The Security Offering Process: Role of the Investment Banker - Financial Management

Investment bankers are financial middlemen who bring together suppliers and users of long -term funds in the capital markets and thereby play a key role in the security offering process.Whenever a large corporation is considering raising funds in the capital markets, it almost always enlists the services of an investment banker. In fact, most large industrial corporations have ongoing relationships with their investment bankers.

Investment bankers assist client corporations in the offering process in a variety of ways, including the following:

  • Long-range financial planning
  • The timing of security issues
  • The purchase of securities
  • The marketing of securities
  • The arrangement of private loans and leases
  • The negotiation of mergers

In summary, the investment banker is an important source of financial market expertise and an important part of the security offering process.

How Securities Are Sold

Firms can sell securities in the primary capital markets in one of three ways:

  • By selling securities through investment bankers to the public in a public cash offering
  • By placing a debt or stock issue with one or more large investors in a private, or direct, Placement
  • By selling common stock to existing stockholders through a rights offering

Investment bankers usually assist firms in all three methods of sale. Figure 8.3 is a flowchart that outlines the various methods and steps for the sale of corporate securities.

Public Cash Offerings Normally, when a corporation wishes to issue new securities and sell them to the public, it makes an arrangement with an investment banker whereby the investment banker agrees to purchase the entire issue at a set price. This is called a firm commitment underwriting. The investment banker then resells the issue to the public at a higher price.

Underwriting can be accomplished either through negotiations between the underwriter and the issuing company or by competitive bidding. A negotiated underwriting is simply an arrangement between the issuing firm and its investment bankers. Most large industrial corporations turn to investment bankers with whom they have had ongoing relationships. In competitive bidding, the firm sells the securities to the underwriter (usually a group) that bids the highest price.Many regulated companies, such as utilities and railroads, are required by their regulatory commissions (for example, the Federal Energy Regulatory Commission, the Interstate Commerce Commission, and state regulatory bodies) to sell new security issues in this way.

How Securities Are Sold:A Flowchart

How Securities Are Sold:A Flowchart

Security issues sold to the public through underwriters normally exceed $25 million in size; amounts totaling several hundred million dollars (particularly bond issues) are not uncommon. Due to the size of these issues, individual investment bankers usually do not want to underwrite an entire issue by themselves.Normally, a group of underwriters, called a purchasing syndicate, agrees to underwrite the issue in order to spread the risk. Sometimes the purchasing syndicate can sell an entire issue to large institutional investors; this is often true with high -quality debt issues.

On other occasions —particularly with large debt issues or equity issues —the underwriters organize a selling group of security firms to market the issue to the public. It is not uncommon for a selling group responsible for marketing a large issue to number over 100 security firms. Figure shows the underwriting syndicate for an ARIBA Corporation common stock offering. An important part of the negotiations between the issuing firm and the investment banker is the determination of the security’s selling price. It is in the best interests of both the issuing firm and the underwriter to have the security “fairly priced.” If the security is underpriced, the issuing firm will not raise the amount of capital it could have, and the underwriter may lose a customer.

If the security is overpriced, the underwriter may have difficulty selling the issue, and investors who discover that they paid too much may choose not to purchase the next issue offered by either the corporation or the underwriter. Occasionally, with smaller company issues, the investment banker agrees to help market the issue on a “best efforts” basis rather than underwriting it. Under this type of arrangement, the investment banker has no further obligation to the issuing company if some of the securities cannot be sold. The investment banker functions as a dealer in an underwriting situation and as a broker in a best-efforts situation. In a best-efforts offering, the investment banker does not assume the risk that the securities will not be sold at a favorable price.

Private Placements Many industrial companies choose to directly, or privately, place debt or preferred stock issues with one or more institutional investors instead of having them underwritten and sold to the public. In these cases, investment bankers who act on behalf of the issuing company receive a “finder’s fee” for finding a buyer and negotiating the terms of the agreement. The private market is an important source of long-term debt capital, especially for smaller corporations.

Private security placements have a number of advantages:

  • They can save on flotation costs by eliminating underwriting costs.
  • They can avoid the time delays associated with the preparation of registration statements and with the waiting period.
  • They can offer greater flexibility in the writing of the terms of the contract(called the indenture) between the borrower and the lender.

An offsetting disadvantage is that, as a very general rule, interest rates for private placements are about one -eighth of a percentage point higher than they are for debt and preferred issues sold through underwriters. For small debt and preferred stock issues —that is, those that are less than about $20 million —the percentage cost of underwriting becomes fairly large. Because of this, these smaller issues are frequently placed privately with institutional investors.

Rights Offerings and Standby Underwritings Firms may sell their common stock directly to their existing stockholders through the issuance of rights, which entitle the stockholders to purchase new shares of the firm’s stock at a subscription price below the market price. (Rights offerings also are called privileged subscriptions.) Each stockholder receives one right for each share owned; in other words, if a firm has 100 million shares outstanding and wishes to sell an additional 10 million shares through a rights offering, each right entitles the holder to purchase 0.1 shares, and it takes 10 rights to purchase one share.

When selling stock through a rights offering, firms usually enlist the services of investment bankers, who urge rights holders to purchase the stock. In an arrangement called a standby underwriting, the investment banker agrees to purchase—at the subscription price —any shares that are not sold to rights holders. The investment banker then resells the shares. In a standby underwriting, the investment banker bears risk and is compensated by an underwriting fee.

Rights offerings have declined in popularity as a method of raising equity capital in the United States.However, in the United Kingdom, rights offerings are more common. In October 1992, British Aerospace attempted an underwritten rights offering totaling $732 million (£432 million). The offering price was 380 pence per share. Unfortunately, the price of British Aerospace stock declined to 363 pence during the period of the offering and only a small portion (4.9 percent) of the offering was purchased by rights holders. The underwriters were forced to take large losses on the offering when they were stuck with the balance of the issue.

Direct Issuance Costs An investment banker who agrees to underwrite a security issue assumes a certain amount of risk and, in turn, requires compensation in the form of an underwriting discount or underwriting spread, computed as follows:

Underwriting spread = Selling price to public – Proceeds to company

Examples of underwriting spread amounts are shown in table. It is difficult to compare underwriting spreads for negotiated and competitive offerings because rarely are two offerings brought to market at the same time that differ only in the ways in which they are underwritten. Generally, underwriters receive lower spreads for competitively bid utility issues than for negotiated industrial offers. This is primarily because utilities tend to have a lower level of risk than industrial companies. In addition to the underwriting spread, other direct costs of security offerings include legal and accounting fees, taxes, the cost of registration with the Securities and Exchange Commission, and printing costs. For small equity offerings of less than $10 million, these direct costs may exceed 10 percent of the gross proceeds from the offering, on average.

For offerings with gross proceeds in the $20 million to $50 million range, direct costs averaged slightly less than 5 percent of gross proceeds. For large equity offerings (greater than $200 million), the direct issuance costs have averaged about 3.3 percent of gross proceeds.11 An offering of 1.35 million shares of common equity by Service Corporation International had an underwriting spread of $2,160,000 and other direct issue expenses of $280,564. Direct costs of underwritten debt offerings are much lower than direct equity issuance costs, often ranging from 0.5 percent to 4.0 percent.

enerally, direct issuance costs are higher for common stock than for preferred stock issues, and direct issuance costs of preferred stock are higher than those of debt issues. One reason for this is the amount of risk each type of issue involves. Common stocks usually involve more risk for underwriters than preferred stock, and preferred stock involves more risk than debt. Stock prices are subject to wider price movements than debt prices. Another reason for these differences in direct issuance costs is that investment bankers usually incur greater marketing expenses for common stock than for preferred stock or debt issues. Common stock is customarily sold to a large number of individual investors, whereas debt securities are frequently purchased by a much smaller number of institutional investors.

Sample Underwriting Spreads for Selected Issues

Sample Underwriting Spreads for Selected Issues

Direct issuance costs also depend on the quality of the issue. Low-quality debt issues, for example, tend to have higher percentage direct issuance costs than high -quality issues because underwriters bear more risk with low-quality issues and therefore require greater compensation. And, finally, direct issuance costs are dependent on the size of the issue— costs tend to be a higher percentage of small issues, all other things being equal, because underwriters have various fixed expenses (such as advertising expenses, legal fees, registration statement costs, and so on) that are incurred regardless of the issue’s size.

Other Issuance Costs In addition to direct costs, there are significant other costs associated with new security offerings, including

  1. The cost of management time in preparing the offering.
  2. The cost of underpricing a new (initial) equity offering below the correct market value.

    Underpricing occurs because of the uncertainty associated with the value of initial public offerings and a desire to ensure that the offering is a success. For example, the initial public offering for Krispy Kreme Doughnuts in April 2000 was priced at $21. After the first day of trading it closed at $38.37, or a gain of 82.7 percent, and by the end of the year 2000 it closed at $83, or a gain of 295 percent. Examples such as this and many Internet company stocks in the late 1990s are extreme, although not uncommon, examples of the underpricing associated with many initial public offerings.

  3. The cost of stock price declines for stock offerings by firms whose shares are already outstanding— so-called seasoned offerings. The announcement of new stock issues by a firm whose shares are already outstanding causes a price decline averaging about 3 percent for the outstanding shares.
  4. The cost of other incentives provided to the investment banker, including the overallotment or “Green Shoe” option. This option, often contained in underwriting contracts, gives the investment bankers the right to buy up to 15 percent more new shares than the initial offering amount at a price equal to the offering price. The option is designed to allow investment bankers to handle oversubscriptions. This option normally lasts for 30 days.

These indirect costs can, in aggregate, constitute a very significant expense associated with security offerings (especially for common equity). Ritter has estimated that the sum of direct issue costs and underpricing for new equity offerings averages over 31 percent for best -efforts offerings and over 21 percent for firm commitment underwritings.

Registration Requirements The Securities Act of 1933 requires any firm offering new securities to the public to make a complete disclosure of all pertinent facts regarding these securities; the Securities Exchange Act of 1934 expanded the coverage to include trading in existing securities. The 1934 act also created the Securities and Exchange Commission (SEC), which is responsible for administering federal securities legislation. These federal laws make no judgments regarding the quality of securities issues; they simply require full disclosure of the facts.

Any company that plans to sell an interstate security issue totaling over $1.5 million and having a maturity greater than 270 days is required to register the issue with the SEC. The procedure involves the preparation of a registration statement and a prospectus. The registration statement contains a vast amount of information about the company’s legal, operational, and financial position; the prospectus summarizes the information contained in the registration statement and is intended for the use of potential investors.

After a company has filed a registration statement and prospectus, there is normally a waiting period of 20 days before the SEC approves the issue and the company can begin selling the securities. During the waiting period, the company may use a preliminary prospectus in connection with the anticipated sale of securities. This preliminary prospectus is often called a “red herring” because it contains a statement, usually marked in red, saying that the prospectus is “not an offer to sell.” When the registration statement is approved by the SEC, the new securities can be formally offered for sale. All buyers of the new securities must be provided with a final copy of the prospectus.

Shelf Registration In November 1983, the SEC permanently adopted a new registration option that it had allowed experimentally for the preceding one-and-a-half years. Rule 415 permits the shelf registration of debt and equity securities. The shelf registration option is available only to larger firms (the market value of outstanding equity must exceed $150 million) with a high (investment grade) rating. Under the shelf registration procedure, a firm files a master registration statement with the SEC. The company is then free to sell small increments of the offering over an extended time period (two years) merely by filing a brief short -form statement with the SEC only hours before the actual offering.

By placing its new securities “on the shelf” awaiting an opportune time for issuance, the company has the capability to time their issuance with the specific financing needs of the firm and to take advantage of perceived favorable pricing windows in the market. There is some evidence that the shelf registration procedure is less costly than traditional underwriting for equity offerings.15 In spite of this apparent cost advantage, shelf registrations of new equity offerings have not been popular.

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