Distressed Debt Strategy: Chapter 11 Bankruptcy Process

In a prior post, I had mentioned that, during the bankruptcy process, an investor can take control by holding 33% of the debt.  How can the investor have control with a large yet minority postion?  The answer is in the Chapter 11 process.  It gives the company breathing space for its debts and the ability to reorganize its capital structure.  This gives the company a second chance to become a profitable concern.

The company initiates the process by filing Chapter 11 petition with the court.  Upon receiving the filing, the court freezes debt and collection actions.  The company, now called the "debtor in possession" maintains its business operations and submits a reorganization plan to the court.  This plan may be "prepackaged" or may be created within 120 days of filing.  The company has to get the debt owners to accept the plan 60 days afterwards.  Obviously, if the debt holders are paid in full, the plan will be approved.  Otherwise, the plan is accepted if 50% of debt owners and if holders of 67% of the total amount of debt approve it.  This is when an investor with 33% of the debt holds a power position.  Since the investor is able to block any approval of the reorganization plan, this forces the company to negotiate with them.  After this original period has passed and no plan has been accepted, anyone can submit their own plan.  If the company agrees with the new plan, the court may approve it.  If none of the plans are acceptable to the company and debt owners, the court can force a cramdown plan.  Basically, the court tells everyone what the plan is.

Reorganization of the company usually means reimbursing debt, converting debt into equity and wiping out the current equity holders.  Within the company's bond structure, senior secured debt is paid back first.  Subordinated debt receive less than face value and other debt is converted to equity.

The source for the bankruptcy process summary is Mark Anson, The Handbook of Alternative Assets, pgs 483 - 487.  The book forms the core of the CAIA curriculum.

Distressed Debt Strategies for Private Equity

Distressed debt strategies can be classified three ways.  The investor can try to control the bankruptcy process by buying 33% of troubled company's debt.  Using this large position, the investor will take over the company by getting seats on the board of directors, obtaining ownership by wiping out the equity holders and converting the bonds into equity.  The large debt position allows the investor to influence any reorganization plan.  This is the riskiest strategy.  The investment period is two to four years and the target return is 20% to 25%.  The second strategy is to buy 33% of the bonds and use it only to map out the reorganization plan.  This is called an active investor not seeking control.  The holding period is one to three years and the target return is 15% to 20%.  The last approach is passive.  These investors buy distressed debt that is undervalued.  The debt may be used as part of a capital structure arbitrage strategy.  In this case, the investor buys the bonds and shorts the stock, hoping the stock will decrease in value more than the bonds.  The target return is 12% to 15% and the bonds are held for a year or less.

Managed Futures

I received an article regarding managed futures from Albourne Village named "Decoding the Myths of Managed Futures".  In several hedge fund indexes, managed futures are listed as a strategy.  Within the CAIA program, they are a separate category.  The report talks about its recent growth and elaborates on some controversies:

• Opaqueness regarding their "black box" trading strategy
• Non-correlation to equity returns
• Investing in non-commodity instruments
• Volatility
• Homogeneity of funds

Hedge Fund vs Private Equity Fund Fees

Both hedge funds and private equity funds have similar management and incentive fee structures.  Hedge funds have the famous "2 and 20".  Private equity charge 1% to 3.5% management fee with a 20% to 30% incentive fee.  However, hedge funds charge fees differently:

• Hedge fund fees are calculated based on net asset value while private equity fees are based on realized gains
• Hedge fund fees are collected on a quarterly or semiannual basis
• Incentive fees can be collected before any return of investor capital
• No clawback agreement
• Lower hurdle rates.  The manager will not charge performance fees until the hurdle rate is met.

Secondary Market for Private Equity

Private equity fund investors may want to sell their investments to raise cash, reduce their risk or re-balance their asset allocation.  These positions are similar to hedge fund investments.  They do not trade on a stock market daily and are hard to price.

At the 4th Annual Manager Search and Selection Conference at NYSSA in 2009, Nigel Dawn of UBS spoke about that year's state of affairs.  At the time, he was head of the Secondary Market Advisory team.  Historically, the spread between bid and ask prices was 8%.  In 2009, the spread was 20%.  Surprisingly enough, the growth was in private equity real estate funds.

The following year, David Tom, CFA, of the VCFA Group had a presentation about the secondary private equity market.  He deals with three types of investments:  limited partner interests in small and middle market buyout, venture capital, mezzanine and other private equity funds;  secondary direct private investments; and portfolios of private assets.  Secondary funds had $50 billion in assets under management with larger funds (anything over $500 million) holding 80% of the assets.  The secondary market is steadily growing.  In 2009, it was 4% of the total US private equity AUM and 3% of global AUM.  This is up from 1.5% and 1% in 2000 and 0.2% and 0.2% in 1990.  Historically, there has been a excess of secondary investment being sold on the market and not enough buyers.  The gap is much larger during crises such as the credit crisis of 2008 and the dot com meltdown in 2001.

Again, thanks to NYSSA for holding two great events.

Using Distressed Debt to Take a Company Private

An investment firm may turn a public firm into a private firm by buying its distressed debt.  The target firm may be going through bankruptcy proceedings, close to defaulting or already defaulted on its debt.  There are four main methods of buying a company.  A leveraged buyout (LBO) may not have worked.  As part of the LBO, the banks providing financing issued debt to the buyside.  In this case, new investors will buy the loans of the failed deal at distressed prices.  During the bankruptcy process, the debt investors will receive all the equity of the target firm.  A second way is to buy the company's equity and initiate a turnaround of the company.  The last two methods involve Chapter 11 bankruptcy.  Before filing for Chapter 11, a reorganization plan where the debt holders convert their bonds to equity and become majority equity holders.  The public equity owners are wiped out completely.  The last method requires a major debt holder, primarily the company's competitor, to propose a reorganization plan.  This allows the competitor to obtain non-public material information about the target company and initiate a takeover.

Mezzanine Finance

Companies with a market capitalization between $200 million and $2 billion use mezzanine financing to fill a gap in their capital structure.  They are too big for venture capital investors and too small to issue bonds.  Usually, the financing consists of an intermediate term bond with a equity warrant/option (also known as a kicker).  The bonds are below the senior debt and above the equity of the company.  They are unsecured by any assets.  A company may use this type of financing for a management buyout, growth and expansion, to buy another company, to recapitalize its balance sheet, real estate, in leveraged buyouts or as a bridge loan.  Mezzanine financing allows companies to raise money without diluting equity holders of its stock.

Funds that invest in mezzanine financing expect lower returns than venture capital or leveraged buyouts investments.  Generally, pensions, endowments and foundations are the buyside firms that invest in mezzanine funds.  They receive equity returns with less risk.  Mezzanine debt rank higher than equity and unsecured debt in case the company defaults.  The repayment has a specific schedule.  Mezzanine deals are less risky because they are not exposed to the J-curve effect.  The J-curve affects venture capital and leveraged buyout funds.  The initial years have a negative return as the fund managers search for investments and are incurring fees.  The profits are realized in later years.  The investors may be invited to the board of directors of the company issuing the debt and may impose restrictions such as not allowing additional debt to be issued, changing the management or suspending dividends.

Basic Mechanics of a Leveraged Buyout

Let's detail how a leveraged buyout transaction is completed.  We will not discuss how investment ideas are found or performance of private equity fund managers or risk management.  The simplest way to describe a leverage buyout is through an analogy.  A common transaction that everyone is familiar with is a traditional home mortgage.  For example, the home buyer will want to purchase $1 million house.  $200,000 will be paid as a down payment and $800,000 will be financed by the bank.  The lending institution will approve or deny the loan based on the buyer's credit score, salary history, payment history, current debts and assets.  To a certain extent, the information may determine the interest rate of the loan.  The buyer's annual salary will be used to pay back the debt.  The house will be used as collateral for the loan.

For the leveraged buyout, the down payment is the investor's equity in the deal and a consortium of lenders will finance the loan.  In turn, the lenders will package the loan to banks or investors as a leveraged loan or bonds - high yield (junk) or mezzanine debt.  The banks that financed the LBO will earn fees for either transaction.  Both of these vehicles will be considered more risky/have a higher change of defaulting because the company will be saddled with a large amount of debt.  Interest rates will be higher to compensate investors for the increased risk.  The company will use its future earnings to re-pay the loan.  In the example above, this is equivalent to the home buyer's salary.  As in a mortgage, the company's assets will be used as collateral for the leveraged loan.  Leverage gives the buyer the possibility of increased returns or losses.

This is a bare bones, simplistic version of the deal.

Introduction to Leveraged Buyouts

As venture capital invests in emerging companies, leveraged buyouts invest in established, underperforming companies.  The most common scenario is a private equity fund, the merchant bank division of an investment bank or the target company's management buying a publicly traded company.  The company is taken off the markets and becomes private.  Since the initial investment (cash or equity) is usually low, its assets and cash flow are used to finance the transaction.  Financing is a combination of equity and debt with 40% to 60% being senior debt, 20% - 30% being mezzanine debt and 20% - 40% being equity.

The private equity fund has a general partner that makes the investments and several limited partners that are the investors.  The investments are usually reviewed in the first five years of the partnership.  The partnership normally lasts ten years.  As the fund exits its investment companies, the investors receive their profits.

So, how does a private equity firm turn a company that is an unattractive investment to one that everyone wants to buy?  They can improve operating efficiency, create an entrepreneurial mindset, streamline companies, build up companies and turnaround companies.  Improving operations means that there is closer oversight of the company and improved management.  The approach for creating an entrepreneurial mindset is to allow management to improve the company or carve out a subsidiary to follow its own agenda.  Streamlining and building up companies are strategies that are the opposite of each other.  The streamlining strategy means to concentrate on a firm's core businesses while the building up involves combining several companies.  The hope is that the whole is greater than the sum of the parts.  Turnarounds take underperforming companies into outperforming companies.  In each of the strategies, the private equity fund will have members on the board of directors of the target company.  They will help the board in running the company more efficiently.  Taking the firm private allows the company to concentrate on its business rather than focusing on making quarterly projected earnings per share demanded of a public company.

In venture capital, the investor cashes in on the company through an initial public offering or a sale to another company.  For leveraged buyouts, the same exit strategies are used.  Additionally, the company can have another leverage buyout, a straight refinancing or sell it to another private equity firm.  In both the second buyout and straight refinancing, the company adds more debt in order to reward company management or the equity holders a dividend.

Minority Stakes in Hedge Funds: A Mixed Bag for Goldman Sachs

Several institutional investors have bought minority stakes in hedge funds to profit from the management and performance fees earned by them and/or to broaden their investment offerings.  In 2010, there were 13 deals worth $1.4 billion.  The results have been mixed, to say the least.

Goldman Sachs had invested in Shumway Capital and Level Global.  Both funds will not be managing money anymore for outside investors, making the investments worthless.  Shumway handled manager succession poorly and Level Global has been embroiled in the FBI's insider trading investigation.  Both situations caused investors to pull out their money.  On the positive side, Goldman's Petershill Fund has made investments in nine hedge funds.  It is planning on buying stakes in 15.  Two investments have done very well:  Winton Capital Management and Capula Investment Management.  Winton has increased assets under management from $10 billion in 2007 to $16 billion in 2011.  Capula has doubled assets from $3.5 billion in 2008 to $7 billion in 2011.  Eventually, Petershill will be spun out to the public.

Morgan Stanley, who bought FrontPoint Partners for $400 million, has marked the investment down to $30 million. The fund was also hit hard by the FBI's investigation although no one was arrested or indicted.  Investors redeemed their cash at the first hint of trouble.

Other deals include Credit Suisse buying 30% of York Capital for $425 million,  private equity firms Carlyle Group and Apollo Management buying parts of Claren Road Asset Management and Lighthouse Investment Partners respectively.

On the other hand, smaller funds sell stakes to institutions to access a wider investor base that includes high net worth investors and pension funds.  An example of this type of deal is Franklin Resources buying Pelagos ($377 million AUM).

The article can be access at Bloomberg Businessweek.

2010 Hedge Fund Industry Review

Credit Suisse recently published their 2010 Hedge Fund Industry Review.  In a previous post, we had mentioned that the Dow Jones Credit Suisse Hedge Fund Index had returned 10.95%.  The good performance of hedge funds has investors returning.  Hedge funds have returned 31.55% since the bottom of the markets two years ago.

Of the ten strategies tracked, eight had positive returns with Global Macro, Event Driven and Fixed Income Arbitrage leading the way.  Global Macro funds used two themes for investing ideas:  intervention by central banks and commodities.  Event Driven funds using the Distressed Debt strategy found better investments due to the European debt crisis.  Fixed Income Arbitrage managers took advantage of the intervention by central banks to find investing opportunities.

The most successful strategies:  Global Macro and Event Driven received the most interest from investors.  Global Macro had $16.8 billion in asset inflows and Event Driven had $13.8 billion.  Multi-Strategy had $16.9 billion in outflows.

Small funds with assets under management of $100 million have outperformed large funds (with $500+ million AUM) by 3.95% annually.  They may be nimbler than large funds - being able to quickly get in or out of positions due to the smaller size or less bureaucracy - or they may be riskier.  During major market moves, the outperformance is more pronounced.  When markets are quiet, large funds perform on a par with smaller funds.

The research report may be accessed here.

Insider Trader Investigation: SAC Capital

One of the themes that has run through the FBI's insider trading investigation is that people being indicted have an association with SAC Capital, one of the largest hedge funds in the world.  SAC stands for Steven A Cohen, the founder of the very successful fund.  Since 1992, SAC Capital has averaged 30% returns with one down year in 2008 of -19%.  Within the hedge fund community, it has been rumored that the whale of the probe is SAC Capital.

This past week two ex-fund managers, Noah Freeman and Donald Longueuil, were arrested.  Two other people were arrested from Barai Capital - Samir Barai and and an analyst, Jason Pflaum.  Freeman and Pflaum have pleaded guilty.  Freeman has said that expert networking firms, such as Primary Global, gave him the insider tips (Bloomberg source).  The SEC has estimated that the trades had led to $30 million of gains or losses avoided.  A list of the eleven stocks, mostly in the technology sector, that may have been traded using material non-public information is here.  The four also tried to hide their trails by destroying computer hardware, deleting emails and shredding paper.  Read this Wall Street Journal article for details.

Hedge Funds Are Back!

Investors poured $6.6 billion into hedge funds in December 2010 according to a joint report by Trimtabs Investment Research and BarclayHedge.  It was the sixth month in a row that funds experienced inflows and brings assets under management by hedge funds up to $1.7 trillion.  Winning strategies are emerging markets ($5.8 billion), global macro ($3 billion) and fixed income ($2.5 billion).  Fund of hedge funds had redemptions of $1.3 billion.

Managers are also doing better in 2010 with 50% of them collecting performance/incentive fees.  60% of them have recovered losses from the credit crisis in 2008.

The article can be read here.

Some Investing Ideas in China, Russia and the Emerging and Frontier Markets

Being a member of the CAIA New York Chapter affords me access to their events.  This week I went to a panel presentation called "Perspectives on Emerging and Frontier Market Opportunities in 2011".  The three portfolio managers that spoke were Caglar Somek of the Caravel Fund International, Eric Fine of Van Eck G-175 Strategies and Xiao Song of Contrarian Emerging Markets Fund.   The event was moderated by Michael Weinberg, CFA and Global Head of Equities at FRM Americas.

Caglar is your classic fundamental equity manager with a concentrated portfolio of 40 to 50 stocks in the emerging and frontier markets.  Emerging markets is defined as the BRIC countries (Brazil, Russia, India and China), Emerging Europe, Turkey, Israel, East Asia and Latin America.  Frontier markets would be Africa, with the exception of South Africa, the Middle East and parts of Asia such as Vietnam, Laos and Bangladesh.      He seeks countries with a lower market capitalization to GDP ratio.  In these markets, Caglar wants to have liquidity and equity investments have that characteristic.  He also knows that the political risk is higher.

Eric runs a macro fund with a longer term investing horizon.  Like Caglar, he wants the more liquid securities.  Other factors that he looks at are the country's solvency and foreign exchange rates.  The latter is the key to reading inflation.  These fundamentals lead him to attractive securities.  One interesting fact that he shared with the audience is a country's economy is stable if the Central Bank can raise interest rates during a recession.  His main themes for the present are liquidity, emerging market foreign exchange and short the Euro.

Xiao runs emerging market and distressed debt funds.  He searches for good assets that have a bad capital structure.  These debt assets should be liquid with a limited downside.  The upside has to be greater than investing in the distressed debt of US companies.  Otherwise, why take the added risk of going into an emerging market.  He is seeing more investors coming into the emerging markets and competing with him for investments.

There were two countries that the PM's were questioned about - Russia and China.  Caglar stated that there was too much political risk in Russia for him to invest in any companies.  Eric mentioned specifically the Mikhail Khodorkovsky case where he was found guilty of oil theft and money laundering.  For more details about the trial, two articles can be found the Huffington Post and the Economist.  His fund was staying away from Russia.  If he had to invest, he would trade foreign exchange and invest in a government sponsored company such as Gazprom or Sberbank.

They had divergent views on China and the now famous bubble view by Jim Chanos.  The article can be found here.  Caglar and Xiao believe there are bubbles in the Chinese economy.  Xiao thinks that there is a real estate bubble in cities like Shanghai and Beijing.  The price of real estate is comparable to New York and Chicago.  Who can afford those apartments?  Only 1% of the population make enough money.  Also, all mortgages are floating rate.  Since the Central Bank has raised rates to tamp down inflation, the mortgage payments will increase - just like in the US.  Eric is more sanguine about China's real estate.  The house is a savings vehicle and not used for speculation.  Real estate is bought with a sizable down payment.  He has confidence in the policy makers of the Chinese government.  Even if real estate is a bubble, the banks can be re-capitalized by a government that has $2 trillion in reserves.  Caglar sees 10% real inflation in China and a bubble in hard assets.  He would be short equity and bonds.

One of the panelists spoke about the Chinese Reverse Merger Fraud.  A Chinese company takes over a US shell company.  This allows the Chinese company to be traded on the NYSE or NASDAQ.  Investors, believing that the company is subject to the SEC regulations, buy the stock based on false financial statements.  The sources for this development can be accessed the Business Insider and China Briefing.

Thanks to CAIA for hosting a great panel.

Greenshoe or Over Allotment Option

In the prospectus for an IPO, the investment bank is sometimes given an over allotment option, also called a greenshoe.  It gives the bank the right to sell 15% more shares beyond the original deal.  The strike price of the right is the offering price.  It's the only legal way to stabilize the aftermarket for an IPO.

Scenario 1:  The deal drops below the offering price.  The bank over allocates the number of shares by 15%.  In essence, it has a short position where the shares are sold at the offering price.  When the share price goes down, the bank buys it back at or below the offering price until its short position has been closed.

Scenario 2:  If the IPO trades higher than the offering price, the bank still over allocates the shares by 15%.  If it is unable to buy back any shares at the offering price, it avoids a loss by exercising the full greenshoe.  In the case where it is able to buy some shares, it will exercise a partial greenshoe.

Allocating Shares for an Initial Public Offering

In the last article, we went through the IPO process.  There are two major parties on the sellside that handle the deal:  equity sales and capital markets.  In the days leading up to the IPO effective date, salestraders are entering their indications of interest;  that is, the number of shares that their buyside clients want and any additional color that may help their clients get a larger allocation.  For a hot deal, buyside firms know that they will not get their number so they overbid i.e. I really want 100,000 shares but I'll order 200,000 to get it.  After the orders are placed, sales and capital markets management start allocating the IPO shares.  They will initially speak with the issuer company on some broad outlines.  The CEO may instruct the bankers to give minimal amounts of shares to hedge funds.  He may be afraid that they will "flip" the shares on the first day.  By "flipping", the fund makes a quick profit by selling the shares - providing that the IPO appreciates.  Or make sure that this fund gets a good allocation as they are a "friend of the firm".

Management will look at the following criteria (in no particular order) for the allocations:

• Amount of secondary commissions done with the bank
• For the last 3 months in the IPO's market (for example, for Netscape's IPO, management would look at US commissions)
• For the last 6 months in the IPO's market
• For the last year compared to the prior year in the IPO's market
• For the last year compared to the prior year global equity markets
• For the last year for derivative and convertible securities
• Amount of primary commissions done with the bank for the year compared to the prior year
• Amount of total commissions done with the bank (secondary and primary) for the year compared to the prior year
• Ranks for each of the commission categories above
• The fund promises to buy aftermarket shares
• The fund is a notorious flipper
• The fund's strategy is buy and hold

Primary commissions are equivalent to the selling concession from a deal.  Secondary commissions are from everyday trading of previously issued securities.  Note that the broker vote does not seem to hold much weight.

Institutional Sales and the Initial Public Offering

Equity sales and capital markets cooperate to sell and distribute an initial public offering to the buyside.  Institutional sales gets involved after the preliminary prospectus has been filed and approved by the SEC.  As part of the daily morning call, capital markets will hold a kick-off meeting between the issuer company's management, the covering research analyst, the sales force and traders.  From that call, research salespeople and salestraders will notify their clients of the deal and gauge possible interest in the IPO.

The IPO is marketed to interested clients through a roadshow run by capital markets.  Here, the issuer company's senior management will present their business plan, future prospects, market position, etc. to the buyside.  This will be a grueling death march for 3-4 weeks where they will travel all over the place to meet with portfolio managers, research analysts and traders.  At a minimum, they would go to New York, Greenwich, Boston, Philadelphia, Chicago, Houston, Los Angeles and San Francisco.  If they wanted to sell shares to European firms, then London, Paris, Frankfurt, Amsterdam, Madrid, Milan, Geneva and Zurich would be added to the itinerary.  While the roadshow is progressing, the sales force is gathering the buyside's indications of interest, their pricing expectations and the number of shares desired.  Sometimes, the buyside firms commit to buy additional shares in the aftermarket if their order is filled.

The terms of the deal will influence how aggressively a deal is marketed by the sales force.  A deal with a fixed allocation of shares will not be promoted heavily.  For example, the distribution of shares for a deal may be 60%/40% between Credit Suisse and Morgan Stanley.  Since this is guaranteed for both firms, the sales force will not be as excited as for a deal with a flexible allocation.  For example, a deal may be allocated 50%/40% with a 10% jump ball.  In this case, the first firm may get as much as 60% of the sales concession if they sell it aggressively enough to their clients.  When the IPO's orders are being filled out, the buyside firm will tell the managing underwriter the number of shares to credit each bank.  In all cases, the sales force will be more excited when their bank is the bookrunner as a majority of the selling concession is headed their way.

The night before the offering date, the issuer company, sales management and capital markets meet to set the price and number of shares in the deal.  Sales management and capital markets also set the final allocations to the buyside.  The capital markets trading team stays in the office very late to process them.  Then the stock is distributed to the investors and begins trading the next day.  If there are any selling order imbalances, the position traders assigned to the IPO must step in and stabilize the price.  In the months following the offering, the lead underwriter's traders provide liquidity by making a market on the stock.

Initial Public Offering: A High Level Summary

One of the exit strategies for a private equity investment is the initial public offering (IPO).  The company hires a group of investment banks (the syndicate group) to issue equity shares that will be publicly traded on an exchange.  The cash generated in the offering goes to the company with a fee going to the banks.

The fee is usually 6%-7% of the size of the offering.  One of the banks will be the lead underwriter or bookrunner of the IPO.  Other members of the syndicate will take lesser roles.  For a large deal, there may be co-bookrunners but, honestly, only one firm can be the lead.  This can be determined by looking at the offering documents and seeing which bank is on the top left.  Besides the lead managers, there are also underwriting and selling groups that have lesser levels of responsibilities during the IPO process.  The managers and the issuer company choose which firms will participate in the deal and at what level.  At times, issuers have thrown out banks that have displeased them.

The fee is distributed among the three levels in the syndicate group.  There is a 20% management fee for the managing underwriter for determining the structure of the IPO, running the marketing program, doing due diligence on the prospectuses and creating the syndicate.  An underwriting fee of 20% is for the managing underwriter and banks in the underwriting group for assuming transaction risk.  They are buying shares from the issuer company and selling them to their investors.  If any shares remain on their books, the banks have to keep them.  The selling concession is 60% of the fee and goes to all three groups.  It's a finder's fee for getting investors to buy the IPO.  The terms of the deal may have a strict or flexible allocation.  In the latter case, the buyside investors allocate the fees among the different members of the syndicate.

To start the process, the issuer company must register with the SEC and file a preliminary prospectus commonly know as the red herring.    The registration statement contains a description of the issuer's business, information on company officers (names, addresses, salary and five year biographies) and their ownership levels, market capitalization of the firm, description of how the proceeds will be used (i.e. to pay down debt or expand the business) and any legal proceedings.  The preliminary prospectus has the information in the registration statement plus:

• Offering price range
• Option agreements
• Underwriting commissions and discounts
• Balance sheet
• Last three years of earnings

After the documentation is filed, there is a 20 day cooling-off period between filing and approval dates.  Here the issuer and syndicate group cannot discuss the IPO outside of the information in the preliminary prospectus.  The final prospectus is created when the SEC confirms that all the information needed is in the document.   This includes everything in the preliminary prospectus plus the final offering price.  While waiting for approval, the banks are asking buyside investors for their indications of interest to get an estimate of demand and the best price for the deal.

Leading up to the first day of the IPO, sales management and the capital markets desk allocate shares to the institutional investors.  For an oversubscribed or hot deal, not everyone will be getting their entire indication.  Actually, that can be said of any deal.  To ameliorate some of the demand, a greenshoe or over allotment option that gives the banks the right to sell an additional 15% of the shares is exercised.

The day before the IPO's effective date, the issuer company and lead underwriter determine the offer price and number of shares distributed.  After these terms are finalized, the final prospectus is published and sent to the investors.  The deal is closed three days later when the issuer receives the proceeds and delivers the stock to the bank.  The bank then sends it on to the investors.

On the first thirty days of trading, the banks are on the hook for stabilizing the market for the IPO.  In the case that the shares go down in price, they are repurchased.  The banks use the over allotment option to hedge for this event.  The bookrunner has the largest market share for any secondary trading of the IPO.  

After the offering is completed, the banks in the syndicate cannot initiate any research coverage on the issuer for forty days.  Afterwards, they, especially the lead underwriters, will write a report - usually with a buy rating.

This is a summary of a regular IPO.  The Google deal was a dutch auction IPO and will be dealt with in a later article.

Some More Details on Venture Capital

Many mutual fund managers invest in specific areas depending on their areas of comfort.  They may be split by the capitalization/size, sector or the geographic region of the company.  The general partner or managing director of the venture capital fund raises capital and manages the investment portfolio.  Limited partners or shareholders are the investors.  Venture capitalists focus their investments based on the sector or geographic region of the company.  There is a third and most important category - the stage of financing that the target company is in.  The five stages are:

• Angel Investing - Funds are usually from friends and family.  Someone has an idea and a prototype and business plan has to be created.  Capital needs may range from $50,000 - $500,000.  Venture capitalists do not invest at this stage.
• Seed Capital - Smaller venture capital firms invest at this stage.  The prototype is being tested by clients for free to receive their feedback.  About $1 - $5 million are needed to finish and market the final prototype.
• Early Stage Venture Capital - The product is being made on a large scale and being testing by clients.  Unlike the Seed Capital stage, the product is not provided at no cost to the customer.  The financial goal is to break even.  About $2 million are needed at this stage.
• Late Stage Venture Capital - The new company is not losing money any more.  About $5 - $25 million are needed to expand production facilities and staff.
• Mezzanine Stage - The business is making money.  About $5 - $25 million are needed for the company to bridge the gap to the exit strategy - either going public or being sold to another company.  Money can also be used to buyout earlier investors and may be a loan or convertible offering through Rule 144A.

The venture capitalist has to complete different due diligence for each stage.  That is why they invest in particular ones.

Like hedge fund managers, the general partner charges management and incentive fees.  Management fees range from 1% - 3.5% of capital committed to the fund.  The incentive fee is also 20%.  Unlike hedge funds, venture capitalists are subject to a clawback provision.  This prevents them from charging fees if there are no profits at the end of the investment period, usually 7 - 10 years.  Incentive fees are not paid until all investments are paid back to the investors.

More Traders Moving to Hedge Funds

There was an article at www.finalternatives.com regarding a report by Infovest21 that detailed why proprietary traders at investment banks were starting their own or moving to hedge funds.  Prop traders use the bank's capital to earn a profit and act much like funds.  They are kept separate, physically and legally, from the flow traders that handle the buyside's orders.

There are a few reasons for the migration.  In 2008 and 2009, many banks experienced losses from the credit crisis and cut back on their prop trading desks.  Also in 2009, the banks that were bailed-out, which included all of the major investment banks, were being pressured to hold down bonuses by the government, the press and, probably, everybody else.  The Wall Street Reform Act of 2010, signed into law in July, prohibits banks from prop trading.

The article, with two tables of top traders, is here.

Venture Capital: Growing Start-Ups

Venture capital made its mark during the dot-com era about ten years ago.  There were $100 billion of capital committed for the strategy at its height in 2000.  In the early 1990's, they totaled $5-$7 billion annually.  The strategy invests in young, emerging companies.  Because these companies are small and illiquid, banks and normal investors deem them as too risky for their portfolio..  Venture capital funds target high returns, about 30%, for this risk.  Looking at the three, five, ten and twenty year returns, venture capital investments beat the S&P 500 by a significant amount in all the different stages of funds.  There are three types:

• Seed Capital / Early Stage:  Invest in companies with little or no revenues
• Late Stage / Mezzanine Stage:  Invest in companies with revenues
• Balanced:  Mixture of above two

Investors usually have to keep their money in the fund for at least ten years.  As a result, pension funds, endowments, foundations, high net worth individuals and fund of funds are the sources of capital.  In 2008, pensions invested in 50% of all venture capital funds.  This was down from 70% in 1990.

There are five stages in the life cycle of a fund:

• Fund raising:  Take six months to a year to gather capital commitments
• Finding investments:  Take up to five years to conduct due diligence on start-up companies
• Investment of capital:  Invest in different companies
• Monitoring and managing portfolio companies:  After funds have been invested, the venture capital fund's principals grow the company for an IPO or to be sold to another company
• Windup and liquidation:  IPO or sale is closed or company is liquidated

Investing in venture capital takes a lot of patience.  The payoff is ten years into the future.  The investment has a negative return for the first five years as management fees are collected but no profits are created.  This is called the J-curve.

Private Equity: Taking a Company Off the Market

Pension funds are one of the institutional investors that are part of the buyside.  Because of their long term view, they have invested in private equity and hedge funds - two vehicles that have varying lockup periods.  According to www.preqin.com, more pension funds (from 5.1% in October 2008 to 6.3% in December 2010 of US and Canadian funds) are investing more (from 5.7% to 7.5% of their asset under management) in private equity.  According to one article, private equity is replacing fixed income in portfolios.  I have even read that one pension is lowering its hedge fund exposure in favor of private equity (I am sorry that I cannot find that article.).

So, what is private equity?  It is an alternative investment in companies that do not have stock traded on an exchange.  The prime example in the news today is Facebook.  The main strategies are:

• Venture Capital - investing in start-up companies
• Leveraged Buyouts - buying an established public company and turning it into a private company
• Mezzanine Financing - combines private debt and equity investments
• Distressed Debt - investing in companies in financial stress

Since the credit crisis, private equity has struggled to raise funds.  In 2010, there was $225 billion raised.  In 2009, there was only $109 billion.  The high was $800 billion in 2007.