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Chapter 6

Chapter 6 FIN501.rtf

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FIN 502
Coleen Clark

Chapter 6 FIN501 Private equity vs Selling securities to the public Private equity - - Private equity is the term that is used to describe the financing for private companies - Venture capital market is a market where high risk ventures an obtain financing - private equity funds raise funds from investors and invests in private companies The structure of private equity funds - private equity funds are similar to hedge funds where they are both investment companies made as limited partnerships that combine sums of cash from investors and then invest this on behalf of these investors - Hedge funds and private equity funds both use a 2/20 fee structure ( 2% annual management fee, 20% of profits are paid) - Like Hedge funds, private funds have constraints that prevent fund managers from taking too much cash - :Like Hedge funds, private equity funds charge high fees thus reducing the net return - Private equity funds have a high water mark provision and a claw back provision - the purpose of the claw back provision is to make sure that the manager only takes the agreed upon performance fee. If there is a loss, the manager pays back the performance fee paid in a previous period - Managers do not earn performance fees until the fund is liquidated, therefore the performance fee for private equity firms are known as carried interest - the decision to invest in a private equity fund is based on whether private equity funds provide enough diversification benefits to investors - But even if there are diversification benefits that arise, Reasons why a private equity fund may not be a good choice i) High barrier to entry - Investors must be wealthy ii) Funds are extremely illiquid as the funds will not be liquidated due to how these funds operate, maybe more illiquid than hedge funds: - Private equity funds start off by collecting money from investors, with this money they invest in private companies in an attempt to improve them and exiting through an IPO. Types of private equity funds Venture capital - People who finance risky businesses and the owner of these businesses know that they may not be successful, therefore the capitalists limit their risk of losing a large amount of cash by giving money in stages. - at each stage, enough resources are provided to reach the next milestone, or planning stage - Venture capital firms focus on financing certain stages, where some provide seed money or ground floor financing - Financing in the later stages may come from venture capitalists, these levels are known as mezzanine which are the levels above ground floor. This could come in the form of debt or equity, which would be made in a way to limit losses and retain upside profit potential - Venture capitalists limit their risk by not providing additional financing to risky ventures if they are unable to meet their goals - Venture capital financing motivates the owners of the business to reach their goals as to obtain further financing, they must achieve their goals - Venture capitalists help run the firm, providing the benefit of experience with previous risky ventures and additional business expertise - at each stage of financing, the chances of success are higher, and the investment in the business increases as well Middle market - Middle market companies are businesses that continue to operate throughout the operating year, they have a history of operations. They are usually small, family owned and operated - middle market companies are not start up companies, they may be in the market in order to receive additional financing in order to expand their business outside of their area. The founders may want nothing to do with the business and may wish to live a life separate from it. The private equity fund may be interested in buying a portion or all of the business so that others can take over the operations Leveraged buy outs - for a firm to go public, they sell common shares to the public - To take the company private, would mean for the company to purchase all of its outstanding public shares, - a leveraged buy out is where a company goes private by borrowing the cash to purchase back all of its shares - the main difference between the private equity funds are the type of firms that the funds provide financing for Selling securities to the public - the purpose of the private equity funds is to have a stake in an organization by providing a source of capital to a firm, to improve its performance, and to exit the business with a profit - To exit the business would refer to sell to another investor, or to sell ownership to the public through shares - stock market refers to the securities that have been sold to the public, stock market are made up of primary markets and a secondary market - primary market are where businesses sell shares to the investors, the secondary market is where shares are traded among investors - the secondary market is where the prices of shares are determined by the demand for those shares which are present during the transactions among investors The primary market for common stock - The initial public offerings are where stocks are first introduced to the market through the sale of them by the company - IPOs are known as unseasoned equity offerings because shares could not be purchased by the public before the IPO - A seasoned equity offering is where a company that already went through an IPO issued more shares, also known as a secondary offering, or following on offering - a general cash offer are where shares of a company are open to who ever wants them, people who don't want them will not have a chance to own one when they run out, shares are sold for cash - rights offer are where shares of a company are only offered to existing owners of a company - an investing banking firm’s purpose is to help companies gain cash to finance operations and expansion, they do this by finding investors to buy newly issued securities - Investment bankers underwrite, which is when they are given the risk of purchasing newly issued shares from a company and then selling them to investors -The underwriter spread is the profit received by the underwriter, which is the difference between the price they paid, and the amount they received - Underwriters may be compensated through warrants and stocks in addition to the spread - Underwriters join together to form a syndicate which exists to distribute the risk and to help sell a share - in a syndicate, one or more managers arrange the offering, known as the lead manager. They determine the selling price and the rest are responsible for selling the issues The two basic types of underwriting: i) firm commitment and ii) Best efforts. The third type is dutch auction underwriting Firm commitment underwriting - Firm commitment underwriting is where the issuer sells all of its shares to an underwriter who is financially responsible for selling the shares. - the underwriter's fee is the spread - if the underwriter cannot sell the shares at a price, they must lower their prices on the unsold shares - In a firm commitment, the issuer receives the agreed upon amount, the risk associated with the shares are fully transferred to the underwriter - underwriters take on little risk in these as they research the market to see how responsive they are to the stock, therefore they determine a price to liquidate shares Best efforts underwriting - best efforts underwriting are where the underwriter tries to sell as much of the shares as they can at an agreed upon offering price. The underwriter cannot determine how much they can sell, therefore the proceeds for the issuer are ambitious. - the risk of the shares remains with the issuer, the underwriter can return unsold shares to the issuer Dutch auction underwriting - dutch auction underwriting, AKA uniform price underwriting, is where the offer price is based on the bids made by investors - the offer price chosen is the price that is the highest, that will result in selling all of the shares - the uniform price feature is what attracts aggressive bidding, as it acts as a form of protection in case where they may have bid much more than others - the most important restriction in an underwriting contract is that we may not sell our stocks for six months after the underwriting, which ties most of our wealth to the company's success and makes selling the stock to investors a more credible undertaking by the underwriter. - The implication of this is that investors may be assured that we are working hard to grow the company and its new income - before shares can be issued to the public, the issue must be approved by the Ontario Securities Commission which is a provincial regulatory agency responsible for governing Toronto Stock exchange listed securities - To be approved by the OSC, we need to make a prospectus which is a document made as a part of a security offering, disclosing the company's financial position, operations, investment plans for the future - A red Herring is a preliminary prospectus that has not been approved by the OSC, they may be distributed to potential investors to attract them to a certain issue of shares. it is known as a red herring because the cover page is stamped in red ink, representing that the final approval has not been obtained - the preliminary prospectus is only missing the final offering price and other pieces of information which are not determined because market conditions might change while approval is being pursued. - only when the prospectus has been approved, u
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