Public and Private Placement
|LO 15-1||Investment bankers are intermediaries between corporations in need of funds and the investing public. They also provide important advice.|
|LO 15-2||Investment bankers, rather than corporations, normally take the risk of successfully distributing corporate securities and for this there are costs involved.|
|LO 15-3||Distribution of new securities may involve dilution in earnings per share.|
|LO 15-4||Corporations turn to investment bankers when making the critical decision about whether to go public (distribute their securities in the public markets) or stay private.|
|LO 15-5||Leveraged buyouts rely heavily on debt in the restructuring of a corporation.|
In 2014 the IPO (initial public offering) market made a comeback. Alibaba, a Chinese Internet company, set a new record with a $25 billion offering, and other companies you may recognize, like Spotify, Dropbox, and J. Crew, also had initial public offerings of their common stock. Two hundred seventy-five companies came to market in 2014, the most since 2000. They raised a total of $85 billion, with Alibaba accounting for 29 percent of that amount. Table 15-1 lists the 10 largest equity IPOs of 2014.
Table 15-1 Top equity IPOs in 2014
Source: Dealogic, www.dealogic.com.
In 2012 Facebook was the IPO poster child and on its way to over a billion users when it went public. The issue price of $38 per share valued the company at $104 billion, the largest valuation ever for a newly listed public company. The company’s share of the proceeds was $16 billion, and the rest went to existing shareholders. Facebook’s initial public offering (IPO) was one of 94 that occurred in 2012, but this followed the worst environment in modern times for companies wishing to go public. As a worldwide financial crisis took hold in 2008, companies were forced to shelve plans for raising new capital through IPOs. By one count, only 21 companies went public in 2008. Even the revived IPO market of 2012 looks weak when compared to the hot IPO market of the 1990s. Between 1993 and 1999, on average more than 460 companies went public every year. In particular, during the late 1990s investors seemed to go wild over companies that had anything to do with the Internet. It seemed that if a company ended its name with “.com” or was connected to the Internet because of its business model, it could easily raise capital without having any cash flow or earnings. Investors were willing to pay high prices for stocks based on expectations that one day the companies would make large profits. Sometimes things worked out well.
Amazon.com, the Internet book company, became a public company in 1998, as did eBay, the Internet auction company. Actually, eBay was one of those rare Internet companies that made money, and the demand for shares of its initial public offering was 10 times greater than the shares available for sale. Goldman Sachs, its managing investment banker, priced the shares at $18 per share for the 3.5 million shares available for sale on the day of the offering. The opening price for eBay common stock was $53.50 per share. It never traded at its anticipated offering price of $18.
Amazon and eBay are examples of two winners. Amazon’s stock price soared to new highs and split (2:1) three times, so an initial investor would have multiple shares for each share purchased. When Amazon peaked out at $113 in late 1999, an original investor had earned a 7,533 percent return in less than two years. Then, as the Internet stock bubble collapsed, the price of Amazon’s stock fell by more than 95 percent to $5.50 per share in late 2001. By July 2015, Amazon’s stock traded for over $435.00. It had recovered all of the earlier decline almost four times over.
eBay was another highly successful Internet business, and because of stock splits an original investor would have 24 shares of eBay today for each original share purchased. After accounting for splits, the stock traded as high as $765 per original share ($18) by March 2000. Then the stock’s price fell by 79 percent before the end of that year. However, eBay continued to be a successful business, and its price eventually recovered to rise to new highs. Both Amazon and eBay had business strategies that worked. Although they were overpriced in 1999, their business met real market needs, and the companies continued to grow. Eventually their stock prices recovered. In contrast, many other Internet-based “new economy” companies failed or were acquired at low prices by other firms.
Sometimes investors think that all they have to do is buy IPOs and they will get rich. Unfortunately it doesn’t always work out that way. Many companies that went public during the Internet bubble of the late 1990s and 2000 crashed and burned, losing investors their total investment. So while we marvel at the success of companies like Alibaba, we never seem to hear about the failures of 2014 such as MOL Global, Sysorex Global Holdings, Viggle, or Eclipse Resources, companies that all lost close to 80 percent of their issue price within 12 months of their public offerings. So did the investment banker misprice these issues, or did their projections turn out to be wrong? What does an investment banker actually do for a company in an initial public offering? Keep reading.
The Role of Investment Banking
The investment banker is the link between the corporation in need of funds and the investor. As a middleman, the investment banker is responsible for designing a security offering and selling the securities to the public. The investment banking fraternity has long been thought of as an elite group—with appropriate memberships in the country club, the yacht club, and other such venerable institutions. However, several changes have occurred in the investment banking industry over the last decade.
Investment Banking Competition Competition has become the new way of doing business, in which the fittest survive and prosper, while others drop out of the game. Raising capital has become an international proposition, and firms need to be very large to compete. This concentration of capital allows large firms to take additional risks and satisfy the needs of an increasingly hungry capital market. There have been international consolidations under way for some time, with foreign banks buying U.S. firms and U.S. banks buying foreign firms. The high level of global concentration is shown in Table 15-2 with the top 10 global investment bankers listed by revenue generated. The top 10 investment bankers accounted for 51.9 percent of the total revenue generated.
Table 15-2 Global ranking of investment bankers, 2014
Source: Dealogic, www.dealogic.com.
Enumeration of Functions
As a middleman in the distribution of securities, the investment banker has a number of key roles. These functions are described next.
Underwriter In most cases, the investment banker is a risk taker. The investment banker will contract to buy securities from the corporation and resell them to other security dealers and the public. By giving a “firm commitment” to purchase the securities from the corporation, the investment banker is said to underwrite any risks that might be associated with a new issue. While the risk may be fairly low in handling a bond offering for ExxonMobil or General Electric in a stable market, such may not be the case in selling the shares of a lesser-known firm in a volatile market environment.
Though most large, well-established investment bankers would not consider managing a public offering without assuming the risk of distribution, smaller investment houses may handle distributions for relatively unknown corporations on a “best-efforts,” or commission, basis. Some issuing companies even choose to sell their own securities directly. Both the “best-efforts” and “direct” methods account for a relatively small portion of total offerings.
Market Maker During distribution and for a limited time afterward, the investment banker may make a market in a given security—that is, engage in the buying and selling of the security to ensure a liquid market. The investment banker may also provide research on the firm to encourage active investor interest.
Advisor The investment banker may advise clients on a continuing basis about the types of securities to be sold, the number of shares or units for distribution, and the timing of the sale. A company considering a stock issuance to the public may be persuaded, in counsel with an investment banker, to borrow the funds from an insurance company or, if stock is to be sold, to wait for two more quarters of earnings before going to the market. The investment banker also provides important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring.
Agency Functions The investment banker may act as an agent for a corporation that wishes to place its securities privately with an insurance company, a pension fund, or a wealthy individual. In this instance, the investment banker will shop around among potential investors and negotiate the best possible deal for the corporation.
Table 15-3 illustrates the revenue generated for each product serviced by investment bankers. So we can see that the revenues generated by the equity markets, the debt markets, and the merger and acquisition markets for 2014 were all in the $21 billion range and that syndicated lending accounted for more than $17 billion. Each category has a subheading with the respective amounts listed. We can see that follow-on offerings in the secondary equity markets generated more revenue than equity IPOs. Under the debt heading, investment-grade bonds generated more revenue than high-yield bonds, but notice that high-yield bonds (junk bonds) are quite a significant slice of the debt pie. Investment bankers love to advise on mergers and acquisitions because they are profitable and don’t entail as much risk as initial public offerings. An interesting fact is that even though the investment banking markets are global, three U.S. firms dominate the revenue generated, with Morgan Stanley leading in three categories, Goldman Sachs in one, and JPMorgan in six.