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The Investment Banking Process

The Investment Banking Process

The Investment Banking Process



In the preceding section we discussed the role of investment bankers and learned that (1) investment banking is quite different from commercial banking, (2) the major investment banking houses often are divisions of large financial service corporations engaged in a wide range of activities, (3) investment bankers help firms issue new securities in the primary markets, and (4) they also operate as brokers or dealers in the secondary markets. In this section, we describe how securities are issued, and explain the role of investment bankers in this process.



1a. Raising Capital: Stage I Decisions

The firm itself makes some preliminary decisions with respect to the sale of securities. The decisions relate to the following.


i) AMOUNT TO BE RAISED.

At first, the firm decides the amount to be raised. The firm uses different financial forecasting tools to estimate the amount to be raised.


ii) TYPE OF SECURITIES USED.

A firm can use different types of securities such as bonds, preferred stocks, common stocks, etc. to raise required funds. These securities have their own merits and demerits. Based on these merits and demerits of each security, a company should decide on which security—common stock or preferred stock or bonds or a combination to use. Further, if common stock is to be issued, the firm should decide whether it should be offered to existing stockholders or sold to the general public.


iii) COMPETITIVE BID VERSUS NEGOTIATED DEAL.

A company can offer a block of its securities for sale to the highest bidder, or it can negotiate a deal with an investment banker. These two procedures are called competitive bids and negotiated deals. Only large, well-established, creditworthy firms, whose securities are well-known to the investment banking community, are in a position to use the competitive bid process. The investment bank would have to investigate in detail in order to bid on an issue unless they already were quite familiar with the firm. The costs involved in such an investigation are too high. Therefore, the majority of offerings of corporate stock or bonds are made on a negotiated basis.


iv) SELECTION OF AN INVESTMENT BANKER.

When a company chooses negotiated deal, it should select an investment banker. Different investment banking houses are better suited for different companies. Size of issue, the riskiness of the security, amount of commission, etc are major factors that are considered while selecting an investment banker.



1b. Raising Capital: Stage Il Decisions

Once an investment banker is selected, stage Il decisions are made jointly by the firm and its selected investment banker. These decisions include the following:


i) REEVALUATING THE INITIAL DECISIONS.

The firm and its investment banker will reevaluate the initial decisions about the size of the issue and the type of securities to be issued. For example, the firm initially might have decided to raise Rs 30 million by selling common stock, but the investment banker might convince management that it would be better off, in view of current market conditions, to limit the stock issue to Rs 20 million and raise Rs 10 million as debt.


ii) BEST EFFORTS OR UNDERWRITTEN ISSUES.

The firm and its investment banker must decide whether the investment banker will work on a best efforts basis or underwrite the issue. In the underwritten arrangement, the investment banker assures the company the entire issue will be sold, so the investment banker bears significant risks in such an offering. In a best efforts arrangement, the investment banker does•not guarantee that the securities will be sold and the company will be able to raise the required funds.


iii) ISSUANCE COSTS.

The investment banker's fee must be negotiated. The firm also must estimate the other expenses it will incur in connection with the issue lawyers' fees, accountants' costs, printing cost, etc. Usually, the investment banker will buy the issue from the company at a discount below the price at which the securities are to be offered to the public. Underwriting spread covers the investment banker's costs and provides a profit.


iv) SETTING THE OFFERING PRICE.

If the company already is publicly owned, the offering price will be based on the existing market price of the stock or the yield on the bonds. Investment bankers have an easier job if an issue is priced relatively low, but the issuer of the securities naturally wants as high a price as possible. Therefore, an inherent conflict of interest on price exists between the investment banker and the issuer. Investment bankers may require a high commission for the relatively higher offer prices.

If the company is going public for the first time, it will have no established price, so the firm and the investment bankers will have to estimate the equilibrium price at which the stock price will sell after the issue. If the offering price is set below the true equilibrium price, the stock will rise sharply after the issue. If the offering price is set above the true equilibrium price, either the issue will fail purchasers will lose money when stock price subsequently falls to its equilibrium level. Therefore, it is important that the equilibrium price be approximated as closely as possible.



2. Selling Procedures

Once the company and its investment bankers have decided how much money to raise, the type of securities to issue, and the basis for pricing the issue, they will prepare and file a registration statement and prospectus with the concerned authority, for example, Nepal Security Board in Nepal and Securities Exchange Commission in the United States. A company cannot sell the security in the market unless the authority permits it to do so. It generally takes a few days/weeks for the issue to be approved by the authority.

The issue will be oversubscribed when the company and investment banker set relatively low issue prices. In case of over-subscription, shares are allotted as per the allotment directives of the concerned authority. Over-subscription of the security may increase the price of the security after the issue. On the other hand, when the company and investment banker set the offering price too high, the securities will be under-subscribed, hence the investment banker would not be able to sell the issue. In such cases, investment bankers often may suffer a loss.

In case of very large securities issues, the investment banker brings in other bankers as partners to form a_n underwriting syndicate. The syndicate shares financial risk associated with buying the entire issue from the issuer and reselling the securities to the public. The investment banking house which sets up the deal is called the lead, or managing underwriter.

In addition to the underwriting syndicate, for larger offerings, still more investment bankers are included in a selling group. The selling group includes all members of the underwriting syndicate plus additional dealers who handle the distribution of securities to individual investors. The underwriters act as wholesalers whereas members of the selling group act as retailers. The number of investment banking houses in a selling group depends mainly on the size of the issue.



3. Shelf Registrations

The public issue registration process with the concerned authority may take several weeks to complete. Often few months elapse between the time a company decides to finance and the time the security offering actually takes place. Therefore, large, well-known, public companies that issue securities frequently might file a master registration with the concerned authority and update it with a short-form statement just prior to each individual offering.

This process is known as shelf registration. Shelf registration allows a company to register a large number of securities, "put them on the shelf' and then sell in successive issues for up to two years. By using a shelf registration, a company is able to go to the market within. few days as opposed to weeks or months. As a result, the firm has flexibility in the timing of the issue and the size of the issue.



4. Maintenance of the Secondary Market

In the case of a large, well-established company, the investment banker's responsibility is complete once it has sold all the stocks and paid the specified amount collected from the sale of stocks. However, in the case of a company going public for the first time, the investment banker may be obliged to maintain a market for the shares after the issue. Such stocks typically are traded in the over-the-counter market and 'the investment banker generally agrees to make a market in the stock and keep it reasonably liquid.

In making a market, the underwriter maintains a position in the stock, quotes a price at which the stock will be purchased (a bid price) and a price at which the stock will be sold (an asked price), and stands ready to buy and sell it at those prices. With this secondary market activity provided by the investment banker, the stock has greater liquidity to investors. This added liquidity increases the chances for the success of the original offerings.





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