Raising Capital The Process and the Players Decisions Facing the Firms nFirms can raise investment capital from many sources with a variety of financial instruments. qThe firm’s financial policy describes the mix of financial instruments used to finance the firms nInternal Capital qFirms raise capital internally by retaining the earnings that generate nExternal Capital: Debt vs. Equity qFirms must gain an access to the capital market and make a decision about a type of funds to raise. Sources of Capital n Public and Private Source of Capital nFirms raise debt and equity capital from both public and private sources qCapital raised from public sources must be in the form of registered securities nSecurities are publicly traded financial instruments nPublic securities differ from private instruments because they can be traded in public secondary market like NYSE, PSE, FSE etc. nPrivate capital comes at most in the form of bank loans or in the form called as private placements qFinancial claims takes of the registration requirements that apply to securities qTo quality for this private placement exemption, the issue must be restricted to a small group of sophisticate investors – fewer than 35 in number – with minimum income or wealth requirements nThese sophisticate investor are very often represented by insurance companies of pension funds n Public and Private Source of Capital nPublic markets tend to be anonymous, that is, buyers and sellers can complete they transactions without knowing each others identities qUninformed investor run the risk of trading with other investors that are more informed because they have “inside” information about the particular company and can make a profit from it. nAlthough, insider trading is illegal and uninformed investors are at least partially protected by laws that prevent investors from buying and selling public securities based on insider information. nInsider information is an internal company information that has not been made public qIn contrast, investors of privately placed debt and equity are allowed to base their decision of information that is not publicly known. §Because traders in private market are assumed to be sophisticate investors who are aware of each other’s identities, inside information about privately placed securities in not as problematic nBecause private market are not anonymous, they generally are less liquid qTransaction costs associated with buying and selling private debt and equity are generally much higher than the costs of buying and selling public securities q The Environment for Raising Capital nA bulk of regulations govern public debt and equity issue. qThese regulations certainly increase the costs of issuing public securities, but also provide protection for investors which support the value of securities. nMarkets that are highly regulated are e.g. markets in Western Europe or in the US n less regulated are e.g. emerging market qMajor risk in emerging markets is that shareholder rights will not be respected and as a result and, many stocks traded in these markets sell for substantially less than the value of their asset The Environment for Raising Capital nFor example: qIn 1995 Lukoil, Russia’s biggest oil company with proven reserves of 16 billion barrels, was valued at 850 USD million, that implies that its oil was worth 5 cents a barrel qAt the same time Royal Dutch/Shell with about 17 billion barrels of reserves, had a market value 94 billion USD, making its oil worth more than 5 USD per barrel qLukoil is worth so substantially less because of uncertainty about shareholder’s rights in Russia. q Investment banks nThe most important subject in the process of issuing of securities nModern investment banks are made up of two parts qCorporate businesses qTrading businesses Investment banks nThe Corporate Business qThe corporate side of investment banking is a fee-for-service business nInvestment bank sells its expertise qThe main expertise banks have is in underwriting securities qBut they are also sell other services nMerge and acquisition advice qProspecting for takeover targets qAdvising clients about the price to be offered for these targets qFinding financing for the take over qPlanning takeover tactics or on the other side takeover defenses qMajor investment banking houses are also actively engaged in the process of new financial instruments design nETFs, investment certificates, etc. n Investment banks nThe Sale and Trading Business qInvestment banks that underwrite securities sell them to the bank’s institutional investors qThese investors include mutual funds, pension funds or insurance companies qSales and trading of these institutions also consists of public market making, trading for clients, etc. nMarket making requires that investment bank act as a dealer in securities. It means that is standing ready to buy and sell, respectively, announces its bid and ask prices. The bank makes money from the difference between the bid and ask price called bid-ask spread. n The Underwriting Process nThe underwriting of a security issue performs four functions qOrigination qDistribution qRisk bearing qcertification Origination nOrigination involves giving advice to the issuing forms about qthe type of security to issue qthe timing of the issue qand the pricing of the issue nOrigination also means working with the firm to develop the registration statement and forming a syndicate of investment bankers to market the issue Distribution nIt is the second function in underwriting process, distribution means selling of the issue nDistribution is generally carried out by a syndicate of banks formed by the lead underwriter nThe banks in the syndicate are listed in the prospectus along with how much of the issue each has aggregate to sell Risk Bearing nThe third function the underwriting process is risk bearing nIn most cases, the underwriter has agreed to buy the securities the firm is selling and to resell them to its clients nThe Rules of Fair Practices prevents the underwriter from selling securities at a price higher than that agreed on at the pricing meeting, so the underwriter’s upside is limited nIf the issue does poorly, the underwriter may be stuck with securities that must be sold at bargain prices n Certification nAn addition 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 nAn investment banker’s reputation quickly decline if the certification task is not performed correctly nIf an underwriter substantially misprices an issue, in the future business is likely to be damaged qStudies suggested (Booth and Smith 1986) that underwrites require higher fees on issues that are harder to value Underwriting Agreement nThe underwriting agreement between the firm and the investment bank is the document that specifies what is being sold, the amount that being sold and the selling price. nThe agreement also specifies the underwriting spread, which is the difference between the total proceeds of the offering and the net proceeds that is accrue to the issuing firm nThe underwriting agreement also shows the amount of fixed fees the firm must pay like listing fees, taxes, etc. n Classifying Offering nIPO qInitial Public Offering nIssuing equity to the public for the first time nSEO qSeasoned Offering nIf a firm has already publicly traded and is simply selling more common stock nBoth IPO and SEO can include primary and secondary issues nIn a primary issue qA firm rises capital for itself by selling stock to the public nIn a secondary issue qIt is undertaken by existing shareholders who want to sell a number of shares they currently own The Costs of Debt and Equity Issues n The Costs of Debt and Equity Issues nDebt fees are lower than equity fees qEquities are related with higher risk qBonds are easier for pricing than stock nThere are economies of scale in issuing qFixed fees decline as issue size rises nIPO is much more expensive than SEO qIPOs are far riskier and much more difficult to price q Trend in Raising Capital nGlobalization nDeregulation nInnovative Instruments nTechnology nSecuritization Globalization nCapital market are now global nLarge multinational firms routinely issue debt and equity outside their domestic country nBy taking advantages of the differences in taxes and regulations across countries, corporation can sometimes lower their cost of funds qAs firms are better able to shop globally for capital, we can expect regulation around the world to become similar and the taxes associated with raising capital to decline nAs a result, the costs of raising capital in different part of worlds are likely to equalized Deregulation nDeregulation and globalization go hand in hand nCapital will tend to go to countries where returns are large and restrictions on inflows and outflows are small Innovative Instruments nNew instruments qAllow firms to avoid the constraints and costs imposed by government qTailor securities to appeal to new sets of investors qAllow firms to diminish the effects of fluctuating interest and exchange rates nThe result of this process is a wide range of financial instruments available in the global amrket place Technology nTechnology allows many of these recent trends to take place qTechnology leads to continuous 24-hour trading around the world, thus producing a true world market in some securities Securitization nIt is the process of bundling qthat is, combining financial instruments that are not securities, registering the bundles as securities, and selling them directly to the public nE.g. CMOs – Collateralized Mortgage Obligations qDebt contracts based on the payoffs of bundles of publicly traded mortgages nMarket of asset-backed securities Investment Banks and Venture Capital Firms Investment Banks nInvestment banks are best known as qIntermediaries that help corporations raise funds nInvestment banks provide many valuable and sophisticate services qInvestment bank is not a bank in the ordinary sense, that is, it is not a financial intermediary that takes in deposits and then lend them out nIn addition to underwriting the initial sale of stocks and bonds qInvestment banks also play a pivotal role as deal markets in merges and acquisitions area nAs intermediaries in the buying and selling of companies nWell-known investment banking firms are qMorgan Stanley, Merrill Lynch or Goldman Sachs q Investment Banks nOne feature of investment banks that distinguishes them from stockbrokers and dealers is qThat they usually earn their income from fees charged to clients rather than from commissions on stock trades qThese fees are often set as a fixed percentage of size of the deal being worked qThe percentage fee will be smaller for large deals n3% qAnd much larger for smaller deals nSometimes exceeding 10% Investment Banks: Background nIn the early 1800s most of the American securities had to be sold in Europe nAs a result, most of the securities firms developed from merchants that operated a security business as a sideline to their primary business qMorgans built their initial fortune with the railroads qTo help raise the money to finance railroad expansion, J.P. Morgan’s father resisted in London and sold their Morgan railroad securities to European investors nPrior to the Great Depression, many large, money center banks in NY sold securities and conducted conventional banking activities qDuring the Depression, about 10.000 banks failed (about 40% of all commercial banks) nThis led to the passage of the Glass-Steagall Act, which separated commercial banking from investment banking Investment Banks: Background nThe Glass-Steagall Act made it illegal for a commercial bank to buy or sell securities on behalf of its customers nThe original reasoning behind this legislation was to insulate commercial banks from greater risk inherent in the securities business nThere were also concerns that conflicts of interest might arise that would subject commercial banks to increased risk qAn investment banker working at a commercial bank makes a mistake pricing a new stock offering Mergers and Acquisitions nInvestment banks have been active in the mergers and acquisitions market since the 1960s nA merge occurs when two firms combine to form one new company qBoth firms support the merger, and corporate officers are usually selected so that both companies contribute to the new management team qStockholders turn in their stock for stock in the new firm nIn an acquisition, one firm acquires ownership of another by buying its stock qOften this process is friendly qAt other times, the firm being purchased may resist nResisted takeovers are called hostile qIn these cases, the acquirer attempts to purchase sufficient shares of the target firm to gain a majority of the seats on the board of directors n Mergers and Acquisitions nInvestment bankers serve both acquirers and target firms nAcquiring firms require help in locating attractive firm to purchase, soliciting shareholders to sell their shares in a process called a tender offer, and raising the require capital to complete the transaction nTarget firms may hire investment bankers to help ward off undesired takeover attempts Private Equity Investment nWhen is talking about investing there are usually discussing stocks and bonds nHowever, there is an alternative to public equity investing, which is private equity investing nWith private equity investing, instead to raising capital by selling securities to the public, a limited partnership is formed that raises money from a small number of high-wealth investors nWithin the broad universe of private equity sectors, the two most common are qVenture funds qCapital buyouts Venture Capital Firms nVenture capital firms provide the funds a start-up company needs to get established nThis money is most frequently raised by limited partnerships and invested by the general partner in firms showing promise of high returns in the future nVenture capitalists backed many of the most successful high-technology companies during the 1980s and 1990s qApple Computer, Cisco Systems, Microsoft, Sun Microsystems, etc nAnd number of service firms qStarbucks Venture Capitalists Reduce Asymmetric Information nUncertainty and information asymmetries frequently accompany start-up firms qEspecially in high-technology communities nManagers of these firms may engage in wasteful expenditures, such as leasing expensive office space, since the manager may benefit from disproportionately from them but does not bear their entire cost nOr biotechnology company founder may invest in research that brings personal acclaim but little chance for significant returns to investors nAs a result of these information asymmetries, external financing may be costly, difficult, or even impossible to obtain Venture Capitalists Reduce Asymmetric Information nFirst, as opposed to bank loans of bond financing, venture capital firms hold an equity interest in the firm nThe firms are usually privately held, so the stock does not trade publicly nEquity interests in privately held firms are very illiquid nAs a result, venture capital investment horizons are long-term nThe partners do not expect to earn any return for a number of years, often as long as a decade Venture Capitalists Reduce Asymmetric Information nInvestors in stocks or bonds are often unwilling to wait years to see in a new idea, process, innovation, or invention will yield profits nVenture capital financing thus fills an important gap left vacant by alternative sources of capital nAs a second method of addressing the asymmetric information problem, venture capital usually comes with strings attached, the most noteworthy being that the partners in a venture capital firm take seats on the board of directors of the financed firm qVenture capital firms are not passive investors nThey active attempt to add value to the firm through advice, assistance and business contracts Venture Capitalists Reduce Asymmetric Information nOne of the most effective ways venture capitalists have of controlling managers is to distribute funds to the company in stages only as the firm demonstrates progress toward its ultimate goal qIf development stalls or markets changed funds can be withheld to cut losses nImplicit to venture capital financing is an expectation of high risk and large compensating returns nVenture capital firms will search very carefully among hundreds of companies to find a few that show real growth potential Origin of Venture Capital nThe first true venture capital firm was American Research & Development, established in 1946 by MIT president Karl Compton nThe bulk of their success can be traced to on $70.000 investment in a new firm, the Digital Equipment Company qThis invested money grew in value to $355 million over the next three decades Origin of Venture Capital nDuring the 1950s and 1960s, most venture capital funding was for the development of real estate and oil fields nBy the late 1960s, the U.S. Department of labour clarified the prudent man rule, which restricted pension funds from making risky investments qExplicitly allowed investment in some high risky assets qThis resulted in a surge of pension fund dollars going into venture projects Origin of Venture Capital nCorporate funding of venture capital projects increased when many companies reduced their investment in their own in-house R&D in favor of outside start-up companies nThis change was fueled by evidence that many of the best ideas from in-house centralized R&D were unused or were commercialized in new firms started by defecting employees qSalaried employees tend not to be as motivated as businessman who stand to capture a large portion of the profits a new idea may generate q Structure of Venture capital Firms nMost early venture capital firms were organized as closed-end mutual funds qClose-end mutual fund sells a fixed number of shares to investors qOnce all of the shares have been sold, no additional money can be raised qInstead, a new venture fund is established nThe advantage of this organization structure is that it provides the long-term money required for venture investing qInvestors can not pull money out of the investment as they could from an open-end mutual fund Structure of Venture capital Firms nIn the 1970s and 1980s, venture capital firms began organizing as limited partnerships nWhile both organizational forms continue to be used, currently most venture capital firms are limited partnerships The Life of a Deal nMost venture capital deals follow a similar life cycle qThat begins when a limited partnership is formed and funds are raised qIn the second phase, the funds are invested in start-up companies qFinally, the venture firm exits the investment Fundraising nA venture firms begins by soliciting commitments of capital from investors qPension funds, corporations, wealthy investors nVentura capital firms usually have a portfolio target amount that they attempt to raise qBecause the minimum commitment is usually to high, venture capital funding is generally out of reach of most average individual investors nThe limited partners understand that investment in venture funds are long term qIt may be several years before the first investment starts to pay qIn many cases, the capital may be tied up for seven to ten years qThe illiquidity of the investment must be carefully considered by the potential investor Investing nOnce the commitments have been received, the venture fund can begin the investment phase nFrequently, venture capitalists invest in a firm before it has a real product or is even clearly organized as a company qSeed investing 60 % nInvesting in a firm that is a little further along in its life cycle is known as qEarly-stage investing 25 % nFinally, some funds focus on later-stage investing qProviding funds to help the company grow to a critical mass to attract public financing 15% Exiting nThe goal of the venture capital investment is to help a firm until it can be funded with alternative capital nVenture firms hope that an exit can be made in no more than seven to ten years nOnce an exit is made, the partners receive their shares of the profits and fund is dissolved Exiting nThere are number of ways for a venture fund to successfully exit an investment qThrough an IPO nAt a public stock offering, the venture firm is considered as insider and receives stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years nOnce the stock is freely tradable, usually after two years, the venture fund distributes the stock to its limited partners, who may then hold the stock or sell it nOver the last 25 years, over 3.000 companies financed by venture funds have had IPOs nAn equally common type of successful exit for venture investment is through merges and acquisitions qVenture firms receives cash or stocks from the acquiring company nThese proceeds are then distributed to the limited partners n Venture Fund Profitability nVenture investing is extremely high-risk and most start-up firms do not succeed nIf venture investing is high-risk, then there must also be the possibility of a high return to induce investors supplying funds nHistorically, venture capital firms have been very profitable qThe 20-year average return is 16,5% nSeed investing is most profitable with a 20-year average return 20,4%, compare to about 13,5% for later-stage investing Thank you for you attention