Lecture 12

Investment Banks, Security Brokers

and Dealers, & VC Firms

Mingzhu Wang
International Summer Semester 2016
Sungkyunkwan University
 Agenda

• Investment Banks
• Security Brokers and Dealers
• Regulation of Securities Firms
• Relationship Between Securities Firms and
Commercial Banks
• Private Equity Investments
• Private Equity Buyouts
 Investment Banks

• Investment banks perform a variety of

crucial functions in financial markets
─Underwrite the initial sale of stocks and bonds
─Deal maker in mergers, acquisitions, and
spin-offs
─Middleman in the purchase and sale of
companies
─Private broker to the very wealthy
 Investment Banks

• Investment banks were essentially created

in the U.S. by the passage of the Glass-
Steagall Act. Prior to this, investment
banking activities were part of large,
money-center commercial banks.
• The lines between investment banks and
commercial banks again begins to blur as
legal separation between investment banks
and commercial banks is no longer
required.
 Investment Banks

Investment banks play many roles in both the

primary and secondary markets. We will
focus on their role in three areas:
•Underwriting Stocks and Bonds
•Equity Sales
•Mergers and Acquisitions
But first, let’s look at the largest U.S.
underwriters.
 Top Underwriters
Top 10 U.S. Underwriters of Global Debt and Equity Issues, 2013
 Underwriting Stocks and Bonds

• The investment banker purchases 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
 Underwriting Stocks and Bonds

• Giving advice
─Explaining current market conditions in to help
determine why type of security (equity, debt,
etc.) to offer
─Assisting in determining when to issue, how
many, at what price (more important with IPOs
than SEOs)
 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,
including acquiring a credit rating, hire a bond
counsel, etc.
─For equity issues, the investment banker may
also arrange for the securities to appear on one
of the exchanges.
 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.
─An underwriter may form an underwriting
syndicate to diffuse part of the underwriting
risk.
─Placement of a tombstone in the financial
press.
 Underwriting Stocks and Bonds

• The goal of underwriting is for all of the

shares in an offering to be spoken for.
However, this may not occur.
─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 (may lead to rationing).
 Underwriting Stocks and Bonds
Using Investment Bankers to Distribute Securities to the Public
 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.

• Private Placements: The entire issue is

sold to a small, select group of investors.
This is rarely done with equity issues.
 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 to continue, assist
with due diligence, and help reach a
definitive agreement
 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.
 Securities Brokers and Dealers

Securities firms with brokerage services

offer several types of services:
• Brokerage Service
• Other services
• Full-Service Brokers versus Discount
Brokers
 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)
 Securities Brokers and Dealers

• Other Services
─Insurance against loss of actual security
documents
─Margin credit for purchasing equity with
borrowed funds
─Other services driven by market demand (e.g.,
the Merrill Lynch cash management account)
 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.
Many on-line discount brokerage firms do
have significant research available
 Securities Brokers and Dealers

• Securities Dealers
─Hold inventories of securities on their own
account
─Provide liquidity to the market by standing by
ready to buy or sell securities (market maker)
─Especially important for thinly traded securities
 MINI-CASE:
The Limit-Order Book

• The limit-order book for Circuit City might

look like this:

• No transactions will occur because buy and

sell orders do not cross.
 MINI-CASE:
The Limit-Order Book
• The specialist receives a 200-share market
order to buy. She then receives a 300-
share limit order to sell at 37.12. Finally, a
limit order to buy 500 shares at 36.88 is
received. The book will reflect these orders,
as follows:
 Regulation of Securities Firms

Two acts passed in 1933 and 1934 provide

the primary basis of today’s markets. The
major provisions include:
•Establishment of the SEC
•Registration requirement for new securities
•Reporting requirements for companies and
insiders
•Prohibition of market manipulation
 Relationship Between Securities
Firms and Commercial Banks

• Glass-Steagall stipulated that investment

banking and commercial banking would be
separated.
• G-L-B Act removed some of these barriers.
• Commercial banks are slowly gaining
regulatory permission to engage in the full
range of services offered by investment
banks.
 Private Equity Investments
• An alternative to investing via public
securities is private equity (PE)
investments. PE is a limited partnership
raises funds to invest in new companies, to
buyout existing divisions, etc.
• Most common types of PE are venture
funds and capital buyouts.
• PE got a boost in 1978 when pension funds
were permitted to invest in PE firms.
 Venture Capital Firms

• These firms provide funds for start-up

companies

• Often become very involved with firm

management and provide expertise
 Venture Capital Firms

• Description of Industry
─Typically limited partnerships
─Examples of venture-backed firms include
Apple Inc, Cisco Systems, Starbucks, etc.

• Next we see the level of venture

involvement in companies in 1990-2012.
 Venture Capital Investments
Venture Capital Investments Made from 1990–2012
 Venture Capitalists Reduce
Asymmetric Information
• Managers of start-ups may have objectives
that differ significantly from profit
maximization.
• 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
 Origins of Venture Capital

• First U.S. venture capital firm was

established in 1946.
• Most venture capital firms in the 1950s and
1960s funded development in oil and real
estate.
• Funding has shifted from wealthy
individuals to pension funds / corporations.
This is one of the few risky investments
pension funds are permitted.
 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
 Life of Venture Capital Deal

1. Fundraising
─Venture firm solicits commitments, usually less
than 100 per deal
2. Investment phase
─Seed investing
─Early stage investing
─Later stage investing
3. Exit
─Usually IPO as merger
 Venture Profitability

• The 20-year average return is over 16.5%,

with seed investing providing the highest
average (20.4%) and later stage funding
providing the lowest (13.9%).

• Despite some phenomenal years (1999),

venture capital has had negative returns in
recent years.
 Private Equity Buyouts

• A public company is taken private.

• For example, in mid-2007, Thompson Corp.

(NYSE: TOC) sold its Thompson Learning
division to Apax Partners and OMERS
Capital Partners in a private equity buyout.
The price tag? $7.76 billion in cash!
 Private Equity Buyouts

• Why go private?
─Avoid SEC regulation, such as Sarbanes-
Oxley.
─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.
 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.
 Private Equity Buyouts

• Implications of the Ownership Structure

─As the market for underperforming firms
becomes more competitive, PE may not
perform as well, or industry will shrink.
─High risk and high returns are involved, as can
be seen in the next slide.
 E-FINANCE: Venture Capitalists Lose Focus
with Internet Companies

• In the mid-1990s, too much VC money was

chasing too few good deals, many in the
internet industry. Also, quality management
was lacking with spread focus.

• A good example is Webvan, which received

$1 billion in financing, and later declared
bankruptcy in 2001. The $1b? Gone!