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Chapter 23
Investment Banks, Security
Brokers and Dealers,
and Venture Capital Firms
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We examine the role played by investment banks
(primary market), securities dealers and brokers
(secondary market), and venture capital firm (pre-
market).
Topics include:
◦ Investment Banks
◦ Security Brokers and Dealers
◦ Private Equity Investments
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Investment Banks
Investment banks are intermediaries that help
corporations raise funds.
Investment banks perform a variety of crucial
functions in financial markets
◦ Underwrite the initial sale of stocks and bonds
◦ Deal maker in mergers and acquisitions
◦ Middleman in the purchase and sale of companies
◦ Private broker to the very wealthy
They earn their income from fees charged to
clients.
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Underwriting Stocks and Bonds
The process of underwriting a stock or a bond
issue requires that the investment banker
purchase the entire offering at a predetermined
price and then resell the offering (securities) in
the market. The services provided during this
process include:
◦ Giving Advice
◦ Filing Documents
◦ Underwriting,
Best Efforts or Private Placement
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Underwriting Stocks and Bonds
Giving advice
◦ Explaining current market conditions in to help
determine what type of security (equity, debt,
etc.) to offer
◦ Assisting in determining when to issue, how many,
at what price (more important with IPO (initial
public offering)s than SEO (seasoned equity
offering) s)
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Underwriting Stocks and Bonds
Filing Documents
◦ SEC registration (filing) is required for issues greater
than $1.5 million and with a maturity greater than
270 days.
◦ A portion of the registration statement known as the
prospectus is made available to the public.
◦ Debt issues require several additional steps, such as
acquiring a credit rating, etc.
◦ For equity issues, the investment banker may also
arrange for the securities to appear on one of
the exchanges.
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Underwriting Stocks and Bonds
Underwriting (firm commitment)
◦ The investment banker purchases the entire offering
at a fixed price and then resells the offering to the
market (at a higher price).
◦ By underwriting, the investment bank is certifying
the quality of the issue to the public.
◦ An underwriter may form an underwriting syndicate
to diffuse part of the underwriting risk.
A syndicate is a group of investment banking firms,
each of which buys a portion of the security issue.
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Underwriting Stocks and Bonds
Investment banks advertise upcoming security
offerings with ads called tombstones in the Wall
Street Journal.
The longer the investment banker holds the
securities before reselling them to the public, the
greater the risk that a negative price change will
cause losses.
◦ Solicit offers to buy the securities from investors
prior to the date the investment bankers actually take
ownership.
◦ Then, when the securities are available, the orders
are filled and the securities are quickly transferred to
the final buyers. 23-8
Underwriting Stocks and Bonds
Most investment bankers are attached to brokerage
houses with nationwide sales offices.
Each of these offices will be contacted prior to the
issue date and the sales agents will contact their
customers.
The goal of underwriting is for all of the shares in
an offering to be spoken for.
◦ Fully subscribed: all shares are spoken for
◦ Undersubscribed: underwriting syndicate unable to
generate interest in all of the available shares
◦ Oversubscribed: interest in more shares than are
available
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Underwriting Stocks and Bonds
Best Efforts: An alternative to a firm commitment, the
underwriter does not buy the issue, but rather makes
its “best effort” to sell the entire issue.
◦ The investment banker sells the securities on a commission
basis with no guarantee regarding the price the issuing firm
will receive.
◦ Investment banker markets the security at the price the
customer asks.
Private Placements: The entire issue is sold to a small,
select group of investors.
◦ Investment bankers facilitate the transaction by advising the
issuing firm on the terms for the issue and identifying
potential purchasers.
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Underwriting Stocks and Bonds
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Underwriting Stocks and Bonds
Equity Sales: when a firm sells an entire division (or
maybe the entire company), enlisting the aid of an
investment banker.
◦ Assists in determining the value of the division or firm and
find potential buyers
◦ Develop confidential financial statements for the division
for prospective buyer (confidential memorandum)
◦ Prepare a letter of intent
Issued by the prospective buyer
Signals a desire to go forward with a purchase and
outlines preliminary terms
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Underwriting Stocks and Bonds
o When the letter of intent is accepted by the seller, the
due diligence period begins
o This 20-40 day period is used by the buyer to verify
the accuracy of the information in the confidential
memorandum.
o Then the definitive agreement is signed.
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Mergers and Acquisitions
Investment bankers may assist both acquiring
firms and potential targets (although not both in
the same deal).
Deal may be a hostile takeover, where the target
does not wish to be acquired.
Investment bankers will assist in all areas,
including deal specifics, lining up financing, legal
issues, etc.
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Securities Brokers and Dealers
Security brokers and dealers conduct trading in
secondary markets.
Brokers are pure middlemen who acts as agents for
investors in the purchase or sale of securities.
◦ They match buyers with sellers
◦ They are paid brokerage commissions.
Dealers also link buyers and sellers but they buy
and sell securities at given prices.
◦ They hold inventories of securities
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Securities Brokers and Dealers
◦ They sell securities in the inventories at a slightly
higher price then they paid for
◦ The spread between the bid (the price they pay
for securities they buy for the inventory) and ask
price (the price they receive when they sell the
securities)
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Securities Brokers and Dealers
Securities brokers offer several types of services
called brokerage services:
◦ Securities orders
◦ Other services
◦ Full-Service Brokers versus Discount Brokers
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Securities Brokers and Dealers
Securities Orders: when you call a brokerage
house to buy or sell a security, you essentially
have three options:
◦ Market Order: buy or sell security at current price
◦ Limit Order: you specify the most you are willing to
pay (buy) or the least you are willing to accept (sell)
for a security
◦ Short Sales: sell a security you don’t own with the
intent of buying it back at a later date (hopefully at a
lower price)
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Securities Brokers and Dealers
◦ Stop loss order: similar to the limit order but it is for
stocks you already own.
It tells the broker to sell the stock when it reaches
a certain price
You try to minimize your loss.
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Securities Brokers and Dealers
Other Services
◦ Insurance against loss of actual security
documents
◦ Margin credit for purchasing equity with borrowed
funds
Loans advanced by the brokerage house to
help investors to buy securities
◦ Offer services and engage in activiites traditionally
conducted by commercial banks (e.g., the Merrill
Lynch cash management account)
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Securities Brokers and Dealers
Full Service Brokers: offer clients research and
investment advice, but usually charge a higher
commission on trades.
Discount Broker: provides facilities to buy/sell
securities but offers no advice.
◦ Lower transaction costs are charged.
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Securities Brokers and Dealers
Securities Dealers
◦ Hold inventories of securities on their
own account
◦ Provide liquidity to the market by standing ready
to buy or sell securities (this is the reason they
are also called market makers)
◦ Especially important for thinly traded securities
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Private Equity Investments
An alternative to investing via public securities is
private equity (PE) investments.
With PE investments a limited partnership raises funds
(PE) from a small number of high-wealth investors, to
invest in new companies, to buyout existing divisions,
etc.
Most common types of PE are venture funds and capital
buyouts.
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Venture Capital Firms
These firms provide funds for start-up companies
that need to get established
The money is generally raised by limited
partnerships
The expectation is high returns or the high risk.
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Venture Capitalists Reduce Asymmetric
Information
Managers of start-ups may have objectives that differ
significantly from profit maximization
As a result of these information asymmetries, external
financing becomes costly and difficult to obtain
Venture capitalists can reduce this information problem
in several ways
◦ Long-term motivation
◦ Sit on the board of directors
◦ Disburse funds in stages, based on required results
◦ Invest in several firms, diversifying some risk
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Structure of Venture Capital Firms
1. Most are limited partnerships
2. Source of capital includes wealthy individuals,
pension funds, and corporations
3. Investors must be willing to wait years before
withdrawing money
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Life of Venture Capital Deal
• Fundraising
• Limited partnership is formed and funds are
raised
• Venture capital firms have a portfolio target
amount they attempt to raise
• They typically find the funds from investors
such as pension funds, corporations and
wealthy individuals
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Life of Venture Capital Deal
• Investing
• Funds are invested in start-up companies
• Venture capitalists generally invest in a firm
before it has a real product-seed investing
• Or they may invest in a firm that is a little further
along its life cycle-early stage investing
• Or they may provide funds to help the company
grow to a critical mass to attract public financing-
later stage investing
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Life of Venture Capital Deal
• Exiting
• The venture firm exits the investment
• The goal of a venture capital investment is to help
nurture a firm until it can be funded with
alternative capital.
• Once an exit is made, the partners receive their
share of the profits and the fund is dissolved.
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Private Equity Buyouts
In this situation, a public company (or perhaps a
division) is taken private
The publicity trades shares of a company are
purchased by a limited partnership formed for
that purpose.
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Private Equity Buyouts
Why go private?
◦ Avoid SEC regulation
◦ Provides flexibility and ability to avoid public
scrutiny of earnings. Also helps attract top talent
no longer interested in the life of a public-
company CEO.
◦ Tax advantages, and high compensation for
partners.
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Private Equity Buyouts
Lifecycle of a Private Equity Buyout
◦ Investors pledge money (usually $1 million or
more) and intent to leave money in partnership
for 5+ years.
◦ Partners identify an opportunity, buy it, and then
manage its future (typically hire a CEO for day-
to-day operations).
◦ The company is then sold to the public via an
IPO.
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Private Equity Buyouts
Implications of the Ownership Structure
◦ High risk and high returns are involved
◦ As the market for underperforming firms becomes
more competitive, it will likely become more difficult
and costly to locate and buy firms that can be easily
turned around.
◦ Also, if private equity firms compete with each other
to purchase firms than prices will increase and it will
be much more challenging to continue achieving the
results private equity investors have come to expect.
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