The first thing you have to know about investment banks is that they are not banks. The role of such a structure is to help firms to sell securities to public. These securities can be stocks (parts of the equity of a firm) or bonds (debt of the firm). More intuitively an investment bank transfers funds from public to firms, it thus help firms raising capital.
One of the major activities of an investment bank is to conduct Initial Public Offering (IPO). We shall explore what an IPO is and how it works concretely in the following.
When you try to buy a stock of a firm on the market, you basically buy it from a private entity (a person, a bank…) on a so called secondary market. In contrast, the primary market is the place where new stocks or securites are issued. This primary market is the domain of investment banks. An IPO is thus the first sale of securities by a firm. The investment bank plays an important role in the process of an IPO, because it is responsible for bringing the securities to the market and handling the administrative details. So, it is really a necessary intermediary that brings in contact new investors and firms seeking for funds. There exists three major types of IPO, we shall explain them in details.
1. Underwrote IPO:
A process of underwriting in an IPO is a form of a price guarantee for the firm. The investment bank agrees to purchase shares from the firm for a given amount, and resell them on the market. Its own gain beeing (except the not insignificant fees for conducting the IPO) the spread between the purchase and the sell price of the security. The investment bank takes a risk by underwriting, because it has no guarantee that the securities purchased could be sold at a higher prize than the one paid to the firm. This factor of risk is the reason for spreading generally the risk over several investment banks. This process is called syndicate underwriting. A good by-product is that more sellers can be reached.
2. Best Efforts Agreement:
The best efforts agreement process shifts the risk to the issuing firm, which receive whatever price the market pays. The investment bank has no more an underwriting function.
3. Dutch auction:
The dutch auction is a third process in IPO less used than the first two. The seller announced the amount of securities he wants to sell, buyers submit bids for the securities and the auction price move down until the number of demand at a price above the one considered coincide with the number of securities available. It is a more transparent way to do an IPO but a complicated mechanism for firms not big enough.
Process of an IPO:
Let’s explore the process of an IPO from scratch. First private firms negotiate in inside (between the shareholders and investors) to decide whether or not they want to go public. Then the firm choose an investment bank to conduct its IPO. A prospectus must be filled and given to the Securities and Exchange Commission (SEC) in the aim of registering publicly the firm. A version of the prospectus for initial investors is made. The time between the delivery of the prospectus to the SEC and the agreement from the latter is called the Quiet period. The firm has legally the obligation not to release informations about itself during this period (not to inflate the initial public offer price). Finally the IPO is driven.
The question you may ask is how is the initial price set by the investment bank? It’s a very difficult question to answer. If it prices the security too low, the firm will raise less capital than it could and the reputation of the investment bank will go down. If it prices it too high, it will not be able to sell the securities and will lose money.
The last thing I want to point out is that IPO reveals important issues concerning conflict of interest problems. Indeed, often investment banks doing IPO have brokerage department too. So Analysts could recommend the purchase of a stock introduced publicly by the same structure. Moreover problems about insider trading (trading with private informations) is a major subject that requires regulation and control by the SEC.
Introductory picture from: morguefile