Introduction to Corporate Finance

PARt 2: VALUAtIoN, RISk ANd REtURN

bankers also prepare a prospectus, a document containing extensive details about the issuer and the

security it intends to offer. The investment bank circulates the prospectus among potential investors as

a starting point for marketing the new issue. The issue of shares themselves may be made on a public

exchange such as the Australian Securities Exchange (ASX) or to specific parties in the form of private

placements.

In addition to preparing the paperwork for documentary submission to ASIC, the investment bank

also helps set up a due diligence committee. This committee includes representatives of each main group

with an interest in the IPO, such as the investment bank itself, lawyers, accountants, management from

the company and other external persons. The due diligence committee focuses on ensuring that the

prospectus to be issued will meet ASIC regulations.

While it is preparing the necessary legal documents, the investment bank must also begin to estimate

the value of the securities the company intends to sell. Investment banks use a variety of methods to

value IPO shares, including discounted cash flow models and the comparable multiples approach.

Several weeks before a large scheduled offering, the company and its bankers take a tour of potential

major investors, most of which are institutions. Affectionately called the road show, this gruelling process

usually lasts a week or two. It gives managers the opportunity to pitch their business plan to prospective

investors. The investment banker’s goal in this process is to build a book of orders for shares that is

greater (often many times greater) than what the company intends to sell. The expressions of interest by

investors during the road show are not binding purchase agreements, and the investment bank does not

commit to an offer price at this point. Instead, bankers give investors a range of prices at which the offer

might sell based on their assessment of demand. Given the tentative nature of the demand expressed

on the road show, the banker seeks to oversubscribe the offering to minimise the bank’s underwriting risk.

Naturally, one way to create excess demand for an offering is to set the offer price below the market-

clearing level. The majority of IPOs are underpriced, meaning that once IPO shares begin trading, they

do so at a price that is above the original offer price set by the company and its bankers.

After a share offering is successfully sold, the lead underwriter often serves as the principal market

maker for trading in the company’s shares. In this role, the lead underwriter purchases shares from

investors wishing to sell, and sells shares to investors wishing to buy, thus ‘making a market’ in the new

issue. The lead underwriter also assigns one or more research analysts to cover the issuing company.

The research reports these analysts write (which naturally tend to be flattering) help generate additional

interest in trading the company’s securities.

To conclude this section, we want to highlight the conflicts that investment bankers may face.

Companies issuing securities, on the one hand, want to obtain the highest possible price for their

shares (or bonds). Companies also want favourable coverage from securities analysts employed by their

investment bankers. Investors, on the other hand, want to purchase securities at prices low enough

to ensure that they will earn a high return on their investments. Investors also value dispassionate,

unbiased advice from analysts. Investment bankers must therefore walk a thin line, both ethically and

economically, to please their constituents. Companies issuing securities are wise to remember this.

Investment bankers deal with investors, especially large institutional investors, on a repeated basis. They

must approach this group each time a new offering comes to the market. In contrast, over its entire life,

a company conducts just a single IPO.^14

14 A CEO of a company that conducted an IPO during the 1990s told us, ‘You have two friends in an IPO: your lawyer and your accountant.’ Notice

that the investment banker didn’t make the list.

prospectus

A document that contains

extensive details about the

issuer and describes the

security it intends to offer

for sale

road show

A tour of major investors

undertaken by a company and

its bankers several weeks

before a scheduled offering;

the purpose is to pitch the

company’s business plan to

the prospective investors

oversubscribe

When the investment banker

builds a book of orders for

shares that is greater than the

number of shares the company

intends to sell

Jay Goodgold, Managing

Director, Equities Division,

Goldman Sachs

‘The goal here on the

road show is to see the

major institutional clients

in Boston, New York,

Chicago, Denver, Los

Angeles, San Francisco,

London, Paris, Frankfurt

and Tokyo.’

See the entire interview on

the CourseMate website.

CoURSEMAtE
SMARt VIdEo