Financial Markets and Institutions (2-downloads)

fully subscribe the issue. A fully subscribed issue is one where all of the securi-

ties available for sale have been spoken for before the issue date. Security issues may

also be undersubscribed. In this case, the sales agents have been unable to gen-

erate sufficient interest in the security among their customers to sell all of the secu-

rities by the issue date. An issue may also be oversubscribed, in which case there

are more offers to buy than there are securities available.

It is tempting to assume that the best alternative is for an issue to be oversub-

scribed, but in fact this will alienate the investment banker’s customers. Suppose you

were issuing a security for the first time and had negotiated with your investment

banker to sell the issue of 500,000 shares of stock at $20. Now you find out that the

issue is oversubscribed. You would feel that the investment banker had set the price

too low and that you had lost money as a result. Maybe the stock could have sold

for $25 and you could have collected an extra $2.5 million [($25 – $20) 

⫻ 500,000

= $2,500,000]. You, as well as other issuing firms, would be unlikely to use this invest-

ment banker in the future.

It is equally serious for an issue to be undersubscribed, since it may be nec-

essary to lower the price below what the investment bankers paid to the issuer

in order to sell all of the securities to the public. The investment banking firm

stands to lose extremely large amounts of money because of the volume of secu-

rities involved. For example, review the tombstone shown in the Following the

Financial News box once more. There are over 24 million shares being offered

for sale. If the price must be lowered by even $.25 per share, over $6,000,000 would

be lost. The high risk taken by investment bankers explains why they tend to be

the most elite and highest-paid professionals on Wall Street, many earning millions

of dollars per year.

Best Efforts

An alternative to underwriting a securities offering is to offer the secu-

rities under a best efforts agreement. In a best efforts agreement, the investment

banker sells the securities on a commission basis with no guarantee regarding the

price the issuing firm will receive. The advantage to the investment banker of a best

efforts transaction is that there is no risk of mispricing the security. There is also

no need for the time-consuming task of establishing the market value of the secu-

rity. The investment banker simply markets the security at the price the customer

asks. If the security fails to sell, the offering can be canceled.

Private Placements

An alternative method of selling securities is called the private

placement. In a private placement, securities are sold to a limited number of investors

rather than to the public as a whole. The advantage of the private placement is that

the security does not need to be registered with the SEC as long as certain restric-

tive requirements are satisfied. Investment bankers are also often involved in pri-

vate placement transactions. While investment bankers are not required for a private

---

550

Part 6 The Financial Institutions Industry

placement, they often facilitate the transaction by advising the issuing firm on the

appropriate terms for the issue and by identifying potential purchasers.

The buyers of private placements must be large enough to purchase large

amounts of securities at one time. This means that the usual buyers are insurance

companies, commercial banks, pension funds, and mutual funds. Private placements

are more common for the sale of bonds than for stocks. Goldman Sachs is the most

active investment banking firm in the private placement market.

The process of taking a security public is summarized in Figure 22.1.

Equity Sales

Another service offered by investment banks is to help with the sale of companies

or corporate divisions. For example, in 1984, Mattel was dangerously close to hav-

ing its bank loans called when its electronics subsidiary incurred significant losses.

Mattel enlisted the help of the investment banking firm Drexel Burnham Lambert.

The first step in the firm’s restructuring was to sell off all of its nontoy businesses.

Mattel returned to health until it again ran into problems in 1999 due to the acqui-

sition of a software company. In 2000, Mattel again used the services of investment

bankers to sell this subsidiary.

The first step in any equity sale will be the seller’s determination of the business’s

worth. The investment banker will provide a detailed analysis of the current mar-

ket for similar companies and apply various sophisticated models to establish com-

pany value. Unlike a box of detergent or bar of candy, a going concern has no set

price. The company value is based on the use the buyer intends to make of it. If a

buyer is only interested in the physical assets, the firm will be worth one amount.

A buyer who sees the firm as an opportunity to take advantage of synergies between

SEC approval is received; finalized 

prospectus is distributed

Prospectus is distributed to brokerage 

network; preissue sales are solicited

Firm prepares prospectus with 

IB help

Investment bankers (IB) and firm agree 

on type and price of security

Firm decides to issue 

new securities

Funds

to

issuing

firm

SEC reviews 

prospectus

Securities are bought by IB and 

resold to public

F I G U R E   2 2 . 1

Using Investment Bankers to Distribute Securities to the Public

---

Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

551

this firm and another will have a very different price. Despite the elasticity of the

yardstick, investment bankers have developed a number of tools to give business own-

ers a range of values for their firms.

How much cash flows will have to be discounted depends very much on who

will be bidding on the firm. Again, investment bankers help. They may make dis-

creet inquiries to feel out who in the market may be interested. Additionally, they will

prepare a confidential memorandum that presents the detailed financial infor-

mation required by prospective buyers to make an offer for the company. All prospec-

tive buyers must sign a confidentiality agreement stipulating that they will not use

the information to compete or share it with third parties. The investment bank will

screen prospects to ensure that the information goes only to qualified buyers.

The next step in an equity sale will be the letter of intent issued by a prospec-

tive buyer. This document signals a desire to go forward with a purchase and outlines

preliminary terms. The investment banker will negotiate the terms of the sale on

the seller’s behalf and will help to analyze and rank competing offers. The investment

banker may even help structure financing in order to obtain a better offer.

Once the letter of intent has been accepted by the seller, the due diligence

period begins. This 20- to 40-day period is used by the buyer to verify the accuracy

of the information contained in the confidential memorandum. The findings shape

the terms of the definitive agreement. This agreement converts information gath-

ered during the due diligence period and the results of subsequent negotiations into

a legally binding contract.

As this discussion demonstrates, a wide variety of skills are required to move a

typical corporate sale forward. To meet these needs, investment banks often send

in multidisciplined teams of experts to work with clients on their projects. These

teams include attorneys, financial analysts, accountants, and industry experts.

Mergers and Acquisitions

Investment banks have been active in the mergers and acquisitions market since

the 1960s. A merger occurs when two firms combine to form one new company. Both

firms support the merger, and corporate officers are usually selected so that both

companies contribute to the new management team. Stockholders turn in their stock

for stock in the new firm. In an acquisition, one firm acquires ownership of another

by buying its stock. Often this process is friendly, and the firms agree that certain

economies can be captured by combining resources. It is not unusual that a firm

suffering financial stress will even seek out a company to acquire them. At other

times, the firm being purchased may resist. Resisted takeovers are called hostile.

In these cases, the acquirer attempts to purchase sufficient shares of the target firm

to gain a majority of the seats on the board of directors. Board members are then able

to vote to merge the target firm with the acquiring firm.

Investment bankers serve both acquirers and target firms. Acquiring firms require

help in locating attractive firms to pursue, soliciting shareholders to sell their shares

in a process called a tender offer, and raising the required capital to complete the

transaction. Target firms may hire investment bankers to help ward off undesired

takeover attempts.

The mergers and acquisitions markets require very specialized knowledge and

expertise. Investment bankers involved in this market are highly trained (and, not

incidentally, highly paid). The best known investment banker involved in mergers and

acquisitions was Michael R. Milken, who worked at Drexel Burnham Lambert, Inc.

---

552

Part 6 The Financial Institutions Industry

Milken is credited with inventing the junk bond market, which we discussed in

Chapter 12. Junk bonds are high-risk, high-return debt securities that were used pri-

marily to finance takeover attempts. By allowing companies to raise large amounts of

capital, even small firms could pursue and take over large ones. During the 1980s,

when Milken was most active in this market, merger and acquisition activity peaked.

On February 13, 1990, Drexel Burnham Lambert filed for bankruptcy due to rising

default rates on its portfolio of junk bonds, a slow economy, and regulations that

forced the savings and loan industry out of the junk bond market. Milken pled guilty

to securities fraud and was sent to prison.

As a result of the collapse of Drexel and the junk bond market, merger and acqui-

sitions activity slowed during the early 1990s. A healthy economy and regulatory

changes caused a resurgence, especially among commercial banks, in the mid and late

1990s. Mergers and acquisitions again slowed during the recessions in 2001 and 2008.

Many of the most well-known investment companies encountered significant

financial difficulty during the mortgage and credit crisis in 2008 and 2009. There were

several primary causes of their problems. First, some of the investment companies had

purchased and held for their own portfolio bonds securitized by subprime mortgages.

As the market realized that the quality of these securities did not support their price,

the investment companies found that they could not sell them. Second, when the

credit markets essentially froze, some investment companies ran into liquidity prob-

lems. They had maturing securities that they had to fund, but no source of new funds.

Bear Stearns was acquired by J.P. Morgan in April of 2008 with $29 billion in fed-

eral assistance. In September Bank of America acquired Merrill Lynch in a deal that

led to significant losses to Bank of America in subsequent months. At the same time,

Lehman Brothers was the first major investment company to declare bankruptcy. Many

of its assets were later acquired by Barclays. Had it not been for aggressive govern-

ment intervention, it is clear that many more investment firms would have collapsed.

Securities Brokers and Dealers

Securities brokers and dealers conduct trading in secondary markets. Brokers are

pure middlemen who act as agents for investors in the purchase or sale of securi-

ties. Their function is to match buyers with sellers, a function for which they are paid

brokerage commissions.

In contrast to brokers, dealers link buyers and sellers by standing ready to buy

and sell securities at given prices. Therefore, dealers hold inventories of securities

and make their living by selling these securities for a slightly higher price than they

paid for them—that is, on the spread between the bid price, the price that the

broker pays for securities they buy for their inventory, and the ask price, the price

they receive when they sell the securities. This is a high-risk business because deal-

ers hold securities that can rise or fall in price; in recent years, several firms spe-

cializing in bonds have collapsed. Brokers, by contrast, are not as exposed to risk

because they do not own the securities involved in their business dealings.

1

1

It is easy to remember the distinction between dealers and brokers if you relate to auto dealers and

real estate brokers. Auto dealers take ownership of the cars and resell them to the public. Real estate