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Chapter 6

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York University
Administrative Studies
ADMS 3531
Dale Domian

Chapter 6 - The Stock Market 6.1 - Private Equity vs. Selling Securities to the Public Private Equity  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:  middle-market firms  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  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  Individuals  Pension funds  Insurance companies  Large corporations  University endowments  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.  Ground-floor financing  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. Middle Market  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. Leveraged Buyouts  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 first time.  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 investors  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.  IPO Tombstone  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 The Secondary
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