Sources of Capital

Brealey and Myers

Chapter 14, 15

Financial Growth Cycle

Opaque Assets• Insider Finance• Angel Finance• Venture Capital

Tangible Assets• Private Debt

– Bank Debt– Private Placements

• Public finance (traded bonds and traded equity) is available only to the largest firms.

Small Businesses

• Generally must use insider finance while developing a product or business concept, and when most assets are intangible.

• ‘Angel’ finance possible when a formal business plan is in place.

• Bank and finance company debt is generally not available until balance sheet has substantial tangible business assets.

“Angel” Finance

• A very informal market for direct equity finance provided by high net worth individuals.

• Typically provide $50,000 - $1,000,000.

• Angels are very ‘local’, and sometimes operate as investment groups. Often connected by a lawyer or accountant.

Venture Capital Finance

• A venture capitalist is a very active financial intermediary.– Most are limited partnerships– A few are subsidiaries of financial institutions.

• Venture capitalists not only provide financing, but also participate in strategic planning and operational decisions.

How VC’s Raise Funds• ‘General Partners’ put up about 2% of the funds

and do all of the work; ‘limited partners’ put up the other 98%:– Public pension funds

– Corporate pension funds

– Endowments and foundations

• Funds are typically set up to last about 10 years. Many proven VC’s manage multiple funds simultaneously. Investors may not liquidate early and may not freely sell their LP shares.

How VC’s Invest

• VC’s ‘stage’ their investment. Sometimes as many as nine stages.– ‘Seed’ (zero-stage) - prototype– Early stage - production– Later stage – growth.

• Key: only invest ‘big’ money when odds are good; exit bad investments early.

• Most VC’s focus on particular industries and on particular stages.– http://www.vistavc.com/

14.0Value14.0Value

5.0equity originalYour 9.0assetsOther

5.0stage1st fromEquity 1.0assets Fixed

4.0stage 2nd fromequity New 4.0equitynew from Cash

Equityand sLiabilitieAssets

($mil)Sheet BalanceValue Market Stage Second

2.0Value2.0Value

1.0equity originalYour 1.0assetsOther

1.0capital venturefromequity New 1.0equitynew from Cash

Equityand sLiabilitieAssets

($mil)Sheet BalanceValue Market StageFirst

How VC’s Make Money• VC’s profit by liquidating successful investments

through either:– Sale back to management, to a buyout firm or to a large

corporation

– Issuance of an IPO. The IPO serves to liquidate the VC investment AND raise new funds.

• After repaying the initial investments, general partners keep 20% of the profits.

• General partners also take a fee of 2.5% ‘carried interest’ every year.

A note on VC returns• How would we find expected returns on VC

investment, from a limited partner’s perspective?– CAPM? No. This is infeasible due to the limited

information private equity returns. (i.e. what did private equity return on Mar 12, 1994?)

• How would we find expected returns that VCs demand? (From a GPs perspective)– CAPM? No. Partners are not diversified, and so we

cannot use the CAPM.

A note on VC returns• The end result is that we don’t know how

much private equity is expected to return going forward, and we don’t know how much it should return.– Asset allocation problem for pensions,

endowments, etc. is a serious problem.

The Typical VC Investment

• VC’s take preferred equity (like a debt-equity hybrid). The salient features of a VC contract are:– Converts to equity at the time of the IPO– The entrepreneur may be removed from control

by the VC at any time.– VC’s demand that the majority of the

entrepreneur’s wealth be invested in the entity; entrepreneurs typically get very small salaries.

Private Debt

• Banks, and finance companies are the largest providers of private debt.

• Brealey and Myers: typically serve firms whose debt needs are less than $100 million.– Truth: Small size is a sufficient condition for bank

debt, not a necessary one!

• Typically serve firms whose assets are tangible. Provide constant monitoring; lending often based on collateral.

Private Placements• Some firms with larger needs for debt ($100

- $150 million) use the private placement market. Typically, these ‘loans’ are placed with insurance companies.– Collateral and restrictive covenants are not as

important as in the bank loan market.– Must be a better-grade borrower due to

insurer’s desire for AAA ratings on policies.– An intermediate step between bank loan market

and public bond market?

Public Debt• May be senior or subordinated, may be

fixed or floating, may be convertible or straight,” may be puttable, etc.

Public Equity

• Public equity is available to firms with larger needs for capital.

• The first issue of public equity is called an IPO:– Primary offering– Secondary offering

• Later issues are called ‘seasoned’ equity offerings (SEOs)

• Market customs and regulations for IPO’s differ around the world.

• In the US:– Registration– Prospectus, with a price

‘window’– Road show, where informal

‘orders’ are taken– Price setting. 3-way bargain

between issuer, investment bank and major purchasers.

– Trading begins. Underwriter keeps 7% of proceeds.

Salient Features of IPO Aftermarket

• Underpricing• Overallotment Option (The “Greenshoe”)• Price Support• IPO Lockups

– Why its done

– What happens at expiration

• IPO Long-run Performance is poor• IPO Cycles

Why are IPOs underpriced?

• Almost everywhere in the world, investors who buy at the open price make excess returns. But… it is almost impossible to buy at the open price. One explanation is the winner’s curse.

• The average value of a Matisse painting is $X.• You have no private information about the value

of a particular Matisse painting up for sale.• The sale is sealed-bid, first price. What do you

bid?

Initial Public OfferingsAverage Expenses on IPOs

Value of Issues

($mil)

Direct

Costs (%)

Avg First Day

Return (%)

Total

Costs (%)

2 - 9.99 16.96 16.36

10 - 19.99 11.63 9.65

20 - 39.99 9.7 12.48

40 - 59.99 8.72 13.65

60 - 79.99 8.2 11.31

80 - 99.99 7.91 8.91

100 - 199.99 7.06 7.16

200 - 499.99 6.53 5.70

500 and up 5.72 7.53

All Issues 11.00 12.05

25 16

18 15

18 18

17 95

16 35

14 14

12 78

11 10

10 36

18 69

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Gross underwriter spreads of selected issues, 2001

Issue amount, Underwriter's

Type Company millions of dollars spread, percent

IPO Torch Offshore 80.0 7.00IPO Alliance Imaging 122.0 7.00IPO Usp 126.0 7.00IPO Tellium 135.0 7.00IPO Agere Systems 3600.0 3.90

Seasoned National Golf Properties 29.6 5.13Seasoned Lifepoint Hospitals 92.8 5.00Seasoned Valspar corp 168.0 4.25Seasoned Raytheon Co. 343.8 3.75Seasoned Pepsico, Inc. 534.6 2.00Seasoned Allegheny Energy, Inc. 598.3 3.01

Debt:8.3 % Sub notes, 2011 Bank of the West 50 0.656.875% Med term notes, 2006 Maytag Corp 185 0.507.75% Notes, 2011 Shurgard Storage Centers 250 0.658.5% Senior notes, 2011 Hilton Hotels 300 0.885.875% Global bonds, 2004 American Home Products 500 0.353.5% Conv bonds, 2031 Cox Communications 385 2.257.45% Global bonds, 2031 Kellogg 1100 0.88

Can we avoid underpricing?

• By selling securities which are not equity-like?– Probably not.

• By selling securities through an auction mechanism?– WR Hambrecht Open IPO

– Treasury Auctions

– Used with apparently good results in France, Chile, Israel, Japan.

Another Puzzle (for SEOs)

Rights Issue - Issue of securities offered only to current stockholders.

• This would avoid underpricing as well.

• Why not use it to avoid underpricing for small (e.g. private) firms?

• For public firms?

Patterns of Corporate FinancingTABLE 14-1 Sources and uses of funds in nonfinancial corporations expressed as percentage of eachyear's total investment.

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997Uses.'1. Capital expenditures 74 87 87 98 73 89 92 77 81 832. Investment in net 26 13 13 2 27 19 20 23 19 17working capital and otherusesa3. Total investment 100 100 100 100 100 100 100 100 100 100Sources:4. Internally generated 81 87 90 112 88 88 86 78 89 85cash b5. Financial deficit 19 13 10 -12 12 12 14 22 11 15(5 - 4); equals requiredexternal financingFinancial deficit coveredby:6. Net stock issues -26 -27 -14 3 6 4 -7 -8 -9 -147. Net increase in debt 45 40 24 -14 7 8 21 30 20 30

a Changes in short-term borrowing are shown under net increase in debt. "Other uses" are net of any increase inmiscellaneous liabilities and any statistical discrepancy.

b Net income plus depreciation less cash dividends paid to stockholders

Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of FundsAccounts, various issues.