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Kenneth Kim, John Nofsinger & Derek Mohr 3rd Edition Pearson Prentice Hall
CHAPTER
One important role of investment banking is that they bring new debt and equity securities to the market. The process of selling securities to the market:
The bank needs to submit a preliminary prospectus to the SEC. The bank distributes the final prospectus to investors. Road show: The marketing campaign done by bankers to generate interest and to market the issue.
NOTE: Investment bankers are potentially an important source of information and monitoring of a public company.
However,
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While investment banks are expected to offer quality companies to investors, beginning with the greed era of the 1990s, banks began to bring inferior companies to the market. Pets.com initial public offering
In 1999, the firm had only $5.8 million in revenue and reported an operating loss of $61.8 million. Merrill Lynch launched the Pets.com IPO in February 2000 (raised $66 million). Ten months later, Pets.com filed for bankruptcy and folded.
Facebook
Did Morgan Stanley knowingly set the IPO price too high to take advantage of the hype surrounding the IPO?
Structured deals
If a firm has trouble raising capital due to its questionable economic viability, investments banks sometime work with those firms to figure out clever ways to help the firm to issue additional shares. Would you want to buy those shares?
Sell-side analysts
Analysts employed at brokerage houses who analyze stocks to help investors (shareholders) makes investing decisions. Sell-side analysts should be part of the corporate monitoring system!
Analysts are supposed to evaluate firms and their managers on behalf of investors. However, analysts cannot do a good job analyzing firms unless those firms managers help them! So, analysts work with managers, not for shareholders. Example: Analysts will make slightly beatable earnings predictions so managers can beat them and look good.
Are analysts good at picking stocks? Most stocks carry a buy recommendation.
Not surprising: Analysts need investors to buy stocks to make money. So, a buy recommendation should be viewed with caution.
However, when a stock carries a sell recommendation, it often turns out to be a good recommendation.
But yet investment banks in many countries are still allowed to offer brokerage services.
CORPORATE GOVERNANCE
Kenneth Kim, John Nofsinger & Derek Mohr 3rd Edition Pearson Prentice Hall
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Many firms borrow lots of money from banks. Many of these same firms develop close relationships with banks and oftentimes these firms divulge private information to banks to obtain favorable interest rates. Therefore, creditors often know what is going on in client firms more than shareholders do. Banks can monitor firms effectively!
Therefore, creditors are usually inactive monitors of firms due to their lack of incentive.
Credit rating agencies rate bonds (e.g., AAA, Aaa, BBB, Baa) for potential bond investors. A rating grade informs investors about the risk of a bond and thus the firm.
There are only a few credit rating agencies (its a regulated industry), so there is little competition. Rating agencies have become consultants.
Being both consultants and credit raters creates a conflict of interest.
CORPORATE GOVERNANCE
Kenneth Kim, John Nofsinger & Derek Mohr 3rd Edition Pearson Prentice Hall
CHAPTER
Active shareholders - shareholders who express their opinions to try to affect/influence management. Three kinds of shareholders:
Individual (minority) shareholders. Large shareholders. Institutional shareholders (which can also be large shareholders).
Most shareholder proposals submitted by individual investors do not pass. Two reasons are: It is difficult and expensive for one shareholder to communicate with all other shareholders. Most passive shareholders are reluctant to vote against the firms management.
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Minority shareholders like the existence of large shareholders (i.e., minority shareholders can free-ride on large shareholder monitoring), while managers may not like it.
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The existence of a large outside shareholder may exacerbate the agency problem.
There may be lots of fights between a large outside shareholder (e.g, Kirk Kerkorian, Warren Buffet) and managers.
Some public firms can be so large that it would take a lot of wealth to own a significant fraction of it. Many investors (including inside shareholders) want to diversify their portfolios. It is not clear whether the existence of a large shareholder leads to higher firm values.
Institutional Shareholders
Institutional shareholders have become more active in monitoring the companies.
As large shareholders, they have the financial incentive to be active monitors.
Public pension funds often lead the way with regard to institutional shareholder activism.
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Some other studies show little evidence that institutional activism works.
Threats from institutions dont carry much sway.
The short-term view of some institutional shareholders limits their motivation to be activists. Private pension advisors face a big conflict of interests (they are employed by firms). The regulatory and political environment also hinder large institutional shareholders from being activists.
We generally dont like institutions to become too powerful and rich, BUT this makes institutions less active.
CORPORATE GOVERNANCE
Kenneth Kim, John Nofsinger & Derek Mohr 3rd Edition Pearson Prentice Hall
CHAPTER
$1,400
Deal Value
12,000
$1,200 10,000
Number of Deals
$1,000 8,000
Billions
$200
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A merger is often viewed as a combination of two firms. An acquisition is viewed as one firm buying another. However, almost all mergers are essentially acquisitions. M&A can be synergistic/diversifying or disciplinary or both.
Extremely diversifying
e.g., GE and NBC
Many recent mergers have occurred for growth and for increased market power.
e.g., Oracle and PeopleSoft, HP and Compaq.
Target firm is the firm to be acquired. An acquiring firm may want to acquire a target firm because it believes:
Target firm is not performing up to its full potential. Target firm could become a better performer under someone elses control.
Therefore, target firms usually enjoy a share price increase when its acquisition is announced to the public.
To take over the target firm and make it more profitable by:
Cutting target firms fixed or variable costs. Improving target firms operational efficiency. Getting rid of target firms bad managers.
A successful firm An unsuccessful firm Pay a large sum Pay a relatively small sum May be limited May be significantly positive
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Acquirers almost always end up paying a significant premium for target firms. Whether or not the premium paid for target firms is ever fully recovered is still contentious. The target firms shareholders might like their firms are taken over, while the target firms management team may oppose being acquired because they might get fired afterwards.
Hostile Takeover
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A hostile takeover happens when the target firms management rejects a takeover bid. Then, acquirer may take its takeover bid directly to the target firms large shareholders to buy the firm.
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It costs a lot of money to buy a firm. There are too many defenses/regulations against takeovers.
Takeover Regulations
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Freeze-out laws Fair price laws Poison pill endorsement laws Control share acquisition law Constituency statute There are also antitrust laws (to ensure competition and prevent monopolies).
Poison pillany strategy that makes a target firm less attractive immediately after it is taken over. A golden parachutean automatic payment made to managers if their firms gets taken over. Supermajority rulestwo-thirds, or even 90 percent, of the shareholders have to approve a hand-over in control. Staggered boardsonly a fraction of the board can get elected each year to multiple-
Greenmaillike a bribe that prevents someone from pursuing a takeover. Other reactionary defenses include:
The firms management trying to convince its shareholders that the offer price is too low. Raise antitrust issues. Find another acquirer who might not fire management after the takeover. Find an investor to buy enough shares so that he/she can have sufficient power to block the acquisition.
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