Foundations of Financial Management: An Analysis (part 55)

“You can be young without money, but you can’t be old without it.” 

– Tennessee Williams

Investment Banking

by

Charles Lamson

Enumeration of Functions

As a middleman in the distribution of securities, the investment banker has a number of key roles. These functions are described below.

Underwriter In most cases the investment banker is a risk-taker. The investment banker will contract to buy securities from the corporation and resell them to other security dealers and the public. By giving a "firm commitment" to purchase the securities from the corporation, the investment banker is said to underwrite any risks that might be associated with a new issue. While the risk may be fairly low in handling a bond offering for ExxonMobil or General Electric in a stable market, such may not be the case in selling the shares of a lesser-known firm in a very volatile market environment.

Though most large, well-established investment bankers would not consider managing a public offering without assuming the risk of distribution, smaller investment houses may handle distributions for relatively unknown corporations on a "best-efforts," or commission, basis. Some issuing companies even choose to sell their own securities directly. Both the "best-efforts" and "direct" methods account for a relatively a small portion of total offerings.

Market Maker During distribution and for a limited time afterward, the investment banker may make a market in a given security---that is, engage in the buying and selling of the security to ensure a liquid market. The investment banker may also provide research on the firm to encourage active investor interest.

Advisor The investment banker may advise clients on a continuing basis about the types of securities to be sold, the number of shares or units for distribution, and the timing of the sale. A company considering a stock issuance to the public may be persuaded, in counsel with an investment banker, to borrow the funds from an insurance company or, if stock is to be sold, to wait for two more quarters of earnings before going to the market. The investment banker also provides important advisory services in the area of mergers and acquisitions, leveraged buyouts, and corporate restructuring. 

Agency Functions The investment banker may act as an agent for a corporation that wishes to place its securities privately with an insurance company, a pension fund, or a wealthy individual. In this instance the investment banker will shop around among potential investors and negotiate the best possible deal for the corporation.

The Distribution Process

The actual distribution process requires the active participation of a number of parties. The principal or managing investment banker will call on other investment banking houses to share the burden of risk and to aid in the distribution. To this end, they will form an underwriting syndicate comprising as few as 2 or as many as 100 investment banking houses. In Figure 1 we see a typical case in which a hypothetical firm, the Lamson Corporation, wishes to issue 250,000 additional shares of stock with Merrill Lynch as the managing underwriter and an underwriting syndicate of 15 firms.

Figure 1 Distribution process in investment banking

The underwriting syndicate will purchase shares from the Lamson Corporation and distribute them through the channels of distribution. Syndicate members will act as wholesalers in distributing the shares to brokers and dealers who will eventually sell the shares to the public. Large investment banking houses may be vertically integrated, acting as underwriter-dealer-brokers and capturing all fees and commissions.

The Spread The underwriting spread represents the total compensation for those who participate in the distribution process. If the public or retail price is $21.50 and the managing investment banker pays a price of $20.00 to the issuing company we say there is a total spread of $1.50. The $1.50 may be divided up among the participants as indicated in Figure 2.

Figure 2 Allocation of underwriting spread

Note that the lower a party falls in the distribution process, the higher the price for shares. The managing investment banker pays $20, while dealers pay $20.75. Also, the farther down the line the securities are resold, the higher is the potential profit. If the managing investment banker resells to dealers, he makes $0.75 per share, if he resells to the public, he makes $1.50.

The total spread of $1.50 and the present case represents 7 percent of the offering price ($1.50/$21.50). Generally, the larger the dollar value of an issue, the smaller the spread is as a percentage of the offering price. Percentage figures on underwriting spreads for U.S. corporations are presented in Table 2. This table actually illustrates that the smaller the issue, the higher the fees, and also that equity capital is more expensive than debt capital. The higher equity spreads reflect the fact that there is more uncertainty with common stock than for other types of capital. 

Table 2 Underwriting compensation as a percentage of proceeds

Since the Lamson Corporation stock issue is for $5.375 million (250,000 shares X $21.50), the 7 percent spread is in line with SEC figures in Table 2. It should be noted that the issuer bears not only the "give-up" expense of the spread in the underwriting process but also out-of-pocket costs related to legal and accounting fees, printing expenses, and so forth. As indicated in Table 3, when the spread plus the out-of-pocket costs are considered, the total cost of a small issue is rather high but decreases as the issue size increases. Of course substantial benefits may still be received. 

Table 3 Total costs to issue stock (percentage of total proceeds)

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 442-445*

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