investment banking, private equity & subprime crisis

Investment Banking

&

Private Equity

&

Subprime Crisis

by

CA. Sunny Sabharwal

Today’s Points of Discussion

1. Investment banking

2. Private Equity

3. Sub-prime Crisis & Indian Markets

2

Today’s Points of Discussion

1. Investment banking

2. Private Equity

3. Sub-prime Crisis & Indian Markets

3

Defining IB (if possible!)

No clear definition as such

Deal with securities

Question – What are securities?

Answer – A fungible, negotiable instrument representing financial value

Service Corporates, Government, Institutions and HNIs

Commercial banks primarily cater to general public

Not as regulated as Commercials (Why?)

4

Organizational structure of an I-bank

Corporate Finance

Underwriting

Strategic Advisory

― Mergers & Acquisitions

― Private Placements

― Divestitures

Sales & Trading

Institutional & Private Clients

Pitching & cold calls

Research

Recommend “buy”, “sell” or “hold”

Guess what “Contrarians” do!5

Organizational structure of an I-bank

Activities classified in nature:

Origination –

― Getting Business (have knowledge of products, business)

― Finding Investors

Execution –

― Due Diligence

― Documentation : Agreements, term sheets

― Financial Analysis (Valuation)

― Prepare Materials for Internal Committees

6

Organizational structure of an I-bank

Industry Coverage

focus on a specific industry such as healthcare, industrials, or technology

Product Coverage

focus on financial products, such as mergers and acquisitions, leveraged

finance, equity, and high-grade debt

Region Coverage

focus on particular geography (-ies)

7

IB G

am

ut

of

Se

rvic

es

INVESTMENT BANKING

Initial Public

Offering (IPOs)

Mergers & Acquisitions

Private Equity

Placements

Qualified Institutional Placements

(QIPs)

Follow-on Offerings

Buyback of Equities

8

Types of Stock Issues

Issues

Public Issue

IPO

FPO

Rights Issue Bonus IssuePrivate

Placement

Preferential Issue

Qualified Institutional Placement

9

IB Gamut of Services

Initial Public Offering

Do we need a primer!!!

But why go public?

― Fund the growth – purchase another firm using own stock as currency

― Exit option for Promoters

― Ease in raising finance

Underwriting or Best Efforts

― Most offerings underwritten

― In very small, risky deals on best efforts basis

10

IB Gamut of Services

Initial Public Offering

Pricing

― Since firm going public, no established price

― Banker and company project the company’s future earnings & cash flows

Normalize the data

― Market data on similar listed companies

― Price set to place the firm’s P/E and M/B ratios in line with publicly traded

firms in the same industry having similar risk and growth prospects

― Conflict of interest - because Banker has an incentive to set a low price :

to make brokerage customers happy

to make it easy to sell the issue

Firm would like price to be high

11

IB Gamut of Services

Initial Public Offering

Process

― Hiring Managers –

Who gives the best bet!

Reputation of IB

Type of Clients – Institutional or Retail

Support in the post-IPO secondary market

» Reputation of analyst covering the stock

― Due Diligence & Legal

― Marketing

12

IB Gamut of Services

Follow-on offerings

Additional Capital

Exit option for large shareholders

Since more shares mean dilution (EPS effect), stock price usually falls on

news of secondary offering

Less complicated and lengthy than IPO

― Valuation is provided by the market

― Usually same managers/underwriters used

13

IB Gamut of Services

14

Mergers & Acquisitions (buy Vs build)

Why

― New market, new product

― Vertical or Horizontal Integration

― Additional capital

― Reduce competition (when you can’t fight them, join them)

― Strategic Reasons

Loss-making company having valuable assets

Process

― Target identification

― Determination of appropriate price

― Structuring the finance

IB Gamut of Services

15

Mergers & Acquisitions

Mode of Acquisition

― Pure Equity

Equity & Preference

Special Class (Differential voting rights, dividends or otherwise)

― Leveraged Acquisitions

Due Diligence

― Approval rights of financiers

― Title to Properties & Assets

― Statutory Dues

― Litigations

― IPR protection

Growth of IB

16

IB Gamut of Services

17

Private Equity Placements

Private sale of unregistered securities by a public company to a select

group of individuals or institutions

SCRA provides that

― When issuer issues securities to a select group of persons not exceeding 49

Types:

― Preferential allotment: Listed issuer issues shares to a select group

― Qualified institutions placement (QIP): Listed issuer issues shares to

Qualified Institutions Buyers (Public financial institution, Banks, Mutual funds,

FIIs, Venture capital funds, Pension Funds, etc.)

Today’s Points of Discussion

1. Investment banking

2. Private Equity

3. Sub-prime Crisis & Indian Markets

18

Private Equity

Definition – equity securities in operating companies that are not

publicly traded on a stock exchange

Why –

Long investment horizon

Building businesses and teams

Facilitating outpacing of competition – through global networks

Ensuring high standard of Corporate Governance – disclosures, etc.

Average investment horizon 7-10 years

Private Equity

Private equity activity

Fund raising

Investment

Divestments

Structure of PE Funds –

Usually Limited Partnerships

Managers : General Partners (GPs); Investors : Limited Partners (LPs)

LPs – Corporates, Pension Funds, Other PE Funds, HNIs

Compensation of GPs –

Management fee - 1-2% of invested capital

Carry - 20% of excess return on fund

Private Equity

Venture capital – investment in companies that have undeveloped

or developing products

Types –

Seed stage – Financing provided to research, assess and develop initial

concept

Start-up stage – Financing for product development and initial

marketing

Expansion stage – Financing for growth and expansion

Private Equity

What do VCs look for:

Strong management team

― Good people management and business development skills

― Prior relevant experience

― Commitment – risks taken / capital invested

Sound business model

― What’s different / USP

― Large customer base

― Sustainable & profitable growth after fully funded

Private Equity

Exit Options:

Selling stake to strategic investors

― Competitors

Initial Public Offering (IPO) in India or overseas

Sale to any other private equity fund or venture capital fund

Merger with an existing listed company

Management / Company buy-backs

Valuation Methods

Income-based Approach

― Discounted Cash Flows

― Dividend Discount Model

Asset-based Approach

― Net Asset Valuation

Market Approach

― Relative Valuation

P/E, P/BV, EV/EBITDA, EV/Sales

SUBJECTIVITY

24

Private Equity

Discounted Cash Flows

Premise : ownership is essentially a claim on the cash flows

Process :

― Estimate free cash flows available to all investors

Historical performance

Company projections

Equity research analyst estimates

Industry data

― Normalize earnings

― Estimate terminal value (TV)

― Using WACC, determine the appropriate discount rate

― Calculate Enterprise Value

25

Private Equity

Today’s Points of Discussion

1. Investment banking

2. Private Equity

3. Sub-prime Crisis & Indian Markets

26

Sub-prime Crisis

Description – Pick any newspaper!!!

Let’s start with the basics

What is Sub-prime?

― which is not PRIME

What is Securitization?

― Bundling of securities

― Payments to investors from mortgage payments by borrowers

― Further sold as Collateralized Debt Obligations (CDOs)

Tranches – maturity, security, rating

27

Sub-prime Crisis

28

Introduction of exotic loans and relaxed

standards ―> increase in sub-prime

mortgage lending

Low interest rates encouraged Wall

Street investors to back sub-prime loans in greater quantities

Hedge funds worldwide borrowed

money to invest heavily in sub-prime mortgages

Prices go beyond FED’s tolerance limit. Interest rates rise and housing

prices fall

Lenders, rating agencies, and investors

underestimated the number of loans that

would default.

Who’s fault is it anyway

Lenders: for their predatory lending practices focused on subprime

mortgage candidates

Rating Agencies: Overrate the MBS and other derivatives with underlying

securities of little value

Mortgage brokers: for steering borrowers to unaffordable loans

Wall Street investors: for backing subprime mortgage loans without first

verifying the security of the portfolio

Borrowers: for overstating income levels on loan applications and entering

into loan agreements they could not afford

Government: for lack of oversight

29

Sub-prime Crisis

30

Sub-prime Crisis

A Typical Securitization Process

Impact of crisis on Indian market –

In India, the closeted financial system is not heavily exposed to the

financial crisis

PM: None can be immune from a global melt down

But,

― FII Outflows

― SENSEX plunges

― High Inflation

― Liquidity crunch

Affecting all industries across the board

31

Sub-prime Crisis

Requisites for Professionals

Financial knowledge (a must!) – understanding financial statements

Financial Economics – GDP, Inflation, Money Supply, etc.

Understanding and tracking markets – Indian & global

About the industry – industry cycle, major players, business

models, entry/exit barriers, regulatory issues, etc.

Valuation Methods

Other skills –

Networking & Personal Communication

Computer skills - Financial modeling, Presentations

32

Books / Sources / Links

“The Intelligent Investor” by BENJAMIN GRAHAM

“Investment Banking Explained – An insider’s guide” by MICHEL FLEURIET

“Principles of Private Firm Valuation” by STANLEY J. FELDMAN

Any financial newspaper

www.vccircle.com – For latest in PE world

www.stockmarketguide.in – For keeping abreast of Stock Market Events

33

Let’s discuss

Thank You

CA. Sunny Sabharwal

+ 9 1 9 9 5 8 6 7 7 7 6 6

sabharwal.sunny@yahoo.com

www.sunnysabharwal.blogspot.com