CHAPTER 5Investment Banks and Securities Analysts

CORPORATE GOVERNANCE

Kenneth Kim,John Nofsinger &Derek Mohr

3rd EditionPearson Prentice Hall

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Why we can no longer trust investment bankers to monitor.

One important role of investment banking is that they bring new debt and equity securities to the market.The process of selling securities to the market:

The bank needs to submit a preliminary prospectus to the SEC. The bank distributes the final prospectus to investors.Road show: The marketing campaign done by bankers to generate interest and to market the issue.

NOTE: Investment bankers are potentially an important source of information and monitoring of a public company.

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However,…

While investment banks are expected to offer quality companies to investors, beginning with the greed era of the 1990s, banks began to bring inferior companies to the market. Pets.com initial public offering

In 1999, the firm had only $5.8 million in revenue and reported an operating loss of $61.8 million.Merrill Lynch launched the Pets.com IPO in February 2000 (raised $66 million).Ten months later, Pets.com filed for bankruptcy and folded.

Facebook Did Morgan Stanley knowingly set the IPO price too high to take advantage of the hype surrounding the IPO?

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More bad news about investment banks.

Structured dealsIf a firm has trouble raising capital due to its questionable economic viability, investments banks sometime work with those firms to figure out “clever” ways to help the firm to issue additional shares.Would you want to buy those shares?

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Why we were never able to trust securities analysts to monitor.

Analysts generally fall into two categories:

Buy-side analystsAnalysts hired by institutional investors.

Sell-side analystsAnalysts employed at brokerage houses who analyze stocks to help investors (shareholders) makes investing decisions.Sell-side analysts should be part of the corporate monitoring system!

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Sell-side analyst’s job

A sell-side analyst will assess the following:Firm’s operating and financial conditions.Firm’s immediate and long-term future prospects.Effectiveness of firm’s management team.General outlook of the industry in which a firm belongs.

Based on her analyses:She will make earnings predictions (e.g., EPS).She will make investing recommendations (e.g., buy/sell/hold).

And she will update her recommendations frequently.

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Quality of Analysts’ Recommendations

Analysts are supposed to evaluate firms and their managers on behalf of investors.However, analysts cannot do a good job analyzing firms unless those firms’ managers help them!So, analysts work with managers, not for shareholders.

Example: Analysts will make slightly beatable earnings predictions so managers can beat them and look good.

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Analysts’ ability to recommend stocks

Are analysts good at picking stocks?Most stocks carry a “buy” recommendation.

Not surprising: Analysts need investors to buy stocks to make money. So, a buy recommendation should be viewed with caution.

However, when a stock carries a “sell” recommendation, it often turns out to be a good recommendation.

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Analysts Working at Investment Banks

Can you trust an analyst who works at an investment bank?

She may not give a firm’s stock a sell recommendation if the firm is a former client of the bank. She may not give a firm’s stock a sell recommendation if the bank wants the firm’s business.

But yet investment banks in many countries are still allowed to offer brokerage services.

CHAPTER 6Creditors And Credit Rating Agencies

CORPORATE GOVERNANCE

Kenneth Kim,John Nofsinger &Derek Mohr

3rd EditionPearson Prentice Hall

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The Existence of Corporate Debt

The existence of corporate debt creates three important corporate system monitors or devices:

Debt, in and of itself, can be a disciplinary mechanism.Monitoring by institutional lenders.Monitoring and debt ratings by credit agencies.

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Debt As a Disciplinary Mechanism

Because interest payments represent fixed and regular obligations of the firm, debt actually imposes discipline on to the firm’s management.Interest expense also discourages superfluous spending by management.Other covenants can be written into the debt contracts.In brief, debt in a firm’s capital structure potentially provides protection to investors.

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Institutional Lenders As Corporate Monitors

Many firms borrow lots of money from banks. Many of these same firms develop close relationships with banks and oftentimes these firms divulge private information to banks to obtain favorable interest rates.Therefore, creditors often know what is going on in client firms more than shareholders do.Banks can monitor firms effectively!

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But why should creditors care about stockholders?

Creditor’s claims have seniority over stock holder’s claims.

Creditors get their money (from earnings, from liquidations) before stockholders.

Therefore, creditors are usually inactive monitors of firms due to their lack of incentive.

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Credit Rating Agencies

Credit rating agencies rate bonds (e.g., AAA, Aaa, BBB, Baa) for potential bond investors.A rating grade informs investors about the risk of a bond and thus the firm.

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Why Credit Rating Agencies are not perfect monitors.

There are only a few credit rating agencies (it’s a regulated industry), so there is little competition. Rating agencies have become consultants.

Being both consultants and credit raters creates a conflict of interest.

In many countries, credit rating agencies have the right to secrecy.

They don’t have to divulge what they know about a firm.

CHAPTER 7Shareholders and Shareholder Activism

CORPORATE GOVERNANCE

Kenneth Kim,John Nofsinger &Derek Mohr

3rd EditionPearson Prentice Hall

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What Is Shareholder Activism?

Active shareholders - shareholders who express their opinions to try to affect/influence management.Three kinds of shareholders:

Individual (minority) shareholders. Large shareholders.Institutional shareholders (which can also be large shareholders).

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Activism by Individual Shareholders

An individual investor with only a modest number of shares is able to:

Attend shareholder meetings.Submit proposals to be voted on at shareholder meeting.

You have to have a minimum amount of shares to do this, but this amount is tiny.

Vote at shareholder meetings.

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Activism by Individual Shareholders in Practice

Most shareholder proposals submitted by individual investors do not pass. Two reasons are:

It is difficult and expensive for one shareholder to communicate with all other shareholders.Most passive shareholders are reluctant to vote against the firm’s management.

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Monitoring by Large Shareholders

Large shareholders are active monitors of the firm.

They have a financial incentive to be active owners.

Minority shareholders like the existence of large shareholders (i.e., minority shareholders can free-ride on large shareholder monitoring), while managers may not like it.

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Inside and Outside Large Shareholders

The existence of a large inside shareholder minimizes the agency problem.

Interest of inside shareholder/manager is aligned with outside minority shareholders.

The existence of a large outside shareholder may exacerbate the agency problem.

There may be lots of fights between a large outside shareholder (e.g, Kirk Kerkorian, Warren Buffet) and managers.

Minority shareholders benefit in both cases.

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Why do many firms not have large shareholders?

Some public firms can be so large that it would take a lot of wealth to own a significant fraction of it.

Many investors (including inside shareholders) want to diversify their portfolios.

It is not clear whether the existence of a large shareholder leads to higher firm values.

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Institutional Shareholders

Institutional shareholders have become more active in monitoring the companies.

As large shareholders, they have the financial incentive to be active monitors.

Public pension funds often lead the way with regard to institutional shareholder activism.

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1970 2002

Shareholders of Stocks by Investor Type

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Does Institutional Shareholder Activism Work?

Some research suggest that institutional activism works.

Some institutions will threaten “targeted” bad firms by warning them they will sell their shares.

Some other studies show little evidence that institutional activism works.

Threats from institutions don’t carry much sway.

It is still under debate whether institutional shareholder activism works or not.

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Potential Roadblocks to Effective Institutional Shareholder Activism

The short-term view of some institutional shareholders limits their motivation to be activists.Private pension advisors face a big conflict of interests (they are employed by firms).The regulatory and political environment also hinder large institutional shareholders from being activists.

We generally don’t like institutions to become too powerful and rich, BUT this makes institutions less active.

CHAPTER 8Corporate Takeovers: A Governance Mechanism?

CORPORATE GOVERNANCE

Kenneth Kim,John Nofsinger &Derek Mohr

3rd EditionPearson Prentice Hall

U.S. and U.S. Cross-Border M&A Activity Transactions

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Brief Overview of M&A

A merger is often viewed as a combination of two firms. An acquisition is viewed as one firm buying another.However, almost all mergers are essentially acquisitions.M&A can be synergistic/diversifying or disciplinary or both.

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M&A for synergy/diversification

To improve operational or financial synergies.e.g., Exxon and Mobil

To diversify by expanding into new businesses.

e.g., AOL and Time Warner

Both synergistic and diversifyinge.g., Morgan Stanley and Dean Witter

Extremely diversifyinge.g., GE and NBC

Many recent mergers have occurred for growth and for increased market power.

e.g., Oracle and PeopleSoft, HP and Compaq.

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The Target Firm

“Target” firm is the firm to be acquired.An acquiring firm may want to acquire a target firm because it believes:

Target firm is not performing up to its full potential.Target firm could become a better performer under someone else’s control.

Therefore, target firms usually enjoy a share price increase when its acquisition is announced to the public.

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The Acquirer’s Goals

To take over the target firm and make it more profitable by:

Cutting target firm’s fixed or variable costs.Improving target firm’s operational efficiency.Getting rid of target firm’s bad managers.

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To Acquire a Successful Firm or an Unsuccessful Firm?

A successful firm An unsuccessful firm

Takeover cost Pay a large sum Pay a relatively small sum

Subsequent net gains

May be limited May be significantly positive

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Paying a Significant Premium for Target Firms

Acquirers almost always end up paying a significant premium for target firms.Whether or not the premium paid for target firms is ever fully recovered is still contentious.The target firms’ shareholders might like their firms are taken over, while the target firms’ management team may oppose being acquired because they might get fired afterwards.

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Hostile Takeover

A hostile takeover happens when the target firm’s management rejects a takeover bid. Then, acquirer may take its takeover bid directly to the target firm’s large shareholders to buy the firm.

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The Notion of the Disciplinary Takeover

Takeovers are viewed as an important governance mechanism because some firms that get taken over are poorly performing firms.The fear of a potential takeover might represent a powerful disciplinary mechanism over “bad” managers.

When bad firms are taken over, the bad managers of those firms are fired.

So, to avoid being taken over, managers perform to the best of their abilities.

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Why we may not be able to rely on takeovers to discipline managers.

It costs a lot of money to buy a firm.There are too many defenses/regulations against takeovers.

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Takeover Regulations

Freeze-out lawsFair price lawsPoison pill endorsement lawsControl share acquisition lawConstituency statuteThere are also antitrust laws (to ensure competition and prevent monopolies).

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Firm-level Pre-emptive Takeover Defenses

Poison pill—any strategy that makes a target firm less attractive immediately after it is taken over.A golden parachute—an automatic payment made to managers if their firms gets taken over.Supermajority rules—two-thirds, or even 90 percent, of the shareholders have to approve a hand-over in control.Staggered boards—only a fraction of the board can get elected each year to multiple-year terms.

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Firm-level Reactionary Takeover Defenses

Greenmail—like a bribe that prevents someone from pursuing a takeover.Other reactionary defenses include:

The firm’s management trying to convince its shareholders that the offer price is too low.Raise antitrust issues.Find another acquirer who might not fire management after the takeover.Find an investor to buy enough shares so that he/she can have sufficient power to block the acquisition.

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Assessments of Takeover Defenses

Takeover defenses at least contributed to the end of disciplinary takeovers.Takeover defenses are bad for the governance system.