Debt versus Equity Offerings
Students are often surprised that debt offerings outnumber equity offerings in number and dollar amounts. Perhaps it is because we are bombarded with daily Dow Jones updates in the financial press that stock seems to take preference over bonds. Table 15-6 however shows that for 2014 and 2013, debt offerings were more than three times equity offerings. In 2014 $6.325 trillion of debt was issued globally while $935 billion of equity was issued. There were 20,728 debt offerings and 5,464 equity offerings. But referring back to Table 15-3, you can see that investment banking revenue from debt and equity was almost equal, which magnifies the point that equity is more profitable to the investment banker because there is more risk involved in an equity IPO than in a debt IPO.
Table 15-6 Global debt and equity capital markets bookrunner rankings
Source: Dealogic, www.dealogic.com.
A problem a company faces when issuing additional securities is the actual or perceived dilution of earnings effect on shares currently outstanding. In the case of the Maxwell Corporation, the 250,000 new shares may represent a 10 percent increment to shares currently in existence. Perhaps the firm had earnings of $5 million on 2,500,000 shares before the offering, indicating earnings per share of $2. With 250,000 new shares to be issued, earnings per share will temporarily slip to $1.82 ($5,000,000 ÷ 2,750,000).
The proceeds from the sale of new shares may well be expected to provide the increased earnings necessary to bring earnings back to at least $2. While financial theory dictates that a new equity issue should not be undertaken if it diminishes the overall wealth of current stockholders, there may be a perceived time lag in the recovery of earnings per share as a result of the increased shares outstanding. For this reason, there may be a temporary weakness in a stock when an issue of additional shares is proposed. In most cases this is overcome with time.
Another problem may set in when the actual public distribution begins—namely, unanticipated weakness in the stock or bond market. Since the sales group normally has made a firm commitment to purchase stock at a given price for redistribution, it is essential that the price of the stock remain relatively strong. Syndicate members, committed to purchasing the stock at $20 or better, could be in trouble if the sale price falls to $19 or $18. The managing investment banker is generally responsible for stabilizing the offering during the distribution period and may accomplish this by repurchasing securities as the market price moves below the initial public offering price.
The period of market stabilization usually lasts two or three days after the initial offering, but it may extend up to 30 days for difficult-to-distribute securities. In a very poor market environment, stabilization may be virtually impossible to achieve. Consider Facebook’s initial public offering on Friday, May 18, 2012. The initial IPO price was set at $38 by the lead underwriter, Morgan Stanley. The offering was a big news event, and many small investors rushed into the stock in the first minutes of trading. The stock was extremely volatile on the first day of trading, but the stock price never fell below the offering price because Morgan Stanley was actively buying shares when the price hit $38.
Figure 15-3 shows that the price fell to $38 during the morning when Morgan Stanley apparently intervened. The price fell back to $38 later in the day as price support activities held the price above $38 at the close.
Figure 15-3 Facebook share price on the first day of trading
Facebook’s price quotes near the end of the first trading day show the magnitude of the price support. In Figure 15-4, notice that there is a bid for almost 10 million shares of Facebook stock at exactly $38 per share. This is almost certainly a bid by Morgan Stanley attempting to support the price at that level. To put the size of this support into perspective, it was not unusual for the bid size to be less than 5,000 shares in later transactions.
Figure 15-4 Facebook closing quotes on May 18, 2012
On Monday, May 21, the price support was removed and the price fell to $34. By September, the price had collapsed to a low of $17.55. Investors who understood that the underwriter was only temporarily supporting the price were probably able to avoid these early losses.
Manipulation of prices in security markets is normally illegal. Market stabilization or underwriter price support is a rare exception to the general market manipulation prohibition. Temporary market stabilization is accepted by the Securities and Exchange Commission as necessary for smoothly functioning new-issue markets.
The investment banker is also interested in how well the underwritten security behaves after the distribution period because the banker’s ultimate reputation rests on bringing strong securities to the market. This is particularly true of initial public offerings.
Exhaustive research shows that initial public offerings tend to perform well in the immediate aftermarket. Between 1980 and 2012 there were more than 7,700 initial public offerings in the United States. The average first-day return for these stocks was 18 percent. In many countries, the initial aftermarket returns are even higher. In China, initial aftermarket returns have averaged more than 160 percent. Studies covering over 22,000 non-U.S. IPOs from 38 other countries show initial returns that average more than40 percent. In fact, IPOs are underpriced in every country where stocks are publicly traded.
After the issuance, initial public offerings appear to lose their luster. Over the first three years of trading, excluding the first-day price jump, IPO returns are approximately 7 percent lower than those of similar firms. The typical IPO is a good deal for investors who purchase shares from the underwriter at the offering price, but after the first day of trading most companies underperform the market for several years.
The Securities and Exchange Commission also allows a filing process called shelf registration under SEC Rule 415. Shelf registration permits large companies, such as IBM or Citigroup, to file one comprehensive registration statement that outlines the firm’s financing plans for up to the next two years. Then, when market conditions seem appropriate, the firm can issue the securities without further SEC approval. Future issues are thought to be sitting on the shelf, waiting for the appropriate time to appear.
Shelf registration is at variance with the traditional requirement that security issuers file a detailed registration statement for SEC review and approval every time they plan a sale. Whether investors are deprived of important “current” information as a result of shelf registration is difficult to judge. While shelf registration was started on an experimental basis by the SEC in 1982, it has now become a permanent part of the underwriting process. Shelf registration has been most frequently used with debt issues, with relatively less utilization in the equity markets (corporations do not wish to announce equity dilution in advance).
Shelf registration has contributed to the concentrated nature of the investment banking business, previously discussed. The strong firms are acquiring more and more business and, in some cases, are less dependent on large syndications to handle debt issues. Only investment banking firms with a big capital base and substantial expertise are in a position to benefit from this registration process.
The Gramm–Leach–Bliley Act Repeals the Glass–Steagall Act The Glass–Steagall Act, passed after the great crash of 1929 and bank runs of the early 1930s, required U.S. banks to separate their commercial banking operations and investment banking operations into two different entities. Banks like J.P. Morgan were forced to sell off Morgan Stanley. Congress took this position because they thought the risk of the securities business impaired bank capital and put the banking system at risk of default. As global financial markets grew, it became clear that U.S. commercial and investment banks were at a competitive disadvantage against large European and Japanese banks, who were not hobbled by these restrictions. Foreign banks were universal banks and could offer traditional banking services as well as insurance, securities brokerage, and investment banking.
In 1999 the U.S. Congress passed the Gramm–Leach–Bliley Act, which repealed Depression-era laws that had separated banking, brokerage, insurance, and investment banking. Now banks may engage in all these activities. The Federal Reserve and the Treasury, however, still have the power to impose restrictions on the activities of banks. Recently the Fed and Treasury have been concerned that banks’ investments into risky venture capital companies may impair their capital. The Fed has effectively banned some banks from participating in this merchant banking activity unless they set aside reserves equal to 50 percent of their capital. This allows the strong banks to participate in the venture capital market but forces the weak ones to sit on the sidelines.
Economists (and politicians) currently argue over whether repeal of Glass–Steagall was a major cause of the banking crisis in 2008, but most agree that inadequate regulatory oversight was the main cause. The Dodd–Frank law enacted in 2010 included the Volcker Rule, named for a former Federal Reserve Chairman Paul Volcker. The rule is intended to restrict banks from making certain risky investments that the repeal of Glass–Steagall allowed. The Volcker Rule has been criticized as a watered-down version of the old Glass–Steagall restrictions.