Investment Banking, parte 2

Investment banking Vincenzo Capizzi 17 IB deals

Slide set 6

Capital markets SBU.

Thanks to the information potential of stock practices, market “process” … of practices, changing every day and giving information to investors about future profitability of the listed companies.

Secondary “provision”… and that’s something provided by the market.

A reduction “costs”… so, in the transaction costs, because capital markets are a mid of market no needs to know each other and be fiscally place with for borrowers and investors to in connection.

“Asymmetries”… thanks also the rating agencies, to the presence of the regulatory authorities, setting information disclosure requirements that listed companies have to satisfy.

Differently from an unlisted listed and I’m the manager “management”… company, if I’m a one of it or the CEO, I’m encouraging to run the company at my best in the most effective way because, if I don’t do that, will the stock price of my company fall down.

And outside investors maybe some of the market sooner or later will realize that the stock price of my company is undervalued because of the low quality management: so, there is a grow potential as far as the market price of the stock is considered.

So, the outside investors may launch a public bid (OPA), a hostile takeover and, therefore, I’m going to lose my position/my seat because the first thing that the new owners will do after the change in the ownership and control will be the replacement of the top managers (including the CEO, me) and place another one more trusted.

Therefore, the possibility to be listed in the capital markets is a great incentive to an effective and efficient fair management.

Golden parachute (A manager also could have some stocks of the company as a remuneration. (buonuscita): it’s a big big way out compensation. Consider that usually each top manager, when hired by company, in his contract, because he knows that he may be fired at any time, he asks to be written in the contract that, in case of way out, he will have to be assigned a golden parachute, a dramatically high compensation (millions of €!). And that’s something that prevents the stockholders to change that much frequently the top managers because they want avoid to use the corporate cash flows to pay such huge compensation.)

Types of markets

“Debt market”… or fixed income capital markets.

“Money market”… where there are traded securities expiring in less than 12 months.

“Forward-Derivative market”… where the delivery has to be made in 2 or 6 months: so, not when signing the contracts of a purchase or sale of securities.

“Auction market”… like, for instance, the FTSE MIB, the London Stock Exchange, …

“Brokered market”… where there are brokers.

“Dealer market”… where there are market makers and dealers.

Usually these are markets where are traded Government Bonds.

We might have… “country”… the advantage of this market is that the burden of the regulatory requirements is much lower that the regulation dealing with domestic and foreign markets.

Simple test: imagine we have Apple issuing a Bond.

Depending on the nature of the Bond issue this could be a foreign, a domestic or a Euromarket depending on the kind bond issue: of the bond issue, we could have different costs for the issuer, different information disclosure requirement and different regulatory costs.

Examples of bond issues

• 1) Apple issues a Bond denominated in Yen placed at Tokyo. Yen isn’t the currency of Apple: so, this is not a domestic market Bond issue. Then, which is in Tokyo, Yen the currency? Yes: so, that is a foreign market issue;
• 2) Apple issues a Bond denominated in Yen placed at Shangai (China). Euromarket transaction, because we have a bond issue in a currency which is outside the jurisdiction of China, which is a foreign currency for Chinese investors;
• 3) Apple issues a Bond denominated in Euro placed at New Delhi. Euromarket, same explanation;
• 4) Apple issues a Bond denominated in Dollars placed at New York. Domestic market transaction;
• 5) Apple issues a Bond denominated in IRN (Indian Rupies) placed at Milan. Euromarket;
• 6) Apple issues a Bond denominated in IRN placed at New Delhi. Foreign market.

Reasons for listing

Reasons for listing: why a company has to get listed in the capital markets.

Fundraising is the commercial just final effect.

These are motivations from a standpoint: we are saying that these reasons are not all important or share the same importance or that, when get listed in the capital markets, we will simultaneously achieve all such benefits.

But we are saying that, if I’m your chief and you are my employee and I ask you to go to a company, which is big and unlisted, and try to get a mandate in order to get listed it in the capital markets, we can start an interaction with our part trying to focus on the main possible advantages that the company can achieve once it gets listed in the capital markets.

“Financing”… advantage: we can reduce the dependence on the banking system.

“Base”…: having so, instead of having just 2 stockholders having the 49% of your company, we might have dozens, hundreds and thousands of stockholders each one having no more than 0.01% and therefore with no control right, with no possibility to have a strong impact on a corporate decision-making process taken by the majority equity holders.

“Investors”… If you are a listed company, investors desiring not anymore to be inboard of the company, they can just sell their equity holdings in the secondary capital market: so, it’s easy to satisfy such a way-out desire.

“Gains”… because stocks of the companies are priced on a daily basis: so, it’s easy to decide when to exit when you are sure you can realize a given capital gain.

“Power”…: that’s a strategic (!) advantage: so, once listed, you just don’t achieve financial advantages, but you are famous, the standing of the company is much higher and so you can negotiate your commercial contracts (also with the employees) with an higher burdening power.

“Standing”… because the perception of the risk-default is lower for the banks if you are listed, because even you are under the control of the regulatory authorities and you have to produce much more information reports (also on a monthly base).

“Managers”… you are less risky and so your Beta, WACC, etc… are lower.

“Stress”… because managers know that they are evaluated on daily basis depending on the movement of the stock price: upward or downward so, they are not encouraged to make long-term investments or to cut dividends because maybe in order to make investments, they will be penalized the following day by the market.

So, they have to keep constant policy “dividend target”… slide.

In the previous list we have primary needs satisfied by the capital markets.

So, in this slide we have explained that there are a number of reasons not just to get access to the capital markets through an IPO, but also to remain having your stocks traded in the secondary capital markets.

“Collaterals”… because if I have stocks of my company that are traded in the capital markets, I can use as collaterals when asking for a loan to a bank.

Assignment 7a

18 Assignment 7a: Why do IPOs improve the probability of future M&A deals, thus contributing to stockholders’ value?

Answer: Imagine we have two companies, one listed and another unlisted, but imagine that they are equal, that is as for the size, the industry, the kind of products, the profitability, the future capability to get access to financial resources, etc… they are the same (!).

We could even say that this is the same company under two different assumptions: being listed or not.

If I’m listed, I have the probability to acquire more companies than the unlisted ones just because I’m listed.

The consequences are that, if in t0 these two companies were equal, maybe in t5 the listed company will be higher and will have higher stockholders’ value because in these 5 years it had the possibility to buy more companies and therefore to grow faster than the unlisted company.

Why? Once listed the company acquire a new currency: its shares (!).

If you are an unlisted company and you want you buy something, you can pay just with cash, you can’t offer as a tool of payment your stocks because you are not listed and therefore your stocks are not tradable.

But if I’m a listed company and I want to buy you and imagine you are the owners of the shares of the target company, I can come to you and, wanting to buy your company, I can ask for your shares and, in exchange, I can give cash or my shares (!).

And if you want liquidity and don’t want to have in your portfolio my stocks, that’s the secondary market, where in the following day I can go there and sell my stocks and I have liquidity (!).

We will see that there are some M&A deals called cash deals and others called stock deals, where in the first we pay for the stocks we are buying with cash; whereas in the second we pay for the stocks we are buying with our stocks to the owners of the stocks of the target company.

And we will learn how to determine the exchange ratio: so, how many stocks of the buyer do I have to give you in order to receive one stock of the target?

Assignment 7b

Assignment 7b: Using the framework of the DCF Analysis (Asset Side Approach), show clearly the impact of the IPO’s benefits n stockholder’s value.

Answer: ∑W = FIRM =1 (1+)

We have to pick all the benefits coming from a listing and the sum of this benefits have an impact on the numerator and the sum of others on the denominator.

Some of the benefits have an impact on the numerator, so on the cash flows, like:

• 1) Better governance, allowing to, for instance, design a perfect competitive strategy aimed at increasing revenues and cash flows due to a better market positioning;
• 2) Bargaining power (potere contrattuale), because you have a high image, a high reputation, you are well known and therefore you increase your bargaining power with suppliers, clients and other kind of stakeholder like employees, banks and so for;
• 3) Standing/visibility, which allows to grow more and to negotiate better contracts and to have a wider possible number of clients all around the world;
• 4) External growth;
• 5) Best manager, that allows you to design and implement best strategies and therefore to increase size and profitability over time.

But there are some reasons demonstrating why an IPO has a positive impact on the denominator, the WACC, decreasing it:

• 1) Lower Beta;
• 2) Lower spread, because of the decreased perception of the default risk by banking system, therefore lower K and D;
• 3) Higher debt capacity and interests, because if your credit standing is higher, the banks not only reduce the spread but, also, they are available to increase the debt, so they increase the leverage and, in doing so, they increase the debt capacity and, if they do it, they increase weight to be associated to K (D/D+E). The D source of financing is cheaper because K is lower than K E (!).
• 4) Tax shield: if you have higher debt, you have higher interests and therefore you pay less taxes because you maximize the tax benefit associated to the debt when compared to the other source of financing which is equity, which doesn’t enjoy this tax benefit.

Assignment 7c

Assignment 7c [Possible open exam question]: Why do listed companies prefer to distribute value to stockholders through buyback programs rather than through extraordinary dividend payments?

Answer: Buyback = stock repurchases.

If we are an unlisted company, and we realize that we had an extraordinary year with a lot of sales, etc…, we can decide to give back to our stockholders part of this value.

It’s the case in which I’m the company CEO, you are my stockholders and I just want to give you cash.

How can make you benefit of the value creation taken place? Two alternative ways:

• 1) I give you cash: therefore, I distribute you dividends;
• 2) Instead of giving cash, I’m trying to increase the value of the stocks the stockholders have: so, I’m trying to make them benefit from a capital gain.

Therefore, I start buying my stocks in the market.

And, if I’m doing this, the price of the stocks will increase and so, if you will sell in the secondary market the stocks, you will benefit from a capital gain.

I can demonstrate that I’m able to identify the number of shares to buy in the market in order to realize the capital gain that I do want you to achieve which is exactly the value I decided to distribute to the stockholders.

Ex: If I want to distribute 10 million € to my stockholders, I have two options:

• 1) I pay dividends for 10 million €;
• 2) I buy a number of stocks in the secondary market of my company in order to favor an increase in the stock price, which is exactly the increase required in order to have an upward movement of the stock price and to make you achieve a capital gain for an overall sum of 10 million €.

In the recent years, companies started to choose the second option.

Why?

Imagine I’m the CEO of the company and you are the market/the stock investors and imagine you have the stocks of my company.

Imagine that it’s 10 years that you are investors of my company and that every year I pay dividends, a constant stream of dividends, for instance a payout ratio of 10%, which is the portion of the overall net income produced.

So, you know that I’m going to more or less pay every year the 10% in dividends of the net earnings created.

But imagine that today I say that last year we had a wonderful year because of the turnover doubled, etc… so, due to this extraordinary performance of the company, I want you, as my investors, to benefit from such value creation.

In order to do that, I’m going to make double the payout ratio when compared to the payout ratio of the previous years: so, I want to give you an extraordinary dividend in order that the payout ratio would be, for instance, 20%.

Imagine that the following year I have a good performance, but not that brilliant as the last year, but just because it was extraordinarily high the performance of the previous year: so, now it’s not my fault that I will not be able to come out with the same extraordinary performance.

And, therefore, the following year I say that the payout ratio would be 10%, not anymore the 20% of the last year.

Now it is a cut of the 50% when considered the extraordinary dividends paid last year (!).

What is going to be the reaction of the market when I’m announcing a 50% cut in the dividends when compared to the dividends of the previous year?

Remember that market is short-term oriented, have short memory.

So, all the investors are going to be unsatisfied and worried and they will start selling the stocks and therefore the stock price will start experiencing a downward trend: stock price will start decreasing.

And I cannot pray them to don’t sell the stocks explaining why, but I won’t be able to convince the market because of this short-term orientation.

So, managers have understood that is better keeping a constant dividend policy over time (!) in order to not be penalized by the market.

And, in case one year there is an extraordinary performance, I will try to make benefit the investors through capital gains (!).

And I can make you achieve a capital gain through stock repurchases, through buybacks.

How to structure an IPO

When you structure an IPO, there are major decisions/…

“Market”… so, choose that segment of the capital markets which you desire to get access to.

Question: how to structure an IPO? The answer should be: I structure an IPO by taking a decision making reference to each one of these dimensions/typologies and options.

Every country and every capital market form its own listing requirements: for instance, the balance sheet, the status of the companies, the number of outstanding shares to put in the market, etc…

Substantial requirements.

So, each company, apart from the strictly legal requirement, has to satisfy some substantial requirements, like good track record…

“Structured” … that must be publicly disclosed in a transparent way.

As for the choice of the company vehicle, you can choose to list…

“Holding company” = capogruppo.

“Owned operating company” = società controllata.

Crown’s jewel because is that controlled company with highest potential of cash flow generation.

“Newco”… : so, through a corporate finance deal, we create a new company, inside this new company we put the assets that are the highest cash flow generating one and we list in the capital markets this Newco with this assets inside (that’s the equity carve out).

“SPAC”… : so, we list a vehicle in the capital markets and then this vehicle will be used to make an M&A deal (and therefore to buy an unlisted company) and then it would be made a merge between the target unlisted company and the SPAC.

At the end, we will have an operating company listed. That operating company stemming from the merge from the lis