Fundamentals of Corporate Finance PDF

Fundamentals of Corporate Finance Fourth Edition Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D. Chapter 10 How Firms Raise Capital Chapter 10: How Firms Raise Capita...

Fundamentals of Corporate Finance Fourth Edition Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D. Chapter 10 How Firms Raise Capital Chapter 10: How Firms Raise Capital Copyright ©2018 John Wiley & Sons, Inc. 2 Learning Objectives (1 of 2) 1. Explain what is meant by bootstrapping when raising seed financing and why bootstrapping is important 2. Describe the role of venture capitalists in the economy and discuss how they reduce their risk when investing in start- up businesses 3. Discuss the advantages and disadvantages of going public and compute the net proceeds from an IPO 4. Explain why, when underwriting new security offerings, investment bankers prefer that the securities be underpriced; compute the total cost of an IPO Copyright ©2018 John Wiley & Sons, Inc. 3 Learning Objectives (2 of 2) 5. Discuss the costs of bringing a general cash offer to market 6. Explain why a firm that has access to the public markets might elect to raise money through a private placement 7. Review some advantages of borrowing from a commercial bank rather than selling securities in financial markets and discuss bank term loans Copyright ©2018 John Wiley & Sons, Inc. 4 Bootstrapping How new businesses get started o Most businesses are started by an entrepreneur who has a vision for a new business or product and a passionate belief in the concept’s viability o The entrepreneur often fleshes out his or her ideas and makes them operational through informal discussions with people whom the entrepreneur respects and trusts, such as friends and early investors Copyright ©2018 John Wiley & Sons, Inc. 5 Initial Funding of the Firm The process by which many entrepreneurs raise “seed” money and obtain other resources necessary to start their businesses is often called bootstrapping The initial “seed” money usually comes from the entrepreneur or other founders o Other cash may come from personal savings, the sale of assets such as cars and boats, loans from family members and friends, and loans secured from credit cards o The seed money, in most cases, is spent on developing a prototype of the product or service and a business plan Copyright ©2018 John Wiley & Sons, Inc. 6 Venture Capital (1 of 4) The bootstrapping period usually lasts no more than one or two years At some point, the founders will have developed a prototype of the product and a business plan, which they can “take on the road” to seek venture-capital funding to grow the business o Venture capitalists are individuals or firms that help new businesses get started and provide much of their early-stage financing o Individual venture capitalists, angels (or angel investors), are typically wealthy individuals who invest their own money in emerging businesses at very early stages in small deals Copyright ©2018 John Wiley & Sons, Inc. 7 Venture Capital Industry (1 of 2) Emerged in the late 1960s with the formation of the first venture-capital limited partnerships Today, the venture industry consists of several-thousand professionals at about one-thousand venture capital firms, with the biggest concentration of firms in California and Massachusetts Modern venture capital firms tend to specialize in a specific line of business, such as hospitality, food manufacturing, or medical devices A significant number of venture capital firms focus on high- technology investments Copyright ©2018 John Wiley & Sons, Inc. 8 Venture Capital Industry (2 of 2) Exhibit 15.1 Venture Capital Industry Characteristics, 2009–2016 At the end of 2016, there were 898 venture capital firms and 1,562 separate venture capital funds in the United States. The funds had an average of $213.5 million of investable capital. Venture capital firms invested a total of $69.0 billion in 8,136 deals during 2016. The number of firms and funds, and the level of investment activity, increased over the 2009–2016 period. Venture Capital Firms and Funds Investments by Venture Capital Firms Year Number of Total Number of Average Fund Size Number of Total Dollar Value firmsa Existing Funds ($ millions) Deals ($ billions) 2009 791 1,276 $204.8 4,458 $26.0 2010 791 1,294 194.3 5,411 31.0 2011 815 1,344 202.6 6,771 44.0 2012 844 1,372 194.7 7,987 41.0 2013 869 1,408 190.3 9,326 45.0 2014 898 1,481 194.8 10,550 69.0 2015 906 1,528 206.3 10,468 79.0 2016 898 1,562 213.5 8,136 69.0 Average 852 1,408 $200.2 7,888 $50.5 a Number of firms that had raised funds in the previous eight years. Source: National Venture Capital Association 2017 Yearbook. Copyright ©2018 John Wiley & Sons, Inc. 9 Venture Capital (2 of 4) Why venture capital is different o Venture capital is important because entrepreneurs have only limited access to traditional sources of funding o There are three primary reasons why traditional sources of funding do not work for new or emerging businesses There is a high degree of risk involved in starting a new business Types of productive assets: new firms whose primary assets are often intangible (patents or trade secrets) find it difficult to secure financing from traditional lending sources Information asymmetry problems: an entrepreneur knows more about his or her company’s prospects than a lender does Copyright ©2018 John Wiley & Sons, Inc. 10 Venture Capital Funding Cycle (1 of 7) Starting a new business o Suppose you have been in the pizza business for several years and have developed a concept for a high-end pizzeria that you believe has the potential to grow into a national chain The business plan o The business plan describes what you want your business to become, why consumers will find your pizzerias attractive, how you are going to accomplish your objectives, and what resources you will need Copyright ©2018 John Wiley & Sons, Inc. 11 Venture Capital Funding Cycle (2 of 7) Exhibit 15.2 The Venture Capital Funding Cycle The typical venture capital funding cycle begins when the entrepreneur runs low on bootstrap financing. Venture capitalists then provide equity financing. They will later exit through a private or public sale of their equity. The duration of the cycle is typically three to seven years, and only a small percentage of new ventures make it all the way to the end. Copyright ©2018 John Wiley & Sons, Inc. 12 Venture Capital Funding Cycle (3 of 7) First-stage financing o After a number of meetings with you and your management team, the venture capital firm may agree to fund the project, but only in stages, and for less than the full amount being requested How venture capitalists reduce their risk o Venture capitalists know that only a handful of new companies will survive to become successful firms o They use a number of tactics when they invest in new ventures, including funding the ventures in stages, requiring entrepreneurs to make personal investments, syndicating investments, and maintaining in-depth knowledge about the industry in which they specialize Copyright ©2018 John Wiley & Sons, Inc. 13 Venture Capital Funding Cycle (4 of 7) Staged funding o The key idea behind staged funding is that each funding stage gives the venture capitalist an opportunity to reassess the management team and the firm’s financial performance o The venture capitalists’ investments give them an equity interest in the company, typically in the form of convertible preferred stock Personal investment o Venture capitalists often require an entrepreneur to make a substantial personal investment in the business Copyright ©2018 John Wiley & Sons, Inc. 14 Venture Capital Funding Cycle (5 of 7) Syndication o It is a common practice to syndicate seed and early-stage venture capital investments o Occurs when the originating venture capitalist sells a percentage of a deal to other venture capitalists o Reduces risk in two ways: Increases the diversification of the originating venture capitalist’s investment portfolio The willingness of other venture capitalists to share in the investment provides independent corroboration that the investment is a reasonable decision Copyright ©2018 John Wiley & Sons, Inc. 15 Venture Capital Funding Cycle (6 of 7) In-depth knowledge o Another factor that reduces risk is the venture capitalist’s in-depth knowledge of the industry and technology Exit strategy o Venture capitalists are not long-term investors in the companies, but usually exit over a period of three to seven years o Every venture capital agreement includes provisions identifying who has the authority to make critical decisions concerning the exit process o Exit strategy provisions usually include the following: Timing (when to exit) The method of exit What price is acceptable Copyright ©2018 John Wiley & Sons, Inc. 16 Venture Capital Funding Cycle (7 of 7) Exit Strategy: three principal ways in which venture capital firms exit venture-backed companies: o Strategic Buyer: selling part of the firm’s equity to a strategic buyer in the private market o Financial Buyer: a private equity firm buying the new firm with the intention of holding it for a period of time, usually three to five years, and then selling it for a higher price o Initial Public Offering: selling common stock in an initial public offering Copyright ©2018 John Wiley & Sons, Inc. 17 Venture Capital (3 of 4) Venture capitalists provide more than financing o The extent of the venture capitalists’ involvement depends on the experience of the management team o One of their most important roles is to provide advice o Because of their industry and general knowledge about what it takes for a business to succeed, they provide counsel for entrepreneurs when a business is started and during early stages of operation Copyright ©2018 John Wiley & Sons, Inc. 18 Venture Capital (4 of 4) Exhibit 15.3 Strategic and Financial Sales and Venture-Backed I PO Exits in the United States, 2003–2016 Comparing the number of strategic and financial (M&A) sales of new businesses with the number of venture-backed IPOs from 2003 through 2016 shows that strategic and financial sales were far more common than I POs during this period. Source: National Venture Capital Association 2017 Yearbook. Copyright ©2018 John Wiley & Sons, Inc. 19 Venture Capital: Cost The cost of venture-capital funding o The cost is very high, but the high rates of return earned by venture capitalists are not unreasonable o A typical venture-capital fund may generate annual returns of 15-25%, compared with an average annual return for the S&P500 of about 12% Copyright ©2018 John Wiley & Sons, Inc. 20 Initial Public Offering (1 of 2) One way to raise larger sums of cash or to facilitate the exit of a venture capitalist is through an initial public offering, or IPO, of the company’s common stock o First-time stock issues are given a special name because the marketing and pricing of these issues are distinctly different from those of seasoned offerings Copyright ©2018 John Wiley & Sons, Inc. 21 Initial Public Offering: Advantages of Going of Public (1 of 2) The amount of equity capital that can be raised in the public equity markets is typically larger than the amount that can be raised through private sources Once an IPO has been completed, additional equity capital can usually be raised through follow-on seasoned public offerings at a lower cost Copyright ©2018 John Wiley & Sons, Inc. 22 Initial Public Offering: Advantages of Going of Public (2 of 2) Can enable an entrepreneur to fund a growing business without giving up control After the IPO, there is an active secondary market in which stockholders can buy and sell its shares Publicly traded firms find it easier to attract top management talent and to better motivate current managers if a firm’s stock is publicly traded Copyright ©2018 John Wiley & Sons, Inc. 23 Initial Public Offering: Disadvantages of Going of Public High cost of the IPO The costs of complying with ongoing SEC disclosure requirements also represent a disadvantage of going public The transparency that results from these SEC compliances can be costly for some firms Finally, some investors argue that the SEC’s requirement of quarterly earnings forecasts and quarterly financial statements encourages managers to focus on short-term profits rather than long-term wealth maximization Copyright ©2018 John Wiley & Sons, Inc. 24 Initial Public Offering: Investment-Banking Services (1 of 2) To complete an IPO, a firm will need the services of investment bankers, who are experts in bringing new securities to the market Investment bankers provide three basic services when bringing securities to market: origination, underwriting, and distribution Copyright ©2018 John Wiley & Sons, Inc. 25 Initial Public Offering: Investment-Banking Services (2 of 2) Identifying the investment-banking firm that will manage the IPO process is an important task for the management of a firm because not all investment banks are equal Securing the services of an investment-banking firm with a reputation for quality and honesty will improve the market’s receptivity and help ensure a successful IPO Copyright ©2018 John Wiley & Sons, Inc. 26 Initial Public Offering: Origination Includes giving the firm financial advice and getting the issue ready to sell The investment banker helps the firm determine whether it is ready for an IPO Once the decision to sell stock is made, the firm’s management must obtain a number of approvals Since securities sold to the public must be registered in advance with the SEC, the first step in this process is to file a registration statement with the SEC o The preliminary prospectus is the initial registration statement Copyright ©2018 John Wiley & Sons, Inc. 27 Initial Public Offering: Underwriting Underwriting is the risk-bearing part of investment banking The securities can be underwritten in two ways: o On a firm-commitment basis o On a best-efforts basis Copyright ©2018 John Wiley & Sons, Inc. 28 Initial Public Offering: Firm-Commitment Underwriting (1 of 2) More typical: the investment banker guarantees the issuer a fixed amount of money from the stock sale The investment banker actually buys the stock from the firm at a fixed price and then resells it to the public The underwriter bears the risk that the resale price might be lower than the price the underwriter pays, called price risk Copyright ©2018 John Wiley & Sons, Inc. 29 Initial Public Offering: Firm-Commitment Underwriting (2 of 2) The investment banker’s compensation is called the underwriter’s spread, the difference between the investment banker’s purchase price and the offer price The underwriter’s spread is 7% in the vast majority of IPOs in the U.S. Copyright ©2018 John Wiley & Sons, Inc. 30 Initial Public Offering: Best-Effort Underwriting With best-effort underwriting, the investment banking firm makes no guarantee to sell the securities at a particular price The investment banker does not bear the price risk associated with underwriting the issue, and compensation is based on the number of shares sold Copyright ©2018 John Wiley & Sons, Inc. 31 Initial Public Offering: Underwriting Syndicates To share the underwriting risk and to sell the new security issue more efficiently, underwriters may combine to form a group called an underwriting syndicate Participating in the syndicate entitles each underwriter to receive a portion of the underwriting fee as well as an allocation of the securities to sell to its own customers Copyright ©2018 John Wiley & Sons, Inc. 32 Initial Public Offering (2 of 2) Determining the offer price o One of the investment banker’s most difficult tasks is to determine the highest price at which the bankers will be able to quickly sell all of the shares being offered and that will result in a stable secondary market for the shares Due diligence meeting o Before the shares are sold, representatives from the underwriting syndicate hold a due diligence meeting with representative of the issuer o Investment bankers hold due diligence meeting to protect their reputations and to reduce the risk of investor’s lawsuits in the event the investment goes sour later on Copyright ©2018 John Wiley & Sons, Inc. 33 Initial Public Offering: Distribution (1 of 2) Once the due-diligence process is complete, the underwriters and the issuer determine the final offer price in a pricing call The pricing call typically takes place after the market has closed for the day By either accepting or rejecting the investment banker’s recommendation, management ultimately makes the pricing decision Copyright ©2018 John Wiley & Sons, Inc. 34 Initial Public Offering: Distribution (2 of 2) First day of trading: o The underwriter sells the shares to investors in the market, after registration with the SEC o Speed of sale is important because the offer price reflects market conditions at the end of the previous day, and these conditions can change quickly Copyright ©2018 John Wiley & Sons, Inc. 35 Initial Public Offering: The Closing At the closing of a firm-commitment offering, the issuing firm delivers the security certificates to the underwriter and the underwriter delivers the payment for the securities, net of the underwriting fee, to the issuer The closing usually takes place on the third business day after the trading has started Copyright ©2018 John Wiley & Sons, Inc. 36 Initial Public Offering: The Proceeds What are the total expected proceeds from the common stock sale? How much money does the issuer expect to get from the offering? What is the investment bank’s expected compensation from the offering? o The best approach to calculating these amounts is to first work through the funding allocations on a per-share basis and then compute the total dollar amounts Copyright ©2018 John Wiley & Sons, Inc. 37 IPO Pricing and Cost (1 of 6) The underpricing debate o The issuer prefers the stock price to be as high as realistically possible while the underwriters prefer some degree of underpricing o Underpricing is defined as offering new securities for sale at a price below their true value o In a firm-commitment offering, the underwriters will suffer a financial loss if the offer price is set too high; under a best- effort agreement, the issuing firm will lose o If the underpricing is significant, the investment banking firm will suffer a loss of reputation for failing to price the new issue correctly and raising less money for its client Copyright ©2018 John Wiley & Sons, Inc. 38 IPO Pricing and Cost (2 of 6) IPOs are consistently underpriced o Data from the marketplace show that the shares sold in an IPO are typically priced between 10 and 15 percent below the price at which they close at the end of first day of trading o The average first-day return is a measure of the amount of underpricing Copyright ©2018 John Wiley & Sons, Inc. 39 IPO Pricing and Cost (3 of 6) Exhibit 15.4 Initial Public Offerings, Gross Proceeds, and Returns, 19 97–2016 This exhibit summarizes the number of I POs per year, the gross proceeds, and the average first-day returns to investors from all I POs for the 1997–2016 period. The average first-day return represents the amount of underpricing. The exhibit illustrates the substantial variation in I PO activity and underpricing in the U.S. public equity markets during this period. Year Number of IPOs Gross Proceeds ($ billions) Avg First Day Return (%)a 1997 474 $31.8 14.4% 1998 281 33.7 15.6 1999 477 65.0 57.1 2000 381 64.9 46.0 2001 79 34.2 8.7 2002 66 22.0 5.1 2003 63 9.5 10.4 2004 173 31.2 12.4 Copyright ©2018 John Wiley & Sons, Inc. 40 IPO Pricing and Cost (4 of 6) Year Number of IPOs Gross Proceeds ($ billions) Avg First Day Return (%)a 2005 159 28.2 9.3 2006 157 30.5 13.0 2007 159 35.7 13.9 2008 21 22.8 24.8 2009 41 13.2 11.1 2010 91 29.8 6.2 2011 81 27.0 13.0 2012 93 31.1 8.9 2013 157 38.8 20.5 2014 206 42.2 12.8 2015 115 21.7 18.7 2016 74 12.1 14.4 Average 167 $31.3 21.1% a Average returns are calculated as the weighted average where the dollar amount of each issue is the weight. Source: Jay R. Ritter, Table 1 in unpublished note titled “Initial Public Offerings: Updated Statistics,” dated February 20, 2017. Copyright ©2018 John Wiley & Sons, Inc. 41 IPO Pricing and Cost (5 of 6) There are three basic costs associated with issuing stock in an IPO: o Underwriting spread is the difference between the proceeds the issuer receives and the total amount raised in the offering o Out-of-pocket expenses include other investment banking fees, legal fees, accounting expenses, printing costs, travel expenses, SEC filing fees, consultant fees, and taxes o Underpricing, defined as the difference between the offering price and the closing price at the end of the first day of the IPO Copyright ©2018 John Wiley & Sons, Inc. 42 IPO Pricing and Cost (6 of 6) Exhibit 15.5 Costs of Issuing an IPO, 2001–2016 This exhibit shows IPO costs in the United States for the period from 2001 to 2016, by the total value of the shares issued. IPO costs include the direct costs associated with the underwriter’s spread and out-of-pocket expenses plus the costs of underpricing (represented by the average first-day return). As you can see, underpricing costs tend to be higher in larger issues, while direct costs decline as the size of the issue increases. Value of Issue ($ Number of IPOs Direct Costa (%) Average First-Day Returnb (%) millions) $2–9.99 24 16.46% −0.27% $10–19.99 65 11.37 10.20 $20–39.99 126 9.18 6.40 $40–59.99 190 8.28 9.65 $60–79.99 216 7.88 11.74 $80–99.99 199 7.70 19.78 $100–199.99 402 7.56 17.84 $200–499.99 306 6.47 12.72 $500 and over 127 5.35 11.44 All issues 1,655 8.92% 11.06% a Direct costs (underwriting spread plus out-of pocket expenses). b Average first-day returns are reported as a percent of the issue price. Source: Securities Data Corporation and author estimates. Copyright ©2018 John Wiley & Sons, Inc. 43 General Cash Offer by a Public Company (1 of 3) If a public firm has a high credit rating, the lowest-cost source of external funds is often a general cash offer, also referred to as a registered public offering A general cash offer is a sale of debt or equity, open to all investors, by a registered public company that has previously sold stock to the public Copyright ©2018 John Wiley & Sons, Inc. 44 General Cash Offer by a Public Company (2 of 3) Similarities in procedures between general cash offer and those involved in an IPO o Management decides type of security and amount to be raised o Approval is obtained from the board of directors to issue securities o The issuer files a registration statement and satisfies all of the securities laws enforced by the SEC Copyright ©2018 John Wiley & Sons, Inc. 45 General Cash Offer by a Public Company (3 of 3) Similarities in procedures between general cash offer and those involved in an IPO o After assessing demand, the underwriter and the issuer agree on an offer price o At the closing of a firm-commitment offering, the issuer delivers the securities to the underwriter, and the underwriter pays for them, net of its fees Copyright ©2018 John Wiley & Sons, Inc. 46 Competitive vs. Negotiated Sale (1 of 6) In a general cash offer, management must decide whether to sell the securities on a competitive or a negotiated basis In a competitive sale, the firm specifies the type and amount of securities it wants to sell and hires an investment banking firm to do the origination work o Once the origination is completed, the firm invites underwriters to bid competitively to buy the issue Copyright ©2018 John Wiley & Sons, Inc. 47 Competitive vs. Negotiated Sale (2 of 6) In a negotiated sale, the issuer selects the underwriter at the beginning of the origination process o At that time, the scope of the work is defined, and the issuer negotiates the origination and underwriter’s fees to be charged Lowest-cost method of sale o Which method of sale, competitive or negotiated, results in the lowest possible funding cost of the issuing firm? o Competitive bidding keeps everyone honest: the greater the number of bidders, the greater the competition for the security issue, and the lower the cost to the issuer o Negotiated sales lack competition and therefore should be the more costly method of sale Copyright ©2018 John Wiley & Sons, Inc. 48 Competitive vs. Negotiated Sale (3 of 6) Selecting the best method o For debt issues, most experts believe that competitive sales are the least-costly method of selling so called vanilla bonds when market conditions are stable o For equity securities, negotiated sales provide the lowest cost method Copyright ©2018 John Wiley & Sons, Inc. 49 Competitive vs. Negotiated Sale (4 of 6) Shelf Registration o This allows a firm to register an inventory of securities for a two-year period, during which time the firm can take the securities “off the shelf” and sell them as needed o Costs associated with selling the securities are reduced because only a single registration statement is required o A shelf registration statement can cover multiple securities, and there is no penalty if authorized securities are not issued o Benefits of Shelf Registration Greater flexibility in bringing securities to market; securities can be taken off the shelf and sold within minutes Allows firms to periodically sell small amounts of securities, raising money as it is actually needed, rather than banking a large amount of money from a single security sale and spending it over time Copyright ©2018 John Wiley & Sons, Inc. 50 Competitive vs. Negotiated Sale (5 of 6) Exhibit 15.6 Average Gross Underwriting Spread and Out-of-Pocket Expenses as a Percentage of Amount Raised for Public Offerings, 1977–2001 You can see from this exhibit that issuing common stock is the most expensive method of obtaining funds, while issuing corporate bonds (debt) is the least expensive. The higher cost for the stock issues reflects the greater underwriting risk (higher sales commissions) and the higher out-of-pocket expenses required to bring equity securities to market. For all three types of securities shown—common stock, preferred stock, and bonds—there are economies of scale; as issue size increases, total issue cost, as a percent of the amount raised, declines. Common Stock Preferred Stock Bonds Gross Gross Gross Principal Under Out-of- Underwrit Out-of- Underwriti Out-of- Amount writing Pocket ing Pocket ng Pocket ($ Spread Expenses Total Spread Expenses Total Spread Expenses Total millions) (%) (%) (%) (%) (%) (%) (%) (%) (%) $0.0–$9.9 7.69% 5.94% 13.63% 4.69% 3.65% 8.34 2.04% 1.91% 3.95 % % $10.0– 5.99 2.70 8.69 3.05 1.24 4.29 1.29 1.11 2.40 $24.9 $25.0– 5.52 1.57 7.09 2.33 0.57 2.90 0.95 0.68 1.63 $49.9 Copyright ©2018 John Wiley & Sons, Inc. 51 Competitive vs. Negotiated Sale (6 of 6) Gross Gross Gross Principal Under Out-of- Underwrit Out-of- Underwriti Out-of- Amount writing Pocket ing Pocket ng Pocket ($ Spread Expenses Total Spread Expenses Total Spread Expenses Total millions) (%) (%) (%) (%) (%) (%) (%) (%) (%) $50.0– 5.13 0.89 6.02 2.06 0.28 2.34 0.96 0.43 1.39 $99.9 $100.0– 4.68 0.59 5.27 2.76 0.28 3.04 0.90 0.30 1.20 $199. $200.0– 4.16 0.41 4.57 2.63 0.17 2.80 0.84 0.16 1.00 $499.9 $500.0 3.49 0.14 3.63 2.62 0.10 2.72 0.57 0.08 0.65 and over Excludes rights issues, issues callable or putable in under one year, and issues that are not underwritten. Source: Thomson Reuters. Copyright ©2018 John Wiley & Sons, Inc. 52 The Cost of a General Cash Offer Exhibit 15.6 shows the average underwriting spread, out-of- pocket expenses, and total cost for common stock, preferred stock, and corporate bond issues of various sizes Total cost includes only underwriting spread and out-of- pocket expenses Issuing common stock is the most costly alternative, and issuing corporate bonds (nonconvertible) is the least costly Copyright ©2018 John Wiley & Sons, Inc. 53 Private vs. Public Markets (1 of 2) Because many smaller firms and firms of lower credit standing have limited or no access to the public markets, the cheapest source of external funding is often the private markets When market conditions are unstable, some smaller firms that were previously able to sell securities in the public markets no longer can Bootstrapping and venture capital financing are part of the private market as well Copyright ©2018 John Wiley & Sons, Inc. 54 Private vs. Public Markets (2 of 2) Many private companies that are owned by entrepreneurs, families, or family foundations and are sizable companies of high credit quality, prefer to sell their securities in the private markets even though they can access public markets Choice of markets is a function of: o The desire to avoid regulatory costs and transparency requirements o Preference for working with a small group of sophisticated investors rather than the public at large Copyright ©2018 John Wiley & Sons, Inc. 55 Private Placements (1 of 3) Occur when a firm sells unregistered securities directly to investors such as insurance companies, commercial banks, or wealthy individuals About half of all corporate debt is sold through the private placement market Investment banks and money center banks often assist firms with private placements o These banks help the issuer locate potential buyers for their securities, put the deal together, and do the necessary origination work, but do not underwrite the issue o In a traditional private placement, the issuer sells the securities directly to investors Copyright ©2018 John Wiley & Sons, Inc. 56 Private Placements (2 of 3) Private placements have a number of advantages, relative to public offerings, for certain issuers o The cost of funds, net of transaction costs, may be lower with private placements o Private lenders are more willing to negotiate changes to a bond contract o If a firm suffers financial distress, the problems are more likely to be resolved without going to a bankruptcy court o Other advantages include the speed of private placement deals and flexibility in issue size Copyright ©2018 John Wiley & Sons, Inc. 57 Private Placements (3 of 3) The biggest drawback of private placements involves restrictions on the resale of the securities The SEC limits the sale of private placements to several dozen “knowledgeable” investors who have the capacity to evaluate the securities’ investment potential and risk To compensate for the lack of marketability, investors in private placements require a higher yield relative to a comparable public offering Copyright ©2018 John Wiley & Sons, Inc. 58 Private Equity Firms (1 of 4) Like venture capitalists, private equity firms pool money from wealthy investors, pension funds, insurance companies, and other sources to make investments Invest in more mature companies, and they often purchase 100 percent of a business Private equity firm managers look to increase the value of the firms they acquire by closely monitoring their performance and providing better management Copyright ©2018 John Wiley & Sons, Inc. 59 Private Equity Firms (2 of 4) Once value is increased, they sell the firms for a profit. Private equity firms generally hold investments for three to five years Large public firms often sell businesses when they no longer fit the firms’ strategies or when they are offered a price they cannot refuse Establish private equity funds to make investments; these funds are usually organized as limited partnerships or limited liability companies Copyright ©2018 John Wiley & Sons, Inc. 60 Private Equity Firms (3 of 4) Private equity firms focus on firms that have stable cash flows because they use a lot of debt to finance their acquisitions When a large amount of debt is used to take over a company, the transaction is called a leveraged buyout Improve the performance of firms in which they invest by: o Making sure that the firms have the best possible management teams o Closely monitoring each firm’s performance and providing advice and counsel to the firm’s management team o Facilitating mergers and acquisitions that help improve the competitive positions of the companies in which they invest Copyright ©2018 John Wiley & Sons, Inc. 61 Private Equity Firms (4 of 4) Private equity firms carry a much smaller regulatory burden and fewer financial reporting requirements than do public 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 Copyright ©2018 John Wiley & Sons, Inc. 62 Private Investments in Public Equity (1 of 2) Private Investments In Public Equity (PIPE) transactions are transactions in which a public company sells unregistered stock to an investor—often a hedge fund or some other institutional investor o Have been around for a long time, but the number of these transactions has increased greatly since the late 19 90s o Investors purchase securities (equity or debt) directly from a publicly traded company in a private placement o The securities are virtually always sold to the investors at a discount to the price at which they would sell in the public markets to compensate the buyer for limits on the liquidity associated with these securities and, often, for being able to provide capital quickly Copyright ©2018 John Wiley & Sons, Inc. 63 Private Investments in Public Equity (2 of 2) Transactions are not registered with the SEC, they are “restricted securities” Under federal securities law, they cannot be resold to investors in the public markets for a year or two unless the company registers them The company often agrees to register the restricted securities with the SEC, usually within 90 days of the PIPE closing o PIPE transactions involving a healthy firm can also be executed without the use of an investment bank, resulting in a cost saving of 7 to 8 percent of the proceeds o A PIPE transaction can be the only way for a small financially distressed company to raise equity capital Copyright ©2018 John Wiley & Sons, Inc. 64 Commercial Bank Lending Prime-rate loans o The common types of bank loans are prime-rate loans and bank term loans o Prime rate loans are loans in which the borrowing rate is based on the prime rate of interest o The prime rate charged by a bank may be higher than other market borrowing rates because banks provide a range of se Bank term loans o Term loans are business loans with maturities greater than one year o May be secured or unsecured, and the funds can be used to buy inventory or to finance plant and equipment Copyright ©2018 John Wiley & Sons, Inc. 65 The Loan Pricing Model In determining the interest rate to charge on a loan, the banks take the prime rate (PR) plus an adjustment for default risk above the prime rate (DRP), and an adjustment for the yield curve for term loans (MAT ) into account Equation 15.1 ki  PR  DRP  MAT Copyright ©2018 John Wiley & Sons, Inc. 66 Example: Loan Pricing A bank has two customers: 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%. What is the appropriate loan rate for each customer, assuming the loan is a term loan? Firm A : 4.25% Firm B : 4.25%  3.00%  7.25% Copyright ©2018 John Wiley & Sons, Inc. 67 Copyright Copyright © 2018 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright ©2018 John Wiley & Sons, Inc. 68