Why might an investment bank place higher priority on sell-side M&A engagements over buy-side engagements?
The sell-side of the M&A group is often given the highest priority since it has a higher probability of completion, which results in accompanying fees. The buy-side has a lower probability of completion. However, in the case of buy-side transactions, a nominal retainer fee may be charged during the period of the engagement.
Many investment banks have a principal investment group that invests directly in public and private companies. What conflicts of interest might arise from operating this type of business?
Similar to a private equity firm, the principal investment group of an investment bank invests directly in securities and real estate for their own account. This can include leveraged buyouts (sometimes referred to as control investments) and purchases of minority positions in companies. However, conflicts of interest arise if the investment bank is also advising the companies they invest in. This is dealt with in a similar way to the proprietary trading division with Chinese walls.
What conflicts might exist between the proprietary trading division and the rest of the investment bank?
Proprietary traders must be dealt with on an arm’s length basis by internal salespeople, and confidentiality is paramount. Because proprietary trading happens with the firm’s money, they could benefit greatly from having inside information on the companies that the investment bank deals with as clients. Therefore, there are strict compliance guidelines that wall off proprietary traders from certain information that is available to the client-related areas of the firm. Some firms go even further and completely wall off proprietary traders from any interaction with client-related sales and trading.
What conflicts might exist as a result of having both an Asset Management (AM) business and a Private Wealth (PW) Management business?
The Private Wealth Management Division advise investors on where they can invest their resources. The problem lies in the fact that the PW and AM Divisions are under one division head, and PW could have the incentive to direct investors into investments managed by AM, which may not best meet the risk and return objectives of the investors.
Chapter 2 – Regulation of the Securities Industry
Following the 1929 stock market crash, Congress passed a series of Acts to regulate the securities industries. Name four of these Acts and briefly describe their purpose
The securities act of 1933 – meant to bring stability to capital markets and stop manipulative and deceptive practices in the sale or distribution of financial securities. Disclose their information.
The 1933 glass steagall act – separated commercial and investment banks and created the FDIC which insured depositors’ assets in the event of a bank default up to 250,000 today.
1934 securities exchange act – this law dealt primarily with the supervision of new security offerings, ongoing reporting requirements for these offerings and the conduct of exchanges. Made the SEC.
Investment Company Act of 1940 – determined what constitutes an investment company (best known as mutual funds) and separates the functions of investment banks and investment companies. Sets out restrictions on the number of investment bankers who can serve as directors of an investment company and restricts business transactions between investment banks and investment companies.
The Sarbanex Oxyley Act (spelling?) – restoring confidence in the accounting profession, improving tone at the top, improving disclosure and financial reporting, improving performance of gatekeepers and enhancing enforcement tools.
A goal of many parts of U.S. regulatory legislation has been to eliminate or minimize conflicts of interest between issuers, investment banks, and investors. Provide examples of conflicts of interest in the U.S. investment banking industry and the corresponding regulations that attempted to resolve those issues.
Sell-side research vs. banking division: global research settlement; spinning: global research settlement; insider trading: ’34 Act; independence of outside auditors: Sarbanes-Oxley; commercial banks vs. investment banks: Glass-Steagall; bankers’ involvement in bankruptcies: Chandler Act; investment bank/mutual fund cross holdings/mgmt: ICA 1940.
Disclosure of information to investors is another recurring theme in U.S. regulation of the securities industry. Provide examples of disclosure required by U.S. regulations.
must disclose, summary information, risk factors and ratio of earnings to fixed charges, use of proceeds, dilution, selling security holders, plan of distribution, description of securities to be registered, interests of names experts and counsel…. . A description of the company’s properties and business, a description of the security to be offered for sale, information about management of the company and financial statements certified by independent accountants
What is the role of U.S states in regulating investment banks?
Only anti-fraud matters.
What types of U.S. securities offerings do not need to be registered with the SEC?
private offerings to a limited number of persons or institutions, offering of limited size, intrastate offerings and securities of municipal, state and federal governments.
What is a red herring?
Prior to reforms promulgated during 2008, oral and written offers by an issuer were prohibited during the waiting period. During the waiting period, oral or written offers, but not sales, could be made and any offers made in writing could only be made by means of a prospectus that conformed to the requirements of the 1933 Act. This prospectus is typically called a red herring prospectus because of the red legend on the first page that reminds investors that the information contained in the prospectus is preliminary.
Widgets Inc. is a publicly traded company with approximately $300 million in market capitalization. The company filed a registration statement for a follow-on offering in May of this year, but began selectively speaking to investors about the issue in March. Its offering is now being delayed by the SEC. What is the likely reason for the delay?
The reason for the delay could because during the waiting period offers could only be made by means of a prospectus. Since they violated this rule the SEC could make them wait. They have violated the gun-jumping rules. Violations of these basic restrictions are referred to as gun jumping, and may result in an SEC imposed cooling off period, rescission right to purchasers in the public offering, and class action or other litigation.
What are the risk factors in a prospectus? Why are they important to the issuer and to the investor?
Risk Factors are disclosures about potential problems the company may encounter, including possible losses, unpredictable revenue, capacity constraints, reliance on suppliers, technological change, competition, litigation regulation, customer mix, etc.
Issuer: The issuer must list every reasonable risk in order to meet full disclosure requirements of securities laws and to therefore have a defense in case they are sued by shareholders if the company’s share price drops. Investors: Investors should read these disclosures to ensure that they understand all relevant risks before making decisions regarding purchase of securities
What is the significance of the Gramm-Leach-Bliley Act of 1999 in relation to the securities industry?
This act overturned the mandatory separation of commercial and investment banks as originally required by the Glass-Steagall Act.
What are some securities regulations in place in the United Kingdom, Japan and China that mirror U.S. regulations?
Japan and China: Originally separated the functions of commercial and investment banks (these changes happened within a much shorter time frame for China). Later, like the U.S., those restrictions were eliminated. Also, various Japanese laws requiring disclosure and internal controls in public companies were similar to those in the U.S. The U.K. also has an SRO system like the U.S. China instituted anti-fraud and insider trading rules in 2005 similar to those in the U.S.
What are some major differences between the regulatory frameworks of the four countries covered in this chapter?
One main difference is the U.S. has somewhat fragmented and decentralized securities regulatory bodies, whereas in the other three countries, securities regulation is centralized.
Compare the regulatory bodies of the four countries covered in this chapter.
The Financial Supervisory Agency in Japan, the Financial Services Authority in U.K., and the China Securities Regulatory Commission are the sole financial regulators in those countries (centralized). In the U.S., the two main regulators are the Fed and the SEC (US more fragmented). In addition, entities such as the Commodity Futures Trading Commission and the FDIC also have regulatory powers (US even more fragmented)
What type of securities offerings do not need to be registered with the SEC?
Private placement securities do not need to be registered with the SEC, These are completed under the exemption rule 144a, which applies to qualified institutional buyers (QIB investing over $100 million)
List the three types of bank participants in an underwriting syndicate and their core responsibilities, in order of compensation received, from high to low.
Lead Bookrunner: determine the marketing method and pricing for the transaction, highest underwriting allocation.
Co-Managers: provide minor input on marketing and pricing, do small underwriting allocation. There are 1-7 co-managers
Selling group: doesn’t take on any financial risk, just sell.
What are league tables and why are league tables important in investment banking?
A league table keeps track of underwriting participation of all banks, and is a basis for comparing different banks underwriting capabilities. League tables are important in investment banking as it is how their clients can compare them. League table leaders are more attractive when seeking a bank as an advisor.
Describe the function of the equity capital markets group, including the two major divisions they directly work with and the two types of clients they indirectly work with.
Capital market groups originate and execute capital market transactions. They work directly with client coverage bankers and the syndicate desk. They work indirectly with issuers and investors. The capital markets group basically runs between the issuers and the buyers of securities.
Describe the unique process utilized by Google in its IPO, including its intended advantages and potential disadvantages.
Google wanted their IPO to be done in a Dutch auction fashion. This was designed to allow for a greater distribution to retail investors, by issuing stocks to the highest bidders. This process would also avoid some of the excess seen in an IPO. Investment bankers were concerned that this strategy would alienate the biggest clients, as they would hold no large advantage in claiming a large allocation of the IPO.
What is a shelf registration statement and what securities can be included in it?
A shelf registration statement allows a company to file a single registration statement that covers multiple issues of different types of securities. Equity offerings, debt, and convertible securities can all be included in a shelf registration statement. It is filed at least annually.
Why might a younger high-tech company select equity over debt when raising capital?
Equity strengthens the balance sheet. A stronger balance sheet will lead to higher ratings, and permit further funding to be available in the future using cheaper debt. A young company may want to initially strengthen their balance sheet before issuing bonds.
A BBB-/Baa3 rated company is looking at acquiring a smaller (but sizeable) competitor. Discuss considerations the company should take into account when deciding whether to fund the acquisition with new debt, equity, or convertible securities.
The company would want to consider 1) the cost of capital that comes with stock issuance, 2) the current state of their balance sheet (leveraged), 3) the impact on future cash flows, and 4) the EPS impact of issuing new stock and/or a convertible bond.
Suppose a company issues a $180 million convertible bond when its stock is trading at $30. Assuming it is convertible into 5 million shares, what is the conversion premium of the convertible?
Proceeds/# of Shares=Conversion Price
(Conversion Price-Current Price)/Current Price=Conversion Premium
$180 million/5 million=$36
20% Conversion Premium
How many shares will be issued by a convertible issuer if conversion occurs for a $200 million convertible with a conversion premium of 20%, which is issued when the issuer’s stock price is $25? Show your calculation.
Current Price*(1+Premium)=Conversion price
Proceeds/Conversion Price=# of Shares
$200 million/$30=6.67 million
Why did the SEC delay declaring Google’s IPO registration effective?
The SEC did not elaborate on the delay in declaring Google’s IPO. Assumptions have been made that the delay in declaring Google’s IPO registration effective was likely due to there being an issue or error in the paperwork.
Provide reasons that an investment bank might give to support their advice that a private company should “go public.”
Reasons for taking a company public include: 1) access to the public market, 2) enhanced profile and marketing benefits, 3) creation of an acquisition currency and compensation vehicle, 4) liquidity for shareholders.
List six characteristics of companies that are good targets for an equity issuance.
strong stock performance or supportive equity research, 2) large insider holding or small float/illiquid trading, 3) overly leveraged capital structure, 4) strategic event: finance acquisition or large capital expenditure, 5) sum of the parts analysis indicates hidden value, 6) investor focus.
How does a negotiated (best efforts) transaction differ from a “bought deal”?
Best efforts transactions is where the bank buys the entire issue at a discount, and then tries to resell at a higher price. The gross spread represents the compensation for the bank taking on the risk. A bought deal is when the bank buys the whole transaction at a specified price, and again, tries to sell at a higher price to other investors. The difference between these two transaction who bears the risk. In a best efforts transaction, the issuer bears the risk, and it a bought deal, the bank bears the risk.
What are some methods used by investment banks to help equity issuers mitigate price risk during the marketing process?
To mitigate price risk during the marketing process by filing a registration statement. The prospectus portion of this filing notes a share price range. During the marketing process, a red herring prospectus is shown during the marketing period to display pricing during this process.
Explain what a green shoe is.
A green shoe option gives an investment bank the right to sell short 15% of the shares the bank is underwriting. This creates a “naked” short position. Shares need to be bought following the initial offering.
When a company has agreed to a green shoe, who does the underwriter buy shares from if the share price drops? Who do they buy shares from if the share price increases?
Share price drops – market
Share price increases – issuer
This feature is intended to stabilize the price of an equity following its initial placement in the market.
Calculate the investment bank’s fees and profit for a 5 million share equity offering at $40/share, with a 15% green shoe option (fully exercised) assuming a 2% gross spread, assuming the issuer’s share price decreases to $38/share after the offering.
5 million shares * $40/share = $200 million * 2% underwriting fee = $4 million total bank underwriting fee
(5 million * 15% greenshoe option) * $40 = $30 million sold short
(5 million * 15%) *$38 = $28.5 million how much what they sold short is worth now that the share price has decreased to $38/share
$30 million – $28.5 million = $1.5 million profit bank makes on share price decreasing
=1.5 million + $4 million = $5.5 million
What is the tradeoff for having a stabilizing green shoe option in a common equity offering?
There is a potential risk for negative EPS, as there is a chance that more shares will have to be issued. Because earnings are split among shares, so the > # of shares the < EPS
Provide definitions for strategic buyers and financial buyers in a prospective M&A transaction.
A strategic buyer is a company whose business is currently in line with that of the company to be purchased. The strategic buyer would gain synergies from purchasing a company similar to itself because of similar operations and business.
Financial buyers typically take on debt to fund the purchase of a company. The purchase of the company is primarily to capture profits in a return on their investments from growth opportunities. These buyers are typically hedge funds, private equity firms, and venture capital firms. Financial buyers are often involved in leverage buyouts.
Why have strategic buyers traditionally been able to out bid financial buyers in auctions?
Strategic buyers are more inclined to outbid financial buyers because of synergies.
Why are revenue synergies typically given less weight than cost synergies when evaluating the combination benefits of a transaction?
Revenue synergies are typically more difficult to capture than cost synergies (like revenue based departments are more prestigious than cost based departments).
In the United States, if an M&A transaction is relatively large within its industry, what is the name of the regulatory filing that is probably necessary before the transaction can be consummated? Which agency is it filed with? How long is the waiting period after a filing is made? What is the name of the European regulator that may be relevant in an M&A transaction?
Hard-Scott Rodino filing, with the Federal Trading Commission, 30 days, European Commission may be relevant.
Assume an acquiring company’s P/E is 15 and the target company’s P/E is 11. Is the acquirer more or less likely to use stock as the acquisition currency? Why?
The company would be less likely to use stock as the acquisition currency. By using stock as the acquisition currency, EPS is diluted and the acquiring company’s P/E ratio would increase making the stock potentially less attractive.
What is a potential risk of trying to complete a stock-based acquisition during periods of high market volatility?
When prices swing drastically, purchasing stock or issuing stock to complete an M&A could potentially be detrimental to a company’s stock price. If the swing goes negative and EPS is diluted, the swing will be even more negative.
Assume an investment bank has provided a fairness opinion on a proposed M&A transaction. Does this mean the board should go ahead and approve the transaction?
Not necessarily, it merely included a summary of the valuation analysis conducted by the investment bank to show the basis on which the opinion is offered.
Why might a board want to include a “go-shop” provision in the merger/purchase agreement?
A firm could potentially find a buyer whose synergies and/offer may be better than previous synergies and/or offers of other companies. Another firm may also prove to be more beneficial to the board even after the break-up fee included. A go-shop provision allows firms to find additional buyers
When is a break-up fee paid? What is the typical fee charged as a percent of equity value?
When the target company walks away from a transaction after the M&A or Stock Purchase Agreement has been made. Typical fees charged are 2-4% of equity value.
Of the various methods by which a corporate subsidiary can be separated from the parent company in the public markets (IPO, carve-out, spin-off, split-off, and tracking stock), which ones offer the subsidiary the most and least independence?
The most independent methods are: IPO, Spin-off, and Split-off (much less common than the Spin-off). Methods that are not Independent: Carve-out, and Tracking stock.
List the four principal alternative methods for establishing value in an M&A transaction.
-Comparable Company analysis
-comparable transaction analysis
-leveraged buyout analysis
-discounted cash flow analysis.
Of the major valuation methods, which one(s) are based on relative values? on intrinsic values? on ability to pay?
DCF is based on intrinsic values, Comparable company, and comparable transaction analysis are based on relative values, and LBO is ability to pay.
Suppose you are the sell-side advisor for a multinational household and personal products manufacturer and marketer that sells primarily to the mass consumer markets. The analyst on your deal team prepares the following comparable companies analysis. Which, if any, of the companies in the list would you potentially remove from the analysis?
P&G may be too big; Prestige may be too small; McBride only sells in Europe (and may be too small).
Which valuation method tends to show the lowest valuation range? Why?
LBO method tends to show the lowest valuation range because it does not include synergies, has a high cost of capital and has a high required return (IRR).
Which of the following companies would make a better LBO target, and why? (a) A diversified manufacturer of consumer snack products or (b) a manufacturer of factory automation equipment for car makers, agricultural equipment and other heavy machinery.
The target for the LBO should be the consumer snack product manufacturer because that is (1) a more stable industry, (2) a higher likelihood of predictable and increasing cash flows, and (3) most likely a lower CAPEX than company B.
When might an investment bank decline participation in an underwriting and why?
Page 111 – “The decision is made based on both trading considerations and the amount of regulatory capital needed to support the business.” A riskier deal requires the firm to use a larger portion of its own cash to cushion against potential trading losses. “If they are convinced that the firm will lose money on the underwriting or expose itself to other significant risks, they will likely oppose a transaction.”
How do professionals in sales, trading and research work together?
Page 111-113 – “Traders conduct extensive research to gain insight into the securities that they trade.” – “Research can focus on specific securities, industries, and financial products or on general economic, political, or regulatory topics.” – “Sales professionals cover individual and institutional investing clients.” – Research analysts make stock recommendations to traders and to salespeople. Sales and Trading work together and with other institutional traders to buy and sell securities held by the firm.
Sales talk to clients
Trading conduct research to learn about the securities they trade
Research make stock recommendations to traders and salespeople
Describe what Prime Brokerage is, including four principal products in this area and the generic name of the financial institutions that are targeted for this business.
Prime Brokerage provides
securities lending and margin loans
trade clearing, custody, and settlement
real estate and computer assistance
and performance measurement and reporting.
Hedge funds are the main Prime Brokerage clients.
Explain traders’ market-making function.
Page 123 – “If a client wishes to buy a security or derivative, the bank will sell it to them and if the client wishes to sell, the bank stands ready to buy.” Hence, “the bank stands willing to ‘make a market’ any time it is requested by a client. In other words, the bank will quote a client a bid price or an offer price on many securities or derivatives at any time.” Market makers make money by “capturing” the spread “by continuously buying securities at the bid price, and selling securities at the higher offer price.”
Why would a prospective issuer prefer to hire as underwriter an investment bank that has traders already active in its security?
Page 112 – “Being active in the stock can lead to more accurate pricing and higher trading-based revenue” – Active traders “become well versed in the trading characteristics of that stock, and have a deeper understanding of who currently holds the stock, the approximate price at which the stock was acquired, and which investors are willing to sell.
Traders active in that stock are more familiar with that stock.
FICC is one of the main Divisions in an Investment Bank. What does FICC stand for? Other than during 2007 and 2008, how does this division typically rank from a profitability point of view, compared to other Divisions? What happened during these two years, and which part of the FICC Division was most responsible for this outcome?
Page 116-122 – Fixed Income, Currencies, and Commodities – “Has historically been the most profitable division in most of the large investment banks”. – “During 2007 and 2008, investment banks recorded significant losses on their structured credit positions because of the credit crisis..” The Structured Credit (CDO, MBS, CBO, CLO, etc.) business was most responsible for this outcome.
Which stock would likely have a lower rebate and why: a stock whose issuer has a large amount of convertible securities outstanding, or a stock whose issuer has no convertible securities and has no significant share-moving news in the near-term?
Page 114 & 177 – Because purchasers of convertible securities often simultaneously sell short the underlying shares, the stock whose issuer has a large amount of convertibles outstanding is likely to have higher short interest than the other stock and would thus be harder to borrow. Because these shares are harder to borrow, the stock with the convertibles is likely to have a lower rebate.
An investor lends 10,000 shares of ABC for two months when the stock is at $50 and requires 102% cash collateral. The market interest on cash collateral is 4.0%. The rebate rate on ABC shares is 2.5%. Calculate the combined profit for the stock lender and investment bank.
Page 114 –
10,000 shares * $50 = $500,000 * 102% = $510,000 total collateral.
$510,000 * 4% = $20,400 / 12 = $1,700 * 2 months = $3,400 Market Interest
$510,000 * 2.5% = $12,750 / 12 = $1,062.50 * 2 months = $2,125 Rebate to borrower
$3,400 – $2,125 = $1,275 profit for stock lender and investment bank.
Cash collateral is the % * total market value
Stock lender gets interest, but loses rebate
Interest is % * total market value
Rebate is % * total market value
Stock lender profit is interest – rebate
REMEMBER IF IT’S MONTHS YOU HAVE TO MULTIPLY BY months/12
Suppose Company XYZ has an average daily trading volume of 1 million shares and shows a current short interest ratio of 3.0. It currently has a $100 million convertible outstanding that is convertible into 4 million shares. The hedge ratio on convertible bond is 55%, which means hedge funds investing in the security will sell short 55% of the shares underlying the convertible. Assume all investors in the convertible are hedge funds. Based on this information, estimate the adjusted short interest ratio that is a better representation of the current “bearish sentiment” on the stock.
Page 115 & 177-178
1 million average daily volume * short interest ratio 3.0 = 3 million shares short
*short interest ratio is average daily volume * short interest ratio = how many shares are shorted total by investors & hedge funds
4 million convertible shares * 55% = 2.2 million shares short by hedge funds
*hedge ratio is % of shares that hedge funds short (these shares are on top of the shares they already have, so just take convertible shares * hedge ratio = shares shorted by hedge funds)
3 million total short – 2.2 million short by hedge funds – 800k short by bearish investors
*since short interest ratio is total shares shorted, to get how many are shorted by investors you need to subtract total shares shorted – shares shorted by hedge funds
800k / 1 million = .8 = adjusted short interest ratio
*divide the shares shorted by investors by average trading volume to get adjusted short interest ratio
How were senior tranches of a CDO able to obtain investment-grade credit ratings when some of the underlying assets were non-investment-grade?
Page 118 – Because the models used by the ratings agencies failed to consider the “possibility of a significant decline in housing prices across the country.”
“Because the pool includes a broadly diversified group of assets, credit rating agencies have given an investment grade rating to certain tranches in many of these CDO’s.”
A domestic airline based in the United States has placed a large $10 billion order for new airplanes with French aircraft manufacturer Airbus. Delivery is scheduled in 4 years. Payments are staggered based on a percentage of completion rate. The U.S. airline believes the Euro will appreciate against the Dollar during this time frame. How can the U.S. airline hedge currency risk related to this purchase with an investment bank?
Hedge $10 billion worth of puts on the $/calls on the Euro against the $10 billion it is paying the French aircraft.
What does VaR stand for? What is its definition and why is it important to investment banks? What are some of the criticisms of VaR?
Page 128-129 – Value at Risk – “The potential loss in value of trading positions due to adverse market movements over a defined time horizon based on a specified statistical confidence level.” – Investment banks use VaR to determine their “worst case” losses if conditions quickly deteriorate from normal.
Criticisms – “the distribution of past changes in market risk factors may not produce an accurate prediction of future market risk. In addition, VaR calculated over a one-day time period does not completely capture the market risk of positions that cannot be liquidated within one day.”
Chapter 6 – Asset Management, Wealth Management, and Research
What is the difference between asset management (AM) and wealth management (WM)?
Asset management refers to the professional management of investment funds for individuals, families, and institutions. Investments include stocks, bonds, convertibles, alternative assets (such as hedge funds, private equity, and real estate), commodities, indexes, of each of these asset classes, and money market investments. Asset managers specialize in different asset classes, and management fees are paid based on the asset class. For alternative assets, additional fees are paid based upon investment performance as well.
(Like Private Wealth Management) Wealth Management refers to advisors who provide investment advice to selected individual, family, and institutional investing clients. Wealth management advisors attempt to identify investors who have a significant amount of funds to invest and then work with these investors to make investments in the asset classes described previously. In other words, WM professionals create investment advisory relationships with investors, and are not directly involved in the management of asset classes (which is the role of asset managers). An investment bank’s WM advisors help investors define their risk tolerance and diversification preferences. They then either assist investors in self-directed investments or persuade them to entrust the advisor to make investments on their behalf.
Why would a wealth manager choose to allocate some of a client’s asset to another bank?
(Reputation and integrity) WM advisors at investment banks have a duty to help clients achieve the best possible returns in the context of their risk tolerance. If you work in PWM in a bank and that bank does not offer an investment vehicle a client is interested in, a wealth manager may allocate some of those assets to a competitors bank. There are usually incentives to keep clients within one bank as there are obvious conflicts of interest.
How are the different functions of the sell-side versus the buy-side manifested through their fee structures?
The sell-side collects fees through an indirect approach as part of the commission for selling a security to an investing client which is then reallocated to the research department. As for the buy side, who are concerned with additional fees impacting their investment record, were initially against a direct fee for research as it would lower their investment return (because the purchase price would be higher with a separate fee for research). However, the model changed in 2006 with Fidelity coming to terms with many investment banks that allowed a separate fee while simultaneously reducing commissions
What drove the need to separate research and investment banking?
The potential conflicts of interest drove the need to separate research and investment banking. There was the potential for the sell-side analysts to skew their research activities based on the Investment Banking Division’s underwriting or M&A effort, rather than on the firm’s investing clients’ priorities for objective research.
How have the U.S. enforcement actions against sell-side research in 2003 heightened the issue of declining research revenues?
The NASD and the NYSE announced enforcement against 10 investment banks for a total of 1.4 billion to be paid in penalties and other fines. Banks also had to comply with new requirements that included the potential for the investment banking department to skew the research department, and making independent research available to consumers. These actions highlighted the fact that research was no longer becoming a profitable source of income to banks. The lack of clear revenue routes to research also play a role in the decreased role of research.
What are the objectives of Regulation FD? What are the concerns about this U.S.-based regulation?
It prohibits company’s executives from selectively disclosing material information that could impact a company’s share price. This means that prior to a discussing any potential “stock moving” information with research analysts, the company must disclose this information with a SEC filing. The benefit of this regulation is that it levels the playing field, enabling all investors to receive the same information at the same time. It is an attempt to bring better transparency and fairness to all investors.
The concerns are that because companies must now be more careful in what they say to analysts and investors, and when they say it, less information is distributed in a less timely way. In addition, it is usually filtered through lawyers, causing a dilution in the quality of the information. Some investors feel that, as a result of FD, no one in the investment community, including retail investors, has the same quality or depth of information that they used to have.
Chapter 7 – Credit Rating Agencies, Exchanges and Clearing and Settlement
Compare the different roles provided to the investor community by credit rating analysts and sell-side research analysts.
Credit rating analysis help investors assess the credit risk of their investment in debt related securities. Sell-side analysis have a dual-role, to assess security valuations and generate compelling investment ideas for investing clients that ultimately should generate trading revenues for sales and trading divisions.
What is the difference between business risk and financial risk?
Business risk: industry characteristics for specific business lines. Competitive position within respective industries, business diversity, profitability/peer comparison, and management. Financial risk: accounting, corporate governance/risk tolerance/financial policies, cash flow adequacy, capital structure/asset protection and financial flexibility.
What precipitated the decline in CDO values during the 2007-2008 credit crisis?
Deterioration of the creditworthiness of underlying assets; rating downgrade of the monoline insurers; ratings downgrade of the CDOs.
What are the major criticisms directed at Moody’s, Standard & Poor’s, and Fitch?
(Credit rating agencies have been heavily criticized for their role in working with investment banks to create mortgage-backed securities that had higher ratings than they deserved. They have also been criticized for not downgrading mortgage-backed securities as early as they should have. It has also been suggested that agencies are susceptible to undue influence from corporations, since they are the actual paying clients.
In 2001, the NYSE switched from a fractional pricing system (stock priced in increments of 1/8 of a dollar) to a decimal pricing system (stock priced in increments as small as 1 cent). Explain how this might encourage front-running by traders?
(It reduces the buy-sell spread when trading in front of other orders. On the fractional system, the spread from larger tick increments may eat away any expected gain from front running a customer’s large incoming order.
Why might OTC derivatives be considered more risky than exchange-traded derivatives?
OTC derivatives might be considered more risky because OTC trades are not in the public domain and, unless reported by the parties to the trade, remain confidential. Due to exceptional growth experiences by the global OTC derivateives market, regulators are increasingly concerned about the potential systematic risk posed by the market.
How is derivatives settlement different from securities settlement?
Instead of clearing and settling within three days( like securities settlement) deriviatives often remain outstanding for a much longer time – sometimes months and years. Unlike securities, where the security is delivered and simultaneously paid for in full, derivatives represent an obligation or an option to buy or sell a financial instrument or asset at a future date, which can be weeks, months, or years in the future. As a result, the buyer and seller pose financial risks to an exchange for an exteneded period of time. Because of this large risk, exchanges require daily mark-to-market posting and adjustment of collateral based on the changing value of the derivatives contract. Derivatives therefore require substantially more complex risk management systems than are required for securities.
Chapter 8 – International Banking
What are the benefits of issuing and investing Eurobonds?
Eurobonds are lightly regulated due to the fact they are outside the regulation of a single country. The interest income on a Eurobond is exempt from taxes and the bonds can be issued in various forms and currencies
Why are most corporate Eurobond issuers large, multinational corporations?
Most Eurobond issuers are larger MNC’s or sovereign entities because they typically have the high credit quality required
A put option gives the holder the right, but not the obligation, to sell an underlying asset at an agreed-upon price. Discuss why the Japanese government’s guarantee to Ripplewood as part of its buyout of Long Term Credit Bank is similar to granting Ripplewood a put option on the bank’s assets.
Ripplewood led the buyout of Long-Term Credit Bank in 2000, which was suffering a severe financial reversal. As part of the acquisition agreement, the Japanese government agreed to purchase any LTCB asset that fell by 20 percent or more post acquisition.
The Japanese Government’s agreement was similar to a put option in that it gave Ripplewood the option to sell any of the newly acquired LTCB assets to the government if they dropped by 20 percent or more—limiting the downside risk. As a result, Ripplewood sold its worst assets at above market prices to the government following acquisition.
Why did China institute an A-share/B-share system? How has regulatory easing benefited QFIIs?
In essence A and B shares were instituted to help Chinese capital remain in China. A-shares are limited to purchases by only Chinese residents and QFIIs (Qualified Financial Institutional Investor). These shares are denominated in renminbi.
B-shares can be purchased by foreign investors and Chinese residents, these shares cannot be converted into A-shares. These shares are denominated in renminbi, but traded in either US dollars (in Shanghai) or Hong Kong dollars (in Shenzhen). Dividends and capital gains from B-shares can be sent outside of China, and foreign securities firms can act as dealers for these shares
QFII allowed qualified foreign investors to participate in the Chinese equity market A-shares and in the Chinese debt market. It has allowed foreign investors to invest in the Chinese market without having to purchase the less liquid B-shares and account for less than 1 percent of A-shares total market value
In a comparable transactions analysis, what additional considerations might an investment banker factor in when valuing an emerging market company?
Investors must take into account incremental risks associated with currency, political, liquidity, accounting, tax, and volatility risks. Risks must be carefully balanced against expected returns to be successful in this market. Risk especially important to consider include intellectual property, political, legal, currency, operational, and financing risk.
All of these risks are much higher in emerging market countries and should be factored into deal considerations. WACC should be adjusted accordingly and a wider range of growth rates should be taken into consideration.
Suppose you are a wealth advisor and a client has asked for your recommendation on which of the BRIC countries poses the least risk and most opportunity for investment growth. Briefly compare the perceived risks and benefits of each of the countries and provide support for your selection.
Brazil: BBB- credit rating, 3rd largest IPO market, US style corporate governance standards, one-share/one-vote rules, greater transparency, minority shareholder protection, and enhanced quality of disclosed information
Russia: Limited liquidity, and opaque pricing systems. Improvements in the listing process, market infrastructure, and trading systems are under way.
India: Strong industrial, energy and power, financial, and real estate sectors. Strict regulations limit a foreign institutional investor to investing no more than 10 percent of total issued capital of a listed Indian company. Exchanges are improving management and regulatory practices.
China: Largest IPO market. Top four industries, by funds raised, were financial services, industrials, real estate, and metals and mining. China has strict capital controls that create supply and demand imbalance. China has opaque listing rules and mainland listings are not very transparent and have strict rules in regards to resident investors. Hong Kong exchanges are more global friendly.
Chapter 9 – Convertible Securities and Wall Street Innovation
After an initial hedge is in place, what do hedge fund investors in convertible bonds do with shares of the underlying stock when the stock price increases or decreases?
After an initial hedge is in place, hedge fund investors buy or short sell additional shares depending on whether the stock price increases or decreases – as the share price decreases, the investor will buy more shares to cover their short position. If the price of the underlying stock price increases, the investor will borrow more shares to sell short. The strategy is to maintain the hedge ratio, which is equal to the risk-neutral probability. As the stock price fluctuates, the investor adjusts his position accordingly. This process of buying low and selling high continues until the convertible either converts or matures. This process is called delta hedging. The purpose of all this trading in the convertible’s issuer’s common stock is to hedge share price risk embedded in the convertible and create trading profits that offset the opportunity cost of purchasing a convertible that has a coupon that is substantially lower than a straight bond from the same issuer with the same maturity.
True or false: Convertible arbitrage hedge funds invest in convertible bonds because the fund managers have a bullish view on the company’s stock. Explain your answer.
False: Convertible arbitrage hedge funds invest in convertible bonds to exploit arbitrage opportunities, and adjust their portfolios to maintain the “hedge ratio”, which is based on the risk-neutral probability equation – therefore, the strategy should have good results in either a bull or bear market.
Discuss whether you feel the SEC’s temporary ban on short-selling financial stocks in 2008 during the financial crisis unfairly punished convertible arbitrage funds.
Part of a convertible arbitrage strategy includes short selling shares while simultaneously buying convertible bonds, so the SEC ban certainly affected operations of convertible arbitrage funds – due to the fact, however, that there were rumors in 2008 of hedge funds targeting investment banks by collaborating to short investment banks’ stocks by mass quantities and aggravating the 2008 financial crisis, I think whether or not the ban punished convertible arbitrage funds, the action was not unfair.
If companies A and B are identical in every respect except B has higher stock price volatility, which company would likely achieve better convertible pricing? Assuming convertibles issued by A and B have the same terms except for conversion price, would the company you selected have a higher or lower conversion price?
The stock with the higher volatility is likely to achieve better convertible pricing because the volatility increases the value of the stock, as there are more opportunities to profit. Stock B would have the higher conversion price, as conversion price is typically set to what would be considered a substantial increase in the value of the stock, to make conversion only attractive if the stock does attain that substantial increase. With increased volatility, it is more likely that the stock will rise (or fall) higher (or lower), and therefore the conversion price needs to be set higher so as to account for the stock’s increased potential to rise higher.
WheelCo is raising $200 million via a mandatory convertible bond issuance. Assuming the company’s share price on the date of issuance is $20 and the convertible bond carries a 25% conversion premium, what is the number of shares WheelCo has to deliver to investors if its share price at maturity is (a) $19; (b) $22; (c) $26; and (d) $30?
200 million / $20 = 10 million shares
Conversion price = 20 x 1.25 = $25, $22 is less than $25, 10 million x $20/$22 = 9090910 shares
$26 is greater than $25, 10 million x $20/$25 = 8 million shares
$30 is greater than $25, 10 million x $20/$25 = 8 million shares
Suppose you are a current shareholder in a company that is contemplating capital raising alternatives. Assuming the transaction would have no negative credit repercussions and you want minimal EPS dilution, rank the following types of convertibles from least potential for dilution to most potential for dilution: coupon-paying convertible, mandatory convertible, zero coupon convertible.
Zero coupon convertibles would have the least risk for dilution, as there is the lowest probability of these bonds being converted into common shares, unless the value exceeds the principal cash redemption (which increases each year). Coupon-paying convertibles would be the next most likely to dilute, because investors will prefer to convert to stock if the prices goes above the conversion price. Mandatory convertibles are the most likely for dilution, because there are no determinants to their conversion – mandatory convertibles must be, by definition, converted regardless of the stock’s price.
A U.S.-based BBB-rated company is looking to make a large acquisition. Management believes synergies from the acquisition will create new market opportunities. Unfortunately, these new opportunities will take a few years to realize, and until then, benefits will not be fully reflected in the company’s stock price. If the company has rating agency concerns and wants tax deductions from interest payments, what type of security is this company likely to issue in support of its acquisition and why?
Unit structure mandatory convertible: Equity credit helps the company maintain its borderline investment grade rating. Since management believes equity is undervalued, would likely not want to issue straight equity today. Also, the tax deductions from coupon payments under the unit structure may be appealing.
Why was the Nikkei Put Warrant program so profitable for Goldman Sachs?
Nikkei put warrants were futures based on the Japanese stock market. Goldman was able to buy the warrants at a price below their theoretical value, making an opportunity for future profit. Goldman used “delta hedging” by buying more futures when the Japanese stock market would decline, and selling when the Japanese stock market would rise, creating a profit for themselves. Goldman was further able to succeed in its strategy because it had accurately estimated that the future volatility of the Nikkei 225 Index would be higher during the delta hedging period than the implied volatility of the Japanese stock market at the time of the purchase of the Nikkei Put Warrants.
What is ASR an abbreviation for? Describe this transaction and the principal benefit for a client. What additional benefit did IBM achieve in the ASR program described in this chapter?
ASR stands for Accelerated Share Repurchase program. An ASR is designed to capture the EPS benefit of a repurchase program up front, rather than waiting for the benefit to be realized over time. This is accomplished by a contract under which a company purchases a large block of its shares from an investment bank at the closing market price on the date of the purchase, with a cash adjustment to follow at the end of the contract. The investment bank borrows the shares it sells to the company from existing shareholders, creating a short position, which it covers through daily open market purchases that are limited to 25% of the company’s ADTV. Assuming it takes one year for the investment bank to purchase enough shares to cover its short position, the total cost for the purchases of shares over this period is determined at the end of the year. If the total purchase cost is higher than the payment received by the investment bank from the short sale of shares to the company one year earlier, the company reimburses the investment bank for the difference. If the total purchase cost is less than the payment one year earlier, the investment bank reimburses the difference to the company. This adjustment amount after one year is modified based on the returns that the investment bank achieves from investing cash they received from the company up front.
An ASR transaction goes as follows: 1) Company buys shares from an investment bank with a cash adjustment to follow. 2) The investment bank borrows these shares from current shareholders. IB covers shares through daily open market purchases. 3) When position is covered, if the total cost of IB is higher than the payment, the company reimburses the IB. If the total cost is lower, the IB reimburses the company. The principal benefit for the client is a rapid and positive impact on EPS.
Assume a company’s ADTV is 240,000 shares. How many days would it take to complete a 10.8 million share repurchase program? The company has 120 million shares outstanding and its estimated EPS for the current fiscal year is $3.40. Assuming the company meets its earnings estimate, what would year-end EPS be under an ASR program for the full 10.8 million shares, assuming it is executed 20 business days before the company’s fiscal year end? And under an open market repurchase program?
120 million shares * $3.40/share = 408 million
120 million shares – 10.8 million shares = 109.2 million shares
$408 million/109.2 million shares = $3.73/share
120 million shares – (60,000 * 20 days before fiscal year end) = 118.8 million shares
$408 million / 118.8 million shares = $3.43/share
Chapter 10 – Investment Banking Careers, Opportunities, and Issues
What are the core differences between Investment Banking (IB) and Sales and Trading career paths?
Page 197-202 – IBD is responsible for advising corporate or government clients on issues including raising or retiring capital, and enhancing shareholder value through acquisitions, divestitures, mergers, or restructurings. – The Trading Division takes positions in securities to provide liquidity for investing clients, provides financing, risk management, and other securities services to clients, provides research to clients, and invests the firm’s own capital. – The entry points, career paths and compensation are similar between the divisions (Analyst, Associate, VP, MD), but bankers typically work much longer hours than the traders. Bankers can be working on multiple deals at any given time and often work 100 hours a week, including all-nighters and weekends. Traders may work 50-60 hours a week, but need to be on the trading floor early in the morning and their work is intense and loud and requires “numerous clear-headed decisions before lunch.”
Describe what a Chinese Wall is and which U.S. regulator would be concerned with issues involving the wall.
Page 202 – The Chinese Wall is the physical and impermeable barrier between the traders and the investment bankers. Investment bankers often have material, nonpublic information about companies they’re working with that cannot be shared. Making trades based on this information would be insider trading. The SEC is the US regulator that would be concerned about this.
What advancement in the mortgage market set the foundation for the subprime crisis and why?
Page 207-208 – Mortgage securitization. “..combining mortgages into pools and then dividing them into portions (tranches) that can be sold as securities in the capital markets.” “By immediately selling the mortgages they have originated, commercial banks transfer credit and interest rate risk onto institutional and individual investors, thereby giving lenders little incentive to adhere to strict mortgage underwriting standards. This agent-principal problem contributed to the development of negative amortizing loans, zero principal loans, and no documentation mortgages, as well as the explosion of subprime loans.”
Describe a Credit Default Swap (CDS). What are regulators trying to do to mitigate risk in the CDS market?
Page 211-212 – “In a CDS, one party (the protection buyer) makes periodic payments to a second party (the protection seller) in exchange for a payoff in the event a third-party (the reference entity) defaults on its debt obligations.” The CDS buyer is essentially buying insurance against a default of the reference entity. This can be used as a hedge against a long position or as a way to speculate on an impending default. The CDS seller benefits from the periodic cash flow, but bears the risk that it may have to pay out the face value of the reference entity. – The Dodd-Frank Act classified CDSs as securities and gave the SEC regulatory jurisdiction over them. Regulators aim to increase disclosure within the CDS market by requiring sellers to “disclose the nature and terms of the [CDS], the reason it was entered into, and the current status of its payment and performance risk. In addition, the seller is required to disclose the amount of future payments it might be required to make.”
Under what scenarios will the SIV market arbitrage model fail to work?
Inability to obtain inexpensive short term financing; or in the case of an inverted yield curve.
Why were U.S. investment banks allowed to operate at higher leverage ratios compared to commercial banks?
Page 210 – “Historically, US investment banks compiled assets based on Basel I guidelines and under supervision by the SEC, while commercial banks compiled assets based on Basel II and under the supervision of the Federal Reserve… Basel II allows for management judgement and management control over models that determine the risk weighting of assets, which, in effect, gives banks some latitude to set their own capital requirements.”
How does the phrase “perception is reality” apply to Bear Stearns?
Rumors (which Bear Stearns insisted were not true) about the bank having a liquidity problem led to a run on the bank, which quickly became a liquidity issue as Bear Stearns’ capital rapidly depleted.
How do Asian and petrodollar investors fit into the genesis of the financial crisis during 2007-2008? Structure your answer around the themes of easy credit, excess liquidity and cheap debt.
Some believe the supply and demand imbalance created by the large amounts of investable cash from Asian investors and oil-producing states was a contributing cause of the credit crisis. These investors channeled a significant amount of capital into the U.S., in search of yield. Investment in U.S. Treasuries kept interest rates low, which fueled a credit and housing boom. In addition, in the search for higher yields, these investors (along with others) found the senior tranches of MBS securities (which had yields slightly higher comparably rated debt instruments) very attractive, driving up the demand for these securities (as banks and mortgage lenders struggled to keep up with demand, underwriting standards deteriorated significantly for mortgages).
Discuss how CDS can be used for hedging and speculative purposes.
Page 211-212 – A CDSs can be used to hedge a long position because it offers the purchaser a payout in the event of default or bankruptcy of the security held. CDSs can be used for speculative purposes as well because neither the buyer nor the seller of the CDS are required to have any relationship with the reference entity. Party A is simply making a bet with party B that security/party C will fail. If C does fail, A gets a cash payout. If C does not fail, B has benefitted from the periodic payments from A for the term of the contract.
Looking at the leverage ratios of former pure-play investment banks GS and MS in Exhibit 1.3, why were these banks able to operate at higher leverage ratios as investment banks, compared to as bank holding companies?
As bank holding companies, Goldman Sachs and Morgan Stanley are regulated by the Fed. Because of this regulatory body’s requirements, the banks are not allowed to have the high leverage ratios they had when they were investment banks.
U.S. companies currently report their financials based on U.S. GAAP
Generally Accepted Accounting Principles) rules. Many companies in Europe report according to IFRS (International Financial Reporting Standards) rules. There has been a movement for all companies to shift to an IFRS basis globally. When this occurs, what may happen to the leverage ratios of U.S. banks?
( Operating under an IFRS basis would allow U.S. companies to increase their leverage much higher than allowed under GAAP rules. For example, Barclays, Deutsche Bank, and UBS operate under IFRS and maintained high leverage ratios through 2008 and 2009 (Barclays above 40, Deutsche Bank above 50, and UBS above 50) whereas Goldman Sachs and Morgan Stanley decreased their leverage from between 26-33 in 2007 to 13-14 in 2008 and 2009.
Why might a universal bank be better able to compete against a pure-play investment bank for M&A and other investment banking engagements?
One reason for this is that a universal bank is able to use their significant lending capability as a platform from which they are able to capture investment banking market share.
Investment bank clients can be categorized into two broad groups of issuers and investors. These two groups often have competing objectives
issue equity at highest possible price vs. acquire stock in companies at lowest possible price). Who within the investment bank is responsible for balancing these competing interests?
( The Equity Capital Markets Bankers intermediate between the Investment Banking Division’s issuing clients and the Trading Division’s investing clients. This poses a challenge to balance competing interest and structure an optimal equity-related security.
What is a key consideration in determining the cost and other parameters of a corporate debt offering and why is it important?
Of critical importance is the determination of the likely impact that a new debt offering will have on the company’s credit ratings. This can affect its future cost of capital. Additionally, Debt Capital Market Bankers gauge investor reaction to a potential offering, decide timing, maturity, size, covenants, call features, and other aspects of debt financing.