Assignment 1- Case study

SHIVAM SHARMA
VARTIKA SHUKLA
ANAND SARANG

PGDBFS 01 (2019-20)

Dated: 09-01-2020

SVKM’s NMIMS

Deemed to be UNIVERSITY

Bengaluru Campus

Page 1 of 6
A Note on the Initial Public Offering Process

As a coin has two sides in the same manner firms going public will have both advantages as well as
disadvantages. The most important aspect is to raise capital, most of the private equity groups are
restricted from investing not more than 10% to 15% of their capital in a single firm. Second is the
desire to achieve liquidity. Thirdly going public may help the firm in its interactions with customers
or suppliers. A firm which is public will project an image of stability and dependability.

As far as the drawbacks are concerned, going public involves some costs, from legal to accounting to
investment banking, the fees totals to approximately 10% of the total amount raised. Secondly, the
inconvenience caused because of too much of scrutiny and disclosures is distressing. Thirdly if a firm
going public with its IPO is made to withdraw it due to reasons that are not in the control of the
company then this will result in maligning the image of the company.

The very initial step in going public process is the selection of underwriter. Selection is an important
step as it is done based on their reputation in the industry, performance of past IPO’s underwritten
by them and the commitments made to provide analyst coverage in the months or years after the
offering. Firms can select multiple underwriters to manage their offerings. Even before the offerings
are marketed, the underwriter plays an important role which include undertaking due diligence on
the company, determining the size of offering and preparing the marketing materials. Permission
from one or more regulatory bodies is required before a firm can go public. Regulatory bodies focus
on whether the company has disclosed all the information or whether the offerings are
appropriately priced.

After this the investment bank begins the process of marketing the offering and a “red herring” is
circulated. The firm also undertakes a “road show” in which the management team describes the
company’s lines of business and prospects to potential investors.

The United States uses a mechanism called “book building” in order to determine the prices. In this
process the underwriter after analysing the potential investor predicts about the number of shares
that will be demanded at each proposed price which helps him to set the best price for the
company. All the analysis done by the lead underwriter are recorded in a central “book”. In other
countries the share prices are set before the information about the demand is gathered. Although
countries like Britain and Japan are imitating the US.

Well known investment banks undertake only “firm commitment offerings” in the investment banks
commits to sell the shares to investors at a decided price. The price is decided the night before the
offering reducing the risk of not being able to sell the shares. While the prices are decided the
bankers also factor in the information about the valuation of comparable firms and also the
discounted cash-flow analysis of the firm’s projected cash flows.

While a medium firm goes through a very modest increase in its price, but a significant number of
firms have experienced a good jump in their prices after going public, for example, the prices of
companies like Yahoo!, TheGlobe.com and the Internet Capital Group saw a jump of several hundred
percent on their day one of trading.

Page 2 of 6
Some of the possibilities for the same are given below-

 Increase in price or discounts offered to the investors who purchase the IPO shares is
important to attract more investors.
 After the sophisticated investors express their willingness to purchase the stocks the less
sophisticated investors would rush to buy the shares.
 The investment bank has “market power” which means the bankers intentionally set low
prices in order to transfer the wealth to their favoured clients.

In the United States the underwriters also try to prevent the prices of the share from falling
below the offering price. For this they use the “Green Shoe” option, in which the banker
sells 15% of the projected offering size and if the shares prices rise after the offering the
bank declares it to have been 15% larger than the size which was projected initially, but if
the prices fall the bank buys back the additional 15% of the shares sold. In this way the
bank supports the stock price effectively while profiting from its trading strategy.

Even after offering this association between the underwriter and the portfolio company
continues, especially in the countries like the US, where the bank serves as a market maker
or a trader who is responsible for insuring the systematic transactions each day for months.
The underwriter goes on to become a financial advisor and is usually employed as an
underwriter in future also.

Page 3 of 6
Freeport-McMoRan (Financing an Acquisition)
Freeport-McMoRan Copper & Gold would become the world’s largest publically traded
copper company upon its acquisition of Phelps Dodge. This acquisition will help FCX to
increase it’s geographical reach, diversify it’s asset and lower the cost of capital. The
resulting company would continue with its investment in future growth opportunities with
high rates of return and will seek to reduce its debt by using the cash flows which are
generated from the resultant business.
As per FCX it was a company that explores for, develops, mines, and processes ore
containing copper, gold, and silver in Indonesia, and smelts and refines copper concentrates
in Spain and Indonesia. While Phelps Dodge was one of the world’s leading producers of
copper and molybdenum and is the largest producer of molybdenum-based chemicals and
continuous-cast copper rod. The merger was being announced after the price of copper
increased due to high demand from China, making FCX the world’s largest publicly traded
company.
On 19th November 2006, FCX and Phelps Dodge signed the merger agreement in which FCX
bought Phelps Dodge for $25.9 billion in cash and stock. FCX was to acquire all the
outstanding shares of Phelps Dodge, and would pay them in cash and FCX shares. Each
Phelps Dodge share would get $88 as cash and pus 0.67 as FCX share and the total value will
amount to $126.46 per share. This represents a premium of 33 percent to Phelps Dodge’s
closing price on November 17, 2006, and 29 percent to its one-month average price at that
date.

Initial the announcement got a mixed response from the Wall Street analysts. As per Bear
Stearns Equity Research there would be several positives aspects of this transaction:

 an improved cost position (vs. PD standalone);

 long reserve life;
 a more diversified geographic footprint;
 an attractive growth profile;
 enhanced management depth.

JPMorgan and Merrill Lynch were selected to advice about the merger and underwriting of
the financings because together they committed $6 billion in bridge loans and to underwrite
the entire $17.5 billion in debt financing, plus $1.5 billion in credit lines. This created
significant risk by aligning the interests of FCX and the two firms in terms of placing the debt
and credit with other banks and institutional investors. Because this commitment was
critical in facilitating the M&A transaction, FCX gave all of the book-running and M&A
business to these two firms. JPMorgan and Merrill Lynch had guided FCX through the M&A
pre-deal conception and the activity targeting Phelps Dodge. In addition, both the firms held
high positions in league tables for financings, M&A and had existing long-term relationships
with FCX’s management. But the key to their fee bonanza was the risky commitment to
provide bridge loans if placement was not possible in the capital markets.

Role of investment banks in merger and accusation is very crucial, JPMorgan and Merrill
Lynch were associated with this merger in every step, and companies choose investment

Page 4 of 6
banks based on their existing relationship in addition to factors such as execution capability,
independent research function and league table rankings.

JPMorgan’s leveraged finance group was responsible for making the bridge financing
commitment that allowed FCX to make a bid for Phelps Dodge. In order to ensure that the
M&A transaction could be carried out properly, it became very essential to line up the
financing of the acquisition. This leveraged financing became particularly important as FCX
was taking new debts as it was acquiring a company larger than itself. The leveraged finance
group had to analyse everything from the new capital structure to the impact on credit
ratings to the ability to “resell” the debt to other investors and banks. The group had to also
lead the effort to secure internal firm commitments and gain acceptance for associated
capital charges. The group’s understanding of the market played a very crucial for the
success of the acquisition.

Capital risk is the financing risk associated with an investment bank’s underwriting
commitment in relation to financing an acquisition. Whenever an investment bank has to
fund an acquisition through an underwriting, the bank has arrange road shows between
potential investors and the management of the issuing company and then for potential
investors in order to subscribe the offering. The firm sets aside capital when it takes on an
underwriting risk position. If the firm bears market risk, it means that it will buy securities at
the offered price if the investors do not, the capital set aside could play a significant role
here in this case. If the issuer bears market risk, the firm still has a small amount of risk, for
which it must set aside a small amount of capital. Setting aside capital means placing cash in
a risk-free security such as a treasury bond, this provides a return below shareholder’s
equity return requirements, so it is considered as an opportunity cost. The risk that comes
from associating the investment banking firm with the company for which it is raising capital
or completing an M&A transaction is called reputation risk. Before an investment bank
brings security investment ideas to investors or attempts to complete an M&A transaction,
it is important that the bank consider the quality of the companies it represents. If a
company has had or is expected to have serious problems, an investment bank’s “brand”
can be negatively affected, making reputation risk an important consideration.

Credit rating agencies were critically important to the transaction because they determined
the credit rating associated with the post-acquisition capital structure of FCX. The higher the
credit rating, the lower the cost of debt capital. This, in turn, could affect valuation of the
company’s stock and return on equity. A ratings agency group within the debt capital
markets group has the responsibility of advising corporate clients regarding the probable
rating decision resulting from alternative financing structures. This group works closely with
both the high-grade and leverage-loan teams within debt capital markets. With regard to
the FCX acquisition of Phelps Dodge, the credit ratings on different debt portions improved
due to the significant increase in cash flow and because Phelps Dodge had a higher credit
rating than FCX.

Michael Gambardella, the metals and mining industry analyst in JPMorgan’s equity research
team, was “restricted” from providing an investment opinion on shares of FCX because
JPMorgan had acted as an advisor on the M&A transaction and therefore had inside

Page 5 of 6
information. Gambardella was able to meet with JPMorgan’s institutional sales force to
provide an overview of the equity and convertible offerings and answer questions. He was
not, however, allowed to express an opinion on the pricing for these offerings. Gambardella
also wrote research on competitor companies, which was used by FCX in the analysis of
both the M&A transaction and the equity-related offerings. Since 2003, the role of equity
research has changed dramatically. Before then, equity researchers frequently joined
investment bankers in soliciting mandates, and they committed to writing research if an
equity transaction was book-run by their firm. The research opinion was often favourable,
which aided in marketing the deal. Following an April 2003 SEC enforcement action against
major investment banks, equity researchers have been completely walled off from
investment bankers. Bankers cannot pay research professionals any compensation.
Researchers cannot join bankers in pitches to clients or even talk with bankers without a
“referee” present. Furthermore, they are not allowed to write research or suggest what
their research opinion may be with regard to a specific company that is under an
investment-banking mandate.

Clients include mutual funds, hedge funds, pension funds, insurance companies, and other
large institutional investors. A limit order is created when a buyer places a “limit,” or ceiling,
on the maximum price the buyer will pay for a given number of securities. This makes the
sales process more difficult because the sales team is asked to sell securities at the highest
possible price. If especially large purchase orders include limits, the pricing for the offering
will sometimes have to be lowered to accommodate the large orders. Limit orders often
come from buyers, such as Fidelity, that the issuing company wants as long-term investors.
An inherent trade-off exists, as the sales team must determine the correct balance between
allocating shares to large, desirable investors with orders that may include limits and
smaller, lower-priority investors that do not require limits.
The Equity Capital Markets Syndicate group coordinates with sales force management to
decide among investors when demand exceeds supply, and when limit orders are provided
by large potential investors. Ultimately, this group decides the price range at which the
security is offered and the final price at which the security will be sold. The group keeps
close contact with the markets, especially with regard to comparable offerings, in order to
gauge the current appetite of investors for specific structures, deals, and industries.

Page 6 of 6