principal or managing investment banker
The actual distribution process requires the active participation of a number of parties. The principal or managing investment banker, often referred to as the bookrunner, will call on other investment banking houses to share the burden of risk and to aid in the distribution. To this end, they will form an underwriting syndicate comprising as few as 2 or as many as 100 investment banking houses. In Figure 15-1 we see a typical case in which a hypothetical firm, the Maxwell Corporation, wishes to issue 250,000 additional shares of stock with Bank of America Merrill Lynch as the managing underwriter and an underwriting syndicate of 15 firms.
Figure 15-1 Distribution process in investment banking
The underwriting syndicate will purchase shares from the Maxwell Corporation and distribute them through the channels of distribution. Syndicate members will act as wholesalers in distributing the shares to brokers and dealers who will eventually sell the shares to the public. Large investment banking houses may be vertically integrated, acting as underwriter-dealer-brokers and capturing all fees and commissions.
The Spread The underwriting spread represents the total compensation for those who participate in the distribution process. If the public or retail price is $21.50 and the managing investment banker pays a price of $20.00 to the issuing company, we say there is a total spread of $1.50. The $1.50 may be divided among the participants, as indicated in Figure 15-2.
Figure 15-2 Allocation of underwriting spread
Note that the lower a party falls in the distribution process, the higher the price for shares. The managing investment banker pays $20, while dealers pay $20.75. Also, the farther down the line the securities are resold, the higher is the potential profit. If the managing investment banker resells to dealers, he makes 75 cents per share; if he resells to the public, he makes $1.50.
The total spread of $1.50 in the present case represents approximately 7 percent of the offering price ($1.50/$21.50). Generally, the larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price. Percentage figures on underwriting spreads for U.S. corporations are presented in Table 15-4. This table illustrates that the smaller the issue, the higher the fees percentagewise, and also that equity capital is more expensive than debt capital. The higher equity spreads reflect the fact that there is more uncertainty with common stock than for other types of capital.
Since the Maxwell Corporation stock issue is for $5.375 million (250,000 shares × $21.50), the 7 percent spread is in line with SEC figures in Table 15-4. It should be noted that the issuer bears not only the “give-up” expense of the spread in the underwriting process but also out-of-pocket costs related to legal and accounting fees, printing expenses, exchange listing fees, and so forth. As indicated in Table 15-5, when the spread plus the out-of-pocket costs are considered, the total cost of a small issue is high but decreases as the issue size increases. Of course substantial benefits may still be received.
Table 15-4 Underwriting compensation as a percentage of proceeds
|Size of Issue ($ millions)||Common Stock||Debt|
|50.0 and over||2.3||0.8|
Source: Securities and Exchange Commission data.
Table 15-5 Total costs to issue stock (percentage of total proceeds)
*Out-of-pocket cost of debts is approximately the same.
Source: Securities and Exchange Commission data.
Pricing the Security
Because the syndicate members purchase the stock for redistribution in the marketing channels, they must be careful about the pricing of the stock. When a stock is sold to the public for the first time (i.e., the firm is going public), the managing investment banker will do an in-depth analysis of the company to determine its value. The study will include an analysis of the firm’s industry, financial characteristics, and anticipated earnings and dividend-paying capability. Based on valuation techniques that the underwriter deems to be appropriate, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry’s average price-earnings ratio is 20, the firm is likely to be priced near this norm. Anticipated public demand will also be a major factor in pricing a new issue.
Finance in ACTION Managerial Warren Buffett’s Bailout of Goldman Sachs
At the peak of the recent financial crisis, Goldman Sachs turned to Warren Buffett’s Berkshire Hathaway Inc. to bail it out of trouble. After Bear Stearns and Lehman Brothers collapsed at the start of the global financial crisis, Goldman Sachs found itself short of capital. Fortunately, Warren Buffett stood ready with billions to invest. Warren Buffett’s Berkshire Hathaway bought $5 billion of Goldman Sachs Series G preferred stock yielding a 10 percent guaranteed annual return. Along with the preferred stock came warrants to buy an additional $5 billion of common stock, or more precisely, 43.5 million shares of Goldman Sachs at $115 per share.
Before Buffett closed the deal on September 23, 2008, Goldman Sachs (ticker symbol GS) traded for $113. After the announcement the stock rose to $129.95 and closed on the day at $125.05. Just by investing $5 billion, the value of Buffett’s warrants rose by $10 per share, or $435 million. Buffett’s investment didn’t end Goldman’s troubles completely. Over the next two months, financial markets kept getting worse, and Goldman Sachs stock fell as low as $54.54 per share. As the financial crisis bottomed out and the government stabilized the markets, bank and investment bank stock prices increased. The Goldman Sachs stock price hit a high of $193.60 towards the end of 2009, and by June of 2013, it traded at $165 per share.
Berkshire Hathaway had until October 1, 2013, to purchase the 43.5 million shares. By March of 2013, it was clear to Goldman Sachs that the company didn’t need another $5 billion from Buffett through the exercise of the 43.5 million shares of stock, so instead they agreed to a swap. Goldman would subtract the $115 strike price from the average market price 10 days prior to October 1 and give Buffett the value in shares. This was advantageous for Buffett because he didn’t have to come up with $5 billion in cash, and instead he received 13.06 million shares or 2.8 percent ownership in Goldman Sachs. As of July 2015 those shares were worth approximately $2.7 billion, not a bad return on top of a 10 percent annual dividend payment of $500 million over five years.
The great majority of the issues handled by investment bankers are, however, additional issues of stocks or bonds for companies already trading publicly. When additional shares are to be issued, the investment bankers will generally set the price at slightly below the current market value. This process, known as underpricing, will help ensure a receptive market for the securities.
At times, an investment banker also will underwrite the sale of large blocks of stock for existing stockholders, rather than for the company. When holders of these blocks wish to sell too many shares for normal channels to handle, the investment banker will manage the sale and underprice the stock below current market prices. This process is known as a secondary offering. Secondary offerings occur after an IPO, also known as a primary offering, in which securities are sold to the public for the first time. Secondary offerings often combine shareholder blocks with additional shares being issued directly by the company. Table 15-3 refers to secondary offerings in the category “Follow-on.”
A secondary offering can also occur without shareholder blocks being included. Three of the largest equity offerings ever were secondary offerings that occurred in December 2009. Several banking giants (Citigroup, Bank of America, and Wells Fargo) raised over $52 billion in new capital to pay back the U.S. government for bailout funding received the previous year. These banks wished to avoid restrictions on their activities that the government had imposed until repayments were made.