AFM 274 - Chapter 23

How private firms raise equity (7)

• founders (initial investment)

• angel investors (individuals)

• venture capital (group)

• private equity

• institutional investors

• sovereign wealth funds

• corporate investors

What are angel investors?

• individuals who buy equity in small private companies

  • often friends or people in the inner circle of founder

  • often have lots of say in the company’s activities

• believes in small businesses

What is venture capital?

• group with limited partnership that raise funds to invest in company

• looks at young private companies

• venture capitalists = general partner who runs VC on behalf of limited partners

• more diversified compared to angel investors

• have seats on BOD of start-up they invest in

• provides guidance and knowledge

• first dibs on IPO

• also get fees for helping to run the firm

what is private equity

like venture capital but they invest in existing privately owned firms

what is institutional investors

• endowments, foundations and pension funds

• directly or indirectly invest in private companies

• 0 dividend tax rate to encourage saving up for retirement

• private companies have room for growth, which could provide higher rates of return

what is sovereign wealth funds

• government controlled pools of money that make variety of investments

• financed by recourse revenue (oil) or taxes

what are corporate investors

• large companies that buy equity of younger companies

• often have more strategic than financial goals

what are leverage buyouts?

• getting debt to buy firm so firm can go private

What are some things private firm’s preferred shares do?

• typically issued by founders

• won’t pay dividends but have seniority in liquidation

• often have option to turn into common shares

what is pre-money valuation?

firm’s existing shares at new share price

What are exit strategies and why use them?

Not alot of trading in private firm stock so an exit strategy helps investors realize returns

• IPOs (so investors can sell shares)

• merging with another company

Advantages and disadvantages of IPOs

Advantages

• Allows private equity investors to sell shares and get return on investment

• allows large amounts of capital to be raised

Disadvantages

• potential agency costs as more people old stocks ans monitoring management becomes harder

What is an underwriter and what do they do?

Underwriters manage the firm’s IPO process

• small IPOs have a best-effort basis

  • sell stock on behalf on firm at best price but no guarantee of selling it all

• large IPOs have firm commitment basis

  • selling stocks with guarantee for all shares to be sold

  • underwriter buys all stocks at discount and needs to sell all the shares as OG price

  • if not all the shares are sold at OG price, they sell it at discount

What is an auction IPO

investors submit bids on how many shares they’re willing to buy at what price

• supply and demand model

• most popular price wins

What is the IPO process

large IPO = large group of underwriters (ft. lead underwriter)

• other members are called syndicate

• red herring = BODs approval for preliminary prospects

• red herring is evaluated and edited

• underwriters estimates price range depending on valuation

• road show = underwriter tells their friends all about the firm and they do IPO auction

• final price is determined through book building

• final prospect has all the finalized details

  • needs regulators’ approveal

what is the IPO selling process

• not selling price at less than offering price (syndicate)

• lead underwriter can buy shares to manipulate market price

• if unsold after a period, syndicate break up and sell the stocks at whatever price they can

What is a lock-up period

a period of time during an IPO where pre-existing shareholders cannot sell their shares

• this preserves demand

• no period = everyone selling = increased supply = decreased price

How do underwriters manage risk?

1) setting a low offer price

• not always possible as firms will go to another underwriter who will report a higher price

2) over-allotment allocation (greenshoe option)

• underwriters can sell 15% more shares than available

• double booked shares can be shorted

  • price goes up = underwriter buys 15% more shares from firm for market

  • price goes down = underwriter buys 15% more shares from market for firm

what is a naked short position?

short selling more than the over-allotment option. If prices fall, underwritten needs to buy back from market (expensive option) as the firm isn’t willing to issue more than OG % and over-allotment %

What is a reverse greenshoe?

underwritter sell shares back to firm at offer price (price fall = buy from market (cheaper) = sell to firm (higher IPO price)

What are stabilizing bids?

underwriter posting bids in the market to buy shares at market price, helps stabilize the stock price to higher

What are penalty bids?

underwriters give shares to investors who promise not to sell them for a period of time. If they do, they(‘re broker has to) pay a penalty

• prevents price from dropping from increased supply

• different from an lockup period

  • for old investors vs new investors during IPO

Price manipulation

Illegal in any process other than IPO as underwriters take on lots of risk. Some stabilization is transparent to public, while others aren’t

ex. of price manipulation

• stabilizing bids

• penalty bids

risks with setting a IPO price

• if the price is too high, firm will have to cancel IPO and won’t be listed on the stock market

• if the price is too low, the IPO firm will go to another underwriter who is willing to value higher

• therefore, under pricing is very common

  • the closing price on IPO date is higher than opening price

What is the winner’s curse?

• good investors will only buy good IPOs

• uninformed investors will buy both good and bad IPOs

  • will need to diversify their portfolio

• As everyone will be bidding for good IPOs, it’ll be oversubscribed

• Bad IPOs would need to put a discount to encourage uninformed investors to not get discouraged

why is volume of IPOs cyclical?

• periods of economic upturn, everyone is optimistic and more people are investing into companies

• periods of economic downturn, everyone is pessimistic and less people are investing as returns are not highly expected

What does the avg performance of a firm look like after IPO?

• usually it falls

• shares are typically overvalued during IPO as more people are excited about the new IPO

What are some examples of IPO scandals? (4)

• spinning: underwriters selling good IPOs to their buddies (insider trading)

• laddering: forcing investors to buy shares in aftermarket to get into IPO in the first place

• underwriters paying the analysts to write a good review on the IPO firm

• underwriters selling IPOs to investors who get lots of commissions on other stuff

What is a seasoned equity offer? (SEO)

a public company issuing more shares

• shorter + simpler than IPO process

• cash offer

  • offer new share to any investor

• rights offer (pre-emptive right)

  • offer new shares to existing investors first

  • avoid dilution of ownership structure and %

Rights Offers

• one right per share

• subscription price = price of shares being used to buy with existing share rights

• must be a shareholder on record date (ex-div date)

  • on share it specifies “rights-on” or “ex-right”

• can exercise or sell right

• standby underwriting: if existing shareholders don’t get all the newly issued shares, the person/group in the standby underwriting buys the rest

Effects of an SEO

• share price drops because of information asymmetry

• Here’s what the equity holders think:

  • managerial information: shares are overpriced, so management is trynna cash in on the profit

  • debt capacity: must not be able to borrow more debt, so the firm might be financially not good

  • insufficient earnings: can’t generate future CF, so issue more shares to get CF going

what are the costs of issuing new equity?

• flotation costs:

  • direct costs: administrative fees, prospective costs, legal fees, etc.

  • indirect costs: management time, under pricing, greenshoe (IPO) or price drops (SEO)

what is the prompt offering prospective (POP)?

Canadian system that allows large firms to file annual statements with OSC

• whether they are issuing new shares or not this yr

• whether they want to use a shorter prospective

American system is shelf registration