Lecture 13

1. Lecture13 Long Term and Short Term Financing Berk, De Marzo Reference: 23,24, 26,27

2. Long Term Financing • A venture capital firm is a limited partnership that specializes in raising money to invest in the private equity of young firms. Typically institutional investors such as pension funds are the limited partners. The general partners run the venture capital firm. They are called venture capitalists. • Venture capital fims offer limited partners a number of advantages over investing directly in start-ups. Venture firms invest in many start-ups, so limited partners get benefits of diversification. General partners charge limited ones substantial fees to run the firm. In addition to an annual management fee, general partners also take a share of any positive return generated by the fund in a fee called carried interest. • A private equity firm is organized like a venture, but it invest in the equity of existing firms, rather than start-ups. Often private equity buy equity of publicly traded firms and make them private through leveraged buyout (LBO), using also debt for the purchase. Institutional investors are also active in investing in private companies. They may invest directly or indirectly (becoming limited partners) • Institutional Investors: such as pension funds, insurance companies, endowments, and foundations are active investors in private companies. Institutional investors may invest directly in private firms or they may invest indirectly by becoming limited partners in venture capital firms.Corporate Investor: A corporation that invests in private companies

3. Long Term Financing • The process of selling stocks to the public for the first time is called an Initial public offering (IPO). After deciding to go public, managers of the company work with an underwriter, an investment banking firm that manages the offering and design itsstructure. • Primary and secondary offerings: a firm offers a large block of shares for sale to the public for the first time. The shares may be new shares that raise new capital (primary offering) or existing shares sold by current shareholders (secondary offering). For smaller IPO the underwriter accepts the deal on a best-efforts IPO basis, trying to sell the stock at the highest possible price, without guarantee. • Most commonly an underwriter and an issuing firm agree to a firm commitment IPO, in which the underwriter guarantees it will sell the stock at the offer price. The underwriter purchases the entire issue and sells on the market at the offer price. If the entire issue does not sell out, the remaining will have to be sold at lower price. • Preferred Stock: Preferred stock issued by mature companies usually has a preferential dividend and seniority in any liquidation and sometimes special voting rights.Convertible Preferred Stock: Preferred stock that gives the owner an option to convert it into common stock on some future date.

4. Long Term Financing • Then they arrange a road show for promotion of the company around the world, explaining the offer to customers. At the end of the road show customers inform the underwriters of their interest by telling how many shares they want to purchase. Based on this information prices is adjusted according to total demand (book building). • • Often, to finance new growth opportunities during its life, companies go back to equity markets and offer new shares for sale (Seasoned equity offer SEO). • • Primary shares are sold to new investors, while secondary shares are sold from existing shareholders. Intermediaries would advertise the sale of stock by taking out advertisements in newspapers called tombstones. • • When a firm offers new shares to new investors, we have a cash offer. In a rights offer instead shares are sold only to existing shareholders.

5. Long Term Financing • Corporate bonds are securities issued by corporations. Similarly to equity issuance, a prospectus must be produced, describing the details of the offering and containing an indenture, formal contract between bond issuer and a trust company. • • The face value of the bond is denominated in standard increments, like 100 or 1,000. if a coupon is issued at a discount instead of face value it is called an original issue discount (OID) bond. • • Four types of corporate debt are typically issued: • – Notes and Debentures are unsecured debt, so in event of bankruptcy • bondholders have claim only to assets not pledged as collateral on other debt. • – Asset-Backed bonds and Mortgage bonds are secure debt: specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy. Mortgage bonds are secured by real property, asset-backed bonds are secured by any kind of assets.

6. Long Term Financing • Public Debt • – Domestic bonds are issued by a local entity, traded in a local market, but purchasedby foreigners. • – Foreign bonds are issued by foreign entity, traded on local markets, intended for localinvestors. • – Eurobonds are international bonds denominated in a foreign currency. Consequently there is no connection between the physical location of the trading market and the location of the issuing entity. • – Global bonds combine the features of the others and are offered on different markets simoultaneously.

7. Long Term Financing • Private Debt • – Bank loans are an example of private debt, not publicly traded. A syndicated loan is financed by a group of banks instead of only one. Term loan indicates a loan that lasts for a pre-specified period. • – A revolving line of credit is a credit commitment for a specific time period up to some limit, which a company can use if needed. • – A private placement is a bond issue that does not trade on public market but is sold to a small group of investors. It is less costly to issue. • • Sovereign debt is debt issued by national governments. US government issues Treasury bills (up to 26 weeks) and bonds of various maturities (2, 3, 5, 10 years). Moreover long bonds with maturities 20 years and 30 years.

8. Long Term Financing • An Asset-backed security (ABS) is a security that is made up of other financial securities. The cash flows come from the cash flows of underlying securities that “back” it. Creating ABS packaging a portfolio of assets and issuing the corresponding securities is called asset securitization. • • Mortgage-backed security is a security backed by home mortgages. A mortgage borrower has always the option to repay the debt early so the holders of securities face prepayment risk. • • A call feature allows the issuer of the bond the right to retire all the outstanding debt on or after a spedified call date for the call price (usually set at or above). • • A convertible bond is a bond which can be converted before maturity into a predetermined number of shares of the issuing company. Basically it is like a normal bond with an embedded warrant which represents a call option on the stock.

9. Long Term Financing • A Convertible Security is a bond or a preferred stock that is convertible into a specified number of shares of common stock at the option of the holder. This provides the convertible holder a fixed return (interest or dividend) and the option to exchange a bond or preferred stock for common stock. The option allows the company to sell convertible securities at a lower yield than it would have to pay on a straight bond or preferred stock issue. • • Conversion Price is the price per share at which common stock will be exchanged for a convertible security. It is equal to the par value of the convertible security divided by the conversion ratio. • • Conversion Ratio is the number of shares of common stock into which a convertible security can be converted. It is equal to the face value of the convertible security divided by the conversion price.

10. Short Term Financing • In essence trade credit is a loan from the selling firm to its customer. The price discount represent an interest rate. The benefits of trade credits is the simplicity and convenience of use. It has very low transaction costs, compared to other sources, since no paper work or complicated procedure is required. It is quite flexible and helps a lot companies that do not have access to other sources of funds. • Trade credit is convenient to some extent to the issuing company, since it gives a nice way to lower price to certain specific customers. This is a way to attract bad credit customers, who do not have access to normal bank credit, so they would represent lost opportunity to the company. • • A way to then protect against bad creditors is to threaten cut of future supplies in case of no payment in time. This is usually enough to guarantee that even bad creditors will anyway provide good payments, while good creditors will keep accessing bank credit and therefore be buyers as well

11. Short Term Financing • Collection float is the time it takes to the company to be able to use the funds after a customer has made a payment. Firms can reduce their working capital needs by reducingthe collection float. • • There are basically three factors affecting collection float. • – Mail Float: time to get the check after mailed by the customer • – Processing Float: time to process the check and deposit it in the bank • – Available Float: time the bank takes to credit the money • • On the other hand this applies also to outgoing flows and the disbursement float represents the time it takes before payments to suppliers translate into the cash outflowfor the company • • Electronic systems have reduced quite consistently the problem in recent years. Anyway, in order to optimize the process, also internal procedures must be well fit.

12. Short Term Financing • One of primary sources of short-term funds is commercial banks. The most simple form of bank loan is the single, end-of-period-payment loan. It requires the company to pay an interest (fixed or floating rate) on the loan and repay back the principal in one lump sum at the end of the loan. • • Another type of bank loan is the line of credit, where the bank agrees to make a specific maximum amount of funds available to the company. That allows to get access to the credit whenever needed. The credit can be uncommitted, giving the bank the right to withdraw if the financial conditions of the company become unstable, or committed, when the bank is legally binded to give access to credit even if the financial situation of the company turns bad, as long as the conditions in the agreementaresatisfied. • • Usually commitments are yearly. A revolving line of credit involves a much longer commitment, typically 2 or 3 years.

13. FinancialMeltdown • http://www.youtube.com/watch?v=l4XfNiqwQDo

14. The potential for conflicts of interests to arise in the natural course of trading activities is quite large.  There are many limited liquidity trades where the bank intermediates risk and stands between buyer and seller.  The bank benefiting one side of a trade could disadvantage the other. Investment banking has material non-public information that could, if (ill-legally) shared with trading would disadvantage the client and the other side of any trade.  Clients come to the bank to trade large positions.  This creates the potential issue of front running the client. Conflicts of Interest in Financial Intermediation and do additional reading to determine if there are reasonable and sufficient safeguards that the bank and regulators can impose that reduce or eliminate the conflicts of interest.  • Question: Suggest how these regulations and enforcement procedures would be implemented and discuss issues that might prevent them from being effective.  Support your arguments with further references.