory until they are sold
• Let the market find a lower price level that will
induce investors to purchase
• NEITHER CHOICE IS GOOD!
– If the securities are held in inventory, the
investment bankers will be either tying up their own
funds or pay interest on borrowed funds
Pricing and IPO
Overpricing inflicts losses on initial
buyers and investment bankers.
Tendency to underprice to assure
successful sale
Underpricing leads to windfall gains for
initial buyers.
Marketing a New Security
 Once the terms of sale have been agreed
upon, the managing house may issue a
preliminary prospectus
– Often referred to as a “red herring”
• A term that means the document should be read with
caution as it is not final or complete
– Initial document detailing the financial
condition of a firm that must be filed with the
SEC to register a new issue of securities
– Cost of printing this is the issuing firms
responsibility
Marketing a New Security
– The Preliminary Prospectus Includes:
•
•
•
•
•
•
•
Description of company
Securities to be issued
Income statement
Balance sheet
Current activities
Regulations
Nature of competition
– Does not include:
• Price of securities
– That is determined on the day the securities are
issued
Marketing a New Security
 Securities and Exchange Commission
– Government agency that enforces the federal security
laws
 Registration
– The process of filing information with the SEC
concerning a proposed sale of securities to the general
public
 Registration Acceptance
– After the SEC accepts the registration, a final
prospectus is published
– Does not approve investment worth
– Approves the completeness of the prospectus
Marketing a New Security
 Cost of Underwriting
– A.K.A. Flotation costs or Underwriting Discount
– The difference between the price of securities to the
public and the proceeds received by the firm
The Price Volatility of IPOs
– Extremely volatile
• Because…
– Number of securities that are offered
– Price changes of new issues (Prices can rise
dramatically)
• Many firms that go public will fail and will
inflict losses on those investors who have
accepted this risk by purchasing securities
issued by small firms
• Few investors get to participate in IPOs.
Shelf Registration
 Firms that have previously sold securities to the
public and wish to sell more
 Construct a prospectus and file with SEC
 Same basic procedures apply
 Differences
– Price of securities
• There is no guessing on what the initial price should be
• The price is set by the securities current market
• Less need for a detailed prospectus (already done)
 After shelf registration has been accepted, the
firm can sell those securities any time funds are
needed
Private Placement
 Nonpublic sale of securities to a financial
institution
 Venture Capital Firms
– Often sustain a large loss
– But successes usually generate large returns
– After a firm achieves success, the venture
capital company may sell to the general public
 Mutual Funds that specialize in emerging
firms
Regulation
 Federal Level
A. Protect the investing public
1. Provide information to help prevent fraud
2. Notify investors so they can make informed
decisions
3. Prevent employee’s from using privileged
information for personal gain
B. Will not assure you that profits will be made
C. You must protect yourself from your own
mistakes
Regulation
D. Securities and Exchange Commission (SEC)
• Enforces Federal security laws
– New issues
– Trading in securities
• Can suspend trading
Regulation
E. Full Disclosure Laws
• Law requires a timely disclosure of information that
may affect the value of a firm’s securities
• Firm’s do not have to tell you everything
– Trade secrets
F. 10-K Report
• Required annual report filed with the SEC by
publically held firms
G. Firm’s must issue new information
throughout the year that may affect the value
of a security
Regulation
H. Firm’s must issue new information
throughout the year that may affect the
value of a security
I. Insider Information
• Not limited to employees
• Applies to people who work elsewhere but have
access to privileged information
J. Securities Investor Protection Corporation
(SIPC)
• Federal agency that insures investors against
failure by brokerage firms (similar to FDIC)
– $500,000 per customer of which only $100,000 can be
cash
• Brokerage firms may carry additional insurance.
Sarbanes-Oxley Act of 2002
 Intended to restore public confidence
 Main provisions:
– The independence of auditors and the creation
on the Public Company Accounting Oversight
Board
• Oversees the auditing of the financial statements of
publically held companies
– Corporate Responsibility and Financial
Disclosure
• Require a publically held CEO and CFO to certify that
the financial statements do not contain untrue
statements or material omissions
Sarbanes-Oxley Act of 2002
– Conflicts of Interest and corporate fraud and
accountability
• Usually securities analysts and investment bankers
cannot work for the same firm
– Must be independent
 Penalties for Violation
– Fines
– Imprisonment for up to 20 years