Module 4: Raising Public and Private Equity Flashcards
Underwriting
The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt).
The word “underwriter” is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he or she was willing to accept at a specified premium. In a way, this is still true today, as new issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment.
Initial Public Offering
The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.
In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market.
IPOs can be a risky investment. For the individual investor, it is tough to predict what the stock will do on its initial day of trading and in the near future because there is often little historical data with which to analyze the company. Also, most IPOs are of companies going through a transitory growth period, which are subject to additional uncertainty regarding their future values.
Seasoned Offering
An issue of additional securities from an established company whose securities already trade in the secondary market. A seasoned issue is also known as a “seasoned equity offering” or “follow-on offering.” New shares issued by blue-chip companies are considered seasoned issues. Outstanding bonds trading in secondary markets are also called seasoned issues.
Seasoned issues are handled by underwriting firms in much the same way as initial public offerings, except that the price of the new shares is based on the market price of the outstanding shares. Investors may construe a seasoned issue as a sign that a company is having financial problems. This news can cause the price of both the outstanding shares and the new shares to fall.
Glass-Steagall Act
An act the U.S. Congress passed in 1933 as the Banking Act, which prohibited commercial banks from participating in the investment banking business. The Glass-Steagall Act was sponsored by Senator Carter Glass, a former Treasury secretary, and Senator Henry Steagall, a member of the House of Representatives and chairman of the House Banking and Currency Committee. The Act was passed as an emergency measure to counter the failure of almost 5,000 banks during the Great Depression. The Glass-Steagall lost its potency in subsequent decades and was finally repealed in 1999.
Apart from separating commercial and investment banking, the Glass-Steagall Act also created the Federal Deposit Insurance Corporation, which guaranteed bank deposits up to a specified limit. The Act also created the Federal Open Market Committee and introduced Regulation Q, which prohibited banks from paying interest on demand deposits and capped interest rates on other deposit products (it was repealed in July 2011).
The Glass-Steagall Act’s primary objectives were twofold – to stop the unprecedented run on banks and restore public confidence in the U.S. banking system; and to sever the linkages between commercial and investment banking that were believed to have been responsible for the 1929 market crash. The rationale for seeking the separation was the conflict of interest that arose when banks were engaged in both commercial and investment banking, and the tendency of such banks to engage in excessively speculative activity.
The Glass-Steagall Act’s repeal in 1999 is believed in some circles to have contributed to the 2008 global credit crisis. Commercial banks, around the world, were saddled with billions of dollars in losses due to the excessive exposure of their investment banking arms to derivatives and securities that were tied to U.S. home prices. The severity of the crisis forced Goldman Sachs and Morgan Stanley, the last of the top-tier independent investment banks, to convert to bank holding companies. Coupled with the acquisition of other prominent investment banks Bear Stearns and Merrill Lynch by commercial banking giants JP Morgan and Bank of America, respectively, the 2008 developments ironically signaled the final demise of the Glass-Steagall Act.
Equity Capital Markets
A market that exists between companies and financial institutions that is used to raise equity capital for the companies. Some activities that companies operate in the equity capital markets include: overall marketing, distribution and allocation of new issues; initial public offerings, special warrants, and private placements. Along with stocks, the equity capital markets deal with derivative instruments such as futures, options and swaps.
Equity capital markets are very dependent on the information provided by companies regarding their current financial situations and estimates of future performance. Equity capital market teams from different investments banks are responsible for helping companies execute primary market transactions by managing the structure, syndication, marketing and distribution.
The major players within the ECMs are large financial institutions such Goldman Sachs, Citigroup and UBS.
Road Show
A presentation by an issuer of securities to potential buyers. Road shows refer to when the management of a company that is issuing securities or doing an initial public offering (IPO) travels around the country to give presentations to analysts, fund managers and potential investors. The road show is intended to generate excitement and interest in the issue or IPO, and is often critical to the success of the offering. A non-deal road show occurs where executives hold discussions with current and potential investors, but nothing is offered for sale.
A road show is also known as a “dog and pony show.”
Road show events may attract hundreds of prospective buyers interested in learning more about the offering. The events may include multimedia presentations and question-and-answer sessions with several of the company’s officers present. Many of today’s companies take advantage of the Internet and post versions of road show presentations online. In addition to the larger road show events, companies may also holder smaller, private meetings in the months and weeks preceding the offering.
Prospectus
A formal legal document, which is required by and filed with the Securities and Exchange Commission, that provides details about an investment offering for sale to the public. A prospectus should contain the facts that an investor needs to make an informed investment decision.
Also known as an “offer document.”
There are two types of prospectuses for stocks and bonds: preliminary and final. The preliminary prospectus is the first offering document provided by a securities issuer and includes most of the details of the business and transaction in question. Some lettering on the front cover is printed in red, which results in the use of the nickname “red herring” for this document. The final prospectus is printed after the deal has been made effective and can be offered for sale, and supersedes the preliminary prospectus. It contains finalized background information including such details as the exact number of shares/certificates issued and the precise offering price.
In the case of mutual funds, which, apart from their initial share offering, continuously offer shares for sale to the public, the prospectus used is a final prospectus. A fund prospectus contains details on its objectives, investment strategies, risks, performance, distribution policy, fees and expenses, and fund management.
Red Herring
A preliminary prospectus filed by a company with the Securities and Exchange Commission (SEC), usually in connection with the company’s initial public offering. A red herring prospectus contains most of the information pertaining to the company’s operations and prospects, but does not include key details of the issue such as its price and the number of shares offered. The term “red herring” is derived from the bold disclaimer in red on the cover page of the preliminary prospectus. The disclaimer states that a registration statement relating to the securities being offered has been filed with the SEC but has not yet become effective, the information contained in the prospectus is incomplete and may be changed, the securities may not be sold and offers to buy may not be accepted before the registration statement becomes effective. No price or issue size is stated in the red herring.
The red herring prospectus contains substantial information on the company, including use of proceeds from the offering, market potential for its product/service, financial statements, details of officers, directors and major shareholders, pending litigation, etc.
The red herring prospectus is used to solicit expressions of interest in the issue. Once the registration statement becomes effective, a final prospectus that contains the final IPO price and issue size is disseminated. Expressions of interest are then converted to orders for the issue at the buyer’s option.
The minimum period between the time a registration statement is filed and its effective date is 20 days. Note that the SEC does not approve the securities but simply ensures that all relevant information is disclosed in the registration statement.
SEC Form S-1
The initial registration form for new securities required by the Securities and Exchange Commission (SEC) for public companies. Any security that meets the criteria must have an S-1 filing before shares can be listed on a national exchange.
Form S-1 requires companies to provide information on the planned use of capital proceeds, detail the current business model and competition, as well provide a a brief prospectus of the planned security itself, offering price methodology, and any dilution that will occur to other listed securities. The SEC also requires the disclosure of any material business dealings between the company and its directors and outside counsel.
Form S-1 is also known as the “Registration Statement Under the Securities Exchange Act of 1933”.
Investors can view S-1 filings online to perform due diligence on new offerings prior to their issue. The form is sometimes amended as material information changes or general market conditions cause a delay in the offering.
The Securities Exchange Act of 1933, often referred to as the “truth in securities” law, requires that these registration forms are filed to disclose important information upon registration of a company’s securities. This helps the SEC achieve the objectives of this act, which is requiring investors to receive significant information regarding securities offered, and to prohibit fraud in the sale of the offered securities.
A less rigid registration form is the S-3, which is for companies that don’t have the same ongoing reporting requirements.
Firm Commitment
An underwriter’s agreement to assume all inventory risk and purchase all securities directly from the issuer for sale to the public at the price specified.
In a firm commitment, underwriters act dealers and are responsible for any unsold inventory. The dealer profits from the spread between the purchase price and the public offering price. Also known as a “firm commitment underwriting”.
Green Shoe Option
A provision contained in an underwriting agreement that gives the underwriter the right to sell investors more shares than originally planned by the issuer. This would normally be done if the demand for a security issue proves higher than expected. Legally referred to as an over-allotment option.
A greenshoe option can provide additional price stability to a security issue because the underwriter has the ability to increase supply and smooth out price fluctuations if demand surges.
Greenshoe options typically allow underwriters to sell up to 15% more shares than the original number set by the issuer, if demand conditions warrant such action. However, some issuers prefer not to include greenshoe options in their underwriting agreements under certain circumstances, such as if the issuer wants to fund a specific project with a fixed amount of cost and does not want more capital than it originally sought.
The term is derived from the fact that the Green Shoe Company was the first to issue this type of option.
Dutch Auction
A public offering auction structure in which the price of the offering is set after taking in all bids and determining the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price.
If a company is using a Dutch auction IPO, potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. For example, an investor may place a bid for 100 shares at $100 while another investor offers $95 for 500 shares.
Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid. Therefore, even if you bid $100 for your 1,000 shares, if the last successful bid is $80, you will only have to pay $80 for your 1,000 shares.
The U.S. Treasury (and other countries) uses a Dutch auction to sell securities. The Dutch auction also provides an alternative bidding process to IPO pricing. When Google launched its public offering, it relied on a Dutch auction to earn a fair price.
Privatization
- The transfer of ownership of property or businesses from a government to a privately owned entity.
- The transition from a publicly traded and owned company to a company which is privately owned and no longer trades publicly on a stock exchange. When a publicly traded company becomes private, investors can no longer purchase a stake in that company.
- One of the main arguments for the privatization of publicly owned operations is the estimated increases in efficiency that can result from private ownership. The increased efficiency is thought to come from the greater importance private owners tend to place on profit maximization as compared to government, which tends to be less concerned about profits.
- Most companies start as private companies funded by a small group of investors. As they grow in size, they will often access the equity market for financing or ownership transfer through the sale of shares. In some cases, the process is subsequently reversed when a group of investors or a private company purchases all of the shares in a public company, making the company private and, therefore, removing it from the stock market.
Equity Carve-Out
The partial divestiture of a business unit. A company undertaking a carve-out is not selling a business unit outright, and may instead sell an equity stake in that business or spin the business off on its own while retaining an equity stake itself. A carve-out allows a company to capitalize on a business unit that may not be part of its core operations.
A company may use a carve-out strategy rather than a total divestiture for several reasons, and regulators take this into account when approving or disapproving such restructuring. Sometimes a business unit is deeply integrated, making it hard for the company to sell the unit off completely while keeping it solvent. Those looking at investing in the carve-out must consider what would happen if the original company completely cut ties, and what prompted the carve-out in the first place.
In an equity carve-out, a business sells shares in a business unit. The ultimate goal of the company may be to fully divest its interests, but this may not be for several years. The equity carve-out allows the company to receive cash for the shares it sells now. This type of carve-out may be used if the company does not believe that a single buyer for the entire business is available, or if the company wants to maintain some control over the business unit.
Another carve-out option is the spinoff. In this strategy, the company divests a business unit by making that unit its own stand-alone company. Rather than sell shares in the business unit publicly, current investors are given shares in the new company. The business unit spun off is now an independent company with its own shareholders, though the original parent company may still own an equity stake.
Spin-Off
The creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent company. A spinoff is a type of divestiture. Businesses wishing to streamline their operations often sell less productive or unrelated subsidiary businesses as spinoffs. For example, a company might spin off one of its mature business units that is experiencing little or no growth so it can focus on a product or service with higher growth prospects. The spun-off companies are expected to be worth more as independent entities than as parts of a larger business.
Spinoffs are a common occurrence; there are typically about 50 per year in the United States. You may be familiar with Expedia’s spinoff of TripAdvisor in 2011, United Online’s spinoff of FTD companies in 2013 or Sears Holding Corporation’s spinoff of Sears Canada in 2012, to name just a few examples.
A corporation creates a spinoff by distributing 100% of its ownership interest in that business unit as a stock dividend to existing shareholders. It can also offer its existing shareholders a discount to exchange their shares in the parent for shares of the spinoff. For example, an investor could exchange $100 of the parent’s stock for $110 of the spinoff’s stock. Spinoffs tend to increase returns for shareholders because the newly independent companies can better focus on their specific products or services. Both the parent and the spinoff tend to perform better as a result of the spinoff transaction, with the spinoff being the greater performer.
The downside of spinoffs is that their share prices can be more volatile and can tend to underperform in weak markets and outperform in strong markets. They can also experience high selling activity; shareholders of the parent may not want the shares of the spinoff they received because it may not fit their investment criteria. Share price may dip in the short term because of this selling activity, even if the spinoff’s long-term prospects are positive.
