Risk Management and Financial Institutions. Hull John C.

to a small number of large institutional investors, such as life insurance companies or pension funds, and the investment bank receives a fee. On other occasions it takes the form of a public offering, where securities are offered to the general public. A public offering may be on a best efforts or firm commitment basis. In the case of a best efforts public offering, the investment bank does as well as it can to place the securities with investors and is paid a fee that depends, to some extent, on its success. In the case of a firm commitment public offering, the investment bank agrees to buy the securities from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price. It makes a profit equal to the difference between the price at which it sells the securities and the price it pays the issuer. If for any reason it is unable to sell the securities, it ends up owning them itself. The difference between the two arrangements is illustrated in Example 2.1.

      EXAMPLE 2.1

      A bank has agreed to underwrite an issue of 50 million shares by ABC Corporation. In negotiations between the bank and the corporation the target price to be received by the corporation has been set at $30 per share. This means that the corporation is expecting to raise 30 × 50 million dollars or $1.5 billion in total. The bank can either offer the client a best efforts arrangement where it charges a fee of $0.30 per share sold so that, assuming all shares are sold, it obtains a total fee of 0.3 × 50 = $15 million. Alternatively, it can offer a firm commitment where it agrees to buy the shares from ABC Corporation for $30 per share.

      The bank is confident that it will be able to sell the shares, but is uncertain about the price. As part of its procedures for assessing risk, it considers two alternative scenarios. Under the first scenario, it can obtain a price of $32 per share; under the second scenario, it is able to obtain only $29 per share.

      In a best-efforts deal, the bank obtains a fee of $15 million in both cases. In a firm commitment deal, its profit depends on the price it is able to obtain. If it sells the shares for $32, it makes a profit of (32 − 30) × 50 = $100 million because it has agreed to pay ABC Corporation $30 per share. However, if it can only sell the shares for $29 per share, it loses (30 − 29) × 50 = $50 million because it still has to pay ABC Corporation $30 per share. The situation is summarized in the table following. The decision taken is likely to depend on the probabilities assigned by the bank to different outcomes and what is referred to as its “risk appetite” (see Section 27.1).

      When equity financing is being raised and the company is already publicly traded, the investment bank can look at the prices at which the company's shares are trading a few days before the issue is to be sold as a guide to the issue price. Typically it will agree to attempt to issue new shares at a target price slightly below the current price. The main risk then is that the price of the company's shares will show a substantial decline before the new shares are sold.

      IPOs

      When the company wishing to issue shares is not publicly traded, the share issue is known as an initial public offering (IPO). These types of offering are typically made on a best efforts basis. The correct offering price is difficult to determine and depends on the investment bank's assessment of the company's value. The bank's best estimate of the market price is its estimate of the company's value divided by the number of shares currently outstanding. However, the bank will typically set the offering price below its best estimate of the market price. This is because it does not want to take the chance that the issue will not sell. (It typically earns the same fee per share sold regardless of the offering price.)

      Often there is a substantial increase in the share price immediately after shares are sold in an IPO (sometimes as much as 40 %), indicating that the company could have raised more money if the issue price had been higher. As a result, IPOs are considered attractive buys by many investors. Banks frequently offer IPOs to the fund managers that are their best customers and to senior executives of large companies in the hope that they will provide them with business. (The latter is known as “spinning” and is frowned upon by regulators.)

      Dutch Auction Approach

      A few companies have used a Dutch auction approach for their IPOs. As for a regular IPO, a prospectus is issued and usually there is a road show. Individuals and companies bid by indicating the number of shares they want and the price they are prepared to pay. Shares are first issued to the highest bidder, then to the next highest bidder, and so on, until all the shares have been sold. The price paid by all successful bidders is the lowest bid that leads to a share allocation. This is illustrated in Example 2.2.

      EXAMPLE 2.2

      A company wants to sell one million shares in an IPO. It decides to use the Dutch auction approach. The bidders are shown in the table following. In this case, shares are allocated first to C, then to F, then to E, then to H, then to A. At this point, 800,000 shares have been allocated. The next highest bidder is D who has bid for 300,000 shares. Because only 200,000 remain unallocated, D's order is only two-thirds filled. The price paid by all the investors to whom shares are allocated (A, C, D, E, F, and H) is the price bid by D, or $29.00.

      Dutch auctions potentially overcome two of the problems with a traditional IPO that we have mentioned. First, the price that clears the market ($29.00 in Example 2.2) should be the market price if all potential investors have participated in the bidding process. Second, the situations where investment banks offer IPOs only to their favored clients are avoided. However, the company does not take advantage of the relationships that investment bankers have developed with large investors that usually enable the investment bankers to sell an IPO very quickly. One high profile IPO that used a Dutch auction was the Google IPO in 2004. This is discussed in Business Snapshot 2.1.

      Advisory Services

      In addition to assisting companies with new issues of securities, investment banks offer advice to companies on mergers and acquisitions, divestments, major corporate restructurings, and so on. They will assist in finding merger partners and takeover targets or help companies find buyers for divisions or subsidiaries of which they want to divest themselves. They will also advise the management of companies which are themselves merger or takeover targets. Sometimes they suggest steps they should take to avoid a merger or takeover. These are known as poison pills. Examples of poison pills are:

      1. A potential target adds to its charter a provision where, if another company acquires one third of the shares, other shareholders have the right to sell their shares to that company for twice the recent average share price.

      2. A potential target grants to its key employees stock options that vest (i.e., can be exercised) in the event of a takeover. This is liable to create an exodus of key employees immediately after a takeover, leaving an empty shell for the new owner.

      3. A potential target adds to its charter provisions making it impossible for a new owner to get rid of existing directors for one or two years after an acquisition.

      4. A potential target issues preferred shares that automatically get converted to regular shares when there is a change in control.

      5. A potential target adds a provision where existing shareholders have the right to purchase shares at a discounted price during or after a takeover.

      6. A potential target changes the voting structure so that shares owned by management have more votes than those owned by others.

      Poison pills, which are illegal in many countries outside the United States, have to be approved by a majority of shareholders. Often shareholders oppose poison pills because they see them as benefiting only management. An unusual poison pill, tried by PeopleSoft to fight a takeover by Oracle, is explained in Business Snapshot 2.2.

      BUSINESS SNAPSHOT 2.1

      Google's IPO

      Google, developer of the well-known Internet search engine, decided to go public in 2004. It chose the Dutch auction approach. It was assisted by two investment banks, Morgan Stanley and Credit Suisse First Boston. The SEC gave approval for it to raise funds up to a maximum of $2,718,281,828. (Why the odd number?