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Copyright © 2006 Scott Bauguess

Part V: Investment Banking

Topic 15 – Securities Underwriting


Investment BankingInvestment banking: involves activities related to underwriting and distribution new issues of debt and equity securities


Investment Banking

I. Primary Markets: Newly issued securities1. Raise new capital for the firm2. Agents (investment banks) create a public market for the client’s securities

II. Secondary Markets: Previously issued securities1. Market makers facilitate trading of previously issued securities2. Trades through agency transactions match buyers and sellers (ie. brokers

operating through an exchange like the NYSE)3. Trades through principal transactions – institutions trading on their own account

a (taking a long or short position in a security)


Primary Market Choices

Financing choices available to the firm:1. Venture capital2. Private equity3. Bank financing (loans)4. Private security issuance (fewer than 35 investors)5. Public issue of securities

Investment bank focus1. on items (4) and (5), underwriting issuances2. but are also increasingly engaged in (1) and (2), taking positions in private firms

on behalf of their customers or on their own account


Types of Public Security Issuances

There are several different ways in which a firm can raise capital in public markets, including:

1. Initial Public Offering (IPO): A private firm issues publicly traded shares for the first time

2. Seasoned Equity offering (SEO): An already public firm issues new shares, again.

3. Carve-out: A corporation issues shares in a subsidiary to the public4. Spin-off: Firm issues all subsidiary shares to current shareholders of the firm5. Fixed income: Debt issuances (corporate bonds)6. Direct Public Offering (DPO): Shares are offered direct to public shareholders

Questions that highlight the differences between each type of offering:1. Is capital being raised by the firm?2. Is this the first time raising capital in public markets?3. What type of security is being issues (debt/equity)?4. Who is the original owner of the firm (entrepreneur, public firm)?



IPO Issuances:1. This is the most visible type of security issuance with respect to exposure in

financial publications2. Consider the Google IPO of 2005 and the news surrounding the issuance events3. IPO firms are being valued by the “market” for the first time, and establishing the

initial valuation (based on firm private information) and finding public market investors willing to pay that valuation is the specialization of an investment bank

SEO Issuances:1. Market values are already established, so placing these securities is generally

less difficult than an IPO since there is less asymmetric information.2. Types of SEO’s

• Follow-on offering: Is an SEO in which new shares are issued to the public• Secondary offering: Is an SEO in which existing shares held by current

owners (like the found of the firm – Bill Gates of Microsoft for instance) are sold to the market



Carve-outs: Firm issues shares in a subsidiary to the market for the first time1. This is often confused with a spin-off, but it is NOT a spin-off2. A carve-out is essentially an IPO of a subsidiary of a public firm 3. e.g. Freescale was carved out of Motorola, Kraft from Philip Morris, Agilent from

Hewlett Packard4. The parent firm (original owner of the carved out firm) usually retains a majority

interest in the new issue5. The parent firm retains the proceeds from the public offer (they are raising

capital)6. Pricing shares of carved out firms is different from an IPO firm since many of the

assets and earnings were previously reported to the public through the parent firm’s SEC filings

7. The parent firm must clearly define which assets are included in the carved out firm, include debt liabilities

8. Tax considerations: the parent generally will not issue more than 20% of the subsidiary’s equity if it plans to subsequently spin-off the subsidiary (see next slide)


Types of Public Security IssuancesSpin-off: A parent firm issues shares of a subsidiary to current owners of the parent

firm1. The subsidiary becomes a stand-alone firm, with no tie to the original parent except for

common owners2. Shares go to existing owners similar to a stock dividend, so only current owners of the

parent receive the distribution3. No capital is raised by the parent firm in this process (as is the case for a carve-out)4. Spin-offs generally occur after a carve-out, subsequent to an established secondary

market for the subsidiary. 5. Pure spin-off, in which no public shares of the subsidiary pre-exist, are rare6. Example:

• AT&T carved out Lucent, selling 17.6% of outstanding shares to the public market• One year later, AT&T spun-off the remaining 82.4% to AT&T shareholders• AT&T share value dropped from approximately $52 to $38 after the spin-off• Lucent began trading at a market value essentially equal to this $14 difference,

thus AT&T shareholders effectively owned the same firm, but divided into separate securities.

7. Tax consideration: a spin-off is a tax-free distribution if at least 80% of the subsidiary’s equity is distributed


Carveout

A L

E

AT&T Balance sheet

Lucent Technologies

Lucent operations is an asset (subsidiary) owned by AT&T

Lucent liabs

Part of AT&T’s liabs help support this operation

Lucent equity

Lucent contributes to AT&T equity

cashCarve-out: AT&T sells 17.6% of this asset to the market

AT&T receives cash in return

Lucent technologies is a “mini” firm contained within AT&T, but becomes delineated from AT&T operations once it is carved out. AT&T owns the remaining 82.4% of the equity.

The contribution of Lucent to AT&T equity decreases by this same amount


Spin-off

A L

E

AT&T Balance sheet ($52/shr)

Lucent Technologies

Lucent liabs

Lucent equity

cash

AT&T distributes the remaining 82.4% stake in lucent operations to AT&T shareholders

A L

ELucent

Spin-off$14/shr

A L

E

cash

$14/shr

New AT&T

$38/shr


Types of Public Security IssuancesFixed Income: Debt issuances

1. Corporate Debt• The firm hires underwriters in the same spirit that they would do for an

equity issuance2. Federal Debt (Treasuries, Bonds)

• Recall from before, these are done at auction.3. Municipal & State bonds

• Hire underwriters similar to a corporation

Direct Public Offering: Shares offered direct to the public. There is no underwriter or other intermediary between the firm and shareholder

1. Direct Public Offering (DPO): Relies on word of mouth (Google thought about doing this through an auction. Requires high reputation and notoriety.)

2. Direct Purchase Plan (DPP): Plans that allow investors to buy firm shares directly from an already public firm (e.g. You can buy shares of Disney direct from the firm)

3. Direct ReInvestment Plan (DRIP): Dividends are automatically reinvested in firm equity


Why go Public?Lack of other financing choices

1. Private financing unavailable2. Too much debt, so firm optimizes capital structure

Allow current investors to cash out 1. Founders demand liquidity, want to sell stake in firm2. Issue seasoned equity – “secondary share offering”3. Firm is valued by the market, shares sold get market price

Future source of capital 1. Establish the firm in public capital markets for future capital raising (SEOs, bond

issuances)2. Lowers the cost of capital (cost of equity mitigates cost of debt)3. Diversification / Risk sharing4. Increases transparency of firm actions

Employee compensation 1. Firm can offer incentive contracts – stock options


Why not go Public?Going public is costly and may not be appropriate for all firms, even when they are

in need of additional financing

Ownership is diluted1. Decision making is delegated to an increased number of owners2. Founder (entrepreneur) loses control

Public monitoring increases1. SEC filing requirements (Disclosure)2. Competitors benefit from transparency3. Regulators have increased authority (legal restrictions to public firms)

Direct financial costs1. Filing costs of prospectus and subsequent federal filings – requires additional staff2. Investment banks and new investors charge the firm via large transactions costs

• Shares are under priced (can be greater than 15%)• Underwriters collect fees (7% of gross proceeds)


Securities Underwriting

Underwriting: To assume financial responsibility and guarantee against failure1. Insurance underwriters create contracts that indemnify (protect against loss) their

customers (auto liability, life insurance, flood protection etc.)2. Securities underwriters guarantee the placement of new debt or equity with

public financial markets• Historically investment banks (e.g. Goldman Sachs, Merrill Lynch, Morgan

Stanley etc.) have specialized in securities issuance• Since GLB in 1999, commercial banks and insurance companies can also

engage in securities underwriting, either directly, or through the addition of an affiliate (ie. Salomon Smith Barney as part of Citigroup)

3. Underwriting process• Is similar for all securities and issuance type• The IPO process involves the most asymmetric information and thus is the

most complex, so we will use this as an example


The IPO ProcessFirm selects an underwriter (investment bank) who also acts as the advisor, basing

the decision on:1. The reputation and expertise of the underwriter (the advisor must be credible)2. Follow-on products like research coverage3. Prior relationships between the firm owners (often VC’s) and investment banks4. Distribution channels available to underwriter (institutional clients)5. The investment banks willingness to take on the firm (high reputation underwriters

may not risk their reputation on a firm with uncertain prospects)

Firm and underwriter agree on the offering method:1. Firm commitment: firm sells the entire issue to the underwriter who then attempts to

sell it to the public (insured) – Although the underwriter fully commits to purchasing the issue, the price is not agreed (or committed to) until later in the issuance process.

2. Best effort: underwriter makes no promise about the price, but makes a best effort to sell at the agreed price (uninsured)

3. Rights offering: securities are first offered to existing shareholders (not common in the U.S.)

• Rights offer can be insured or uninsured


The IPO Process

Valuing the offer: Underwriter performs its due-diligence and provides a value of the firm1. Firm opens its books to the underwriter so that they have full

information for determining value – the underwriter is the agent that reduces asymmetric information

2. Discounted cashflow analysis is one valuation method, but more commonly, underwriters identify a peer group of publicly traded firms and use multiples of different financial metrics to provide a range of values (PE, Mkt-book, ROS, ROA etc.)

3. Firm and underwriter agree and set an offer range, which may change once the underwriter has a better assessment of market interest in the offering.

4. Six to 8 weeks have passed from the selection of the underwriter until the end of the due diligence.


The IPO ProcessSEC filing: The underwriter files a registration statement with the SEC that gives

specific information on the offering, firm history, financials and future plans.1. SEC spends up to 20 days reviewing the filing (this is known as the

waiting period, or cooling-off period)2. The exact length of the waiting period can change, particularly if the SEC

asks for additional documentation, or the firm violates quiet period rules (see subsequent slides)

3. The intended exchange (NYSE, NASD, AMEX) reviews the filing as well4. The filing contains two parts, one that is made available to the public

(prospectus) and another part that is kept private, only for SEC use.5. Since the prospectus is not effective until final approval from the SEC,

preliminary copies that circulate to prospective investors are printed in red ink along the left side of the front cover, giving the preliminary prospectus the nickname “red herring”


The IPO ProcessSyndication: The underwriter arranges a syndicate to help with the distribution

1. The primary (original) underwriter is designated the “lead” underwriter2. Underwriter may take on a co-manager (co-lead) to help with the

underwriting3. The lead underwriter allocates portions of the offering to syndicate

members with the primary purpose of a syndicate to risk share4. Syndicate members may be lead underwriters on other offerings, so the

relationships are frequently based on equal stature in terms of mutual respect. “you buy from me this time and I’ll buy from you next time.”

5. Securities underwriting syndications is similar in nature to loan syndication by banks


The IPO Process

Road show: Begins a few weeks prior to the IPO, and before the SEC approval of the prospectus, typically lasting 2 weeks.

1. The lead underwriter visits large investors (institutional) to solicit interest and build a demand schedule (a.k.a book building)

2. Book building occurs with “special” clients of the underwriter, including institutions (Fidelity, Janus etc.) and wealthy private investors.

3. Book building is also spreading to smaller clients through electronic road shows, aided by the internet (SEC likes this a lot).

4. Only once the waiting period is over, can the investment bank/underwriter solicit specific pricing and demand information from investors.

5. The waiting period usually ends a few days prior to the IPO, allowing investment banks to reach what they think will be an equilibrium (final) offer price.

6. Although firms and underwriter cannot make forward looking statements once the prospectus has been filed with the SEC (see quiet period rules), road show discussion often communicate this information privately


The IPO Process

Offer: Underwriter sells the issue and an exchange begins trading the issue in a secondary market

1. Depending on demand for shares, the underwriter may have to ration shares to investors.

2. Shares are sold to investors prior to trading in secondary markets3. After the shares are placed, the appropriate market maker begins trading the

shares4. New investors who didn’t get an allocation of the primary shares can now buy

shares in the open market5. Investors who received an initial allocation of shares can begin selling them to

new investors6. Investors who are allocated shares and immediately turn around and sell them in

the market are not viewed favorably by investment bankers and may be cut off from future allocations.


The IPO ProcessQuiet Period: A rule originally implemented as part of the 1933 Securities Act

1. The period of time during which the underwriter and management of the IPO firm cannot make forward looking statements other than what is already in the prospectus

2. This allows (in theory) all investors to make an investment decision based on the same set of information (issue of fairness)

3. Quiet period starts at the time the prospectus is filed, and ends 40 days (until July 2002, it was 25 days) after the IPO.

waiting period

Hire File w/ SEC End QuietUnderwriter SEC approval Period

- 6 weeks -20 days -3 -1 0 40 days

IPO is effective

Quiet Period

Issue


The IPO Process

Quiet Period: continued4. Depending on the length of time it takes for SEC approval, the total time quiet

period time can vary.5. Verbal agreements between underwriter and investors (particularly institutions)

can be made during this period (prior to the IPO)6. Non affiliated investment banks are allowed to make comments during this

period, but generally they do not.7. Once approved by the SEC, the issuing firm can immediately make the IPO

“effective” but generally some time passes (a day or two) to finalize the IPO price.

8. Once the IPO is effective, shares are quickly allocated to investors, that same day, or by the following day.

9. Once allocated, the chosen stock exchange commences trading in the security, and investors receiving allocation, or original owners of shares, can trade with other investors.


The IPO ProcessFees: Underwriters charge issuing firms for their services

1. Fees are earned for reducing the asymmetric information between investors and the firm

2. Investment banks (underwriters) use their reputation in a repeated game setting (they do this over and over with different firms) to convince investors of the firm’s type

3. For firm commitment offerings, fees come from the following sources• Gross spread: price sold to market – price bought from firm. Typically this is

7% of gross proceeds• Underpricing = closing price at end of first trading day – the offer price.

Underwriters generally under price the offer by as much as 15%, and much more in certain cases.

Components of Gross Spread: 1. Selling concession: 60% of fee is distributed to syndicate members to compensate

for distribution2. Lead receives 20% 3. The remaining 20% is used to cover the underwriting expenses, particularly the

road show


IPO Underpricing

Underpricing: Generally believed reasons for why underpricing occurs:1. Reward large institutional and private investors for repeat business and disclosing

their demand schedule during the road show (this allowed the underwriter to price this issue, so a discount is just payment of services rendered by the institutions)

2. Underwriters are looking for repeat business from investors, so they under price the issue to leave a good taste in their mouth.

3. Agency problem: underwriters might under price because they don’t want to work hard, and selling at a lower price is easier.

4. Reduce legal liability: Underwriter doesn’t want to be accused of over pricing an issue, and to reduce this likelihood, they intentionally under-price

5. Winner’s curse: Since “good issues” will be fully allocated (over subscribed), need to compensate for successfully subscribed “bad issues”. The winners curse simply refers to the fact that you are more likely to get your full demand of shares (the schedule that you gave to the underwriter) when the issue is “bad”. Hence, the underwriter under prices all issues to compensate for this effect.

6. Compensation to preferred clients. During the height of the dot.com boom, many CEOs and senior managers of firms considering going public would get allocations of IPO shares from other firms going public. These shares were offered by investment banks hoping to win future business.


Cost of UnderpricingMoney “left on the table”

Source: Jay Ritter IPO webpage http://bear.cba.ufl.edu/ritter/ipodata.htm


Cost of UnderpricingMoney “left on the table”

Underpricing of U.S. firms by year

Dot.com boom years

Source: Jay Ritter IPO webpage http://bear.cba.ufl.edu/ritter/ipodata.htm


IPO Performance 2000Notice from the characteristics of

firms that went public in 2000, just before the stock market decline:

• Only a small fraction of total shares are offered to the public (10-20%)

• Most are technology firms, particularly internet and biotech.

• Under pricing is as high as several hundred percent

• Few firms are trading above their original list price

• Many firms have delisted.

Source: Hoovers online


IPO Performance 2001


IPO performance in the first quarter of 2001, after public markets began to dry up, saw on 18 IPO’s, down from 76 during the same time in 2000

• Notice the absence of technology firms from this list.

• Under pricing is far less than the year prior

• Higher floats are offered (more shares issued)

• Many of these firms have done well since the offering

• Only firms of “good” type could make it into public markets during after the bubble burst, and their post performance is indicative of this relative to firms issued the prior year.


IPO Performance 2005


IPOs in first quarter of 2005• Floats are still higher; >30% is not

uncommon.• Technology companies have not

yet returned to their pre-bubble era

• Under pricing is still prevalent, but at much lower levels.


Shelf Registration of Securities

Shelf Registration of Securities (Rule 415): Approved in 1982, it allows for firms to file one registration statement to be used for any number of future equity/debt issuances.1. The name shelf registration came about since the securities can be

viewed as sitting on the shelf2. A secondary market must already exist for the security class being filed3. Security classes are not limited to equity (bonds too)4. One filing is accommodates up to two years of future offerings5. This type of registration is used for seasoned equity offerings.6. One filed, firms can offer shares more quickly, and potentially offer at a

more attractive time.


Private Placements

Private Placements: Firms can skip the public issuance process by going straight to large investors

1. Buyers are insurance companies, wealthy individuals, mutual funds, other firms etc.

2. Private placement can be below market price.3. According to the 1933/34 Securities Acts, issuing firm is NOT required to register

these securities provided that the offering meets the following three criteria:• Must be sold within the state issued• no simultaneous offering to the public• issue must be less than $1 million

4. 1982, Regulation D provided exemptions to the 1933 ACT: • added that an issue can not be advertised or generally solicited similar to a public

offering• Provided for larger issues depending on number of investors and their level of

accreditation (no little guys).

5. 1990, rule 144A removed a costly restriction, that privately placed shares not be traded for 2 years.

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Documents

underpricing

previously

public security

direct public

investment

investment

road show

financing