Investment Banking Activities

The basic investment banking service is to help companies issue new debt and equity securities. There are several different kinds of securities that a firm can issue. The bank advises the company on which security is optimal for the amount of capital being raised and the situation of the company. For this service, investment banks charge the company a fee. The size of the fee depends on how much risk the investment bank is taking to issue the securities. There are two methods that banks take to issue stock and bonds : underwriting and best-efforts.

Think about the case of issuing stock. When underwriting an issue, the bank will guarantee that a company will receive a specific amount of capital. That is, the bank assures the company that a certain number of shares will sell at a target price. If too few shares sell at that price, the investment bank must buy those shares. To illustrate the risk that the bank is taking, consider what would have happened if an issue were being sold when the September 11, 2001, terrorist attacks occurred. Afterward, stock prices plummeted and investors were not interested in buying stock. If the bank guaranteed the company would get $100 million in capital, and only $70 million were raised, the bank would have to buy $30 million worth of stock. The fee for underwriting a $100 million issue is typically around $7 million for a new issue and $5 million for an existing company's issue.

If the investment bank did not want to take risk on a security issue, it could use the best-efforts method. Here, there is no guarantee of raising the desired amount of capital. The bank does its best to sell as much of the security as possible for the company. In this case, it is the company that is taking the risk of not receiving enough capital. Since the risk is low for the investment bank, the fee it charges is much lower for the best-efforts method than for underwriting.

The process of selling securities to public investors involves registration at the SEC. The document submitted to the SEC includes a preliminary prospectus that contains information about the security issue and the company. For example, the prospectus details the company's financial condition, business activities, management experience, and how the funds raised will be used. The final prospectus is distributed to investors who are interested in the stock issue. This information helps investors make decisions about the condition of the company and about buying the issue. In other words, investment bankers provide information and monitor public companies.

That is why bond investors are angry with Citigroup and JPMorgan's underwriting of $11 billion in bonds for WorldCom. The two investment banks are being sued by investors for a lack of due diligence in the underwriting. The bonds were sold in May 2002. The next month, WorldCom announced that it had improperly capitalized $3.8 billion in expenses. The financial health of WorldCom came into question, and the $11 billion in bonds plummeted in price. ^[3] The lawsuit argues that the banks should have known something was wrong at the firm, but they conducted the bond offering anyway.

The prospectus and the banker's "road show" relay information about the company to investors. The road show is the marketing campaign done by the bankers to pre-sell the issue. They travel the country visiting the large institutional investors, like public pension funds and mutual funds. To sell to individual investors, investment banks use their brokerage operations. For a hot issue, investors call the brokers to order shares of the issue. In a less popular issue, the brokers call them.

The information about the issuing company is especially important to investors when the firm is new. When a firm offers stock to the public for the very first time, it is called an initial public offering (IPO). When a firm comes to market in an IPO, it is typically young, small, and mostly unknown to investors. The information gathered by an investment bank and presented to the SEC may be the only independent data available on the firm. Therefore, investors expect the bank to fully disclose all relevant information so that they can make a good decision.

Investment banks have increased risk when underwriting an IPO because of the uncertainty involved with new firms. To mitigate some of the risk, banks tend to underprice IPO offerings. That is, they offer the new shares of stock at a lower price than the demand for the stock would suggest. For example, on July 25, 2002, the newly public firm LeapFrog Enterprises conducted an IPO to raise $130 million. The company produces technology-enhanced toys and is considered a business of Michael Milken, the junk bond king of the 1980s. Those investors who purchased the stock from the investment banks bought it at $13 per share. There was a syndicate of banks that conducted the underwriting services for this deal. However, there were not enough shares for all the investors who wanted them. Therefore, the investors who were left out of the deal had to buy shares on the New York Stock Exchange later that day. The price opened on the exchange at $15.50 per share and closed the day at $15.85. The first day return for the stock was 22 percent. The investment banks were probably well aware that the first day trading price would be greater than $13 per share, but they underpriced the stock offer anyway to ensure that they would sell all of the stock and reduce their liability to LeapFrog.

Underpricing IPOs lowers the risk to the underwriters and makes the new issues highly desirable to investors. After all, who wouldn't want a 22 percent return in one day? Figure 7-1 shows the number of IPOs offered in each year from 1980 to 2001. ^[4] The line represents the average first day return for the offerings each year. Note that the average first day return is positive in every year. That doesn't mean that every IPO experiences an increase in price on the first day. Some IPOs are in high demand and earn a positive return ”others are in low demand and decline in price the first day. Investors want to get those hot IPO firms and avoid the lemons. The average initial return for IPOs in the late 1990s and 2000 was extraordinarily high. The average in 1999 was more than 70 percent! The average underpricing in the United States was just over 20 percent in the 1990s. This compares to 16.5 percent in France, 40.2 percent in Germany, and 39.6 percent in the United Kingdom. ^[5]

Figure 7-1. The columns show the number of IPOs issued each year. The line reports the average return for those issues measured from the issue price to the closing price on the first day of trading.

The number of IPOs offered is highly correlated with a bull market. Stocks were in a strong bull market in the mid-1980s until the crash of October 1987. After the crash, the number of IPOs declined to around 100 per year. This number increased dramatically in the bull market of the 1990s. Then, after the bear market arrived in 2000, the number of IPOs again declined for 2001. The first six months of 2002 saw only 46 IPOs. In July 2002, during the lows of investor confidence, there were only five IPOs.