Chapter 6 - The Stock Market
6.1 - Private Equity vs. Selling Securities to the Public
Private Equity is used in the rapidly growing area of equity financing for nonpublic companies.
Banks are generally not interested in making loans to start-up companies, especially ones :
with no assets (other than an idea).
run by fledgling entrepreneurs with no track record.
Firms with this profile search for venture capital (VC), an important part of the private equity markets.
Financing for new, often high-risk ventures
Firms other than start-ups might also need financing.
Private equity also includes:
large leveraged buyouts
The Structure of Private Equity Funds
Private equity funds and hedge funds are two types of investment companies. Both
are set up as limited partnerships.
pool money from investors.
invest this money on behalf of these investors.
have built-in constraints to prevent managers from taking excessive compensation.
Like hedge funds, the fees paid to the private equity managers significantly reduce the net return of the fund
The average net return to investors in private equity funds is about equal to the return of small-cap stocks
Private equity = not a reasonable investment choice
Types of Private Equity Funds:
Venture Capital refers to financing new, often high-risk, start-ups.
Individual venture capitalists invest their own money.
Venture capital firms pool funds from various sources, like
Venture capitalists know that many new companies will fail.
The companies that succeed can provide enormous profits.
To limit their risk:
Venture capitalists generally provide financing in stages.
Venture capitalists actively help run the company.
At each stage, enough money is invested to reach the next stage.
Mezzanine Level financing
At each stage of financing, the value of the founder’s stake grows and the probability of success rises.
If goals are not met, the venture capitalists withhold further financing.
If a start-up succeeds:
The big payoff frequently comes when the company is sold to another company or goes public.
Either way, investment bankers are often involved in the process.
Many small, regional private equity funds concentrate their investments in “middle market” companies.
ongoing concerns (i.e., not start-ups) known performance history
typically, small and family owned and operated.
Reasons middle market companies seek more capital
Expansion beyond their existing region
Founder wants to “cash out”
A private equity fund might purchase a portion of the business so that others can now manage the company.
Suppose a company (or someone else) purchases all the shares of the company held by the public at large?
This process is called “taking the company private.”
The cost of going private is often high.
A manager or investor who wants to take a company private probably needs to borrow a significant
amount of money.
Taking a company private is called a leveraged buyout (LBO).
LBO market activity levels depend on credit markets.
Around 2005, the LBO market was quite active.
Activity in the LBO market came to a standstill after the crash of 2008.
Selling Securities to the Public
The primary market is the market where investors purchase newly issued securities.
Initial public offering (IPO): An IPO occurs when a company offers stock for sale to the public for the
Seasoned equity offering (SEO): If a company already has public shares, an SEO occurs when a
company raises more equity.
The secondary market is the market where investors trade previously issued securities. An investor can trade:
Directly with other investors.
Indirectly through a broker who arranges transactions for others.
Directly with a dealer who buys and sells securities from inventory.
The Primary Market for Common Stock
Initial Public Offerings (IPOs) – an initial public offering occurs when a company offers stock for sale to the
public for the first time
Company is small and growing, and it needs to raise capital for further expansion
Often called and unseasoned equity offering because shares are not available to the public before the IPO
Company already has shares owned by the public, it can raise equity with a
Seasoned Equity Offerings (SEO) – the sale of additional shares of stock by a company whose shares
are already publicly traded
General Cash Offer – an issue of securities offered for sale to the general public on a cash basis
Rights Offer - a public issue of securities in which securities are first offered to existing shareholders
(also called a rights offering)
Investment Banking Firm – a firm specializing in arranging financing for companies
Underwrite – to assume the risk of buying newly issued securities from a company and reselling them to
Underwriter Spread – compensation to the underwriter, determined by the difference between the
Syndicate – a group of underwriters formed to share the risk and to help sell an issue
An IPO (and an SEO) involves several steps.
Company appoints an investment banking firm to arrange financing.
Investment banker designs the stock issue and arranges for fixed commitment or best effort underwriting.
Company prepares a prospectus (usually with outside help) and submits it to the Securities and
Exchange Commission (SEC) for approval. Investment banker circulates preliminary prospectus (red
herring). Upon obtaining SEC approval, company finalizes prospectus.
Underwriters place announcements (tombstones) in newspapers and begin selling shares.
Firm Commitment underwriting – the type of underwriting in which the underwriter buys the entire issue,
assuming full financial responsibility for any unsold shares
Best Efforts Underwriting – the type of underwriting in which the underwriter sells as much of the issue as
possible, but can return any unsold shares to the issuer without financial responsibility
Dutch auction underwriting – the type of underwriting in which the offer price is set based on competitive
bidding by investors. Also known as uniform price auction.
Ontario Securities Commission (OSC) – the provincial regulatory agency charged with regulating
Toronto Stock Exchange listed securities and the companies
Prospectus – document prepared as part of a security offering detailing a company’s financial position,
its operations, and investment plans for the future
Red herring – a preliminary prospectus not yet approved by the OSC