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Investment Banks

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

Samuel
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Investment Banks

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  1. Investment Banks Economics 71a Spring 2007 Mayo, Chapter 2 Lecture notes 2.2

  2. Outline • What is an investment bank? • Role in financial markets • Investment banks and new securities • IPO mechanics

  3. 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

  4. 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

  5. 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)

  6. 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”

  7. IPO Scandals • Most involve investment banks giving special deals to some favored customers (low prices)

  8. Best Efforts Agreement • Risk shifted to issuing firm • It receives whatever price the market pays • No underwriting function by investment bank

  9. 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

  10. 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)

  11. 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

  12. 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

  13. 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

  14. Dutch Auction Picture Price IPO Price Demand Shares Offered Q

  15. 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

  16. 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)

  17. Private Placements • Shares sold to private investment groups • Venture capital firms • Private equity hedge funds • Usually, smaller, younger, riskier firms

  18. 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)

  19. 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

  20. Insider Trading • Trading on private information • Illegal (why?) • Who’s an insider? • Employees • Associated • Lawyers • Investment bankers • Enforcement • Trade reporting

  21. 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

  22. Sarbanes-Oxley (2002) • Scandals of the 1990’s • Accounting information shaky and deceptive (Enron, Worldcom,..) • Government response • Protect investors from fraud

  23. Sarbanes-Oxley • Basic provisions • Creates Public Company Accounting Oversight Board • Strengthen the independence of auditors (accountants) • Firm directors take responsibility for numbers

  24. 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”

  25. Reponses to Sarbanes/Oxley • Board insurance • Privatization • Moving off shore • Still very much untested and controversial

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