Chapter 16:

Investment Banking and

the Public Sale of Equity
Securities
Financial Management, 3e
Megginson, Smart, and Graham

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Overview of Global Investment

Banking
Investment banks assist companies in
selling new securities.
Companies that raise capital externally
can issue debt or equity.
Securities can be sold through private
placements or to the public.
First public offering is known as an IPO.
Subsequent offerings are known as
SEOs.
2
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Table 16.1 Securities Underwriting

League Table for 2008

3
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

League Table

The data reveal how sharply the volume of

worldwide corporate security offerings dropped
during 2008: from a record $7.602 trillion during
2007 to $4.697 trillion in 2008

a level not seen since 2002. Second, in sharp contrast to

almost all recent years, U.S. investment banks

In sharp contrast to almost all recent years, U.S.

investment banks did not dominate the underwriting
league table.

Bulge bracket firms generally occupy the lead or

co-lead managers position in large new security
offerings

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Table 16.2 Merger & Acquisition

Advising League Table for 2008

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Key Investment Banking

Activities
Corporate

finance

Trading
Asset

management

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Investment Banks Role in

Equity Offerings
Trading

Investment
banking lines of
business

Asset management
Corporate finance

Investment banks provide advice with structuring

seasone
seasoned
and
unseasoned
issues,
actual
sale
and
unseason
d
post-sale services.
ed
Seasoned
Equity issues by firms that already
have common stock outstanding
offering
Unseasoned
offering

Initial public offering (IPO): issue

of securities that are not traded yet

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Investment Banks Role in

Equity Offerings
Firms can choose an investment bank
through:
Direct negotiated
offer

Competitive bidding

Public security issues can be:

Best
efforts
Firm
commitment

The bank promises its best efforts to

sell the firms securities. No
guarantees though about the
success of the offering.
Underwritten offerings, bank
guarantees certain proceeds.
Vast majority of U.S. security
offerings are underwritten this way.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Investment Banks Role in

Equity Offerings
Securities offerings are usually
handled by a syndicate of many
investment banks.
One of these banks is usually named the
lead underwriter, or book-runner.
Other leading banks are called comanagers.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Investment Banks Role in

Equity Offerings
Best-efforts offering
Bank promises to sell firms securities,
but makes no guarantee it will be for
firms offering price

Firm-commitment offering
Bank guarantees (underwrites) the
offering price

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

10

Services Provided by
Investment Bankers and Their
Costs
Investment banks provide services prior to security
offering.

Prior to offering, lead investment bank negotiates

underwriting agreement:
Sets offer price and spread
Details lock-up agreement
Underwriters spread usually 7% for IPOs
Initial offer price set as range; final price set day before
offer
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

11

Table 16.3 Underwriting

Spreads for Different Types of
Securities

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

12

Figure 16.1 Underwriter Spreads

for Seasoned Common Stock
Offerings

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

13

Table 16.4 Gross Spreads on

international IPOs: Book Buildings vs.
Fixed-Price Offers

Book-building: underwriters ask prospective

investors to indicate their demand for the offering
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Services Provided During

and After a Security
Offering

Lead underwriter sets each syndicate members

percentage of participation.

How many shares each member must sell and

compensation.
Almost all IPOs and SEOs have a Green Shoe option:
over-allotment option to cover excess demand.
Lead underwriter may engage in price stabilization
after offering.
After offering, lead underwriter serves as principal
market maker.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

15

Table 16.5 Key Steps in the

IPO Process

Initial Step

Registration Process

Selecting book-runner and co-manager

Letter of intent
Registration statement and due diligence
Red herring

Marketing

Distribute prospectus
Road show

Pricing and Allocation

Aftermarket Activities

Stabilization; overallotment option

Research coverage

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

16

Legal Rules Governing U.S.

Public Security Sales
Two basic laws governing public issues:
Prescribed security issuance
Securities Act of
procedures, set basic principle
1933
of full disclosure
Securities and
Exchange
Set up SEC, gave it broad
regulatory, rule-making
Commission Act of
powers
1934
Securities laws mandate disclosure of all relevant
corporate information to potential investors.
Investment banks play key disclosure role by performing due
diligence.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

17

Basic Disclosure
Documents

Principal disclosure document: Registration

Statement
Prospectus

Supplemental
Disclosures

Actually a series of registration statements,

beginning with the preliminary prospectus
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.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

18

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 out of
inventory (off the shelf) over the next two years.
Popular with issuers; very flexible

Most qualifying debt and equity issues are shelf

registered.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

19

Benefits of an IPO
IPO can raise large amounts of new capital for
growth.
Publicly traded stock is currency for acquisitions.
Listed stock (options) can be used to attract top
managers.
Provides personal wealth and liquidity for
entrepreneur
Serves as advertising for firm and its
products/services
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

22

Drawbacks of an IPO
High financial costs of IPOs, with no guarantee of
success. Cash expenses of IPO often approach $1
million.
Managerial costs of planning and executing IPO
Need to focus on stock price and deal with
shareholders
Severe constraints on managerial discretion in public
firm

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

23

Types of Specialized IPOs

Equity carveout

Parent sells minority stake in

subsidiary to public through IPO
Raises cash for parent, allows better
monitoring of subsidiary

Spin-off

Parent distributes all of a subsidiarys

stock to shareholders
Full spin-off creates independent new
company

Reverse LBO

Company goes public again after LBO

Successful LBOs create value, so
high returns to second IPO

Tracking
stock

Stock mirrors performance of

division, but not legally or
operationally separate from parent

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

24

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.

Recent research suggests IPO stocks earn normal long-term

returns.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

25

Seasoned Equity Offerings

(SEO)
SEOs infrequent for most U.S. and non-U.S.
firms
Reason

Negative market reaction

when SEOs are announced

SEO announcements convey negative info:

Short-term and long-term performance of SEOs: prices fall on
announcement, underperform over 1-5 years.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

26

Figure 16.3 SEOs: Total Deal Value

by Type, 1991-2004

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

27

Rights Offerings
Existing shareholders have the
right to buy new shares at a
discount or can sell this right to
other investors.

Rarely done today by large American

companies, but still common in other
countries

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

28

Private Placements in the

U.S.
Sale of a security directly to one or a group
of accredited investors
Accredited investors in private placements are
financially sophisticated.
Corporations, institutional investors, wealthy
individuals, pension and mutual funds, venture
capitalists

Rule 144A has allowed limited trading of

PP
qualified institutional
amonginvestors
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

29

International Common
Stock Offerings
Domestic stock offering

Two
types

International, or cross-border,
issues

Total number and value of non-U.S. IPOs exceeds

U.S. total.
All markets show significant IPO underpricing.
Unclear whether international IPOs underperform in
the long run.
Most markets also seem prone to hot and cold
markets.
2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

30

What CFOs Do: Survey Evidence

Factors that Affect Stock Issuance
Decisions

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

31

International Common Stock

Offerings

Many of the same investment anomalies are

common to both U.S and international markets:
non-U.S.

private-sector IPOs also demonstrate

significant first-day returns.
initial international offers also may yield negative
long-term returns.
popular non-U.S. issues also tend to be heavily
oversubscribed
hot-issue markets are as prevalent internationally as
in the United States.
taxation issues (particularly capital gains tax rules)
affect how issues are priced and/or which investors
the offers are targeting.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

32

Average First-Day Returns

(%) on IPOs for 38 Countries

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

33

American Depositary Receipts

(ADRs)
Dollar-denominated claims issued by U.S.
banks
Represent ownership of shares of a foreign
companys stock held on deposit in the issuing firms
home country
Sponsored
ADR

The issuing foreign company pays all

legal and financial costs of creating
and trading the security.

Unsponsor
ed ADR

Issuing firm is not involved with the

issue of ADRs.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

34

Figure 16.5 Trading Volume in

Public ADR Issues, 1990-2008

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

35

Privatizations Impact on
Stock Market Development

A government executing a share issue

privatization (SIP) sells all or part of its
ownership in a state-owned enterprise to
private investors via a public share offering.

27 of the 30 largest share offerings in history

were SIPs.

Positive long-run excess returns to investors

who purchase SIPs

Government allocates shares mainly to

employees and other small domestic
investors.

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

36

Table 16.7 Some of the Worlds

Largest Public Share Offerings

2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.