Investment Banks

Just as the government is ubiquitous in the process of issuing securities, so too are

investment banks. Modern investment banks are made up of two parts: the corporate

business and the sales and trading business.

The Corporate Business.The corporate side of investment banking is a fee-for-

service business; that is, the firm sells its expertise. The main expertise banks have is

in underwriting securities, but they also sell other services. They provide merger and

acquisition advice in the form of prospecting for takeover targets, advising clients about

the price to be offered for these targets, finding financing for the takeover, and plan-

ning takeover tactics or, on the other side, takeover defenses. The major investment

banking houses are also actively engaged in the design of new financial instruments.

The Sales and Trading Business.Investment banks that underwrite securities sell

them on the sales and trading end of their business to the bank’s institutional investors.

These investors include mutual funds, pension funds, and insurance companies. Sales

and trading also consists of public market making, trading for clients, and trading on

the investment banking firm’s own account.

Market makingrequires that the investment bank act as a dealerin securities,

standing ready to buy and sell, respectively, at wholesale (bid) and retail (ask) prices.

The bank makes money on the difference between the bid and ask price, or the bid-

ask spread. Banks do this not only for corporate debt and equity securities, but also

as dealers in a variety of government securities. In addition, investment banks trade

securities using their own funds, which is known as proprietary trading. Proprietary

trading is riskier for an investment bank than being a dealer and earning the bid-ask

spread, but the rewards can be commensurably larger.

The Largest Investment Banks.Although there are hundreds of investment banks

in the United States alone, the largest banks account for most of the activity in all lines

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11

EXHIBIT1.5Top Global Underwriters, 1999

	Proceeds				Fees
Advisor	($Billions)	Rank	Percent	# Deals	($Millions)

Merrill Lynch

412.3

1

12.5

2,368

2,433

Salomon Smith	323.2	2	9.8	1,748	1,653
Barney (Citigroup)

Morgan Stanley	296.3	3	9.0	2,592	2,618
Dean Witter

Goldman Sachs

265.2

4

8.1

1,308

2,453

Credit Suisse	239.3	5	7.3	1,419	1,489
First Boston

Lehman Brothers	202.7	6	6.2	1,104	852
Deutsche Banc	139.4	7	4.2	898	971
Chase Manhattan	131.3	8	4.0	1,158	354
JPMorgan	131.1	9	4.0	710	765
ABN Amro	102.9	10	3.1	1,230	640
Bear Stearns	94.9	11	2.9	666	519
Bank of America	81.4	12	2.5	667	193

Warburg Dillon	80.6	13	2.5	486	657
Read

Donaldson	72.7	14	2.2	475	830
Lufkin Jenrette

BNPParibas	53.1	15	1.6	248	355
Industry Total	3,287.7		100.0	21,724	20,943

Source: Investment Dealers Digest, Worldwide Offerings (Public 144A), with full credit to book manager, January

24, 2000, p. 31.

of business. Exhibit 1.5 lists the top 15 global underwriters for 1999 and the amounts

they underwrote. These underwriters accounted for 80–90 percent of all underwritten

offers. Although U.S. underwriters hold a dominant position in their business, foreign

underwriters, such as Nomura Securities, are strong competitors in global issues.

Result 1.3 summarizes the key points of this discussion.

Result 1.3

In the wake of the Great Depression, U.S. financial markets became more regulated. Theseregulations forced commercial banks, the most important provider of private capital, out ofthe investment banking business. These regulatory constraints were relaxed in the 1980s and1990s, making the banking industry more competitive and providing corporations withgreater variety in their sources of capital.

The Underwriting Process

The essential outline of investment banking in the United States has been in place for

almost a century. The players have changed, of course, but the way they do business

now is roughly the same as it was a century ago.

The underwriter of a security issue performs four functions: (1) origination, (2) dis-

tribution, (3) risk bearing, and (4) certification.

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12Part IFinancial Markets and Financial Instruments

Origination.Originationinvolves giving advice to the issuing firm about the type

of security to issue, the timing of the issue, and the pricing of the issue. Origination

also means working with the firm to develop the registration statement and forming a

syndicate of investment bankers to market the issue. The managing or lead underwriter

performs all these tasks.

Distribution.The second function an underwriter performs is the distribution, or the

selling, of the issue. Distribution is generally carried out by a syndicate of banks formed

by the lead underwriter. The banks in the syndicate are listed in the prospectus along

with how much of the issue each has agreed to sell. Once the registration is made effec-

tive, their names also appear on the tombstone adin a newspaper which announces

the issue and lists the underwriters participating in the syndicate.

Risk Bearing.The third function the underwriter performs is risk bearing. In most

cases, the underwriter has agreed to buy the securities the firm is selling and to resell

them to its clients. The Rules of FairPractice(promulgated by the National Associ-

ation of Security Dealers) prevents the underwriter from selling the securities at a price

higher than that agreed on at the pricing meeting, so the underwriter’s upside is lim-

ited. If the issue does poorly, the underwriter may be stuck with securities that must

be sold at bargain prices. However, the actual risk that underwriters take when mar-

keting securities is generally limited since most issues are not priced until the day, or

even hours, before they go on sale. Until that final pricing meeting, the investment bank

is not committed to selling the issue.

Certification.An additional role of an investment bank is to certify the quality of an

issue, which requires that the bank maintain a sound reputation in capital markets. An

investment banker’s reputation will quickly decline if the certification task is not per-

formed correctly. If an underwriter substantially misprices an issue, its future business

is likely to be damaged and it might even be sued. Astudy by Booth and Smith (1986)

suggested that underwriters, aware of the costs associated with mispricing an issue,

charge higher fees on issues that are harder to value.

The Underwriting Agreement

The underwriting agreementbetween the firm and the investment bank is the docu-

ment that specifies what is being sold, the amount being sold, and the selling price.

The agreement also specifies the underwriting spread, which is the difference between

the total proceeds of the offering and the net proceeds that accrue to the issuing firm,

and the existence and extent of the overallotment option. This option, sometimes

called the “Green-Shoe option”after the firm that first used it, permits the investment

banker to request that more shares be issued on the same terms as those already sold.⁶

Exhibit 1.6, which contains parts of a stock prospectus, illustrates many of the features

of the agreement.

⁶Since August 1983, the overallotment shares can be, at most, 15 percent of the amount issued, which

means that if the agreement specifies that the underwriter will issue 1.0 million shares, the underwriter

has the option to issue 1.15 million shares. Nearly all industrial offerings have overallotment options,

which are generally set at 15 percent. In practice, investment bankers typically offer 115 percent of an

offering for a firm going public and then stand ready to buy back 15 percent of the shares to support the

price if demand in the secondary market is weak. See Aggarwal (2000).

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13

EXHIBIT1.6AStock Prospectus: CoverPage

( continued)

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14Part IFinancial Markets and Financial Instruments

EXHIBIT1.6(continued)AStock Prospectus: Underwriting

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Chapter 1

Raising Capital

15

The underwriting agreement also shows the amount of fixed fees the firm must

pay, including listing fees, taxes, SEC fees, transfer agent’s fees, legal and accounting

costs, and printing expenses. In addition to these fixed fees, firms may have to pay sev-

eral other forms of compensation to the underwriters. For example, underwriters often

receive warrants as part of their compensation.⁷

Classifying Offerings

If a firm is issuing equity to the public for the first time, it is making an initial pub-

lic offering (IPO). If a firm is already publicly traded and is simply selling more

common stock, it is making a seasoned offering (SEO). Both IPOs and seasoned

offerings can include both primary and secondary issues. In a primary issue, the firm

raises capital for itself by selling stock to the public; a secondary issueis under-

taken by existing large shareholders who want to sell a substantial number of shares

they currently own.⁸

The Costs of Debt and Equity Issues

Exhibit 1.7 shows the direct costs of both seasoned and unseasoned equity offerings as

well as the direct costs of bond offerings. Three things stand out: First, debt fees are

lower than equity fees. This is not surprising in view of equity’s larger exposure to risk

and the fact that bonds are much easier to price than stock. Second, there are economies

of scale in issuing. As a percentage of the proceeds, fixed fees decline as issue size

rises. Again, this is not surprising given that the expenses classified under fixed fees

simply do not vary much. Whether a firm sells $1 million or $100 million, the audi-

tors, for example, have the same basic job to do. Finally, initial public offerings are

much more expensive than seasoned offerings because the initial public offerings are

far riskier and much more difficult to price.⁹

Result 1.4 summarizes the main points of this subsection.

Result 1.4

Issuing public debt and equity can be a lengthy and expensive process. For large corpora-tions, the issuance of public debt is relatively routine and the costs are relatively low. How-ever, equity is much more costly to issue for large as well as small firms, and it is espe-cially costly for firms issuing equity for the first time.

Types of Underwriting Arrangements

Firm Commitment vs. Best-Efforts Offering.Apublic offering can be executed on

either a firm commitment or a best-efforts basis. In a firm commitment offering, the

underwriter agrees to buy the whole offering from the firm at a set price and to offer

it to the public at a slightly higher price. In this case, the underwriter bears the risk of

not selling the issue, and the firm’s proceeds are guaranteed. In a best-efforts offer-

ing, the underwriter and the firm fix a price and the minimum and maximum number

of shares to be sold. The underwriter then makes the “best effort” to sell the issue.

7

See Barry, Muscarella, and Vetsuypens (1991). Also, Chapter 3 discusses warrants in more detail.

⁸Sometimes the term secondarymeans any non-IPO, even if the shares are primary. To avoid

confusion, some investment bankers use the term add-on, meaning primary shares for an already public

company.

⁹The costs associated with initial public offerings of equity will be discussed in detail in Chapter 3.

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16	Part IFinancial Markets and Financial Instruments

EXHIBIT1.7

Direct Costs as a Percentage of Gross Proceeds forEquity (IPOs and SEOs) and Straight and Convertible Bonds Offered by Domestic Operating Companies,1990–1994

Equity

Bonds

Proceeds		IPOs	SEOs		Convertible Bonds	Straight Bonds
(millions
of dollars	GSa	bc		c	c	c
		ETDC	GSE	TDC	GSETDC	GSETDC

$2–9.999.05%7.91%16.96%7.72%5.56%13.28%6.07%2.68%8.75%2.07%2.32%4.39%

10–19.997.244.3911.636.232.498.725.483.188.661.361.402.76

20–39.997.012.699.705.601.336.934.161.956.111.540.882.42

40–59.996.961.768.725.050.825.873.261.044.300.720.601.32

60–79.996.741.468.204.570.615.182.640.593.231.760.582.34

80–99.996.471.447.914.250.484.732.430.613.041.550.612.16

100–199.996.031.037.063.850.374.222.340.422.761.770.542.31

200–499.995.670.866.533.260.213.471.990.192.181.790.402.19

500 and up5.210.515.723.030.123.152.000.092.091.390.251.64

Average7.31%3.69%11.00%5.44%1.67%7.11%2.92%0.87%x3.79%1.62%0.62%2.24%

Note:

^aGS—gross spreads as a percentage of total proceeds, including management fee, underwriting fee, and selling concession.

^bE—other direct expenses as a percentage of total proceeds, including management fee, underwriting fee, and selling concession.^cTDC—total direct costs as a percentage of total proceeds (total direct costs are the sum of gross spreads and other direct expenses).Source: Reprinted with permission from the Journal of Financial Research,Vol. 19, No. 1 (Spring 1996), pp. 59–74, “The Costs of RaisingCapital,” by Inmoo Lee, Scott Lochhead, Jay Ritter, and Quanshui Zhao.

Investors express their interest by depositing payments into the underwriter’s escrow

account. If the underwriter has not sold the minimum number of shares after a speci-

fied period, usually 90 days, the offer is withdrawn, the money refunded, and the issu-

ing firm can try again later. Nearly all seasoned offerings are made with firm commit-

ment offerings. The more well-known firms that do IPOs tend to use firm commitment

offerings for their IPOs, but the less established firms tend to go public with best-efforts

offerings.

Negotiated vs. Competitive Offering.The issuing firm also can choose between a

negotiated offering and a competitive offering. In a negotiated offering, the firm nego-

tiates the underwriting agreement with the underwriter. In a competitive offering, the

firm specifies the underwriting agreement and puts it out to bid. In practice, except for

a few utilities that are required to use them, firms almost never use competitive offer-

ings. This is somewhat puzzling since competitive offerings appear to have lower issue

costs.¹⁰

Shelf Offerings.Another way to offer securities is through a shelf offering. In 1982,

the SEC adopted Rule 415, which permits a firm to register all the securities it plans

to issue within two years. The firm can file one registration statement and make offer-

ings in any amount and at any time without further notice to the SEC. When the need

¹⁰For

a discussion of this matter, see Bhagat and Frost (1986).

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17

EXHIBIT1.8Daily Prices forthe 1991 Time WarnerRights Offer

	Stock	Rights	Exercise
	Price	Price	Value	Difference
Date	(a)	(b)	(c)	(c) – (b)

July 15

$88.750

$5.500

$8.750

$3.250

July 16	86.750	7.250	6.750	–0.500
July 17	87.625	8.250	7.625	–0.625
July 18	88.125	8.875	8.125	–0.750
July 19	87.250	8.250	7.250	–1.000
July 22	86.500	7.000	6.500	–0.500
July 23	85.375	6.375	5.375	–1.000
July 24	83.750	4.625	3.750	–0.875
July 25	84.875	5.500	4.875	–0.625
July 26	83.750	4.250	3.750	–0.500
July 29	82.500	2.500	2.500	$0.000
July 30	82.750	3.125	2.750	–0.375
July 31	84.750	4.750	4.750	$0.000
Aug. 1	85.750	5.625	5.750	$0.125
Aug. 2	85.000	5.000	5.000	$0.000
Aug. 5	85.000	4.500	5.000	$0.500

Source: ©1996 American Bankers Association. Reprinted with permission. All rights reserved.

for financing arises, the firm simply asks an investment bank for a bid to take the secu-

rities “off the shelf” and sell them. If the issuing firm is not satisfied with this bid, it

can shop among other investment banks for better bids.

Rights Offerings.Finally, for firms selling common stock, there is a possibility of a

rights offering. Rights entitle existing shareholders to buy new shares in the firm at

what is generally a discounted price. Rights offerings can be made without investment

bankers or with them on a standby basis. Arights offering on a standby basisincludes

an agreement by the investment bank to take up any unexercised rights and exercise

them, paying the subscription price to the firm in exchange for the new shares.

In some cases, rights are actively traded after they are distributed by the firm. For

example, Time Warner used a rights offering to raise additional equity capital in 1991.

As the case study below illustrates with respect to this offering, the value of a right is

usually close to the value of the stock less the subscription price, which is the price

that the rights holders must pay for the stock.

The Time WarnerRights Offer

The Time Warner rights offer gave shareholders the option to purchase one share at $80 per

share for each right owned. Time Warner issued three rights for each five shares owned. If

you purchased the stock on July 16, 1991, or later, you did not receive the right. The rights

expired on August 5, 1991.

Exhibit 1.8 shows Time Warner’s stock price [column (a)], the price at which the rights

traded [column (b)], the exercise value of a right [column (c)], and the difference, which is

calculated as the exercise value, estimated as the stock price minus the exercise price of a

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18Part IFinancial Markets and Financial Instruments

right, minus the market price of a right. After July 15, the last date at which the stock price

is worth both the value of the stock and the value of the right, the stock price drops,

reflecting the loss of the right. From July 16 on, the market price of a right is close to its

exercise value.

The Time Warner rights offer was unusual in many respects. First, it was one of

the largest equity offerings. Second, the original structure of the deal was unique.

Finally, only rarely do U.S. firms choose to use rights offerings to issue new equity.

Some financial economists are puzzled that so few firms use rights offerings since

the direct cost of a rights issue is substantially less than the direct cost of an under-

written offering. Aplausible explanation for this is that rights offerings, when used, are

less expensive because firms using them have a large-block shareholder who has agreed

to take up the offer. This is true in Europe, where large-block shareholders, who are

likely to agree to exercise the rights, are more prevalent.¹¹

Where rights are not used,

there may be no large-block shareholders, which would make the rights offering more

expensive. In addition, studies of the costs of rights offers examine only the costs to

the firm and ignore the costs to the shareholders, which could conceivably be quite

large.