Understanding Private Equity & Stock Markets

1. Chapter 5 The Stock Market

2. The Stock Market “One of the funny things about the stock market is that every time one man buys, another sells, and both think they are astute.” –William Feather “If you don’t know who you are, the stock market is an expensive place to find out.” –Adam Smith (pseud. for George J. W. Goodman)

3. Learning Objectives Take stock in yourself. Make sure you have a good understanding of: • The difference between private and public equity and primary and secondary stock markets. • How Stock Exchange operates. • How to calculate index returns.

4. Private Equity • Private Equityis used in the rapidly growing area of equity financing for nonpublic companies. • Banks are generally not interested in making loans to startup companies, especially ones : • with no assets (other than an idea). • Run by fledgling entrepreneurs with no track record. • Firms with this profile search for Venture Capital (VC), an important part of the private equity markets. • Firms other than start-ups might also need financing. • Private equity also includes: • middle-market firms & large leveraged buyouts

5. The Structure of Private Equity Funds • Private equity funds &hedge funds are 2types of investment companies. Both • Are set up as limited partnerships. • Pool money from investors. • Invest this money on behalf of these investors. • Use, typically, a 2/20 fee structure (i.e., a 2% annual management fee and 20% of profits). • Have built-in constraints to prevent managers from taking excessive compensation. • Private equity funds generally have: • a high-water-mark provision • a “clawback” provision

6. Types of Private Equity Funds: Venture Capital • Venture Capitalrefers to financing new, often high-risk, start-ups • Individual venture capitalists invest their own money • Venture capital firms pool funds from various sources: • Individuals, Pension funds, Insurance companies, Large corporations & University endowments • Venture capitalists know that many new companies will fail. • The companies that succeed can provide enormous profits. • To limit their risk: VCs generally provide financing in stages. • Venture capitalists actively help run the company.

7. Venture Capital, II • At each stage, enough money is invested to reach the next stage. • Ground-floorfinancing • Mezzanine Levelfinancing • At each stage of financing, the value of the founder’s stake grows &the probability of success rises. • If goals are not met, the venture capitalists withhold further financing. • If a start-up succeeds: • The big payoff frequently comes when the company is sold to another company or goes public (IPO). • Either way, investment bankers are often involved in the process.

8. Types of Private Equity Funds:Middle Market • Many small, regional private equity funds concentrate their investments in “middle market” companies. • ongoing concerns (i.e., not start-ups) • known performance history • typically, small and family owned and operated. • Reasons middle market companies seek more capital • Expansion beyond their existing region • Founder wants to “cash out” • A private equity fund might purchase a portion of the business so that others can now manage the company.

9. Types of Private Equity Funds:Leveraged Buyouts • Suppose a company (or someone else) purchases all the shares of the company held by the public at large? • This process is called “taking the company private.” • The cost of going private is often high. • A manager or investor who wants to take a company private probably needs to borrow a significant amount of money. • Taking a company private is called a leveraged buyout (LBO). • LBO market activity levels depend on credit markets. • Around 2005, the LBO market was quite active. • Activity in the LBO market came to a standstill after the crash of 2008.

10. Selling Securities to the Public • Theprimary marketis the market where investors purchase newly issued securities. • Initial public offering (IPO): An IPO occurs when a company offers stock for sale to the public for the 1st time • Seasoned equity offering (SEO): If a firm already has public shares,an SEO occurs when a company raises more equity • Thesecondary market is the market where investors trade previously issued securities. An investor can trade: • Directly with other investors. • Indirectly through a broker who arranges transactions for others • Directly with a dealer who buys & sells securities from inventory

11. Corporate Governance & Corporate Ethics • Businesses and markets require trust to operate efficiently • Without trust additional laws and regulations are required • Laws and regulations are costly • Governance and ethics failures cost the economy billions, if not trillions • Eroding public support and confidence

12. Financial Markets and the Economy • In February 2008, Microsoft offered to buy Yahoo at $31 per share when Yahoo was trading at $19.18 • Yahoo rejected the offer, holding out for $37 a share • Proxy fight to seize control of Yahoo's board and force Yahoo to accept offer • Proxy failed; Yahoo stock fell from $29 to $21 • Did Yahoo managers act in the best interests of their shareholders?

13. The Primary Market for Common Stock An IPO (and an SEO) involves several steps. • Appoints an investment banking firm to arrange financing. • Investment banker designs the stock issue and arranges for fixed commitment or best effort underwriting. • Prepares a prospectus(usually with outside help) & submits it to the Securities &Exchange Commission (SEC) for approval. • Investment banker circulates preliminary prospectus (red herring) • Upon obtaining SEC approval, company finalizes prospectus • Underwriters place announcements (tombstones) in newspapers and begin selling shares.

14. The Secondary Market for Common Stock • The goal of a secondary market is to match investors wishing to buy stocks with investors wishing to sell stocks. • Common stock trading typically occurs on either an organized stock exchange or a trading network. • Important concepts: • The bid price: The price dealers pay investors. • The price investors receive from dealers. • The ask price: The price dealers receive from investors. • The price investors pay dealers. • The difference between the bid and ask prices is called the bid-ask spread, or simply the spread.

15. Listed Stocks • Initial and annual listing fees are charged • For dually listedstocks, regional exchanges also attract substantial trading volume. • To apply for listing, companies have to meet certain minimum requirements with respect to: • The number of shareholders • Trading activity • The number and value of shares held in public hands • Annual earnings

16. Circuit Breakers • Sometimes the market wide order flow is such that regulators have deemed that a trading cease for a short time. • These trading halts are call Circuit Breakers. • All U.S. securities trading halts for 15 minutes when the S&P 500 falls 7% before 3:25 p.m. • A plunge of 20% in the S&P 500 causes all trading to stop for the day. • Note: The SEC is constantly tinkering with circuit breakers and what triggers them.

17. Stock Market Order Types

18. Types of Orders: Market and Limit Orders • Market orders: • You specify ticker and quantity • Immediate execution at best available price • Market buy will be executed at lowest ask • Market sell will be executed at highest bid • Limit orders: • You specify ticker, quantity, and price • The order will be executed only if trade can be made at the limit price or better • Limit Buy can only be executed at limit price or lower • Limit Sell can only be executed at limit price or higher

19. Types of Orders: Stop Orders Sell Stop (or stop loss) Use this order when you have a long position and want to protect yourself from a price decline. • The Stop price will be below the current price of the stock. • The Stop price is the trigger or activation point. • If the stop price is reached or passed (the price goes lower), the order becomes a market order to be executed at the best available price (which may be higher or lower than stop price). • Risk: price suddenly plummets & your position is liquidated at a large loss. Buy Stop Use this order when you have a short position and want to protect yourself if the stock price rises. • The Stop price will be above the current price of the stock. • The Stop is the trigger or activation point. • If the stop price is reached or passed (goes higher), the order becomes a market order to be executed at the best available price • Risk: price suddenly rockets and you buy at a higher price than your buy stop.

20. Types of Orders: Stop Limit Orders Intended to prevent something bad from happening (But, in an active market, the Limit can hurt you) • Sell Stop Limit • Use when you have a long position and want to protect yourself from a price decline. • The Stop price will be below the current price of the stock. • The Stop price is the trigger or activation point. • The limit says you will not accept a selling price below the limit. • Risk: The price plummets and you might not get out. • Buy Stop Limit • Use when you have a short position and want to protect yourself if the stock price rises. • The Stop price will be above the current price of the stock. • The Stop price is the trigger or activation point. • The Limit says you will not accept a purchase price above the limit. • Risk: The price rockets and you might not get out.

21. Stop Orders versus Stop Limit Orders • Stop orders guarantee execution (if the stock reaches or moves past your stop price), but not the price. • Stop limit orders guarantee price, but not execution. • Stop and Limit prices do not have to be the same. • You could use a stop of $45 with a limit of $44.

22. Comparing Stop & Stop Limit Orders, I.

23. Comparing Stop & Stop Limit Orders, II.

24. Comparing Stop and Stop Limit Orders, III.

25. Stock Market Information • The most widely followed barometer of day-to-day stock market activity is the Dow Jones Industrial Average (DJIA), or “Dow” for short. • The DJIA is an index of the stock prices of 30 large companies representative of American industry.

26. Stock Market Indexes, I. • Indexes can be distinguished in four ways: • The market covered, • The types of stocks included, • How many stocks are included, and • How the index is calculated . • Stocks that do not trade during a time period cause index staleness over that time period. • That is, we do not know the "true" index level if all the stock prices are not updated, i.e., fresh. • The level of index staleness changes during the trading day. • Uses • Track average returns • Compare performance of managers • Base of derivatives

27. Constructing Market Indexes • For a market value-weightedindex (i.e., S&P 500, NASDAQ), companies with larger market values have higher weights. • Return equals weighted average of returns of each component security, with weights proportional to outstanding market value • Equally weighted index (Value Line Index) : Computed from simple average of returns • For a price-weighted index (i.e., the DJIA), higher priced stocks receive higher weights. • Computed by adding prices of stocks and dividing by “divisor” • This means stock splits cause issues. • But, stock splits can be addressed by adjusting the index divisor. • Note: As of May 9, 2012, the DJIA divisor was a nice “round” 0.132129493!

28. Ex I: $1,000,000 to Invest, Price-Weighted Portfolio Note: Shares = $1,000,000 / 131.130 = 7,626

29. Ex II: Changing the Divisor when a New Stock is Added to the Index What would have happened to the divisor if Home Depot shares were selling at $65.72 per share instead of $32.90?

30. Ex III: $1,000,000 to Invest, Value-Weighted Portfolio Note: Shares to Buy = $1,000,000*Weight / Price

31. Ex IV: How Does the Value-Weighted Index Change? Using the Portfolio from Example III:

32. The Day 3 Index Can be Calculated in Two Ways:

33. Useful Internet Sites • www.vfinance.com (for a list of well-known VC Firms) • www.nvca.org (source of venture capital information) • www.secondmarket.com (Want to buy shares in companies yet to go public?) • www.hoovers.com (information on Initial Public Offerings, or IPOs) • www.hsx.com (reference for an interesting stock exchange) • www.nyse.com (website for the New York Stock Exchange) • www.nasdaq.com (website for the NASDAQ) • www.djindexes.com (reference for current divisor for the DIJA) • www.russell.com (the Russell Indexes) • www.msci.com (reference for value and growth indexes) • jmdinvestments.blogspot.com (reference for recent financial information)