Corporate Banking and Credit Analysis

Chapter 16: Lending Policies and Procedures: Managing Credit Risk

16-1 Introduction:
- However, risky or not, the principal reason many financial firms are issued charters of
incorporation by state and national governments is to make loans
- Lenders are expected to supply credit for all legitimate business and consumer
financial needs and to price that credit reasonably
- Loans support the growth of new businesses and jobs within the lender’s market area
→ fuels local economic growth and development → greater flow of income and
spending throughout the local economy
- Loans frequently convey information to the marketplace about a borrower’s credit
quality
- The lending process bears careful monitoring at all times

16-2 Types of Loans:

- Types of loans
o Real Estate Loans
o Financial Institution Loans
o Agriculture Loans
o Commercial and Industrial Loans
o Loans to Individuals
o Miscellaneous Loans
o Lease Financing Receivables
➔ largest category in dollar volume is real estate loans, followed by loans to
individuals, and commercial and industrial (C&I) loans
- Factors Determining the Growth and Mix of Loans
o Characteristics of the market area
▪ respond to the demands for credit arising from customers in its own
market
o Lender size
▪ Wholesale lenders vs. retail credit
▪ Capital held limits lending to a single borrower
o Experience and expertise of management
o Loan policy
▪ prohibits loan officers from making certain kinds of loans
o Expected yield of each type of loan
▪ net yields (with expenses and loss rates deducted from revenues
received)
▪ real estate and commercial loans often rank relatively high
o Regulation
- general rule, a lending institution should make those types of loans for which it
is the most efficient producer
16-4 Steps in the Lending Process:
1. Finding Prospective Loan Customers
o Direct requests
o Contacts (sales position)
2. Evaluating a Customer’s Character and Sincerity of Purpose
o Interview with loan officer
o assess the customer’s character and sincerity of purpose
3. Making Site Visits and Evaluating a Customer’s Credit Record
o assess the customer’s location and the condition of the property and to ask
clarifying questions
o contact other creditors who have previously loaned money to this customer
to see what their experience has been
o how is the company operating its business?
4. Evaluating a Prospective Customer’s Financial Condition
o Customer submits crucial documents the lender needs in order to fully
evaluate the loan request (e.g., financial statements)
5. Assessing Possible Loan Collateral and Signing the Loan Agreement
o check on the property or other assets to be pledged as collateral
6. Monitoring Compliance with the Loan Agreement and Other Customer Service
Needs
o new agreement must be monitored continuously to ensure the terms of the
loan are being followed and all required payments of principal and interest
are being made as promised
16-5 Credit Analysis: What makes a good loan?
1. Is the Borrower Creditworthy? The Cs of Credit
o Character
▪ Specific purpose of loan and serious intent to repay the loan
o Capacity
▪ Legal authority to sign binding contract
o Cash
▪ Ability to generate enough cash to repay loan
▪ three sources of cash to repay loans:
• (a) cash flows generated from sales or income,
• (b) the sale or liquidation of assets,
• (c) funds raised by issuing debt or equity securities
▪ CF most important (especially Operating CF)
▪ Analyze level and trends of
• Sales Revenues
• Cost of Goods Sold
• Selling, General and Administrative Expenses
• Taxes Paid in Cash
• Noncash Expenses
o Collateral
 ▪ Adequate assets to support the loan
o Conditions
▪ Economic conditions faced by borrower
o Control
▪ Does loan meet written loan policy and how would loan be affected by
changing laws and regulations

2. Can the Loan Agreement Be Properly Structured and Documented?

o This requires drafting a loan agreement that meets the borrower’s need for
funds with a comfortable repayment schedule
o If a major borrower gets into trouble because of an inability to service a loan,
the lending institution may find itself in trouble
o Proper accommodation of a customer may involve lending more or less
money than requested over a longer or shorter period
▪ Maturity depends on
• Investing period
• loan should fit future CFs
• Shorter maturities favored (less risk)
o Protect lender through covenants

3. Can the Lender Perfect Its Claim against the Borrower’s Earnings and Any Assets
That May Be Pledged as Collateral?
o Reasons for Taking Collateral
▪ If the borrower cannot pay, the pledge of collateral gives the lender
the right to seize and sell those assets
▪ It gives the lender a psychological advantage over the borrower
o Types of Collateral
▪ Working Capital
• Accounts Receivables
o security interest in the form of a stated percentage of
the face amount of accounts receivable
o cash payments of the customers are applied to the
balance of the borrower’s loan
• Factoring
o lender can purchase a borrower’s accounts receivable
based upon some percentage of their book value
• Inventory
o security interest against the current amount of
inventory of goods or raw materials a business
borrower owns.
 ▪ Real Assets
• Real Property
• Personal Property
o E.g., automobiles, furniture and equipment, jewelry,
securities
▪ Personal Guarantees
• Obligation of someone else to settle the payment if the
borrower is unable to
• Worth based on the capacity of the guarantor/guarantee to
pay
o Need to precisely define and document the claim

- Safety Zones Surrounding Funds Loaned in Order to Protect a Lender

o Operating cash flow is most important
o Strength of the BS is important since CFs are unsecure
▪ More important the less you trust the forecasted CFs
o Personal guarantees and pledges are outside the legal parameters of the
company
16–7 Parts of a Typical Loan Agreement:
- The Promissory Note
o Principal Amount, interest rate, maturity ….
- Loan Commitment Agreement
o Make credit available for commitment fee
o common in the extension of short-term business credit lines
- Collateral
o Unsecured (no specific assets pledged) vs. secured
- Covenants
o Affirmative: taking actions (insurance coverage, liquidity, leverage ….)
▪ Else the lender can e.g., ask back the loan
▪ Liquidity = short-term assets vs short-term debt
o Negative: not taking actions without the permission of lender (new debt, new
fixed assets, extraordinary operations …)
o Protect the lender
o Widely used but not essential
- Borrower Guaranties or Warranties
o borrower specifically guarantees or warranties that the information supplied
in the loan application is true and correct
- Events of Default
o specifying what actions or inactions by the borrower would represent a
significant violation of the terms of the loan
o and what actions the lender is legally authorized to take

16-8 Loan Review (Monitoring Process):

1. Carrying out reviews of all types of loans on a periodic basis
o Normally every quarter
2. Structuring the loan review process
o Record of borrower payments
o Quality and condition of collateral
o Completeness of loan documentation
o Evaluation of borrower’s financial condition
o Assessment as to whether the loan fits with the lender’s loan policies
3. Reviewing Largest Loans Most Frequently
4. Conducting More Frequent Reviews of Troubled Loans
5. Accelerating the Loan Review Schedule if Economy or Industry Experiences Problems

- acts as a continuing check on whether loan officers are adhering to their institution’s
own loan policy
- helps to assess the institution’s overall exposure to risk and its possible need for
more capital in the future
16–9 Loan Workouts:
- Loan workout – the process of recovering funds from a problem loan situation
- problem loans
o Usually this means the borrower has missed one or more promised payments
or the collateral pledged behind a loan has declined significantly in value
o Arises more due to quantity than quality of loans
- Warning Signs of Problem Loans
o 1. Unusual or unexpected delays in receiving financial statements
o 2. Any sudden changes in accounting methods
o 3. Restructuring debt or eliminating dividend payments or change in credit
rating
o 4. Adverse changes in the price of stock
o 5. Losses in one or more years
o 6. Adverse changes in capital structure (equity/debt, liquidity, Inventory and
Receivables/Sales ….)
o 7. Deviations in actual sales from projections
o 8. Unexpected or unexplained changes in deposits

- What steps should a lender take when a loan is in trouble?

o 1. Do not forget the goal: Maximize full recovery of funds
o 2. Rapid detection and reporting of problems is essential
o 3. Loan workout should be separate from lending function
▪ Lending emphasizes on new clients/more loans → look less at risk
▪ Workout decision affects decision of lending division
→ avoid possible conflicts of interest
o 4. Should consult with customer quickly regarding possible options
▪ Cut expenses, increase cash flow, and improve management control
o 5. Estimate resources available to collect on loan
o 6. Conduct tax and litigation search
o 7. Evaluate quality and competence of management
 ▪ And assess property and operations through site visits
o 8. Consider all reasonable alternatives
➔ Preferred option: Seek a revised loan agreement
o Chance to restore normal operations
Chapter 17: Lending to Business Firms and Pricing Business Loans
17–1 Introduction:
- Securing large amounts of credit that many businesses require can be a challenging
task
- Business loans are often called commercial and industrial (C&I) loans
o C&I loans rank among the most important assets banks and their closest
competitors hold
17–2 Brief History of Business Lending:
- Commercial and industrial loans represented the earliest form of lending that banks
carried out
o Loans extended to ship owners, mining operators, goods manufacturers, and
property owners dominated bankers’ loan portfolios for centuries
- In the late 19th and early 20th centuries new competitors, particularly finance
companies, life and property/casualty insurance firms, and some thrift institutions,
entered the business lending field
o This placed downward pressure on the profit margins of many business
lenders
17–3 Types of Business Loans:
- Banks, finance companies, and competing business lenders grant many different
types of commercial loans
- Short-term = < 1 year maturity

➔ Important: Identify if a loan is long or short term!

17–4 Short-Term Loans to Business Firms:
- Self-Liquidating Inventory Loans
o These loans usually were used to finance the purchase of inventory – raw
materials or finished goods to sell
o Such loans take advantage of the normal cash cycle inside a business firm
▪ Buy inventory → produce → sell (on credit) → cash received and used
to repay the loan
▪ Often 60-90 days
o account for a significant share of all loans to business firms
o There appears to be less of a need for traditional inventory financing
▪ Due to the development of just in time (JIT) and supply chain
management techniques
- Working Capital Loans
o Short-run credit that lasts from a few days to one year
o Used to fund the purchase of inventories in order to put goods on shelves or
to purchase raw materials
o Secured by accounts receivable or by pledges of inventory
o Carry a floating interest rate
o A commitment fee is charged on the unused portion of the credit line and
sometimes on the entire amount of funds made available
o Compensating deposit balances may be required from the customer
▪ Recently compensating deposit balances as a part of a business-loan
arrangement has been on the decline
- Interim Construction Financing
o Secured short-term loan used to support the construction of homes,
apartments, office buildings, shopping centers, and other permanent
structures
o Usually paid off once the construction phase is over and replaced by
mortgage
- Security Dealer Financing
o Dealers in securities need short-term financing to purchase new securities
and carry their existing portfolios of securities until they are sold to customers
or reach maturity
o Overnight or a few days
- Retailer and Equipment Financing
o Lenders support installment purchases of automobiles, home appliances, and
other durable goods by financing the receivables that dealers selling these
goods take on when they write installment contracts to cover customer
purchases
- Asset-Based Financing
o Credit secured by the shorter-term assets of a firm that are expected to roll
over into cash in the future
▪ Often these assets are accounts receivable and inventories
 o When working capital is sold a portion of the cash flows directly to the
lending institution to retire the loan
- Syndicated Loans (SNCs)
o A loan package extended to a corporation by a group of lenders
o Enables lenders reduce the heavy risk exposures of these large loan
o Often traded in the secondary market
17–5 Long-Term Loans to Business Firms:
- Term Business Loans
o Designed to fund longer-term business investments, such as the purchase of
equipment or the construction of physical facilities, covering a period longer
than one year
o Usually lump-sum payout and amortizing
o schedule of installment payments structured to cycle of cash flows
o normally are secured by fixed assets
- Revolving Credit Financing
o Allows a customer to borrow up to a prespecified limit, repay all or a portion
of the borrowing, and reborrow as necessary
o One of the most flexible of all business unsecured loans
o May be short-term or long-term
o Lenders normally charge a loan commitment fee
o Two types
▪ formal loan commitment
• most common
• lend up to a maximum amount at a set interest rate
▪ confirmed credit line
• looser form
• indicates its approval of a customer’s request for credit
• used as guarantee for other loans
o Especially important when timing of CFs is uncertain
- Long-Term Project Loans
o Credit to finance the construction of fixed assets
o Most risky of all business loans
o Some of the risks of project loans:
▪ 1. Large amounts of funds are usually involved
▪ 2. The project may be delayed by weather or shortage of materials
▪ 3. Laws and regulations in the region where the project lies may
change
▪ 4. Interest rates may change
o often shared by several lenders
 - Loans to Support the Acquisition of Other Business Firms – Leveraged Buyouts
o The 1980s and 1990s ushered in an explosion of loans to finance mergers and
acquisitions
o Leveraged buyouts (LBOs) usually involve acquiring a controlling interest in
another firm with the use of a great deal of debt (leverage) to finance the
transaction
17-6 Analyzing Business Loan Applications:
- Often business loans are of such large denomination that the lending institution itself
may be at risk if the loan goes bad
- The most common sources of repayment for business loans are:
o 1. The business borrower’s profits or cash flow
o 2. Business assets pledged as collateral behind the loan
o 3. A strong balance sheet with ample amounts of marketable assets and net
worth
o 4. Guarantees given by the business, such as drawing on the owners’ personal
property to backstop a loan
➔ if cash flows are inadequate → lender turns to assets whose value fluctuates with
production in the economy → suggests that lenders should diversify geo-
graphically across different markets and different firms
- Analysis of a Business Borrower’s Financial Statements
o Analysis of the financial typically begins when the lender prepares an analysis
of how key figures on the borrower’s financial statement have changed
o common-size ratios = assets in % of total assets
▪ enables comparative analysis between firms of different sizes
- Important: What does a ratio show?
17–7 Financial Ratio Analysis of a Customer’s Financial Statements:
- Information from balance sheets and income statements is typically supplemented
by financial ratio analysis
- Critical areas of potential borrowers’ loan officers consider:
o 1. Ability to control expenses
o 2. Operating efficiency in using resources to generate sales
o 3. Marketability of product line
o 4. Coverage that earnings provide over financing cost
o 5. Liquidity position, indicating the availability of ready cash
o 6. Track record of profitability
o 7. Financial leverage (or debt relative to equity capital)
o 8. Contingent liabilities that may give rise to substantial claims in the future
➔ Can be grouped in
o Operations of the company and its financial implications
▪ 1. Ability to control expenses
▪ 2. Operating efficiency in using resources to generate sales
▪ 3. Marketability of product line
▪ 6. Track record of profitability
o Interest obligations
▪ 4. Coverage that earnings provide over financing cost
o Cash availability and debt
▪ 5. Liquidity position, indicating the availability of ready cash
▪ 7. Financial leverage (or debt relative to equity capital)
o Uncertainty of future CFs and future liabilities
▪ 8. Contingent liabilities that may give rise to substantial claims in
the future (do not exist yet, but may under some circumstances)

1. The Business Customer’s Control over Expenses

o A barometer of the quality of a firm’s management is how it controls its
expenses and how well its earnings are likely to be protected and grow
o Selected financial ratios to monitor a firm’s expense control:
▪ Wages and salaries/Net sales
▪ Overhead expenses/Net sales
▪ Depreciation expenses/Net sales
▪ Interest expense on borrowed funds/Net sales
▪ Cost of goods sold/Net sales
▪ Selling, administrative, and other expenses/Net sales
▪ Taxes/Net sales
2. Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness
o It is also useful to look at a business customer’s operating Efficiency
▪ How effectively are assets being utilized to generate sales and how
efficiently are sales converted into cash?
o Important financial ratios here include:
▪ Annual cost of goods sold/Average inventory (or inventory turnover
ratio)
▪ Net sales/Net fixed assets (turnover of fixed assets)
▪ Net sales/Total assets
▪ Net sales/Accounts and notes receivable
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
▪ Average collection period = 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
( )
360
3. Marketability of the Customer’s Product or Service
o In order to generate adequate cash flow to repay a loan, the business
customer must be able to market goods, services, or skills successfully
o assess public acceptance of products by analyzing the growth rate of sales
revenues, changes in the business customer’s share of the available market
and the GPM/NPM.
o The gross profit margin (GPM), defined as
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠−𝐶𝑂𝐺𝑆
▪ 𝐺𝑃𝑀 = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
o A closely related and somewhat more refined ratio is the net profit margin
(NPM)
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
▪ 𝑁𝑃𝑀 = 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠

4. Coverage Ratios: Measuring the Adequacy of Earnings

o Coverage refers to the protection afforded creditors based on the amount of
a business customer’s earnings
o The best-known coverage ratios include

o second of these coverage ratios adjusts for the fact that repayments of loan
principal are not tax deductible, while interest and lease payments are
generally tax-deductible expenses
5. Liquidity Indicators for Business Customers
o The borrower’s liquidity position reflects his or her ability to raise cash in
timely fashion at reasonable cost, including the ability to meet loan payments
when they come due
o Popular measures of liquidity include

o concept of working capital is important because it provides a measure of a

firm’s ability to meet its short-term debt obligations from its holdings of
current assets
o Commercial lenders are especially sensitive to changes in a customer’s
liquidity position because loan repayments are usually made through the
conversion of liquid assets, including the cash account
▪ Risk of having to sue non-liquid assets to recover funds → time
consuming, costly and uncertain
6. 6. Profitability Indicators
o How much net income remains for the owners of a business firm after all
expenses (except dividends) are charged against revenue?
o Ultimate standard of performance
o Popular bottom-line indicators include
▪ Before-tax net income / total assets, net worth, or total sales
▪ After-tax net income / total assets (or ROA)
▪ After-tax net income / net worth (or ROE)
▪ After-tax net income / total sales (or ROS) or profit margin
7. The Financial Leverage Factor as a Barometer of a Business Firm’s Capital Structure
o Any lender is concerned about how much debt a borrower has taken on in
addition to the loan being sought
o Key financial ratios used to analyze any borrowing business’s credit standing
and use of financial leverage include
 8. Contingent Liabilities
o Usually not shown on customer balance sheets are other potential claims
against the borrower:
▪ 1. Guarantees and warranties behind the business firm’s products
▪ 2. Derivatives contracts
▪ 3. Litigation or pending lawsuits against the firm
▪ 4. Unfunded pension liabilities
▪ 5. Taxes owed but unpaid
▪ 6. Limiting regulations
▪ (Environmental and Underfunded Pension Liabilities)
o These contingent liabilities can turn into actual claims against the firm’s assets
and earnings at a future date
o Loan officer must ask the customer about pending or potential claims against
the firm

- The primary ratios to analyse corporations:

o 1. Net debt / Equity
▪ leverage
o 2. Net debt / EBITDA (< 5)
▪ Profitability measure with clear financial measure
o 3. EBITDA / Net Interest Expenses (> 2-3)
▪ Sort of “Interest Coverage”
o 4. Debt Service Coverage Ratio (DSCR)
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝐹
▪ 𝐷𝑆𝐶𝑅 = 𝐷𝑒𝑏𝑡𝑠 𝑐𝑜𝑚𝑖𝑛𝑔 𝑑𝑢𝑒+𝑁𝑒𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
• Operating CF = EBITDA – Taxes +/- change WC – capex
▪ If >1 enough cash to serve debt payments
➔ Important
17-8 Comparing a Business Customer’s Performance to the Performance of Its Industry:
- standard to compare each business customer’s performance to the performance of
the customer’s entire industry
17–9 Preparing Statements of Cash Flows from Business Financial Statements:
- The Statement of Cash Flows illustrates how cash receipts and disbursements are
generated by operating, investing, and financing activities
- insights into how and why a firm’s cash balance has changed and helps to answer
several important questions:
o Able to generate sufficient CF in the future?
o Why is cash changing and what are the implications?
 - most important of these activities are the operations of a firm.

- Pro Forma Statements of Cash Flows and Balance Sheets

o estimate the business borrower’s future cash flows and financial condition
- The Loan Officer’s Responsibility to the Lending Institution and the Customer
o must look beyond the immediate facts to the broader, longer-term aspects of
a customer relationship
o must be careful about flatly turning away large corporate accounts without at
least exploring the possibilities for establishing some sort of customer
relationship
17–10 Pricing Business Loans:
- One of the most difficult tasks in lending is deciding how to price a loan
o Lender wants to charge a high enough interest rate to ensure each loan will
be profitable and compensate the lending institution for the risks involved
- loan rate must also be low enough to accommodate the customer → able to repay
the loan and able to accept it
- The Cost-Plus Loan Pricing Method
o consider the cost of raising loanable funds and the operating costs of running
the lending institution

- London Interbank Offered Rate (LIBOR) - EURIBOR

o Leading commercial lenders have switched to LIBOR-based loan pricing due to
the growing use of Eurocurrencies as a source of loanable funds
o LIBOR-based loan rate = LIBOR + Default-risk premium + Profit margin
Lecture Part 4: A FOCUS ON CASH FLOW STATEMENTS AND ANALYSIS
Cash flow statement:
- A cash flow statement presents information about the cash flows associated with the
company’s main operations and those associated with its investing and financing
activities of the period
A cash flow statement functions in conjunction with both the income statement
(performance dimension) and the balance sheet (financial position)
- IAS 7 Cash Flow Statements
Cash flow vs. profit:
- Cash flow and profit are different economic phenomena
o But linked through the mechanisms of accrual accounting!
- Cash flows are factual details of incoming and outgoing flows of cash, while the
balance sheet and income statement emanate from professional judgement and are
not a direct projection of objective economic data
Liquidity/solvency and cash flows:
- Liquidity
o Relates to “nearness to cash” of the structure of assets
▪ Capacity to generate/have short-term cash
o Determined by capacity to convert current assets into cash
- Solvency
o Relates to future availability of cash in order to settle financial liabilities on
due date
▪ Structural capability to cover liabilities in the longer term
▪ Medium- to long-term
o Determined by timing and uncertainty of expected future cash payments and
cash receipts
o Liquidity and solvency ratios are determined on static financial position data,
while cash flows reflect changes in financial position
Usefulness of cash flow information:
- Ability to generate adequate cash flows is a significant performance dimension
- Cash flow information is an essential input for economic decision models
- For Lenders
o Clarifies the dynamics of short-term liquidity and long-term solvency
o Historical Cash flow information allows lenders to understand how financial
resources have been used (payback shareholders and/or creditors) and
collected (new loans, new equity)
o Forecasted Cash flow information allows to understand the sustainability of
company’s plans
Relationship with BS and IS:
- A cash flow statement reflects both “profit related” and “nonprofit related” activities
(investing and financing) with an impact on available cash over the period covered in
the income statement

Related questions:
- From which sources did the company raise cash last year? How was this cash used?
- Were the normal operating activities capable of satisfying its need for cash during the
year?
- If not, is the shortage of cash compensated by new borrowings, issuing new share
capital or by selling fixed assets?
- Is a surplus of cash used for repayment of debt, for investments or for distribution of
dividends?
- Why has the balance of cash available decreased, knowing that the company’s
operations have been profitable?
Cash conversion cycles:
- Cash flows through the company continuously in a series of short-term and long-term
conversion cycles
- The ST - cash conversion cycle (operating cycle) relates to the main business
operations
o = OPERATING ACTIVITIES
▪ Net provider or user of funds
• In later stage/mature companies normally provider of funds
• In start-ups often users of funds
- The LT- cash conversion cycles relate to the acquisition, renewal and disposal of
intangible and tangible infrastructure and the long-term sourcing of funds
o Productive capacity acquired for cash and subsequently consumed during
several ST-operating cycles
o Acquisition and disposal of infrastructure = INVESTING ACTIVITIES
▪ Typically users of funds
▪ Capex
o External sourcing of funds (debt or equity) = FINANCING ACTIVITIES
Format and structure of the cash flow statement:

- Cash flows from operating activities

o Operating activities are primarily the revenue-generating activities of a
company
o “Operating cash flow” is conceptually most near to “net profit”
o Main differences:
▪ 1. non-cash expenses and non-cash revenues (e.g., depreciation
expense)
▪ 2. non-operating items (e.g., gain on disposal of tangible fixed assets)
▪ 3. Timing differences between net profit and underlying cash flow
(e.g., changes in the level of inventories, receivables, creditors, etc.)
o Examples
▪ Receipts from sale of goods and rendering of services (cashing in of
receivables included)
▪ Receipts from taxes on sales and VAT
▪ Receipts from royalties, fees, commissions, …
▪ Payments to suppliers (payment of creditors included)
▪ Payments to employees
▪ Payments of taxes, VAT, fines, …
o Direct vs indirect method
▪ Direct method
• engenders the presentation of the most important categories
of gross operating cash inflows and cash outflows
▪ indirect method = adjusting net income
 - Cash flows from investing activities
o Investing activities relate to the acquisition and disposal of long-term tangible
and intangible assets and other investments
o Cash flows from investing activities are an indication of the expansion or
downsizing of operating capacity
o Examples:
▪ Payments for newly acquired equipment
▪ Receipts from the disposal of a building
▪ Payments for new investments
- Cash flows from financing activities
o Financing activities relate to changes in the size and composition of
contributed capital and financial debt of the company
o Examples:
▪ Receipts from issuing new shares or bonds
▪ Receipts from new bank loan
▪ Payments for buy-back of shares
▪ Repayments of loans
▪ Payments of interest and dividend
Constructing a cash flow statement:
- 1. Determine the net change in cash
o Compare beginning and ending balance
- 2. Identify all transactions of the period leading to a change in cash
o Direct: analyze movements in the accounts of cash (equivalents) transaction
by transaction
o Indirect: explain net change of cash by analyzing all other accounts, knowing
that each transaction with an impact on cash also affects a non-cash account
- 3. Use the information (of step 1 and 2) to construct a cash flow statement according
to the formal rules
Cash Flow Analysis for Lending:
- Analysis of Uses of funds
o 1) Investments are prevailing
▪ Typical of growth companies which use sources to increase
investments – will they be profitable?
o 2) Payback of sources are prevailing
▪ What sources? Equity or debt?
- Analysis of sources of funds
o 1) Operating cash flows (hopefully positive!)
o 2) External sources are prevailing
▪ Equity or liabilities? – limits freedom (has to serve capital givers)
o 3) Disposal of investments/fixed assets are prevailing
▪ The company is getting back what came from past sources.
Understand whether this is due to difficulties in finding further
external sources. → normally user of funds – what are the reasons?
Lecture Part 5: Internal Rating and Pricing:
Internal ratings:
- An assessment of creditworthiness
o Both financial risk and business risk are taken into consideration
▪ Financial risk = leverage (financing)
▪ Business risk = risk of operations and investments
o Borrowers are classified into risk classes
- Allow
o A risk adjusted pricing
o A better allocation of equity capital invested
o A better diversification of loans
Bank Internal Ratings:
- Each bank has its procedures but there are some characterizing features:
o # of rating classes
▪ Lower = better
o Selection of relevant information
o Choice of insolvency definition
o Rating class → Class’ PD → valuation of exposures
o Timing, methodology of rating revision
- # Rating Classes
o High variability among banks
▪ Average 10; Min. 2; Max. 20
▪ Granularity (# of classes) increases with system age → higher for more
expert banks (positive)
→Help avoiding borrower concentration in few classes
→ Allow a more accurate pricing
Rating Steps:
- 1) Rating assignment
o Borrower is given a rating (class of risk)
- 2) Rating quantification
o Rating is associated to 1-year probability of default
Rating Assignment:

- Corporate Assessment (Financial and operational risk of the company)

o 1. Financial Analysis
o 2. Qualitative Analysis
▪ E.g., SWOT or Porters Five Forces
o 3. Sector Analysis
▪ E.g., RE sector condition
➔ Corporate rating
o Evaluation of a company
- Operating Assessment
o National Credit Register (NCR) Operating Score
▪ In many countries loans are communicated to central register
▪ Collects information about borrowers (how they are behaving as
borrowers)
→ credit history
o Internal Operating score
▪ How company (borrower) uses funds and manages loans
• E.g., use of revolving loans → are they used as intended?
➔ Operating Score
▪ From view of lenders
▪ Score of operations with lenders/creditors
• How they behave in regards to creditors
- Operating Score:

o Three categories of companies

▪ In Bonis
• Good loans
▪ In the watch list
• Smaller troubles
▪ Potential insolvent
• Step before big troubles
o Runs a monthly analysis of information on clients selected by Bank to forecast
positions that within a year could deteriorate
- The scale:

- Internal rating scale

o Allow to use instead of binominal approach
▪ Solvent
• Different ways to be solvent → How solvent?
▪ Insolvent
➔ Multinomial approach
Rating quantification:
- Rating is associated to a PD
- Credit risk is given by 4 components
o PD (Probability of default) Depends on
▪ In 1 year borrower
▪ Most important metric
o LGD (Loss Given Default)
▪ Not 100% in most cases → can recover something (collateral,
guarantees) Depend on
o EAD (Exposure at Default) the feature
▪ What could be the usage in case of default of the loan
▪ the total value a bank is exposed to when a loan defaults
o M (Maturity)
▪ Longer = more risk

- Through the rating system the bank

o Allocate borrowers according to their riskiness
o Assess the risk components
- Rating system
o structured and documented set of methodologies, organizational and control
processes, data collecting procedures, which allows to collect and process
relevant information to assess riskiness of a borrower and of loans
Probability of Default:
- default definition
o Past Due: behind payment for more than 90 days
▪ Operating assessment → influences rating even if not 90 days
o Non accrued status for Unlikely to Pay
▪ Loan is dead from the POV of the bank → no more accrual of interest
o UtP: an exposure where full repayment of principal and/or interest by the
o counterparty is unlikely without relying on the bank’s realization of collateral
or risk mitigants
▪ sale of credit obligation with loss > 5%
▪ distressed restructuring (Loss NPV > 1%)
• restructure amortization (longer maturity) → bank is suffering
loss
▪ bankruptcy
▪ additional indicators: fraud, significant increase in obligor leverage,
delay in payments to other creditors …
➔ PD within 12 months
- Expected PD
o A risk quantification
o Based on long run average annual default rates
o A forecast of how many borrowers will be in default
Exposure at Default:
- Regulatory approach (for capital adequacy)
o EAD = Current exposure + 75% of the credit facility not used yet
Loss Given Default:

Maturity:
Expect and unexpected loss:
- EL = Average loss on a large number of expositions
o EL = PD*LGD*EAD.
➔ EL is not the actual loss!!

- Unexpected Loss (UL) is the difference between Actual loss and expected loss (both
with sign +).
o UL either positive or negative (should be unexpected “gain”)
o UL is a problem when it is positive
o UL depends on variance and shape of probability distribution of the actual
losses
o UL is computed under a “worst case” hypothesis
▪ Only focus on the bad outcome (loss)
Summing up:

Pricing:

- Base price is the most important factor

o Related to ratings → big role of ratings in pricing
➔ Important
 - Cost of money (funding) for the bank
o (e.g., interest on deposits)
- Operating costs
o Headquarters, employees, IT, Analyses, etc.
- Expected Loss
o PD, LGD, EAD
- Cost of equity to cover Unexpected Loss
o Cost of Equity
▪ Equity covers the UL
→ Equity > UL
▪ Depends on amount of equity (UL) and risk reward
o Unexpected Loss
▪ Also depends on type of loan (also influences EL)
▪ Risk of the borrower
The importance of pricing:
- The consequences of mispricing:
o Threatens bank profitability (underestimation of credit risk)
o Interest rate does not cover all costs
o Value destruction for shareholders
- Bad allocation of loans
o Less risky clients subsidize riskier ones
o Adverse selection (a relatively higher rate of riskier clients)
Lecture 6: Investment Banks
- IBs facilitate companies’ direct access to the capital markets
- At heart, an IB acts as an intermediary and matches sellers of securities with buyers
of securities
Investment Banks: What is their business?
- 1. Purchase/underwrite new securities from corporates and sell to the public:
o Commercial banks lend money, IBs raise money
- 2. Trade securities on capital markets
o As principal investor (proprietary trading)
o As an intermediary (agency transactions)
- 3. Advise on corporate M&A
- But also much more
o Merchant banking (principal on long run investments in equities)
o Market making
o Private placement
o Venture capital
o Clearing and settlement
o Lending
o Money management
Organization structures – Goldman Sachs:
- 1987 – Four Divisions
o 1. Investment banking
o 2. Equities
o 3. Fixed income
o 4. Currency and commodities trading
- 2007 – Three Divisions
o 1. Investment banking
o 2. Trading and principal investment
o 3. Asset management and securities services
Goldman Sachs – 2018
- 1) Investment Banking
o broad range of investment banking services to a diverse group of
corporations, financial institutions, investment funds and governments.
o Services include
▪ strategic advisory assignments with respect to mergers and
acquisitions,
▪ divestitures,
▪ corporate defense activities,
▪ restructurings,
▪ spin-offs and risk management,
▪ and debt and equity underwriting of public offerings and private
placements,
• including local and cross-border transactions and acquisition
financing, as well as derivative transactions directly related to
these activities.
- 2) Institutional Client Services
o facilitate client transactions and make markets in fixed income, equity,
currency and commodity products,
o primarily with institutional clients such as corporations, financial institutions,
investment funds and governments.
o also make markets in and clear client transactions on major stock, options and
futures exchanges worldwide
o and provide financing, securities lending and other prime brokerage services
to institutional clients
- 3) Investing and lending
o invest in and originate loans to provide financing to clients.
▪ These investments and loans are typically longer-term in nature.
o We make investments, some of which are consolidated, directly and indirectly
through funds and separate accounts that we manage, in
▪ debt securities and loans,
▪ public and private equity securities,
▪ and real estate entities.
- 4) Investment management
o provide investment management services and offer investment products
across all major asset classes to a diverse set of institutional and individual
clients.
▪ primarily through separately managed accounts and commingled
vehicles, such as mutual funds and private investment funds
- offer wealth advisory services, including portfolio management and financial
counseling, and brokerage and other transaction services to high-net-worth
individuals and families.
Goldman Sachs – 2020:
- 1) Investment banking
o A. Mergers and Acquisitions
o B. Financing
▪ Corporate Derivatives
▪ Corporate finance
▪ Equity Capital Market
▪ Investment Grade Capital Markets
▪ Latin America Financing Group
▪ Leveraged Finance Capital Markets (High risk – “junk”)
- 2. Consumer and investment management
o A. Consumer Banking
▪ Personal Loans, Personal Financial Management App ….
o B. Asset Management
▪ Individuals and institutions
o C. Private Wealth Management
▪ High-Net-Worth Individuals
- 3. Investing and Lending
o A. Direct Private Investing
▪ Merchant Banking, but also credit and real estate strategies
▪ Also on their own books
o B. Impact Investing
▪ Innovative commercial solutions that address social and civic
challenges in communities
o C. Launch With GS (Diversity)
▪ Increase access to capital and facilitate connections for women, Black,
Latinx and other diverse entrepreneurs and investors.
- 4. Global Markets
o leading market insight, risk management and execution, helping them to raise
money, invest, and transfer risk across financial asset classes
o for our clients
▪ Asset Managers, Hedge Funds, Banks and Brokerages, Pensions,
Endowments and Foundations, Corporations, and Governments
- 5. Sustainable Finance
o Sustainable finance is increasingly core to a company’s business
o helping our clients accelerate climate transition (low-carbon economy) and
advance inclusive growth
- 6. Global Investment Research
o Provide original, fundamental insights and analysis for clients in the equity,
fixed income, currency and commodities markets
Services to Clients:
- For issuers of securities
o IB offers its capital market services
o ECM
▪ For IPOs
o DCM
▪ New issues of bonds and loans
- For investors
o IB proposes its selling capabilities to advise on the attraction of a financial
product
▪ Investors can diversify, manage risk, and enhance returns
- For buyers and sellers of securities
o proposes its trading expertise to execute transactions in
▪ equities, bonds, currencies, commodities, options, and futures
o Fixed Income, Currencies, and Commodities (FICC) Department
o Equity Department
- For clients dealing in commodities
o makes a market in product
▪ acts as a principal who takes the other side of customer trades
- The research departments of IBs
o convey information to investors about monetary or economic matters of a
region
o recommendations about the prospects of listed securities
- Corporate advisory
o strategic advice and valuation services in M&As, transactions dealing with the
equity capital of corporations

Available Products:
- deliver their services to their corporate clients through client-relationship managers
o the client relationship managers, or RMs, provide advice to clients on the full
spectrum of the bank’s products
o They are often organized by industry sector
- still managed to a considerable extent by product-line specialists
The Revenue Mix:
- Kinds of fees
o Commissions (bank acting as agent)
▪ Intermediary → % of transaction value
o Trading income
▪ Banks invest their money
▪ Gains and losses when “making a market” (take other side of trades)
o Underwriting revenues (profits/losses)
o Interest (margin interest – securities lending, corporate lending)
▪ Like commercial banks through → spread
o Asset management fees
o Others (advisory, dividends ….)
Size Classification
- Tier 1
o Morgan Sanley, Goldman Sachs, Citigroup, JPM
o Handle majority of Wall Street transactions
- Tier 2
o Deutsche Bank, Barclays, Credit Suisse, HSBC … (Subsidiaries of commercial
banks)
o Smaller and less global/more concentrated products
- Tier 3
o BNP Paribas, Société Générale, UBS ….
o Very dominant in particular countries
- Boutiques
o Lazard, Rothschild …..
o Small and focused on a class of service offerings
o Normally no traditional banking

- Universal bank model

o Commercial and investment banking combined in one bank
o After repeal of Glass-Steagall Act → M&A trend
Lectur 7: Overview of Corporate Financing
Patterns of Corporate Financing
- Firms may raise funds from external sources or plow back profits rather than
distribute them to shareholders
- Should a firm elect external financing, they may choose between debt or equity
sources

- Most used funds for investing

o 1. Internal funds
▪ funds from CF allocated to depreciation or retained earnings
▪ shareholders are happy to do so if NPV positive projects
o 2. Debt
o 3. Equity
▪ Net issues negative due to dividends, share buybacks and M&A
- Equity not that much used due to
o Cost of issuing new securities
o Bad signaling to offer new equity to investors
Debt Ratios:

- Market debt ratio lower because market value of equity is higher

- More debt = more risk, but doesn’t mean it is bad (has benefits)
Ownership of a corporation:
- owned by its common stockholders

- Most belongs to Institutional investors which are financial intermediaries

- Ownership refers to
o Cash-flow rights
▪ Residual claim (after debt holders have been served)
o Control rights
▪ Banks often have imposing restrictions to protect their claim →
limited control of stockholders
▪ Determine operating and investment decisions
- In case of bankruptcy
o Ownership of the firm changes
o Shareholders CF and control rights are restricted
- In public corporations (many shareholders)
o Control is often limited to
▪ Vote the board of directors
▪ Crucial matters (like mergers, etc.)
o Managers make decisions about daily business
Voting Procedures:
- Board of directors comes up for re-election every year [(in US) (in Italy every 3 years)]
- Classified board of directors
o One-third of directors come up for reelection every year
▪ Entrenches management
▪ Insulate management from short-term pressure and allow the
company to innovate and take risks.
- Most votes are decided by simple majority, but some need a super majority of 75%
o Entrench management
- Issues on which shareholders are asked to vote on are rare
Dual-Class Shares and Private Benefits:
- Usually, companies have one class of common stock and each share has one vote
- Some companies have two classes of stock
o Same cash-flow rights, different control rights
o Greater control rights grant private benefits
▪ Different price
▪ Typically reserved for founders (or early investors)
o Goes against democracy of a company
o Sometimes enable private benefits captured by the owners of these shares
Google: An Interesting Case
- 2014 Stock Split in 3 Categories
o A
▪ 1 share 1 vote
o B
▪ not listed
▪ 1 share 10 votes
▪ Owned mainly by founders
o C
▪ No voting right
- A and C have similar market price since majority of voting shares are B class shares
- Much debate about this model
Equity in Disguise:
- Partnerships
o Avoid corporate income tax
o Limited life span
- Trusts
o Passive ownership of asset
- Real Estate Investment Trust (REIT)
o Not taxed
o Limited to real estate
o Facilitate public investments in commercial real estate
o Traded like common stocks
- Preferred Stock
o Takes priority over common stock when receiving dividends
o Gains some voting rights if corporation fails to pay preferred dividend
o useful method of financing in mergers and certain other special situations
o offers a series of fixed payments to the investor (like debt)
Corporate Debt:

- Debt has the unique feature of allowing the borrowers to walk away from their
obligation to pay, in exchange for the assets of the company
- “Default risk” is the term used to describe the likelihood that a firm will walk away
from its obligation, either voluntarily or involuntarily
- “Bond ratings” are issued on debt instruments to help investors assess the default
risk of a firm

- Financial Manager Questions

o Should the company borrow short term or long term?
▪ Depends on reason
o Should the debt be fixed or floating?
o Should you borrow dollars or some other currency?
▪ Can make sense if you spend in other currency
o What promises should you make to the lender?
▪ Senior/junior?
▪ Secured? (collateral)
▪ Assurances of not taking too much risk
o Should you issue straight or convertible bonds?
▪ Substantial effect on value
A Debt by Any Other Name:
- Some debts treated differently in accounts
o Accounts payable
▪ Good received, not yet paid for
▪ Very short-term debt
o Rent or lease equipment
▪ Obligation of payments (like debt)
o Unfunded obligations
▪ Senior debt, e.g., employee pensions
o Special-purpose entities (SPEs)
▪ Raise cash through equity and debt
▪ Do not show up on balance sheet
Financial Markets and Intermediaries:
- The Flow of Savings to Corporations:

Financial Markets:
- market where financial assets are issued and traded

- Primary markets
o “First offerings”
- Secondary markets
o Market for owned securities
- OTC markets
o Securities are traded directly between counterparties
o Normally through brokers/dealers
o No organized exchange
Financial Intermediaries:
- Raise money from investors and provide financing for individuals, companies, and
other organizations
- Banks, insurance companies, and investment funds
- between savings and real investment

- Investment Funds
o For example, mutual funds, hedge funds, and pension funds
o Mutual funds
▪ raise money by selling shares to investors
▪ pooled and invested in a portfolio of securities
▪ purchase and sale prices of shares depend on Net asset value (NAV)
▪ offer low-cost diversification and professional management
▪ normally a management fee
▪ invest in
• shares, bonds, or short term safe securities (money market
funds)
▪ normally open-end fund → ready to issue and buy back shares
• closed-end fund → fixed number of shares being traded
o Exchange traded fund (ETF)
▪ portfolio of stocks that can be bought or sold in a single trade
▪ like closed-end investment funds
▪ passive
o hedge funds
▪ usually follow complex investment strategies
▪ access restricted (normally institutionals)
▪ established as limited partnerships
▪ performance-related fees
o pension fund
▪ pension money pooled and invested
▪ long-run investments
▪ tax-deductible and tax-free until withdrawn
 - Financial institutions
o Commercial banks, investment banks and insurance companies
o raise financing in special ways, for example, by accepting deposits or selling
insurance policies,
o provide additional financial services
o invest in securities and lend money

The Role of Financial Markets and Intermediaries

Payment Mechanism:
- Allows individuals to make and receive payments quickly and safely over long
distances
Borrowing and Lending:
- Channels savings towards those who can best use them
Pooling Risk:
- Allows individuals to share risk, i.e., insurance companies or mutual funds
o Diversify risk
Information:
- Allows estimation of expected rates of return
Lecture 8: HOW CORPORATIONS ISSUE SECURITIES
The Initial Public Offering:
Words of an IPO:
- Initial Public Offering (IPO)
o First offering of stock to the general public (often a mixture of primary and
secondary market)
- Underwriter
o Firm that buys an issue of securities from a company and resells it to the
public
o Also give procedural and financial advice
- Spread
o Difference between public offer price and price paid by underwriter
- Prospectus
o Formal summary that provides information on an issue of securities
o Also presents information the firm’s history, existing business, and plans for
the future
- Underpricing
o Issuing securities at an offering price set below the “true/fair” value of the
security
Motives for an IPO:

o Non-financial interests dominate (Point 1-4)

o Financial Interests follow (Point 5-7)
o Minimize Cost of capital – equity requires a higher rate of return
o Many points are connected/similar
- Drawbacks of becoming public
o May end up selling shares for less then their true worth (Discount)
o Long-term costs (administrative)
o Pressure from public investors
The Effect of the Sarbanes Oxley (SOX) on IPOs
- As response to fraud in public companies → more obligations for public companies
- regulations aimed at protecting the public
- CEOs say it deterred companies from going public
o Significant burdens for smaller companies
o Fewer high-growth entrepreneurial companies went public
o Hurts job creation
▪ Job growth accelerates when companies go public
▪ Decelerates when companies are acquired
o To stimulate IPO market and job creation → shareholders of small public
companies (<1 bn) should be able to opt out of some requirements of SOX
Steps in making an IPO:
1. Company appoints managing underwriter (bookrunner) and co-manager(s).
Underwriting syndicate formed.
2. Arrangement with underwriters include agreement on spread and on greenshoe
option.
o Spread
▪ typically 7% for medium-sized IPOs
o Greenshoe option
▪ typically allowing the underwriters t to increase the member of share
bought by 15%
3. Issue registered with SEC and preliminary prospectus (red herring) issued.
4. Roadshow arranged to market the issue to potential investors. Managing underwriter
builds book of potential demand.
5. SEC approves registration. Company and underwriters agree on issue price.
6. Underwriters allot stock (typically with overallotment)
o Already large community of interested investors that buy stocks at the
beginning of the listing
7. Trading starts. Underwriters cover short position by buying stock in the market or by
exercising greenshoe option.
8. Managing underwriter makes liquid market in stock and provides research coverage.
Underwriter Spread
- Spread
o the difference between the public offer price and the price paid by
underwriter
o typically between 5-10%
o main gain for underwriters
Underwriter Arrangements:
- Firm Commitment
o Underwriters buy the securities from the firm and then resell them to the
public
 - Best Efforts Commitment
o Underwriters agree to sell as much of the issue as possible but do not
guarantee the sale of the entire issue
o Done if perceived as particularly risky
- Flotation Costs
o The costs incurred when a firm issues new securities to the public
▪ Preparing Prospectus, legal counsel, advisors, registering …. (around
1% of proceeds)

- Underpricing
o Issuing securities at an offering price set below the “true/fair” value of the
security.
o To attract more interest/else potential (uninformed) investors won’t buy the
stock
o low offering price on an IPO raises the price when it is subsequently traded in
the market and enhances the firm’s ability to raise further capital
o negative for existing shareholders
Underwriting: not always as ethical as believed:
- Not easy to differentiate between good and bad stocks for the public
- Dot Com Boom:
o IB analysts strongly promoted stocks that were overpriced in their eyes
o Allocated stock in hot new issues to CEOs of major corporate clients → buy
future business through giving them these stocks
▪ 2 class of clients → 1 good advice, 1 bad advice
➔ $1.4 bn payout by the banks and agreement to separate IB and research
departments
➔ Risky to do this → reputation is key for underwriters
Average Initial Returns from Investing in IPOs in Different Countries
- Underpricing in most developed countries relatively low
- Not a good strategy to buy stocks before IPOs
o “hot” IPO stocks are hard to get → end up with worse ones
- Also lock up periods for executives and employees (insider information)
- IPO hype during the dot-com boom (1999-2000)

- First day returns on IPOs/underpricing vary tremendously due to IBs advice

- Also returns on IPOs differ from year to year
o Periods of excessive optimism

Alternative Issue Procedures for IPOs:

- Not very popular
- Open auction
o auction them to the highest bidders
o discriminatory auction or a uniform-price auction
▪ discriminatory → every bidder requires the price they bid
▪ uniform-price → price of the lowest winner
Security Sales by Public Companies:
- Public companies can issue securities either by offering them to investors at large or
by making a rights issue that is limited to existing stockholders
- General Cash Offer - Sale of securities open to all investors by an already public
company
o Seasoned Offering
▪ Sale of securities by a firm that is already publicly traded
o Shelf Registration
▪ A procedure that allows firms to file one registration statement for
several issues of the same security
o Process similar to an IPO, but smaller
- International Security Issues - Sale of securities in other countries
o Eurobond
▪ Bonds underwritten by a group of international banks and offered
simultaneously to investors in a number of countries
o Global bonds
▪ Bonds where one part is sold internationally in the eurobond market
and the remainder sold in the company’s domestic market
o Foreign bonds
▪ Issue bonds in another country’s domestic market

- The Costs of a General Cash Offer

o Substantial administrative costs
o Underpricing – however far less than in IPOs
▪ Average of 3%
o Costs ranking:
▪ IPOs
▪ SEOs
▪ Convertibles (convertible into equity under certain circumstances)
▪ Bonds
Market reaction to new stock issue announcement:
- On average a decline of 3-4%
o fall in market value is equivalent, on average, to nearly a third of the new
money raised by the issue
- Why?
o Increased offer?
▪ price of the stock is simply depressed by the prospect of the additional
supply
→ Not Likely
o Information content
▪ A) Top executives think stocks are underpriced
• The new issue will benefit new investors
• The current shareholders are not pleased
• Try to convince the market that the stocks are not underpriced
• Not easy, time consuming, revealing confidential information
→ The managers prefer to wait
▪ B) Top executives think stocks are overpriced
• The new issue will benefit current investors (… pleased)
• The company raises more money (= # of stocks)
→ Why wait? Hurry up and issue new stocks
➔ Investors anticipate this → know stock is overpriced at the current price →
Information effect
- Not really in preferred stock or debt
o Less possibility to make profit by selling overpriced
Rights Issue – American (and Italian) Rules:
- Rights Issue
o Issue of securities offered first to current stockholders
o E.g., right to buy a new share for every two shares held
o Can be used or sold
o Underwriter normally buys unwanted stock (happens rarely)
- Solution for the negative effect of underpricing on existing shareholders

- Value of each share is the price in the market after underwriting → old investment
are worth less, but option counteracts this → still worth the same ($36)
 - Value of the option changes daily between announcement and new underwriting
since market price of stock changes daily

Private Placements and Public Issues:

- Private Placement
o Sale of securities to a limited number of investors without a public offering.
- In Italy
o Less than 150 non qualified investors
o The amount < 8.000.000 within the last 12 months
- Qualified Institutional Buyer
o Entity entitled to purchase and trade private placements
o banks, investment firms ….
- Less costly then public issue
Lecture 9: CREDIT RISK AND THE VALUE OF CORPORATE DEBT:
Yields on Corporate Debt:
- Face value of defaulting debt increase tremendously during a crisis
o Spikes during the dot-com and sub-prime crisis
- The risk of default changes the price of a bond and the Yield to Maturity
o Discount rate depends on credit risk premium and market risk premium
o Rise during crisis

- Return in case of no default = YTM

- Market risk premium needed for very unpredictable uncertainty – risk adversity of
investors → else just go for treasury bonds
- MRP
o General perception of risk
o Investors are risk adverse → more risk = statistically higher expected return
▪ Other way around: risk lovers (e.g., bettor)
- YTM reflects
o Risk free
o Market risk premium
o Default risk premium
- Yield Spreads:

- In 2008 increase in MRP and PD → Higher yield

 - Credit default swap data:

- CDS
o Securities of the credit risk → insure against credit risk
o MRP changes daily in the market
o 2009
▪ Increase in the perception of the PD and/or MRP
▪ Distinguish between PD and MRP
• Look at other similar companies (industry and ratings)
o If something similar happens: consequence of MRP
o if not: consequence of PD
o Higher YTM on Italian government bonds during crisis was due to higher MRP
and credit risk
How does a default work?
- International Swaps and Derivatives Association (ISDA) decides if there is a “credit
event” in case of voluntary changing the bonds
- If there is a Credit event → auction conducted to determine the value of the
defaulted bonds → owners of Default swaps are paid the difference between auction
and face value
- People on the SIDA are involved parties → can lead to problems
Bond Ratings and the Probability of Default:
Key Bond ratings:

- AAA on government bonds typically represents the risk-free rate

- principal rating services—Moody’s, Standard & Poor’s, and Fitch
Bond Ratings and Financial Ratios:

- Typically, worse rating

o Lower operating margin
o Higher debt ratio
o Lower cash coverage ratio
➔ Ratings are related to financial ratios
Bond Ratings and Default:

- Default rates
o Represents observed defaults
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑 𝑏𝑜𝑛𝑑𝑠
▪ 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑏𝑜𝑛𝑑𝑠
o Approximation of Probability of default

Predicting the Probability of Default:

Statistical Models of Default:
Comparison of financial statements from firms that have gone
bankrupt with those firms that have not gone bankrupt reveals
information valuable to the lending decision.
➔ Return on assets diminishes and becomes negative
➔ High ratio of Liabilities to assets
➔ EBITDA vs liabilities low and becomes negative
➔ Cash reserves and working capital decrease
- combine the ratios into a single score
-
Credit Analysis:
- Predicting default
o Chance of failing during the next year relative to the chace of not failing is
best estimated by

▪ ROA = Return on Assets

▪ Liabilities/Assets = Debt-Ratio
▪ EBITDA/Liabilities
- Credit analysis is only worthwhile if the expected savings exceed the cost
o Don’t undertake a full credit analysis unless the order is big enough to justify
it
o Undertake a full credit analysis for the doubtful orders only
- Use market data
o Market value of assets typically diminish as approaching default
Ratings Changes:
- Ratings regularly change
- Normally now huge jumps

Guide to credit rating essentials (S&P):

- What are credit ratings?
o Credit ratings do not indicate investment merit
▪ Transparency of ratings
▪ Only show credit quality (in some cases also what is possible to
recover)
o Credit ratings are not absolute measures of default probability
▪ Good rating is no guarantee of no default
▪ Only shows it is less likely to default then a bond with a lower rating
- Why credit ratings are useful?
o Credit ratings may facilitate the process of issuing and purchasing bonds and
other debt issues by providing an efficient, widely recognized, and long-
standing measure of relative credit risk
- Who uses credit ratings?
o Investors
▪ Rating may be used as an indication of credit quality, but investors
should consider a variety of factors, including their own analysis.
 o Intermediaries
▪ They may use credit ratings
• to benchmark the relative credit risk of different debt issues,
• to set the initial pricing for individual debt issues they structure
• and to help determine the interest rate these issues will pay.
▪ Investment bankers may also serve as arrangers of debt issues
• In this capacity, they may establish special purpose entities
that package assets, such as retail mortgages and student
loans, into securities or structured finance instruments, which
they then market to investors → get rated
• Very common in the market
• Loans normally not tradable → securitization: Transform loans
into securities
• Rating Agency as Agent for the Special Vehicle (So ultimately
for the bank) → could be a problem (Financial Crisis), but they
live on their reputation

• Bank gives a loan to a company

• Pools together many loans → Sell these loans to special vehicle
(SPE) → Issues bonds in the market → Cash for asset
• Balance Sheet of Special purpose entity:
o Assets: Loans
o Liabilities: Bonds
→ Enables banks to sell loans before maturity

-
- Credit rating agencies
o rating agencies are not directly involved in capital market transactions, they
have come to be viewed by both investors and issuers as impartial,
independent providers of opinions on credit risk.
o Rating methodologies
▪ Model driven ratings
• small number of credit rating agencies focus almost exclusively
on quantitative data, which they incorporate into a
mathematical model
▪ Analyst driven ratings
• Typically, analysts obtain information from published reports,
as well as from interviews and discussions with the issuer’s
management
➔ Ratings normally only for large corporations (very expensive) – mostly analyst
driven
➔ However if for smaller corporations often model driven (banks use algorithms)

- How agencies are paid for their services

o Agencies typically receive payment for their services from issuer or
subscribers
o Issuers pay-model
▪ Since the rating agency does not rely solely on subscribers for fees, it
can publish current ratings broadly to the public free of charge
▪ Most common
o Subscription model
▪ Critics of this model also point out that the ratings are available only
to paying subscribers → tend to be large institutional investors,
leaving out smaller investors, including individual investors. In
addition, rating agencies using the subscription model may have more
limited access to issuers. Information from management can be
helpful when providing forward looking ratings.

- Why credit ratings change

o Expressions of change: outlook and creditwatch
▪ a credit rating may change in the coming 6 to 24 months, rating
agencies may issue an updated ratings outlook indicating whether the
possible change is likely to be “positive,” “negative,” “stable,” or
“developing”
▪ if circumstances occur that may affect a credit rating in the near term, usually within 90 days,
S&P Global Ratings may place the rating on CreditWatch
o Agency studies of defaults and ratings changes
▪ track default rates and transitions, which is how much a rating has
changed, up or down, over a certain period of time
▪ lower ratings change more frequently
Lecture 10: MERGERS
- Mergers follow waves/cycles
o periods of intense merger activity
o management spends significant amounts of time either searching for firms to
acquire or worrying about whether some other firm will acquire them
Mergers and the economy:
- Merger waves
o 1967 – 1969, late 80s and 90s, after 2003 until 2008
o Positively associated with stock prices
▪ Buyer often pays with stocks
- Concentrated in few industries
o Prompted by
▪ Deregulation (Telecom and banking, during and after 90s)
▪ “Industry shock”: Changes in technology & Pattern of demand
• Shocks require large scale reallocation of assets
o E.g., smartphones
▪ What does enhance the reallocation?
• Abundant liquidity, loose financial constraints, that is, low
transaction costs
- Do mergers generate net benefits for the economy?
o No easy answer
o Many mergers that seem to make economic sense fail because managers
cannot handle the complex task of integrating two firms
Problems in mergers:
- Human assets: Corporate culture
o Cultural integration is hard
- IT integration
o Hard to use potential synergies
- Overpaying/underestimating costs
Types of Mergers:
- Horizontal Merger
o One that takes place between two firms in the same line of business
o Utilizes economies of scale
- Vertical merger
o Involves companies at different stages of production
▪ Suppliers or clients
o Better pricing (eliminate inefficiencies)
- Conglomerate merger
o Involves companies in unrelated lines of business
▪ Diversification – however seen cautiously
o Not very common today
Sensible Motives for Mergers:
- Economies of Scale
o A larger firm may be able to reduce its per-unit cost by using excess capacity
or spreading fixed costs across more units
- Economies of Vertical Integration
o Control over suppliers “may” reduce costs.
o Over integration can cause the opposite effect
- Complementary Resources
o Merging may result in each firm filling in the “missing pieces” of its firm with
pieces from the other firm.
➔ All three fall under Synergies
- Mergers as a Use for Surplus Funds
o If your firm is in a mature industry with few, if any, positive NPV projects
available, acquisition may be the best use of your funds.
o Alternative to cashing out to investors (dividends)
▪ Can be seen as a weakness → no ideas etc.
→ companies often don’t give back even though it would be better
- Elimination of Inefficiencies
o Poor management may waste money, make poor decisions, conduct improper
risk/return investments and harm the value of the company. Sometimes, the
only way to remedy the situation is to change management.
- Industry Consolidation
o The biggest opportunities to improve efficiency seem to come in industries
with too many firms and too much capacity.
o These conditions often trigger a wave of mergers and acquisitions
▪ Which then force companies to cut capacity and employment and
release capital for reinvestment elsewhere in the economy.
Dubious Reasons for Mergers:
- Diversification
o Investors should not pay a premium for diversification since they can do it
themselves.
▪ To buy a company a premium is needed
- The Bootstrap Game
o Acquiring firm has high P/E ratio
o Selling firm has low P/E ratio (due to low number of shares)
▪ Doesn’t have to be good
o After merger, acquiring firm has short-term EPS rise
o Long term, acquirer will have slower than normal EPS growth due to share
dilution
 o P/E Ratio goes down to 15
o EPS rise
o Current earnings per dollar invest in stocks higher
o BUT: lower earnings per share growth → Higher P/E ratio was due to more
growth expectations → Acquired company has slower growth
▪ Due to more shares lower slope → increase is smaller in the long-run

- Lower financing costs

o Two separate firms don’t “guarantee” each others’ debt: together they do
▪ Does this imply a net gain for the merger?
▪ A&B gain from the lower cost, but this is the consequence of a
guarantee they offer
• A reduction of the value of shareholders’ option to default
• A reduction in shareholders’ wealth
➔ The reason of lower cost of debt for large companies are larger implicit
guarantees
o A positive exception
▪ A company is not willing to exploit the tax shield of debt due to
worries about financial distress
▪ If the merger decreases the risk of financial distress and it allows to
exploit more the tax shield (profits needed for TS)
Estimating Merger Gains:
- Questions
o Is there an overall economic gain to the merger?
o Do the terms of the merger make the company and its shareholders better
off?
▪ 𝑃𝑉𝐴𝐵 > 𝑃𝑉𝐴 + 𝑃𝑉𝐵
• 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠 = 𝑃𝑉𝐴𝐵 – [𝑃𝑉𝐴 + 𝑃𝑉𝐵 ]

➔ Are synergies larger than the premium?

o 𝐺𝑎𝑖𝑛 = 𝑃𝑉𝐴𝐵 – (𝑃𝑉𝐴 + 𝑃𝑉𝐵 ) = 𝛥𝑃𝑉𝐴𝐵
o 𝐶𝑜𝑠𝑡 = 𝐶𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 – 𝑃𝑉𝐵
→ The gain of B shareholder is the cost of A shareholders
o 𝑁𝑃𝑉 = 𝐺𝑎𝑖𝑛 – 𝐶𝑜𝑠𝑡 = 𝛥𝑃𝑉𝐴𝐵 − (𝐶𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 – 𝑃𝑉𝐵 )
▪ 𝐶𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 = 𝑃𝑟𝑖𝑐𝑒 ∗ # 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘𝑠
• 𝑃𝑟𝑖𝑐𝑒 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 + 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
→ In other words the net gain for A shareholders is
o 𝑁𝑃𝑉 = 𝑊𝑒𝑎𝑙𝑡ℎ 𝑤𝑖𝑡ℎ 𝑚𝑒𝑟𝑔𝑒𝑟– 𝑤𝑒𝑎𝑙𝑡ℎ 𝑤𝑖𝑡ℎ𝑜𝑢𝑡 𝑚𝑒𝑟𝑔𝑒𝑟 =
(𝑃𝑉𝐴𝐵 – 𝐶𝑎𝑠ℎ) − 𝑃𝑉𝐴
▪ 𝑁𝑃𝑉 = 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑚𝑖𝑢𝑚

- Gain = Synergies
- Cost = Premium
- NPV = Synergies – Premium

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 𝑓𝑟𝑜𝑚 𝑆𝑦𝑛𝑒𝑟𝑔𝑖𝑒𝑠

- 𝐺𝑎𝑖𝑛 = ∑ 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝐹𝑎𝑐𝑡𝑜𝑟
o A note on discount factor:
▪ Each company should have its own WACC
▪ If we see the «deal» as a new «investment project» we should take
the proper WACC considering the risk of the deal cash flows and how
it is funded
• Synergies are an “investment”
▪ Not an easy matter
What If the Target’s Stock Price Anticipates the Merger?
- When B is listed, market could anticipate the merger
- Possible Market Values
o 𝑃𝑉𝐵 = the market does not anticipate
o 𝑃𝑉𝐵𝑝𝑙𝑢𝑠 = the market do anticipate
▪ Increase in the share price in anticipation of the announcement
o 𝑃𝑉𝐵𝑝𝑙𝑢𝑠 – 𝑃𝑉𝐵 = increase in the cost
▪ Everything else equal cash will be more because A must offer a
premium to B shareholders
➔ Premium 15% → 𝑃𝑉𝐵 = 50; Premium = 7.25 → 𝑃𝑉𝐵𝑝𝑙𝑢𝑠 = 60; Premium = 9
➔ Cost of the Merger increases → B is better off then before, A worse

Estimating Cost When the Merger Is Financed by Stock:

- cost depends on the value of the shares in the new company received by the
shareholders of the selling company
- B shareholders are paid with A stocks
o Cost = 𝑁 𝑥 𝑃𝐴𝐵 – 𝑃𝑉𝐵
▪ N = Number of stocks
- 𝑃𝐴𝐵 = Price of stocks after the merger is announced and benefits appreciated by
investors
- A offers 325,000 new stocks
o 0.325x200 = 65 mln
▪ Apparent cost = 0.325x200 – 50 = 15 mln
• Uses the price before the deal → Wrong!
- Share price of the new company
o 275/1.325 = 207.55
▪ New value of combines companies/# of stocks
▪ True Cost = 0.325x207.55 – 50 = 17.45 mln
• Premium
- In general the cost depend on the % of combined firm given to B shareholders
325
o 𝐶𝑜𝑠𝑡 = % 𝑃𝑉𝐴𝐵 – 𝑃𝑉𝐵 = 1325 ∗ 275 − 50 = 17.45
➔ Cost depends on the gains of the merger (show up in post-merger share price)
➔ Stock financing mitigates the effect of undervaluation or overevaluation of either
firm
➔ In case of cash offering cost is unaffected by merger gains

➔ In case of Cash payment, A holds the down-/upside

➔ In case of stock payment, A and B hold the down-/upside
Asymmetric Information:
- A’s managers are more positive about future value of combined firm (stock = 215
instead of 207.55)
o 𝐶𝑜𝑠𝑡 = 0.325 𝑥 215 – 50 = 19.88 𝑚𝑙𝑛
➔ Better buying cash
- The opposite if they are less positive
➔ Cash financing when they are more “positive” (about future)
➔ Stock financing when they are more “negative” (about future)
- But B’s shareholders and market do understand, and they react accordingly
➔ Stock price of buying firms fall after stock-financed merger announcement
➔ Stock price of buying firms fall not or less after cash-financed merger
announcement

The Mechanics of a Merger:

Mergers, Antitrust Law, and Popular Opposition:
- Clayton Act of 1914 → forbids an acquisition whenever “in any line of commerce or
in any section of the country” the effect “may be substantially to lessen competition,
or to tend to create a monopoly
- Sometimes trustbusters will object to a merger, but then relent if the companies
agree to divest certain assets and operations
- may also be stymied by political pressures and popular resentment
The Form of Acquisition:
- merge the two companies, in which case one company automatically assumes all the
assets and all the liabilities of the other
- alternative is simply to buy the seller’s stock in exchange for cash, shares, or other
securities
- third approach is to buy some or all of the seller’s assets
Merger Accounting:
- Purchase price of 18 million (180% of book value)
o Why?
▪ Tangible assets are worth more → would show up in BS
▪ Intangible assets not on the BS → promising product or technology
o Purchase method → goodwill

o Goodwill = difference of Payment vs. Assets

▪ Balances Assets and Liabilities
▪ A thinks B is worth more then the value of assets
o no loss on the company’s P&L (Cash for assets)
o Goodwill must be reevaluated every year (Impairment test)
▪ Show that goodwill is not impaired

Proxy Fights, Takeovers, and the Market for Corporate Control:

- ownership and management of large corporations are separated
- Shareholders elect the board of directors but have little direct say in most
management decisions → agency costs
o Forces and constraints
- market for corporate control
o the mechanisms by which firms are matched up with owners and
management teams who can make the most of the firm’s resources
o value can be enhanced by changing management or reorganizing under new
owners
- three ways to change the management of a firm
o successful proxy contest
▪ in which a group of shareholders votes in a new board of directors
who then pick a new management team,
o a takeover of one company by another
o a leveraged buyout of the firm by a private group of investors
Proxy Contest:
- Board of directors elected to keep an eye on management
- If the board is lax, shareholders are free to elect a different board
o Launch a proxy meeting at the annual meeting
▪ Proxy = right to vote anther shareholder’s shares
o dissident shareholders attempt to obtain enough proxies to elect their own
slate to the board of directors → board changes management
o expensive and difficult to win
▪ management can use the corporation’s funds
Takeovers:
- would-be acquirer can make a tender offer directly to the shareholders
- successful offer → new owner can make changes
- ownership of 5% or more of the shares has to be reported to the SEC (with
intentions)
- often other bidders enter and drive up the price (want to force up the premium)
o consolation for initial bidder: if bid unsuccessful → sell holding at substantial
profit
Takeover Defenses:
- Firms that are worried about being taken over usually prepare their defenses in
advance
- White knight
o Friendly potential acquirer sought by target company threatened by an
unwelcome suitor
- persuade shareholders to agree to shark-repellent changes to the corporate charter
o Amendments to a company charter made to forestall takeover attempts
o e.g., require that any merger must be approved by a supermajority of 80% of
the share rather than 50%
- deter potential bidders by devising poison pills that make the company unappetizing
o gives existing shareholders the right to buy new shares if a bidder acquires
more than 15%
 - Why does management contest a takeover bid?
o Extract a higher price for the stock
o Protect its own position in the company
▪ Often companies reduce this conflict of interest with a golden
parachute
- Takeover defenses often get contested in court
Tools used to acquire companies:
- proxy contest
- acquisition
- LBO
- MBO
- Merger
- Tender Offer
Benefits and Costs of Mergers:
- Who usually benefits from the merger?
o Shareholders of the target
▪ Size
▪ Competition among bidders
o Lawyers & Brokers
▪ Also hedge funds (Merger arbitrage)
o The executives of the acquiring firm
- Who usually loses in a merger?
o Shareholders of the acquirer due to overpayment
o Executives of the target
o All employees due to restructuring

- The issues with acquirers

o Behavioral biases
▪ Hubris
▪ Overconfidence
o Competition among bidders
- The advantages for targets
o Relatively small
▪ A small cost for the acquirer can be a relatively large benefit for the
target
o Competition among bidders
Merger Announcements and the Stock Price:
- On average the announcement was associated with an abnormal return of 17.3% for
the target shareholder → expected premium
- Buyers share holders break even
➔ looks like they are worth more together then apart
o however this is only very small (since buyers are larger)
Merger Profitability:
- we don’t know how companies would have fared if they had not merged
- different studies show an improvement or decline of productivity
o no clear effect on productivity
- 2.4% average increase of company pretax returns
o Comes from higher level of sales from the same assets
Do Mergers Generate Net Benefits?
- if, on average, mergers appear to break even for the buyer, why do we observe so
much merger activity
o behavioral traits
▪ Hubris or oveconfidence
• Misbelieve they can run the target firm better
o firms can enter or expand in a product market either by building a new plant
or by buying an existing business → if the market is shrinking, it makes more
sense for the firm to expand by acquisition
▪ signals stagnant state of the market to investors
Lecture 11: CORPORATE RESTRUCTURING
Leveraged Buyouts:
- Three main characteristics of LBOs
o High debt
▪ Not permanent, to curb wasteful investment and force improvements
o Incentives
▪ Managers are given greater stake in the business
▪ Show to funders (banks, etc. that provide debt) that you can manage
the company better
o Private ownership
▪ Not intended to be permanent
- Management Buy Out
o Buyout led by the existing management
Unique features of LBOs:
- Equity financing comes from private equity investment partnerships
- Target company goes private
- acquirer finances a large fraction of the purchase price by bank loans and bonds
o which are secured by the assets and cash flows of the target company → buy
company with the money you get from future CF
o often below investment grade bonds
Why leverage?
- Can buy bigger companies (less equity needed) → more deals possible
(diversification)
- Increases ROE (Equity catches upside), but also more risk
- Tax shield

LBO and financial structure:

- Acquisition with leverage and no goodwill:
o Substitute equity with debt →new debt entails an equal reduction in Equity
o LBO brings more leverage → zero-sum game and therefore overall equity
decreases
 - Acquisition with leverage and goodwill = 200 (yes merger loss)
o Substitute Equity with debt and company has a goodwill → Equity reduces,
but not an equal reduction

o Higher leverage does not reduce the equity in the same way as without
goodwill
o ΔE = - ΔDebt + Goodwill = -600 + 200 = - 400
▪ … but the Tangible Equity = 200 – 200 = 0
➔ New leverage entails a corresponding reduction in Tangible equity
Leverage Buyouts: Motives:
- Junk bond market
Cheap money and abundant liquidity
- Leverage and taxes
o Tax shield of debt
▪ However not the main motive → debt is paid back fairly quick
- Other stakeholders
o Loss for “old” creditors
▪ Through new debt their bonds are less secure
▪ However not large enough
- Leverage and incentives
o MBO: employees become owners and the pression of debt causes harder and
(maybe) smarter working
▪ Increase in operating income
- Leverage restructurings
o LBOs and Leverage restructurings
▪ Force mature, successful, but overweight companies to draw down
cash, reduce operating costs and use more efficiently assets
o Same characteristics as LBOs but doesn’t go private
o Leverage is “external pressure” → better performance
Leveraged Restructuring: Example:
- 1989 Sealed Air was a very profitable company
- Profits came easily through patents
➔ When patents expired strong competition was inevitable
➔ Company wasn’t ready
- Solution
o Company borrowed money to pay a special dividend (increase debt by 10
times)
▪ Disrupt status quo, promote internal change and simulate pressure
o Reinforced by new performance measures and incentives, including stock
ownership of employees
➔ Sales and operating profits increased steadily
➔ Stock price quadrupled
Fusion and Fission in Corporate Finance:
- Fission
o the sale or distribution of assets or operating businesses—can be just as
important as fusion
- Fusion
o Merger and Acquisitions
Spin-Offs:
- Debut independent company created by detaching part of a parent company's assets
and operations
- Shares in the new company are distributed to the parent company’s stockholders
- Reasons for spin-offs
o Widen investor choice by allowing them to invest in just one part of the
business.
o Can improve incentives for managers
o Management of the parent company can concentrate on its main activity
o Relieve investors of the worry that funds will be siphoned from one business
to support unprofitable capital investments in another
- Investors generally greet the announcement of a spin-off as good news
o bring about more efficient capital investment decisions by each company and
improved operating performance
Carve-Outs:
- similar to spin-offs, except that shares in the new company are not given to existing
shareholders but are sold in a public offering
- Most carve-outs leave the parent with majority control of the subsidiary
o Usually 80%
o allow the parent to set the manager’s compensation based on the
performance of the subsidiary’s stock price
 - sometimes establish a market for the subsidiary’s stock and subsequently spin off the
remainder of the shares
Asset Sales:
- asset sale or divestiture means sale of a part of one firm to another
o sometimes even whole divisions
- another way of getting rid of “poor fits”
- good news for investors in the selling firm and on aver-age the assets are employed
more productively after the sale
Lecture 12: PRIVATE EQUITY AND VENTURE CAPITAL
Why Private?
- Direct negotiations between the parties, outside an official exchange market
(“public”)
- Why?
o Because finance is not simply a problem of risk-return trade-offs:
▪ "Non-standard" risks do not fit public markets
▪ "Non-standard" timing do not fit public markets
Classification:
- 1. Start-up financing - Early stage financing:
o a. seed financing
o b. start up financing
o c. first stage financing
➔ Venture Capital
- 2. Development financing - Expansion financing
- 3. Financing for the change in the company structure:
o a. Replacement capital
o b. Buy out
o c. Turnaround
Structure of PE & VC Funds: Limited Partnership
- General Partners are the private equity firm itself
o Put 1% of capital (“skin in the game”)
- Limited Partners are Institutional, HNWI → Investors
- GPs get carried interest in 20% of the profits
o Incentives
o Biggest share of earnings
o Like a call option → take risks
 - Time Horizon
o Around 10 years (leave time for later exits)
▪ Year 1-4 to gather funds
▪ Usually 5-7 years for a good exit from investments
- Investment and disinvestments
o Each € is invested only once
o As investments are exited cash is distributed to LP
- Taxation (US)
o Capital gain taxed only when received by LP
- Advisory committee
o Oversight (LP are excluded from management)
- Binding Commitments
o LP are bond to the fund for the duration of the partnership
o Severe penalties
Compensation:
- Management Fee
o 1% (PE) – 2% (VC) to cover general expenses
o Specific expenses of a deal: due diligence, legal costs….
▪ Charged directly on the fund
o % of funds managed (not necessarily invested yet)
o Funds invested ≠ funds committed
o Reserves (typical of VC)
▪ Held by GP to support future rounds of investments in existing
portfolio companies
- Carried interest
o % of Capital Gains allocated to GP (sort of performance fee)
o Further clauses
▪ Hurdle rate: GP get the CI only if the IRR is above the hurdle rate
▪ Catch-up: once the HR is reached the CI is paid on all gains
▪ Clawback: what has been paid could be returned under special
circumstances (not common now)
o Division of CI among GPs
▪ Straight-line division or tiered with the degree of seniority
Managing conflicts of interest:
- LPs and GPs face a principal – agent relationship
o GPs must provide a small % of the funds (1%)
o The management fee must leave the GP hungry
▪ The carried interest makes the difference
o Limit to concentration in a single investment (< 10 – 15%)
o Profits and realized gains are distributed rather than retained and invested
o If a GP has multiple funds under management, strict limitations on cross
investing
o GPs cannot make personal investment in portfolio companies
 o GPs cannot sell their carried interest to a third party. They are allowed to
have limited commercial interests outside of the funds
Valuation:
- Initial: cost
o Hard to use fair value since it’s hard to get an accurate vie of the value of the
company before the exit
- Later: Fair value
o Value for which an asset could be exchanged
- Write down: the company performs much less than expected
- Write up: when a new «external event» occurs
o A further external funding round (from a third party)
o Extremely good performance of the company (but being conservative)
- Valuations are a guidance about the performance of fund managers
o However hard to use in practice since it depends on judgment
o Real performance is only seen at the end (when investments are realized)
- Important to raise new funds (usually every 3-5 y)
o interim performance of the prior fund can be judged only by using subjective
valuations of the underlying portfolio companies
Venture Capital:
- Investment in the early stages of developing a project (or just an idea) or an activity
(often in small, unstructured businesses)
- Entrepreneur needs:
o capital (to finance feasibility studies and organization of the production
structure),
o commercial and organizational skills
o and consulting.
- Degree of risk: very high because there is no history of the company's activity (track
record), often there are no assets that can be offered as collateral and there are
many information asymmetries.
o The risk faced by the operator is:
▪ financial
▪ related to the product
▪ related to the market
▪ managerial
- Limited Partners
o Institutionals (Pension fund, Endowments, balanced fund managers, funds-of-
funds)
o Corporations
o Individuals
Types of Venture Capital:
- Seed financing
o The goal is the support for the development of an idea, a new entrepreneurial
initiative or the experimentation of the business
o Aimed at new products and technologies or innovative sales techniques
o It provides for the contribution of capital and technical/scientific and
managerial skills
o Financial requirement is not always high but with a high risk of failure
- Start up financing
o The investor invests even if he does not know the commercial validity of the
product/service
o Uncertainties in the commercial success of the business
o Higher amount of capital (generally) and high degree of risk
o The goal is to find and organize what is necessary to start producing and
distributing the "prototype" product
o Start production activity when the business is not yet consolidated
- First stage financing
o Purpose: to continue the production and distribution of the product on an
industrial scale
o Business not yet consolidated with little possibility of fully assessing the
commercial validity of the product / market combination
o Extensive financial resources for the strengthening of production facilities and
product distribution

Cash Flows and J Curve at a Fund Level:

- commitment to a VC fund is drawn down over time
- typical pattern of investments and disbursements made by a venture capital fund
during its 10-year life

- performance follows a J-curve

o Lemons ripen early
▪ Bad investments become apparent early
▪ Good investments take more time
 o Valuation rules are conservative
▪ Good investments only written up on a positive external event
o Fund expenses drag early performance
▪ Management fee is charged also on cash raised and not invested yet
Expected returns on a VC fund:
- A premium between 2-5% over public equities
- Reasons for risk premium
o 1. Lack of liquidity
▪ Illiquidity premium
o 2. Unclear timing of drawdowns
▪ LPs make a commitment to invest, but cash is drawn down by VC
when needed and returned only when realized
o 3. High variability in the distribution of returns of funds
▪ Difference between top and lowest quartile is very large
- Performance is often expressed as multiples of funds invested
o Simple, crude way of communicating how well a fund has done
o GP typically earns carry on all gains above the point at which the capital is
returned → emphasis on >1 multiple

- A seeming contradiction - Expected Returns on Individual in a VC Fund

o VCs seek much higher returns on individual investments then a 2-5% premium
o Good investments have to make up for bad investments (write-offs and
sideways)
o if the fund is to return two and a half or three times the capital subscribed to
its LPs, the good investments need to yield a 6 to 7 multiple
o Venture capital investors generally say that they will invest in a company only
where they can see a way to earning a 10 times or higher multiple on the
investment
- The importance of big winners
o distribution of capital returned from investments across a venture capital
portfolio is striking because of the extreme differences from company to
company
o big hits needed to provide the level of return
o big hits are the difference between the highest-performing venture capital
firms and the average one
Portfolio Construction:
- Number of investments
o Use heuristics such as,
▪ One-third will be complete write-offs, one-third will be sideways, and
one-third will be big hits
o Most funds aim to have 15 to 25 investments in a portfolio
- Sector
o ongoing debate in the sector as to whether funds should cover multiple
sectors or focus on one
o easier for a firm to build expertise in a narrow domain area
- Geography
o want to make investments locally
▪ have physical access to the investments
- Stage of investing
o Normally focus on a stage

Private Equity:
Expansion financing:
- Intervention in situations where there is an activity already developed.
- Objective
o to support company development, expand production capacity, develop new
products and / or markets and consolidate financial sources linked to
medium-term growth strategies.
- The development objective could sometimes be related to the desire to reach the
size necessary to be able to be listed => "bridge financing" or pre-IPO.
- The risk of failure is less than the early-stage financing
o as historical and forecasting information is available to understand and
evaluate the potential of the company
Financing for change:
- Replacement
o When one or more minority shareholders of the company decide to leave the
business activity or there are disagreements among the shareholders /
successors it becomes necessary to buy their shares to replace the property.
o Private Equity replaces one or more members who want to sell their
investment
o There are no major changes in the business
- Buyout
o There is the willingness to radically change ownership (changing the majority
o or the entrepreneurial subject).
o The intervention of the Private Equity operator takes the form of financial
support to change the ownership structure by supporting the new business
group in the acquisition of the divested business
o Types of buyouts
▪ Management buyout (MBO)
• internal managers decide to buy the company
▪ Management buy in (MBI)
• external managers decide to buy the company
▪ Buy in management buyout (BIMBO)
• Both internal and external managers decide to buy the
company
▪ Employee or worker buyout
▪ Family buy out
• one member of a family wants to buy the shares of the others
▪ Reverse buy out
• bringing back into publicly traded status a company that had
been privatized by way of a leveraged buyout
- Turnaround
o Corporate crises can generate the need for change
o The intervention of the Private Equity involves
▪ Financing the restructuring of companies in loss or in financial crisis
through investments in capital or in financial instruments similar to
equity
▪ Change of the owner and managerial group
o In addition to significant capital for the reorganization of the company,
managerial skills are provided
Are Private-Equity Funds Today’s Conglomerates?
- conglomerate is a firm that diversifies across a number of unrelated businesses
- Reasons for conglomerates in 1980s
o diversification across industries
▪ supposed to stabilize earnings and reduce risk, no advantage
o operate an internal capital market
 ▪ free cash flow from mature divisions funneled to divisions with
profitable growth opportunities → no need to raise financing from the
outside
• managers probably know more about its investment
opportunities than outside investors
• But
o Internal markets are not markets but a combination of
central planning and intracompany bargaining
o Large mature divisions have more power then small
divisions with growth opportunities
→ Subtract value more then add – bureaucracy
o Good managers are fungible
▪ Partially agreeable
▪ Improve business through better management
- Conglomerates are problematic due to
o Hard to keep track of investment opportunities in all industries
▪ More misallocations
o divisions’ market values can’t be observed independently
▪ difficult to set incentives for divisional managers
- Pes can be seen as temporary conglomerates
o Conglomerates buy, fix and hold
o PE buy, fix and sell
- PE differ
o Funds from one not put into another company
o Each company run as a separate business
▪ Better compensation and reporting

PE partnership pros:
- Reduce the “short termism” of listed companies
o But time frame of PEs also only 10 years
- CI give GMs plenty of upside
o Strong motivation to deliver a profit for LPs
- CI is a call option, incentive to take risk
o VCs invest in early stages
o PEs buyout with leverage
- No separation between ownership and control
- No free-cash-flow problem
o Cash realized must be distributed