Chapter 10.6 Flashcards
Private Markets and Bank Loans
What are public markets for debt and equity?
Wholesale markets where firms can often sell securities at the lowest ossible cost
Typically, what are the characteristics of firms that sell securities in the public market?
Large, well-known firms with high credit quality and sustainable profits
Why do some firms have limited or no access to public markets?
Not every firm reaches high levels of achievement. As a result many smaller firms and firms of lower credit standing have less access to public markets
What is often a smaller firm’s cheapest source of external funding?
The private markets
How do market conditions affect whether a firm can sell its securities in the public markets?
When market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can do so at a reasonable price.
Why is it that when market conditions are unstable, some smaller firms that were previously able to sell securities in the public market no longer can’t at a reasonable price?
During periods of market instability, investors seek to hold high-quality securities, and they’re reluctant to purchase or hold high risk securities in their portfolios
On Wall Street, what does the phenomenon “flight to quality” mean?
Refers to moving capital to the safest possible investments to protect oneself during unsettled periods in the market
Many sizeable companies of high credit quality prefer to sell their securities in the private markets even though they can access public markets. What kinds of owners do these private companies have?
Entrepreneurs, families, or family foundations
What are 2 examples of large “family” businesses that avoid public markets and fund themselves privately?
- Cargill Company
- Carlson Companies
Both located in Minneapolis, Minnesota
Why do large “family owned” private firms elect to avoid the public markets?
For different reasons. Some wish to avoid the regulatory costs and transparency requirements that come w/ public sales of securities.
Others think that their firms have intricate business structures/complex legal or financial structures that can best be explained to small group of sophisticated investors rather than to public at large
Are bootstrapping and venture capital financing part of the private market?
Yes
When does a private placement occur?
When a firm sells unregistered securities directly to investors such as:
- insurance companies
- commercial banks
- wealthy individuals
Most private placements involve the sale of what type of issues?
Debt issues, but equity issues can also be privately placed
About half of all corporate debt is sold through what market?
The private placement market
What do investment banks and money center banks often assist firms with?
With private placements
How do investment banks and money center banks assist firms with private placements?
Help the issuer locate potential buyers for their securities, put the deal together, and do the necessary origination work. May also help negotiate the terms and price of the sale, but they don’t underwrite the issue
In a traditional private placement, how are the securities sold between the issuer and investor?
Securities sold directly to investors
What are the advantages of private placements compared to public offerings?
- Cost of funds, net of transaction costs, may be lower, especially for smaller firms and those w/ low credit ratings
- Bc of their intimate knowledge of the firm and its management, private lenders are more willing to negotiate changes to a bond contract if changes are needed
- If a firm suffers financial distress, problems more likely to be resolved w/o going to bankruptcy court
- Speed which private placements can be completed
- Flexibility in issue size
- If the issuer and investor already have a relationship, a sale can be completed in a few days, and small issues of a few million dollars are not uncommon
What is the biggest drawback of private placements?
Restrictions on the resale of the securities
Do private placements have to be registered with the SEC?
No, as long as the securities are purchased for investment and not fore resale
In practice, who do securities laws in the United States limit the sale of private placements to
Investors who have capacity to evaluate the securities’ investment potential and risk.
What are the drawbacks of the US securities laws limiting the sale of private placements to investors who have the capacity to evaluate the securities investment potential + risk cause
The types of investors they limit to are generally high income investors/investors w/ large investment portfolios. Thus private placement securities have limited marketability unless the firm subsequently registers the issue
To address their concern about the lack of marketability, what do investors in private placements require?
Higher yield relative to a comparable public offering or that the firm agree to register the securities shortly after the transaction is completed
In April 1990, the SEC adopted Rule 144A, which allows large financial institutions to do what?
Trade unregistered securities among themselves
How has SEC adopting Rule 144A affected privately placed securities?
Dramatically improved the marketability of them
How does Rule 144A adopted by the SEC allow issuers to resell securities to QIBs (qualified institutional buyers)?
Allows issuers to sell unregistered securities to investment banking firms which can then resell the securities to QIBs
Where do private equity firms pool money from?
Like venture capitalists, from:
- Financial and insurance firms
- Pension funds
- Individuals and families
- Corporations
- Foundations and endowments
- + other sources to make investments
How are private equity firms similar to venture capitalists?
Pool money from same sources
How are the private equity firms different from venture capitalists in terms of the types of companies, and percentage of company they invest in?
PE firms invest in more mature companies and often purchase 100% of a business
How do private equity managers look to increase the value of the firms they acquire?
By closely monitoring their performance and providing better management
What do private equity managers do once they increase the value of a firm they acquire?
Sell the firms for a profit
How long do private equity firms generally hold investments for?
3-5 years
Although private equity firms often purchase 100% of a business, how do they represent a potential source of capital for large public firms?
Large public firms that have businesses such as divisions/individual plants that they’re interested in selling
When do large public firms sell businesses?
When they no longer fir the firms’ strategies or when they’re offered a price they can’t refuse
What is a large firm selling a business they have an alternative to?
Alternative to selling equity or debt as a means of raising new capital
What do private equity firms establish to make investments?
Private equity funds
How are private equity funds usually organized as?
Limited partnerships (or more recently as limited liability companies)
Private equity funds are usually organized as limited partnerships that consist of what 2 types of partners?
- General partners who manage the firm’s investments
- Limited partners who invest money in the firm, but have limited liability and aren’t involved in the day-to-day activities of the firm
As owners, what do the limited partners of private equity funds share?
- Income
- Capital gains
- Tax benefits from the private equity funds
What do the general partners, who also invest in the private equity funds, receive?
- Income
- Capital gains
- Tax benefits that are proportionate to their investments
In addition to what general partners receive for investing in private equity funds, what do they get as compensation for managing them?
They collect management fees and receive % of income and capital gains earned w/ the limited partner’s money
Private equity funds have historically focused on investments in what size firms with what kind of cashflow?
Small and medium-size firms that have stable cash flows and where there’s potential to improve cash flows substantially
In recent years, how have private equity firms started doing large deals?
Have been able to raise so much capital
How many of the 10 largest private equity transactions in U.S. history have been completed in the last 8 years?
9/10
How much was the private equity transaction involving the Texas utility company, TXU?
One of the 10 largest in U.S. history: $44 billion
Why do private equity investors focus on firms that have stable cash flows?
Because they use a lot of debt to finance their acquisitions
What must a firm have in order to make the interest and principal payments?
Stable positive cash flows
How much can a private equity firm borrow for every dollar it invests?
As much as $3 or $4 for every dollar it invests
What does adding more debt allow private equity firms to do?
The firm frees up its own cash, allowing it to make additional investments and increasing the return on its equity investments
What is a leveraged buyout?
When a large amount of leverage is used to take over a company
What are the 3 ways private equity firms improve the performance of firms in which they invest?
- Make sure that the firms have the best possible management teams
- PE investors closely monitor each firm’s performance and provide advice and counsel to the firm’s management team
- PE investors often facilitate mergers and acquisitions
How do private equity firms make sure that the firms they invest in have the best possible management teams?
Since a private equity firm typically owns 100 percent of the equity in a firm it invests in, its general partners have the ability to replace the management team when necessary
How do private equity firms closely monitor each firm they invest in’s performance and provide advice and counsel to the firm’s management team?
General partners have in-depth knowledge of the industries in which they invest, and some have been CEOs of similar firms
How does private equity investors often facilitating mergers and acquisitions improve the performance of firms in which they invest?
Help improve the competitive positions of the companies in which they invest.
Do agency problems tend to be smaller in firms owned by private equity investors or in public firms?
Firms owned by private equity
In public firms, who are the owners?
Stockholders
Is it practical for dispersed stockholders to be actively engaged in managing the firm?
No, even though in public firms they’re the owners it’s not practical
Who are day-to-day decision-making responsibilities delegated to?
The firm’s managers
Who are managers?
Stockholders, agents and are supposed to act in the best interest of stockholders
Although managers are supposed to act in the best interest of stockholders, is that always the case?
No, they tend to pursue their own self-interest instead of the interests of stockholders
What is the result of the misalignment between the owner’s best interests and the manager’s self-interest?
Results in agency costs
Why do private equity funds have much lower agency costs than the average publicly held firm?
Since the general partners in a private equity fund are owners and benefit greatly from the value they create, they have every incentive to act in a manner consistent with maximizing the value of limited partners’ investments
How strict are regulations and reporting requirements for private equity firms compared to public firms?
They carry much smaller regulatory burden and fewer financial reporting requirements
Give examples of regulatory burdens private equity firms are able to avoid
Most of the SEC’s registration and compliance costs and other regulatory burdens, such as compliance with the Sarbanes-Oxley Act
What size companies can find it difficult and costly to raise money in the public markets?
Small and medium size companies
Since it’s difficult/costly to raise money in public markets, what is a more effecient approach small/medium sized companies can take?
In these circumstances, more efficient/cost effective to sell stock privately, even if the company’s stock is already publicly traded
What is private investment in public equity, or PIPE transactions?
Transactions in which a public company sells unregistered stock to an investor (often a hedge fund or some other institutional investor)
In private investment in public equity (PIPE transactions) what kind of investors are the stocks usually sold to?
Often a hedge fund or some other institutional investor
How long have PIPE transactions been around for?
A long time, but the number of these transactions has increased greatly since the late 1990s
In a PIPE transaction, where and how do investors purchase securities (equity or debt) from?
Directly from a publicly traded company in a private placement. Always virtually sold at a discount to price which they would sell in public markets
What’s different between securities sold virtually in PIPE transactions and in public markets?
The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets
Why are securities sold virtually in PIPE transactions always at a discount?
Compensates the buyer for limits on the marketability of these securities and, often, for being able to provide capital quickly
Why and how are securities sold in a PIPE transactions “restricted securities”
Because they’re not registered with the SEC. Under federal securities law they can’t be resold to investors in the public markets for 1 year unless the company registers them
What is often included in a PIPE contract that allows the securities to be resold freely in the secondary markets?
Company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing, once they’re registered, they can be resold freely
In the even that the issuer is unable to register the securities or the registration is delayed past a deadline date, what may the issuer be required to do?
Pay the investor liquidity damages, usually 1.5%/month, as a compensation for the loss of liquidity
What are the major advantages of a PIPE transaction to issuers?
It gives them faster access to capital and a lower funding cost than a registered public offering
How many days can PIPE transactions be completed in and how does it compare to a typical public offering?
PIPE: in a few days
Public offering underwritten by an investment bank takes much longer
How can PIPE transactions save 7-8% of the proceeds raised?
Transactions involving a healthy firm can be executed w/o the use of an investment bank resulting in cost savings as much as 7-8%
What may be the only way for a small financially distressed company to raise equity capital?
A PIPE transaction
How are commercial banks another important source of funds for businesses?
Almost every company has a working relationship with at least one bank and smaller companies depend on them for funding and financial advice
Where do most small and medium-sized firms borrow from on a regular basis?
Commercial banks
What are 2 common types of bank loans used by businesses?
- Prime-Rate Loans
- Bank Term Loans
What is the most common type of business loan?
Prime-rate loan
What is a prime-rate loan?
Loans in which the borrowing rate is based on the prime rate of interest
What is the prime rate of interest?
Is historically the loan rate that banks charge their most creditworthy customers
Are customers able to borrow below the prime rate?
Some customers are
What are prime-rate loans often used to finance?
Working capital needs such as inventory purchases
What do banks often require in prime-rate borrowing and why?
That the loan balance be brought to zero for a short time each year: to ensure that prime-rate borrowing isn’t used as long-term financing
Is the prime rate charged by a bank higher or lower than other market borrowing rates and why?
Might be higher because banks provide a range of services with these loans, much as venture capitalists provide services to start-up businesses
What is an example of services that are provided by the bank with prime-rate loans?
Small and medium-size firms often rely on bank’s lending officer to serve as firm’s financial adviser and to keep CFO abreast of current developments and trends in financing
What can the cost of a prime-rate loan include?
The cost of the advisory services as well as the cost of the financing
What are term loans?
A business loan with a maturity greater than one year
What is the most common form of intermediate-term financing provided by commercial banks?
Term loans
T or F: term loans are all structured the same
False: there is a wide variation in how they’re structured
In general what maturities do term loans have?
Between 1-15 years, but most are in the 1-5 year range
What can bank term loans be used for, and how are they secured
Funds can be used to buy inventory or to finance plant and equipment and may be secured or unsecured
What is a key characteristic of bank commercial lending relationships?
Banks maintain close relationships with borrowers and closely monitor their performance through active oversight by loan officers.
Is the prime rate a market-determined interest rate? Why or why not?
No since the bank management sets it
How is the prime rate subject to forces that affect the bank?
Affect the bank’s cost of funds and the rate the bank’s customers are willing to accept
How does the bank management raise/lower the prime rate to respond to competitive conditions?
As the general level of interest rates in the economy increases/decreases, bank management raises/lowers the prime rate to adjust for the bank’s cost of funds
In determining the interest rate to charge on a loan, what does the bank take into account?
Prime rate, DRP (adjustment for default risk above the prime rate), MAT (adjustment for the yield curve for term loans)
What is the calculation for the bank loan pricing model?
kₗ = PR + DRP + MAT
where:
kₗ: the loan rate (%)
PR (Prime Rate): adjustment for default risk above the prime rate (%)
DRP (Default Risk Premium): default risk above the prime rate (%)
MAT (term to maturity): adjustment for term loans (%)
Before making a loan, what does a bank conduct of the customer?
A credit analysis
What is the first step in a credit analysis?
To determine the customer’s credit category
How many credit risk categories do banks have and what do they look like?
5-7 credit risk categories, which look very much like bond ratings
If the customer is of the highest credit standing, what are they classified as and what rate can they borrow at?
Prime-rate customer, borrows at prime rate (or below if it doesn’t require substantial services)
For all other customer that aren’t of the highest credit standing (not prime rate customers) what rate do they borrow at?
Some markup above the prime rate
What is DRP?
Default risk premium: the markup above the prime rate (for non prime-rate customers)
Give an example of DRP.
If a bank customer is “prime + 2,” the customer borrows at the prevailing prime rate plus 2 percent.
What is the second step of a credit analysis?
If the customer wants a term loan: adjust for the term to maturity (MAT)
What is MAT?
Term to maturity: defined as the difference between the yield on a Treasury security with the same maturity as the term loan and the yield on a 3 month Treasury bill
How can MAT be expressed mathematically?
MAT = yₙ − y₃₋ₘₒ
where:
yₙ: yield on a Treasury security with n years to maturity
y₃₋ₘₒ: Yield on a 3-month Treasury security
As a practical matter, most financial analysts treat the prime rate as a ____ month interest rate
3
Suppose, for example, that a customer wants a two-year term loan. If the yield on a two-year Treasury security is 4.00 percent and the yield on a three-month Treasury is 3.70 percent, then what is the appropriate MAT?
0.30% (4.00% − 3.70% = 0.30%)
What does the credit analysis for a short-term loan only require the consideration of?
The prime rate and the DRP
Suppose a bank has two customers that are medium-size business firms. Firm A has the bank’s highest credit standing, and Firm B’s credit standing is prime + 3. The bank prime rate is 4.25 percent. What is the appropriate loan rate for each customer, assuming the loan is not a term loan?
Firm A, higher credit standing: prime customer= borrowing rate is prime rate, 4.25%
Firm B: prime +3, or prime plus 3%, so borrowing cost = 7.25% (4.25 percent + 3.00 percent = 7.25 percent)
The prime rate is a floating rate, what does this mean?
If a bank raises its prime rate by 25 basis points, it affects a firm whether they’re a prime customer and borrow at prime rate or borrow at prime +additional. Therefore a firm’s borrowing costs increase by 25 basis points
What does the way a firm raises capital depend on?
- Firm’s stage in its life cycle
- Expected cash flows
- Risk characterstics
For new businesses, where does funding come from?
- Friends
- Family
- Credit cards
- Venture capitalists
What 3 sources of funding do more mature firms rely heavily on?
- Public markets
- Private markets
- Bank loans
How does a firm select the best method of financing?
Each market has particular characteristics, select the one that provides the best combination of low-cost borrowing and favourable terms and conditions
No simple rules/formulas to fund enterprise
