13+-+ch24+debt+financing+part+1.pdf

Finance 317 Corporate Financing Decisions Equity and Debt Financing

Kuncheng Zheng

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The Roadmap

Where we have been ~ Capital structure

PCM, taxes, distress, agency, information

~ Payout policy

Dividends, repurchases, taxes

~ Equity financing

IPOs

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The Roadmap

Where we are going (as far as time permits) ~ Debt financing & Hybrid securities*

~ Short term financing*

Working Capital/Cash

~ Mergers & Acquisitions

~ Risk Management

~ Other topics

Leasing?

Governance?

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Previous Lecture

Equity Financing ~ Providers of initial private equity financing

Angel Investors

Venture Capital Funds

~ Initial Public Offering

Advantages and Disadvantages

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Todays Class

Initial Public Offering ~ Mechanics of the IPO

~ IPO Puzzles

Seasoned Equity Offerings

PIPEs

Corporate Debt ~ Source: Public vs. Private

~ Seniority: Secured vs. Unsecured

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The Mechanics of an IPO

The IPO Process ~ Select the lead underwriter

~ SEC filings: Preliminary Prospectus

~ Preliminary valuation: using cash-flow projections and/or comparables

~ The Road Show and Book Building

~ Final Prospectus set

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Example: theglobes.com ???

In Sept. 1998, theglobes.com (issuer) conduct bake-off competition to select underwriter. Bear Stearns won the competition.

Bear Stearns (underwriter) valued the company with the help of the issuer and set the price range of $11 to $13.

Bear Stearns and theglobes.com hold two-week series of road show meeting with insitutional investors. Market turmoil prompted the price range to $8 to $10.

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Example: theglobes.com ???

Bear Stearns built a book by canvassing big investors to get indication of interest.

On Nov. 12, the day before the trading, Bear Stearns set final price.

On Nov. 13, trading started. ~ $87 when market opened

~ Peak at $97

~ Closed at $65

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SEC Filings ~ Registration Statement:

Provides financial and other information about a company to investors prior to a security issuance

~ Preliminary Prospectus

Part of the registration statement prepared by a company prior to an IPO that is circulated to investors before the stock is offered

~ Final Prospectus

Contains all of the details of the offering, including the number of shares offered and the offer price

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Valuation ~ Determining the value of the company

~ Two main methods:

Compute the present value of the estimated future cash flows (DCF)

Estimate the value by examining comparables (recent IPOs)

When the two approaches yield substantially different results, comparables usually used

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Valuation ~ Road show (see www.retailroadshow.com)

Who?

Senior Management

Underwriters

What?

Convince potential buyers that the firm is a great investment

To Whom?

Mainly institutional investors such as mutual funds and pension funds

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Valuation ~ Book Building

A process used by underwriters for coming up with an offer price based on customers expressions of interest

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Pricing the deal and managing risk ~ Spread

The fee a company pays to its underwriters that is a percentage of the issue price of a share of stock

~ With firm commitment, underwriters expose themselves to risk that the shares will not sell at the offer price

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Pricing the deal and managing risk ~ Over-Allotment Allocation (Greenshoe Provision)

Allows the underwriter to issue more stock, usually amounting to 15%, of the original offer size at the IPO offer price

Underwriter will market the total number of shares including the greenshoe allotment

They buy the over-allotted stock back if the offer is a bust

If its successful, they exercise the greenshoe option

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Pricing the Deal and Managing Risk

~ Lockup

A restriction that prevents major existing shareholders and insiders from selling their shares for some period, usually 180 days, after an IPO

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IPO Puzzles (Outline)

Underpricing

Cyclicality

Costs of an IPO

Long-Run Underperformance

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Underpricing

Generally, underwriters set the issue price so that the average first-day return is positive ~ 75% of first day returns are positive

~ Average first day return in the United States is 18.3%

Venture-backed IPOs are less under-priced.

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Underpricing

Who bears the cost? ~ The underwriters benefit from the underpricing as

it allows them to manage their risk

~ Investors who are able to buy stock from the underwriter at the IPO price also gain

~ The pre-IPO shareholders bear the cost of the underpricing

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Underpricing

Why underprice?

~ Supply side The issuing firm may underprice to ensure a successful

offering

Reduce the possibility of being stuck with unsold securities

Costly and embarrassing

Do favors to their preferred clients who may return favors by

Giving lucrative investment banking business and/or

Paying generous commissions

Typically, the issuing firm can designate about 10% of the newly issue shares to friend and family of its senior executives.

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IPO Scandals

Spinning: Allocating hot IPOs to the personal brokerage accounts of top executives in return for company business

Laddering: Requiring the purchase of additional shares in the aftermarket in return for IPOs

Analyst conflicts of interest: Giving buy recommendations in return for underwriting and M&A business

Commission business in return for IPOs: Underwriters allocated IPOs primarily to investors that generated soft dollar commissions on other trades

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Example of Kickbacks/Commissions

Credit Suisse First Boston (CSFB) received commission business equal to as much as 65% of the profits that some investors received from certain hot IPOs, such as the December 9, 1999 IPO of VA Linux. The VA Linux IPO involved 5.06 million shares ~ Offer price: $30.00

~ Closing market price: $239.25

~ Capital gain: $209.25

~ Gross spread: $2.10

If the investor then traded shares to generate commissions of one-half of this profit the total underwriter compensation per share was $2.10 plus $104.625, or $106.725

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Spinning Scandal Example

Salomon Smith Barney gave

Bernard Ebbers (former CEO of

WorldCom) 869,000 shares of 21

deeply under-priced IPOs. Salomon

received $76 million in investment banking fees from WorldCom.

Ebbers made more than $11 million in trading profit. (Does this remind you what we discussed earlier this semester?)

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Underpricing

Why underprice? ~ Winners Curse

Refers to a situation in competitive bidding when the highest bidder, by virtue of being the highest bidder, has very likely overestimated the value of the item being bid on

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Underpricing

Although IPO returns are attractive, all investors cannot earn these returns ~ When an IPO goes well, the demand for the stock

exceeds the supply

Thus the allocation of shares for each investor is rationed

~ When an IPO does not go well, demand at the issue price is weak, so all initial orders are filled completely

The typical investor will have their investment in good IPOs rationed while fully investing in bad IPOs

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Underpricing

Winners Curse ~ Adverse selection - uncertainty

~ The required underpricing gets larger as the uncertainty increases

~ This is why underpricing is bigger for:

Penny stocks underwritten through best efforts arrangements

IPOs in less developed stock markets

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Underpricing

Entrepreneur Charlie is taking his firm to IPO. He sets the offering price at $100. The true market price can be $120 m or $80 with equal probabilities.

If the issue is over-priced (true price = $80), investor Erica believes that she will get all shares she asked for.

If the issue is under-priced (true price = $120), Erica believes that she will get 25% of what she asked for.

PV of the purchase: -$20*0.5+$20*0.25*0.5=-$7.5

What price would make Erica willing to buy? ~ $88

What if the uncertainty is higher? ($60 or $140) ~ $76

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Underpricing

What can a firm do to minimize underpricing? ~ Reduce uncertainty

~ Be more transparent, more disclosure

~ Road show

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Cyclicality

The number of IPOs is highly cyclical ~ When times are good, the market is flooded with

new issues; when times are bad, the number of issues dries up

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Cyclicality

Cyclicality of IPOs in the USA

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Costs of an IPO

A typical spread is 7% of the issue price ~ By most standards this fee is large, especially

considering the additional cost to the firm associated with underpricing

~ It is puzzling that there seems to be a lack of sensitivity of fees to issue size

One possible explanation: charging low fees signals that the underwriter is of lower quality

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Costs of an IPO

Relative Costs of Issuing Securities

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Long-Run Underperformance

Shares of IPOs generally perform very well immediately following their initial offering

But these newly listed firms subsequently perform relatively poorly over the following 3 to 5 years after their IPOs

Lemons, anyone?

~ Is equity a signal that equity is overpriced?

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The Seasoned Equity Offering and Private Placement

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The Seasoned Equity Offering

When a public company offers new shares for sale

Public firms use SEOs to raise additional equity

~ The firm follows many of the same steps as for an IPO

Main difference?

~ Market price already exists, so the price-setting process isnt necessary

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The Mechanics of an SEO ~ Cash Offer: A type of SEO in which a firm offers

the new shares to investors at large

In the U.S., most offers are cash offers

~ Rights Offer: A type of SEO in which a firm offers the new shares only to existing shareholders

Rights offers protect the existing shareholders from underpricing

In the UK, most SEOs are rights offers

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Price Reaction ~ 3.1% drop in stock price

~ If managers work for existing shareholders, then theyd like to issue equity at a time when shares are over-priced (market timing)

~ The negative reaction is consistent with managers using superior information to benefit existing shareholders at the expense of new shareholders

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Post-SEO Performance

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Issuance Costs ~ Although not as costly as IPOs, seasoned offerings

are still expensive

~ Underwriting fees amount to 5% of the proceeds of the issue

Rights offers have lower costs than cash offers

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Private Placements

Private Investments in Public Equity (PIPE) ~ A PIPE is a private transaction between a limited

group of investors and a public company

~ PIPEs have become an increasingly popular source of financing for young, high-risk firms

~ Key reasons for a PIPE

Speed

Confidentiality

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PIPE

Steven has a high tech firm. The firm went IPO two years ago when the market believed the firm will start to make profit in two years. However, because of some technical difficulty, two more years is needed. Steven needs some money to support the research and hire expert Sagar to help. But, the trading of the stock in NASDAQ is thin and no analyst cover the firm. The technology is not ready for patent yet, which means no asset to secure a loan. What can Steven do?

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Private Placements

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Private Placements

Private Investments in Public Equity ~ The market reacts positively to announcements of

a PIPE: 5.49% over 10 days

Public Offering PIPEs

Issue Discount 3.10% 9.30%

Gross Proceeds 43.6 millions 7.7 millions

Book value of Asset 110.2 millions 31.9 millions

Market Cap. 298.7 millions 92.8 millions

Source: Wu, Y. L. 2004. The choice of equity-selling mechanisms.

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Private Placements

Private Placement Public Offering

Higher issue discount

More dilutive than public offering

Smaller gross proceeds (issue size)

Smaller number of investors

Higher likelihood of increased

ownership concentration after

issue

More incentive to monitor

Better accessibility to poor

performing firm

Lower issue discount

Less dilutive than private

placement

Larger gross proceeds

Increase the total firm value more

than private placement

Atomistic/dispersed investors

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Debt Financing

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Corporate Debt

Corporate debt structure is characterized by: ~ Source:

Public

Private

~ Priority:

Secured

Unsecured Senior

Subordinated

~ Maturity:

Short-Term

Long-Term

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Source of Financing

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Source of Financing

Public Debt ~ e.g.: Commercial Paper, Public Bonds

~ Public debtholders consist of numerous and anonymous public investors

~ Publicly traded

~ Early 2012: $7 trillion in corporate bonds

Private Debt ~ e.g.: Bank, Private Placement

~ Firm needs to convince a limited number of investors privately, not publicly traded

~ Held by a small number of investors

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Source of Financing Public Debt

Public Debt ~ A public bond issue is similar to a stock issue

~ Indenture

Included in a prospectus, it is a formal contract between a bond issuer and a trust company

~ Corporate bonds almost always pay coupons semiannually, although a few corporations have issued zero-coupon bonds

~ Most corporate bonds have maturities of 30 years or less

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Public Debt Market (Bond Market) ~ Domestic Bonds

Bonds issued by a local entity and traded in a local market

They are denominated in the local currency

~ Foreign Bonds

Bonds issued by a foreign company in a local market and intended for local investors

They are denominated in the local currency

e.g.: Yankee, Samurai, Matador and Bulldogs

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Public Debt Market (Bond Market) ~ Eurobonds

International bonds that are not denominated in the local currency of the country in which they are issued

Can be denominated in any currency

~ Global bonds

Combine the features of domestic, foreign and Eurobonds and offered for sale in several different markets simultaneously

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Source of Financing Private Debt

Private Debt ~ Debt that is not publicly traded

Advantage: avoids the cost of registration

Disadvantage: being illiquid

~ Term Loans

~ Revolving Line of Credit

~ Private Placements

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Private Debt: Term Loans ~ Term Loan A (TLA)

amortizing term loans

Require substantial principal repayment throughout

Viewed as less risky by lenders

e.g.: 10%, 10%, 15%, 15%, 25%, 25%

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Private Debt: Term Loans ~ Term Loan B (TLB)

institutional term loans

More prevalent in LBO financing than TLAs

Typically larger and longer maturity than TLAs, sold to institutions

Smaller payments and larger coupons with bullet at maturity

e.g.: 1%, 1%, 1%, 1%, 1%, 1%, 94%

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Private Debt: Revolving Line of Credit ~ A credit commitment for a specific time period,

typically two to three years, which a company can use as needed (5-6 years for LBOs)

~ Freely borrowed/repayed/reborrowed throughout the term, subject to contract conditions

~ The unused portion remains off the balance sheet

~ This is an important instrument in corporate liquidity management

~ Typically secured

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Private Debt: Revolving Line of Credit ~ In terms of pricing, the firm pays a commitment

fee that is a percentage of the unused portion and a predetermined interest rate on any drawn amount

~ Median (commitment fee): 25bp above LIBOR

~ Median (int. rate on drawn funds): 150bp above LIBOR

~ Median Maturity: 3 years

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Private Debt: Syndication ~ A single loan that is funded by a group of banks

rather than just a single bank

~ The syndicate

Lead Bank(s)

Participants

~ Why?

~ Agency/Information issues?

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Private Debt: Private Placements ~ A bond issue that is sold to a small group of

investors rather than the general public

Because a private placement does not need to be registered, it is less costly than public debt

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Private Debt: Private Placements ~ In 1990, the SEC issued Rule 144A

Allows private debt issued under this rule to be traded by large financial institutions among themselves

Because this debt is tradable between financial institutions, it is only slightly less liquid than public debt

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Seniority

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Seniority

Seniority (Priority) ~ The debt priority refers to the order in which

claims are to be paid in the event of bankruptcy

~ Secured, unsecured senior and subordinated

~ Senior debt has a prior claim over subordinated debt with respect to collateral value and cash flow

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Seniority

Secured debt is senior and collateralized with certain, specific assets of the corporation

Senior unsecured debt is junior to the secured debt, but prior to the subordinated debt

Types of Corporate Debt:

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Seniority

Mortgage Bonds ~ A type of secured corporate debt

~ Real property is pledged as collateral that bondholders have a direct claim to in the event of bankruptcy

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Seniority

Asset-Backed Bonds ~ Can be secured by any kind of asset

~ A type of secured corporate debt

~ Specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy

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Seniority

Unsecured Debt ~ Notes

A type of unsecured corporate debt

Notes typically are coupon bonds with maturities shorter than 10 years

~ Debentures

A type of unsecured corporate debt

Debentures typically have longer maturities

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Seniority

Subordinated Debt ~ Subordinated debt is lent based on the amount

and predictability of cash flow required to service senior debt

~ Because subordinated debt usually has little collateral protection, the lender may request warrants convertible into the companys equity

~ Why would they do this?

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Seniority

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Seniority

Quick Review: ~ Secured

Mortgage Bonds

Asset-Backed Bonds

~ Unsecured (Senior and Subordinated)

Notes

Debentures

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Maturity

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Maturity

Maturity: Short- vs. Long-Term

Short-term (15%) ~ Debt with one year or less maturity

~ Easily rolled over (usually)

Long-term (85%) ~ Debt with a maturity of longer than one year

Matching

Recall: Agency implications

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Next Class

Other Types of Debt

Repayment Provisions

Hybrid Securities

13+-+ch24+debt+financing+part+1.pdf

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