CHAPTER 18

Public and Private Financing: Initial Offerings,

Seasoned Offerings, and Investment Banks

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 Topics in Chapter

• Initial Public Offerings

• Investment Banking and Regulation
• The Maturity Structure of Debt
• Refunding Operations
• The Risk Structure of Debt

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 What agencies regulate securities markets?
(1 of 2)
• The Securities and Exchange Commission (SEC)
regulates:
• Interstate public offerings.
• National stock exchanges.
• Trading by corporate insiders.
• The corporate proxy process.
• The Federal Reserve Board controls margin
requirements.
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 What agencies regulate securities markets?
(2 of 2)
• States control the issuance of securities within their
boundaries.
• The securities industry, through the exchanges and the
National Association of Securities Dealers (NASD),
takes actions to ensure the integrity and credibility of
the trading system.
• Why is it important that securities markets be tightly
regulated?

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 How are start-up firms usually financed?

• Founder’s resources
• Angels
• Venture capital funds
• Most capital in fund is provided by institutional investors
• Managers of fund are called venture capitalists
• Venture capitalists (VCs) sit on boards of companies
they fund

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 Differentiate between a private placement and
a public offering. (1 of 2)
• In a private placement, such as to angels or VCs,
securities are sold to a few investors rather than to the
public at large.
• In a public offering, securities are offered to the public
and must be registered with SEC.

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 Differentiate between a private placement and
a public offering. (2 of 2)
• Privately placed stock is not registered, so sales must
be to “accredited” (high net worth) investors.
• Send out “offering memorandum” with 20-30 pages of data
and information, prepared by securities lawyers.
• Buyers certify that they meet net worth/income requirements
and they will not sell to unqualified investors.

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 Why would a company consider going public?

• Advantages of going public

• Current stockholders can diversify.
• Liquidity is increased.
• Easier to raise capital in the future.
• Going public establishes firm value.
• Makes it more feasible to use stock as employee incentives.
• Increases customer recognition.

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 Disadvantages of Going Public

• Must file numerous reports.

• Operating data must be disclosed.
• Officers must disclose holdings.
• Special “deals” to insiders will be more difficult to undertake.
• A small new issue may not be actively traded, so market-
determined price may not reflect true value.
• Managing investor relations is time-consuming.

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 What are the steps of an IPO?

• Select investment banker

• File registration document (S-1) with SEC
• Choose price range for preliminary (or “red herring”)
prospectus
• Go on roadshow
• Set final offer price in final prospectus

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 What criteria are important in choosing
an investment banker?
• Reputation and experience in this industry
• Existing mix of institutional and retail (i.e., individual)
clients
• Support in the post-IPO secondary market
• Reputation of analyst covering the stock

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 Would companies going public use a negotiated
deal or a competitive bid?
• A negotiated deal.
• The competitive bid process is only feasible for large issues
by major firms. Even here, the use of bids is rare for equity
issues.
• It would cost investment bankers too much to learn enough
about the company to make an intelligent bid.

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What would the sale be on an underwritten or best
efforts basis?
• Most offerings are underwritten.
• In very small, risky deals, the investment banker may
insist on a best efforts basis.
• On an underwritten deal, the price is not set until
• Investor interest is assessed.
• Oral commitments are obtained.

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 Choosing a listing location

• Due to the limited size of financial markets in some

parts of Asia, many of its major corporations need to
look beyond its shores for listing location.
• It is common for firms to choose the domestic market to list.
This is a natural choice because the home market is
probably the place where the company is best known by its
investors.
• When investors are familiar, they are then willing and ability
to attribute a higher valuation to a firm’s security.

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 Choosing a listing location

• The same argument could be made for firms with

specialized knowledge or skillsets, e.g. high tech or
biotech.
• For such firms, foreign markets, such as NASDAQ, may be
better locations for listing. This is because they have the
catchment of investors who understand and have higher risk
appetite to appreciate such specialized industries.
• Again, they will be willing and able to attribute a higher
valuation to high tech and biotech firms which have
relatively higher risks.
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 Choosing a listing location

• Some firms like Alibaba list in several locations which

enable them to diversify their shareholder base and
provides good international profile for the firm.
• However, this is a very expensive proposition since the firm
has to comply and satisfy the listing and disclosure rules of
all listing locations.

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 Describe how an IPO would be priced.
(1 of 2)
• Estimate the pre-IPO value of equity:
• Free cash flow valuation model
• Comparables:
• Price to earnings ratio
• Price to cash flow ratio
• Price to sales ratio
• Number of visits to web pages

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 Describe how an IPO would be priced.
(2 of 2)
• Decide on either:
• Amount of dollars company needs (net of flotation costs)
• Percent of company that owners want to retain
• Based on this info, determine the offer price as
shown next.

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 IPO Pricing Assumptions

• Pre-IPO value of equity

• VPre-IPO = $63 million
• Number of existing shares
• nExisting = 4 million
• Amount company needs to raise:
• Net proceeds = $18.6 million
• Underwriter spread
• F = 7%
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 Steps to Set Offer Price (1 of 4)

• Gross proceeds required to get net proceeds:

• Gross proceeds = Net proceeds/(1− F)
• Gross proceeds = $18.6/(1− 0.07)
• Gross proceeds = $20 million.
• Determine Post-IPO equity, VPost-IPO
• VPost-IPO = VPre-IPO + Net proceeds
• VPost-IPO = $63 + $20(1 – 0.07)
• VPost-IPO = $81.6 million.
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 Steps to Set Offer Price (2 of 4)

• Determine percentage of post-IPO value of the firm

that investors require
• % required = Gross proceeds/VPost-IPO
• % required = $20/$81.6 = 24.51%

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 Steps to Set Offer Price (3 of 4)

• Determine number of new shares for required

percentage
• nNew = [(% to new)(nExisting)] / (1 – % to new)
• nNew = [(0.2451)(4)] / (1 – 0.2451)
• nNew = 1.30 million

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 Steps to Set Offer Price (4 of 4)

• The offer price is the amount invested divided by the

number of shares
• POffer = Gross proceeds / nNew
• POffer = $20/1.3 = $15.38

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 What is a roadshow?

• Senior management team, investment banker, and

lawyer visit potential institutional investors
• Usually travel to ten to twenty cities in a two-week
period, making three to five presentations each day.
• Management can’t say anything that is not in
prospectus, because company is in “quiet period.”

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 What is “book building?”

• Investment banker asks investors to indicate how many

shares they plan to buy, and records this in a “book”.
• Investment banker hopes for oversubscribed issue.
• Based on demand, investment banker sets final offer
price on evening before IPO.

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 What are typical first-day returns?

• For 75% of IPOs, price goes up on first day.

• Average first-day return is 16.8%.
• About 10% of IPOs have first-day returns greater than
30%.
• For some companies, the first-day return is well over
100%.

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Are first-day returns due to a conflict of interest between the
company and the investment banker?

• There is an inherent conflict of interest, because the

banker has an incentive to set a low price:
• to make brokerage customers happy.
• to make it easy to sell the issue.
• Firm would like price to be high.
• Note that original owners generally sell only a small
part of their stock, so if price increases, they benefit.
• Later offerings easier if first goes well.

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 What are the long-term returns to
investors in IPOs?
• Two-year return following IPO is lower than for
comparable non-IPO firms.
• On average, the IPO offer price is too low, and the first-
day run-up is too high.

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 What are the direct costs of an IPO?

• Underwriter usually charges a 7% spread between

offer price and proceeds to issuer.
• Direct costs to lawyers, printers, accountants, etc. can
be over $400,000.

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 What are the indirect costs of an IPO?

• Money left on the table

• (End of price on first day - Offer price) x Number of
shares
• Typical IPO raises about $70 million, and leaves $9
million on table.
• Preparing for IPO consumes most of management’s
attention during the pre-IPO months.

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 What are equity carve-outs?

• A special IPO in which a parent company creates a

new public company by selling stock in a subsidiary to
outside investors.
• Parent usually retains controlling interest in new public
company.

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 Other Ways to Access Capital Market

• Seasoned equity offerings

• Public offering
• Private investment in public equity (PIPE)
• Shelf registration (SEC Rule 415).
• Private placements
• Asset securitization

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 Investment Banking Company Activities (1 of 2)

• Repeal of Glass-Stegall in 1999 blurred line between

traditional investment banks and other financial
institutions.
• Investment banking companies engage in:
• Underwriting debt and equity offerings (traditional activity)

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Investment Banking Company Activities (2 of 2)

• Mergers and acquisitions

• Finding targets
• Advising
• Underwriting financing
• Securitization
• Asset management
• Clients
• Own funds
• Trading operations

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 Investment Banks and Risks

• Traditional investment banks were primarily fee-generating

organizations
• Investment banks in 2007:
• Highly levered, often with ST borrowings (such as commercial paper)
• Large positions in risky assets, including mortgage-backed securities
and credit default swaps.
• Investment banks in 2014
• Many from 2007 “failed” and were sold (Bear Stearns; Merrill Lynch),
liquidated (Lehman Brothers), or converted into banks to get TARP
(Goldman Sachs)
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 Reverse Take Over (RTO) – Alternative to IPO

• RTO is particularly popular in some Asian countries

such as Hong Kong and Singapore.
• It involves a private company buying a listed firm.
• Under the RTO mechanism, the private firm will inject/sell its
assets into the listed firm.
• In consideration for the “sale”, the listed firm will issue
shares to the private company.
• The swap will result in the shareholder of the private
company directly owning the shares of the listed firm.
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 Reverse Take Over (RTO) – Alternative to IPO

• While the outcome is similar, the effects are different.

• Although RTOs can be executed quickly and cheaply, it
lacks the public profile of an IPO process.
• In addition, the ability of identifying a suitable and available
listed company is a key factor to success of the RTO
structure.

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 LBOs in Asia

• LBO transactions are not widespread in Asia.

• This is largely because the ability to take control of listed
firms, a fundamental part of LBOs, in Asia are limited.
• The closely held shareholder base of major Asian
corporations pose a challenge to gaining control of listed
firms in Asia, which are often owned and controlled by major
Asian families and governments.
• Much of financing for a limited number of LBOs in Asia
is provided by hedge fund managers.
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 What is meant by going private?

• Going private is the reverse of going public.

• Typically, the firm’s managers team up with a small
group of outside investors and purchase all of the
publicly held shares of the firm.
• The new equity holders usually use a large amount of
debt financing, so such transactions are called
leveraged buyouts (LBOs).

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 Advantages of Going Private

• Gives managers greater incentives and more flexibility in

running the company.
• Removes pressure to report high earnings in the short run.
• After several years as a private firm, owners typically go
public again. Firm is presumably operating more efficiently
and sells for more.

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 Disadvantages of Going Private

• Firms that have recently gone private are normally

leveraged to the hilt, so it’s difficult to raise new capital.
• A difficult period that normally could be weathered
might bankrupt the company.

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 Private Equity Funds

• Private equity funds are often limited partnerships

(although a few are publicly traded companies).
• Use their own equity and a large amount of borrowed
cash to purchase equity in an company (often a private
company or wholly owned subsidiary/division, but
sometimes a public company).
• Sit on board, provide incentives to managers.
• Harvest by sale of IPO.
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 Managing Debt Risk with Project Financing

• Project financings are used to finance a specific large

capital project.
• Sponsors provide the equity capital, while the rest of
the project’s capital is supplied by lenders and/or
lessors.
• Interest is paid from project’s cash flows, and
borrowers don’t have recourse.

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