Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-1 Chapter 11 Investment Banks, Retail Securities Firms, and Venture Capitalists: Management

Copyright © 2000 by Harcourt, Inc. All rights reserved.

11-1

Chapter 11Investment Banks, Retail Securities Firms, and Venture Capitalists: Management and

Ethical Issues


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Growth and Size of Securities Firm Industry

1990’s Data for the U.S.

• About 8,000 securities firms.

• Firms had more than $54 billion in equity capital.

• Firms controlled more than $1.25 trillion in assets.

• In 1997 debt underwriting exceeded $1 trillion and stock underwriting was greater than $150 billion.


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The growth and size of the industry, however, is very cyclical, with increases during bull stock markets, decreases during bear markets and periods of large trading losses.


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Prior toRenaissanceRenaissance17th & 18th

Centuries

Specialization in money lending business by non-Catholics.Catholics adhered to dictums against lending; such church restrictionson commerce weaken in the Renaissance, and in the 17th and 18th

centuries economic prosperity leads to the growth of public securities,banking, and merchant banking.

Late 18th

CenturyGrowth of major European family-run international banking houses(Rothchilds, Baring brothers, Warburgs). Large European governmentneeds to finance wartime activities brings rise of new merchant bankers.

19th Century Rise of London as financial capital; large financings for IndustrialRevolution; large railroad financings; emergence of large U.S.investment banks, such as J.P. Morgan. Immigrants start securitiesfirms, such as Joseph Seligman and Goldman and Sachs; Jay Cooke &Co. uses syndication process to sell bonds to public during the CivilWar. In the later 1800s era of financing tycoons, such as J.P. Morganand development of oligopolistic behavior by prestigious Wall Streetfirms.

Brief Historic Overview of Securities Firms Emphasizing U.S. Securities Firms


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20th Century1914-1950s

New York becomes major financial center during World War I, U.S.security firms assist in foreign and U.S. financings; during 1920sbroader public interest in securities. Modernization of securities issueorigination and distribution process with growth of telephone andtelegraph.1929: Stock market crash followed by lawsuits and hearings againstsecurity firms;1933: Glass Stegall breaks up banks and security firms; poorlycapitalized security firms with severe underwriting losses remain;mergers and cutbacks during the depression.WWII: Securities firms assist in government financings; anti-Wall Streetsentiment ends; English merchant banks facilitate first postwar hostiletakeovers.

Historic Overview (continued)


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1960s Dollar becomes principal currency of international trade. With deficitsin the United States, a stable international climate, the1963 Interest Equalization tax penalizing the sale of some foreignsecurities to American investors, and regulation Q preventing banks tooffer market rates, banks and securities firms flock abroad, resulting inthe development of the Eurodollar and Eurobond market; London isreestablished as a major financial market.First Eurobond issue for the Italian Autostrade in 1963.Greater trading activities; new breed of impersonal traders.Greater number of investment banks with international subsidiaries;high inflation; more active management of investments by institutionalinvestors; securities firms develop services for institutional investorsincluding block trading; this made firms like Salomon Brothers withlarge trading operations prominent.

Historic Overview (Continued)


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1970s Former hierarchy in underwriting of prestigious underwriters is challenged byfull-service security firms, such as Merrill Lynch. Securities firms introduceproduction-oriented compensation to attract traders that creates new rivalries andtensions; entry of new type of “gunslinger;” development of research servicesarea to attract investors.Dollar becomes a floating currency; 1972: Merrill Lynch receives first license tohave a security branch in Japan. Largest Japanese security firms expandoverseas; first yen-denominated bond (samurai bond) issued by non-Japaneseissuer.May 1, 1975: Fixed brokerage commissions abolished, making commissionscompetitively based; a few discount brokerage firms spring up, and security firmsmerge. High inflation leads to innovations to offer market rates, including cashmanagement funds in 1977 by Merrill Lynch; other money and mutual fundsfollowed.

1980s March 16, 1982: Shelf Registration Rule (Rule 415) adopted by SEC, allowingcorporations to register securities and issue them at any time over the next twoyears. SEC Rule 415 gives firms more flexibility to seek competitive bids forofferings, particularly debt offerings, which reduced underwriter gross spreads.



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Mid-1980s Bull market; Go-Go Days; Great merger and acquisition activity;innovation of junk bonds by Drexel Lambert; leveraged buyouts;dramatic growth in underwriting; industry grows from 5,248 firms in1980 to 9,515 in 1987.Securitization rises.1986: “Big Bang” in London removes fixed commissions and otherreforms, including development of a new international Stock ExchangeAutomated System (SEAQ), allowing 24-hour off-exchange trading.

Later 1980s October 1987: Stock Market Crash resulting in lower underwriting and aloss of confidence by investors in equity markets. Insider trading andother scandals contribute to poor perceptions of security firms by thepublic. Profitability of securities industry declines with large drop inunderwriting and brokerage commissions. Between 1987 and 1991,period of consolidation in the industry, mergers, and layoffs. Number offirms declines by about 20 percent.Movement into venture capital, real estate venture, mortgage-backedsecurities, and principal investing.



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1990s Greater competition from major commercial banks with section 20subsidiaries. Recession; low profits; diversification into fixed incomesecurity and derivatives trading; securitization to offset decline inunderwriting.1992 on: Bull stock market and rise in profits but severe drop inunderwriting and profits in 1994. Industry expands to about 8,000firms. Mid and Later 1990s: Acquisitions by large banks and otherfinancial institutions and mergers of wholesale retail firms. Tradingscandals by rouge traders caused large losses, such as the 1995 Baringsscandal and collapse.1992: European Economic Community harmonized regulations andallowed financial institutions to sell services throughout the EC.Lawsuits by customers and employees; greater oversight by SEC andexchanges. Innovations; growth of Internet services; emergence ofonline brokerage firms and the first online investment bank.


Source: Samuel L. Hayes III and Philip M. Hubbard, Investment Banking (Boston: Harvard Business School Press, 1990), Anthony Saunders, Financial Institutions Management: A Modern Perspective, 2ed (Burr Ridge Ill: Irwin, 1997); and Ron Chernow, The House of Morgan (New York: Touchstone (Simon & Schuster), 1990)


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Changes in the Culture of Investment Banking

In mid-1960’s, changed from white glove genteel culture to a competitive, cutthroat one.

• Production-oriented compensation eroded collegiality and generated rivalries and tensions.

• The adoption of a new fee-for-services mentality is directly related to the declining importance of underwriting and the greater importance of fees from M&A activity and trading.


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Investment Banker Reputation

Firms that are being valued and taken public depend on a banker’s good judgement and honesty.

Short-term, unethical abuses ultimately hurt a firm and an individuals’ most valuable asset, reputation.

Examples of ethical breaches:• Salomon Brothers Treasury scandal (1990); and

• Drexel, Burnham, and Lambert junk bond scandal (1988).


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Key Areas of Activities for Securities Firms

Investment banking underwriting for debt and equity securities, private placements, M&A

Principal transactions involving trading and investment activities

Selling and dealing activities for customers as an agent


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Investing activities as an agent Back office activities Other activities such as merchant banking,

real estate investment trust and real estate investment partnerships


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Changing Revenue Sources

Commissions 49.9% 15.4%

Principal Transactions 15.6 17.1

Underwriting Revenues 13.3 9.0

Margin Interest 7.8 5.8

Mutual Fund Sales .6 3.8

Commodities 3.0 1.3

All Other+ 9.9 47.6

Total Revenues 100.0% 100.0%

1975 1996

+Other activities include M&A fees, private placements, market making and global investment management.


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Details on Revenue Sources

Fees for services to institutional investors have become a bigger source of revenue.

With globalization, U.S. gross activity in foreign securities and foreign gross activity in U.S. securities has grown dramatically.


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Between 1975 to 1996:

• the mutual fund/asset management business grew at an annual rate of 30%;

• interest income, private placement, M&A activities grew at an annual rate of 23%;

• revenues grew at an annual compound rate of 43% ; and

• earnings grew at a 13.5% annual rate.


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Financial Ratios Based on the Income Statement

Commissions/revenues(%) Principal transactions/revenues(%) Investment banking/revenues(%) Revenues/expenses(%) Portfolio revenue/investments(%) Revenues per employee Expenses per employee Compensation and benefits per employee Number of employees


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Commissions/revenues will be larger for retail firms than for wholesale firms.

Wholesale investment banking firms typically have fewer employees and higher revenues, expenses, compensation, and benefits per employee than retail firms.


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Types of Assets for Securities Firms

Because of trading and broker/dealer activities, a large percentage of assets are securities.

Other assets are predominantly receivables from customers and broker/dealers.

Fixed assets are a small percentage of assets. Large NYC investment banks will also hold

derivative contracts, debt and currency swaps, and physical commodities as assets.


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Liabilities for Securities Firms

Liabilities are predominantly short-term and include:

• short-term borrowing and repurchase agreements;

• securities sold but not yet purchased; and

• customer payables.

Security firms generally have high financial leverage. Equity-to-asset ratios are lower for wholesale firms than for retail firms.


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In managing trading risks securities firms have….

tried to collect better information on trading risks by using DEAR and VAR measures.

attempted to allocate greater capital and capital cost for potential losses associated with risky activities using RAROC approach.


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position limits for traders based on the market risk of traders’ portfolio.

devised compensation methods that consider traders’ returns along with the additional risk that riskier trades impose on the firm.


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Underwriting Risk

Underwriting risk is the risk of adverse price movements immediately after the issue of new securities.

Under negotiated offerings, investment bankers purchase securities at a given price and sell securities at a higher offering price to the public.


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Underwriters have had greater risk with SEC 415 shelf registration deals. • In a bought deal, an investment bank has not had

time to develop a syndicate or access market interest rates before submitting a bid.

• A kamikaze offer is an offer by a prospective underwriter for a bought deal at such a low yield that other underwriters may decline to participate in the syndicate.


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To reduce underwriting risk investment bankers...

form syndicates of securities firms to take on a portion of the offering and reduce the underwriting and selling risk to the lead underwriter.

hedge their underwriting positions in futures markets.

use stabilization techniques during the first 30 days of a new stock issue, whereby they purchase or sell securities to stabilize the security’s price.


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Venture Capital (VC) Firms

VC firms are investment firms that provide seed capital to startup firms, start-up capital to firms beginning to operate or manufacture a product, and later stage capital and bridge financing.

VC firms’ goal is to make a large return, averaging about 50% per year, for investors who are willing to take the risk of investing in relatively new firms.


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VCs invest in a portfolio of firms with high growth potential, generally taking an equity stake in the firm.

Their objective is to take a firm public or sell it in a short time frame of five to seven years.

Firms must give up a portion of control of the business to the VC firm.


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Types of VC Firms

Private VC firms Angels Venture capital networks (VCNs) Small business investment corporations

(SBICs) Minority enterprise small business

investment companies (MESBICs)


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Steps in the IPO Process

Signing the letter of intent Conducting a valuation of the company Determining the share price and total

number of shares to be sold Performing an active due diligence of the

firm to be taken public Submitting the registration form to the SEC


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Marketing IPO through road shows and publishing a preliminary red herring prospectus

After SEC approval, the underwriting contract is executed and an effective date for the offering is set.

During the 30 days after the offering, the investment banker practices stabilization techniques if needed.

Documents

Copyright © 2000 by Harcourt, Inc. All rights reserved. 11-1 Chapter 11 Investment Banks, Retail Securities Firms, and Venture Capitalists: Management