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Investment Banks. Economics 71a Spring 2007 Mayo, Chapter 2 Lecture notes 2.2. Outline. What is an investment bank? Role in financial markets Investment banks and new securities IPO mechanics. What is an Investment Bank?. Not a bank! Help firms sell securities to public Stocks/Equity

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investment banks

Investment Banks

Economics 71a

Spring 2007

Mayo, Chapter 2

Lecture notes 2.2

outline
Outline
  • What is an investment bank?
  • Role in financial markets
  • Investment banks and new securities
    • IPO mechanics
what is an investment bank
What is an Investment Bank?
  • Not a bank!
  • Help firms sell securities to public
    • Stocks/Equity
    • Bonds/Debt
  • Transfers funds from public to firms
    • Savings -> Investments
  • Example: Goldman/Sachs
initial public offering ipo
Initial Public Offering (IPO)
  • First sale of stock by firm
  • Originating investment bank
    • Key player in bringing the shares to market
    • “Originating house”
    • Handles most administrative details
    • Reputation
underwriting
Underwriting
  • A form of price guarantee
  • Agree to purchase shares from firm for a given amount
  • Then sell to the public
  • Example:
    • Purchase stock from Yahoo ($10/share)
    • Sell on the market ($11/share)
risk of underwriting
Risk of Underwriting
  • Market may not be willing to pay the price paid by investment bank ($10)
  • It would lose money
  • Investment banks often spread this risk over several investment banks
    • “Underwriting Syndicate”
  • Also, try to reach more sellers
    • “Selling group”
ipo scandals
IPO Scandals
  • Most involve investment banks giving special deals to some favored customers (low prices)
best efforts agreement
Best Efforts Agreement
  • Risk shifted to issuing firm
  • It receives whatever price the market pays
  • No underwriting function by investment bank
ipo timing
IPO Timing
  • Private firm
    • Negotiations between shareholders and other initial investors (Venture Capital)
    • Find investment bank to handle IPO
  • Prospectus filed with Securities and Exchange Commission
    • “Registration”
  • Red Herring : Version of prospectus for initial investors
  • Quiet period: filing to 1 month after IPO
    • Restrictions on public information releases
ipo pricing
IPO Pricing
  • How does the initial price get set by investment banks?
  • Difficult problem
  • Set price too high
    • Can’t sell stock at this price
    • Lose money now, or wait and see
  • Set price too low (more common)
    • Bad for issuing firm
    • Raises lower money than it could have
    • Investment bank looks bad (reputation)
dutch auction ipo s another price mechanism
Dutch Auction IPO’s:Another Price Mechanism
  • The “Dutch auction” is another mechanism for an IPO
  • Not many do this
  • Most famous: Google, August 2004
dutch auction
Dutch Auction
  • Seller announces total shares to be auctioned (Qshares)
  • Potential buyers submit bids for
    • (Shares, Price)
  • Auction moves price down until
    • Shares demanded above this price = Qshares
dutch auction example
Dutch Auction Example
  • Qhares = 10
  • Bids
    • 2 at $10
    • 1 at $9
    • 3 at $8
    • 4 at $7
    • 2 at $6
    • 4 at $5
  • Sell 10 to first 4 bidders at price = $7
dutch auction picture
Dutch Auction Picture

Price

IPO

Price

Demand

Shares

Offered

Q

dutch auction analysis
Dutch Auction Analysis
  • Benefits
    • More transparent
    • No need to guess price
      • Price is uncertain though
  • Why isn’t it used more often?
    • Google price increases
      • Did they get a high enough price?
    • Confusing mechanism
      • Not well designed
      • Qshares not specified
      • Many investment banks
    • Patent (Hambrecht)
    • Most firms not big enough to dictate these terms
later stock offerings
Later Stock Offerings
  • “Seasoned equity”
  • Stock issued after IPO
  • Registered with SEC
  • Sold at current market prices
  • Firm often stores these shares
    • “Shelf registration”
  • Google again: How to estimate shelf shares from web (public float and shares outstanding)
private placements
Private Placements
  • Shares sold to private investment groups
    • Venture capital firms
    • Private equity hedge funds
  • Usually, smaller, younger, riskier firms
regulation
Regulation
  • Securities and Exchange Commission
    • Set up in the early 1930’s to oversee securities markets
    • Oversees publicly traded firms
    • Public investment companies (mutual funds)
sec information and regulation
SEC: Information and Regulation
  • Require timely release of information to public
  • 10-K report: Annual information on firm
  • Firms required to report major information events to public
insider trading
Insider Trading
  • Trading on private information
  • Illegal (why?)
  • Who’s an insider?
    • Employees
    • Associated
      • Lawyers
      • Investment bankers
  • Enforcement
    • Trade reporting
securities investor protection corporation sipc
Securities Investor Protection Corporation (SIPC)
  • Insures investors against failure in brokerage firms
  • Not insurance against price drops
  • Limited amounts
    • $500,000 total
    • $100,000 cash balances
sarbanes oxley 2002
Sarbanes-Oxley (2002)
  • Scandals of the 1990’s
    • Accounting information shaky and deceptive (Enron, Worldcom,..)
  • Government response
  • Protect investors from fraud
sarbanes oxley
Sarbanes-Oxley
  • Basic provisions
    • Creates Public Company Accounting Oversight Board
    • Strengthen the independence of auditors (accountants)
    • Firm directors take responsibility for numbers
conflict of interest problems
Conflict of Interest Problems
  • Many investment banks have brokerage sides
  • They will recommend stocks to investors: Analyst recommendations
  • What if same firm is doing IPO and writing recommendations?
  • There is supposed to be a “firewall”
reponses to sarbanes oxley
Reponses to Sarbanes/Oxley
  • Board insurance
  • Privatization
  • Moving off shore
  • Still very much untested and controversial