Foundations of Financial Management: An Analysis (part 56)

“Don’t stay in bed, unless you can make money in bed.” 

– George Burns

Investment Banking (Part B)

by

Charles Lamson

Pricing the Security

If you'll remember from last post, a syndicate in finance is a group of lenders who work together to provide funds for a single borrower or seller of stock. The borrower or seller of stock can be a corporation, a large project, or a sovereign government (Investopedia.com). However, in this instance we are talking only about the selling of stock by corporations. Because the syndicate members purchase the stock for redistribution in the marketing channels, they must be careful about the pricing of the stock. When a stock is sold to the public for the first time (i.e., the firm is going public), the managing investment banker will do an in-depth analysis of the company to determine its value. The study will include an analysis of the firm's industry, financial characteristics, and anticipated earnings and dividend-paying capability. Based on appropriate valuation techniques, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry's average price-earnings ratio (the current market price of a company share divided by the earnings per share of the company) is 20, the firm should not stray too far from this norm. Anticipated public demand will also be a major factor in pricing a new issue.

The great majority of the issues handled by investment bankers are, however, additional issues of stocks or bonds for companies already trading publicly. When additional shares are to be issued, the investment bankers will generally set the price at slightly below the current market value. This process, known as underpricing, will help ensure a receptive market for the securities.

At times an investment banker will also deal in large blocks of securities for existing stockholders. Because the number of shares may be too large to trade in normal channels, the investment banker will manage the issue and underprice the stock below current prices to the public. Such a process is known as a secondary offering, in contrast to a primary offering, in which new corporate securities are sold to the public for the first time.

Dilution

A problem a company faces when issuing additional securities is the actual or perceived dilution of earnings effect on shares currently outstanding. In the case of the Lamson Corporation, the 250,000 new shares may represent a 10 percent increment to shares currently in existence. Perhaps the firm had earnings of $5 million on 2,500,000 shares before the offering, indicating earnings per share of $2. With new shares to be issued, earnings-per-share will temporarily slip to $1.82 ($5,000,000/2,750,000).

The proceeds from the sale of new shares may well be expected to provide the increased earnings necessary to bring earnings back to at least $2. While financial theory dictates that a new equity issue should not be undertaken if it diminishes the overall wealth of current stockholders, there may be a perceived time lag in the recovery of earnings per share as a result of the increased shares outstanding. For this reason, there may be a temporary weakness in a stock when an issue of additional shares is proposed. In most cases this is overcome with time.

Market Stabilization

Another problem may set in when the actual public distribution begins---namely, unanticipated weakness in the stock or bond market. Since the sales group normally has made a firm commitment to purchase stock at a given price for redistribution, it is essential that the price of the stock remain relatively strong. Syndicate members, committed to purchasing the stock at $20 or better, could be in trouble if the sale price falls to $19 or $18. The managing investment banker is generally responsible for stabilizing the offering during the distribution. And may accomplish this by repurchasing securities as the market price moves below the initial public offering price of $21.50 in this example. 

The period of market stabilization usually lasts two or three days after the initial offering, but it may extend up to 30 days for difficult to distribute securities. In a very poor market environment, stabilization may be virtually impossible to achieve.

Aftermarket

The investment banker is also interested in how well the underwritten security behaves after the distribution period, because the banker's ultimate reputation rests on bringing strong securities to the market. This is particularly true of initial public offerings.

Initial public offerings often do well in the immediate aftermarket. Because the managing underwriter may underprice the issue initially to ensure a successful offering, often the value jumps after the issue first goes public. However, the efficiency of the market eventually takes hold, and sustained long-term performance depends on the quality of the issue and the market conditions at play.

Shelf Registration

In February 1982, the Securities and Exchange Commission began allowing a new filing process called shelf registration under SEC Rule 415. Shelf registration permits large companies to file one comprehensive registration statement that outlines the firm's financing plans for up to the next two years. Then, when market conditions seem appropriate, the firm can issue the securities without further SEC approval. Future issues are thought to be sitting on the shelf, waiting for the appropriate time to appear.

Shelf registration is at variance with the traditional requirement that security issuers file a detailed registration statement for SEC review and approval every time they plan a sale. Whether investors are deprived of important "current" information as a result of shelf registration is difficult to judge. While shelf registration was started on an experimental basis by the SEC in 1982, it has now become a permanent part of the underwriting process. Shelf registration has been most frequently used with debt issues, with relatively less utilization in the equity markets (corporations do not wish to announce equity dilution in advance).

Shelf registration has contributed to the concentrated nature of the investment banking business. The strong firms are acquiring more and more business and, in some cases, are less dependent on large syndications to handle debt issues. Only investment banking firms with a big capital base and substantial expertise are in a position to benefit from this registration process. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 446-448*

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