Securities financing is the provision of new funds to a firm whereby the firm either sells new debt instruments or equity or some combination of both. For governments, it entails the sale of short and long-term bonds to raise additional revenue, usually through an auction.
Methods used to carry out sales of equity or new debt differ among countries and classes of securities. The general approach can nonetheless be described in terms of broad categories that span different countries and jurisdictions, private sales, or public offerings and auctions. Securities in this context are any intangible assets the value of which is a claim to future cash accruing to the holder, referred to as an investor. They date back to the 1600s when equity was traded in Antwerp and Amsterdam. Options and futures, called time bargains then, traded on the Amsterdam bourse in 1611. Firms have always needed external funding since then. The amounts have grown bigger and the list of instruments much longer.
Payments are typically fixed for debt instruments such as bank loans and bonds issued by governments and corporations. For equity instruments, on the other hand, the issuer of the financial asset has an obligation to pay the investor on the basis of residual earnings after all investors in debt instruments have been paid their fixed amounts. Both governments and companies can obtain external funding by offering securities to a small number of investors, a given class of investors such as current shareholders of a firm or the general public. For a company, the external source can be an individual investor, a venture capitalist, an institutional investor, a corporate investor, or the public at large.
The other source of funds can be venture capitalists. A venture capital firm is a limited partnership that raises funds specifically for investment in young firms. The limited partners in such firms are often institutional investors like pension funds, bonds, insurance companies, hedge funds, or mutual funds. The firm is run by the general partners, known as venture capitalists. By being limited partners in venture capital firms, the participants are able to diversify their investments. This is in addition to benefiting from the expertise of general partners that they work with in the venture capital firm. The institutional investors can invest indirectly through venture capital or directly into private firms.
There are a variety of forms for public issues. Securities can be offered for sale at a stated fixed price or auctioned off to the highest bidder.
Initial Public Offering (IPO)
An IPO occurs when common stock offerings are issued by companies that have not previously undertaken any sales of common shares to the public. Although not a necessary condition, such public offerings are almost always listed on an organized exchange, such as the New York Stock Exchange (NYSE). IPOs are mostly motivated by the desire of firms to access a higher and more diversified array of financing options. Specifically, public offerings enable firms to reduce expenses on bank lending and enhance their ability to utilize equity as an acquisition currency. Many private firms are heavily dependent on their banks for financing. Case studies confirm that there is value in public listing. Having public funds in the end improves the firm’s relationship with banks, customers, and suppliers. This is partly attributed to the dramatic increase in the flow of information about the firm as a result of going through the process of an initial offering.
With respect to acquisition, when a firm wishes to purchase an existing firm thereby exchanging shares, the purchasing firm faces a binding constraint if it is not publicly traded. Its shares are then not registered and are sold only to exempt buyers rather than to the general public. The resulting lack of liquidity in the stock renders the firm’s shares unattractive as a means of financing acquisitions. Firms that intend to make extensive takeovers find it advantageous to have their shares publicly traded.
Going public entails a procedure whereby an investment banker, a firm specializing in raising capital for companies, is consulted to initiate a formal IPO process in the first instance. Second, a document is produced for the public and for registration with stock market regulatory authorities—the prospectus—disclosing pertinent information regarding the security and its issuer. During this second phase, a choice is made of the broad type and terms of the public offering, out of four different types. In a best efforts offering, the shares are sold by the investment banker by way of an agency agreement undertaken to do its best without guarantee of success, being paid an amount for each share sold. In a firm commitment offering, the investment banker or underwriter purchases the new securities from the issuer at a set price and guarantees the sale of a certain number thereof. In the case of a bought deal, an underwriting arrangement is made whereby an investment bank or group of such banks (syndicate) offers to buy an entire issue of shares from the issuer. This is often even before the preliminary prospectus is drafted. The other option is a standby or rights offering whereby common shares to investors are offered at a discount to investors who already own shares.
Regardless of the type chosen, standard underwriting clauses are included, providing the issuer the authority to issue the securities, requiring it to prepare a prospectus, preventing it from issuing any other securities while the underwriting is still under way, and obligating it to pay the underwriter. The third phase is the waiting period during which the investment banker and issuer wait for final clearance from regulatory authorities to sell the securities.
Seasoned Equity Offering (SEO)
An SEO is the offer of new shares for sale by a public company. In the event of growth opportunities that cannot be fully financed from retained earnings after an IPO, the firm returns to equity markets to put up new shares for sale. The mechanics of an SEO are essentially the same as those of an IPO. The only distinction here is that there already exists a market price for the stock so that the process of price setting and discovery is not required. The SEO takes on two forms, namely, a cash offer and a rights offer. Whereas the firm offers the new shares to all investors in a cash offer, it offers new shares only to existing shareholders in the case of a rights offer.
In auction arrangements to raise external funds used by both private firms and governments, would-be buyers make submissions of both the price and quantities in their orders. The motivation for using auctions partly hinges on the relative advantages with respect to possession of information by investors at large compared to the information the firm and its advisers may have. For companies in some industries, the most relevant source of risk and uncertainty is the general environment under which they function. In such circumstances, it is preferred to pool the views of more investors by carrying out an auction of securities. This is in contrast with the case of industries where the success of the firm depends mainly on the specialized and strategic leadership such that management is better placed to assess and value its stock. A disadvantage of the auction approach is that there may be some sensitivity of the selling price to collusion by buyers. One way to deal with this problem is to adopt a fixed-price offer for sale, whereby the seller determines the price of the securities.
In the conduct of securities auctions, participants do not have an opportunity to revise their initial bids because they get to submit sealed bids. The auctioneer determines the pricing and allocation rules, leading to a choice of auction mechanism. The most common mechanisms are the discriminatory auction and the uniform price auction. In both mechanisms, bidders are able to submit multiple bids and the securities go to the highest bidder.
In uniform-price auctions, all the winning bidders pay one price, which is the lowest winning bid price and constitutes a market clearing price. In the discriminatory auction, the winning bidders each pay the price they put in their respective bids. In the end, this is a form of discriminating monopoly where the seller allocates securities so as to enable each bidder to pay the highest price affordable until all securities have been sold off.
- Laurence Booth and Sean Cleary, Introduction to Corporate Finance (Wiley, 2008);
- Robert F. Bruner, Case Studies in Finance: Managing for Corporate Value Creation (McGraw-Hill, 2007);
- Frank J. Fabozzi and Frank P. Jones, Foundations of Markets and Institutions (Prentice Hall, 2009);
- Frank J. Fabozzi and Vinod Kothari, Introduction to Securitization (John Wiley & Sons, 2008);
- Stewart Myers, “Financial Architecture,” European Financial Management (v.5/2, 1999);
- G. Nyborg and S. Sundaresan, “Discriminatory Versus Uniform Treasury Auctions: Evidence From When Issued Transactions,” Journal of Financial Economics (v.42, 1996);
- Smith, “Investment Banking and the Capital Acquisition Process,” Journal of Financial Economics (v.15, 1986).
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