Solution Manual for Investment Banks, Hedge Funds, and Private Equity, 3rd Edition

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Questions & Answers:Chapter 1–Overview of Investment BankingQ1.What were the two main arguments for rejoining investment banks and retaildeposit-taking banks that led to the passing of the Gramm-Leach-Bliley Act?A.The first argument is that therejoining of the two banking businesses providesfor a more stable and countercyclical business model for these banks. Thesecond argument is to allow US banks to better compete with internationalcounterparts that were less encumbered by the Glass–Steagall Act.Q2.Describe the three principal businesses of an investment bank.A.The investment banking division arranges financing for governments andcorporations as well as advises on M&A transactions. The sales and tradingdivision sells and trades securities and other financial assets as an intermediaryon behalf of institutionalinvesting clients, and provides research to investingclients. The asset management division is responsible for managing money forindividual and institutional investing clients.Q3.Why might a universal bank be better able to compete against a pure-playinvestment bank for M&A and other investment banking engagements?A.Universal banks arebetterable to usetheir balance sheettolend moneytocorporations.Some companies prefer doing business with a bank that can bothprovide loans and investment banking products like M&A.Q4.Investment bank clients can be categorized into two broad groups of issuers andinvestors. These two groups often have competing objectives (issue equity at highestpossible price vs. acquire stock in companies at lowest possible price).Who withinthe investment bank is responsible for balancing these competing interests?A.ECM bankers are the intermediariesbetween these two parties and are chargedwith balancing the needs of each.Q5.What is a key consideration in determining thecost and otherparameters of acorporate debt offering and why is it important?A.Credit rating: impacts future cost of debt; also could trigger covenants in existingdebt.If lowered to below investment grade, certain institutional investors can nolonger invest in the company’sbonds orcommon stock.Q6.Why might an investment bank place higher priority on sell-side M&A engagementsover buy-side engagements?A.Completion-based fees: higher certainty of closing with sell-sides. In buy-sides,clientis up against other bidders andmay not win the bid.Q7.What is two key considerations for bankers in the debt capital markets divisionwhen working with an issuer on an offering?

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A.Determining the likely impact that a new debt offering will have on the issuer’scredit ratings and investor reaction to a potential offering.Q8.Define proprietary trading.A.Using the bank’s own capital to make short-term, nonclient-related investmentsinsecurities, commodities, and derivatives for the bank’s own account, which issimilar to the investment activity of hedge funds.Q9.Whatconflicts might exist between a proprietary trading businessand the rest ofthe investment bank?A.Proprietary trading competes with the bank’s hedge fund clients for tradeopportunities. In addition,weak compliance policies could lead to lapses inconfidentiality,which mayresult in trading on confidential information fromother parts of the bank.Q10.What conflicts might exist as a result of having both an Asset Management businessand a Private Wealth Management business?A.PW advisors may be encouraged to invest client assets in funds managed by theAM division, even when it’s not inthe best interest of the client.Chapter 2–Regulation of the Securities IndustryQ1.Following the 1929 Stock market crash, Congress passed a series of Acts to regulatethe securities industries. Name four of these Acts and briefly describe their purpose.A.The four Acts are:i.Securities Act of 1933–mandated all securities to be properlydocumented and disclosed to the investing public.ii.Securities Act of 1934–created the Securities and Exchange Commission(SEC) to oversee the trading practices of the securities industry.iii.Investment Company Act of 1940–regulated investment companies suchas mutual funds. The Act mandated that open-end mutual funds couldnot take on debt and closed-end funds had restrictions on theirleveraging capacity.iv.Glass Steagall Act: separated deposit taking and loan making “commercialbanking” from underwriting “investment banking.”Q2.A goal of manypartsof U.S. regulatory legislation has been to eliminate/minimizeconflicts of interest between issuers, investment banks, and investors.Provide

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examples of conflicts of interest in the U.S. investment banking industry and thecorresponding regulations that attempted to resolve those issues.A.Sell-side research vs.banking division: global research settlement; spinning:global research settlement; insider trading:’34 Act; independence of outsideauditors: Sarbanes-Oxley; commercial banks vs.investment banks:Glass-Steagall; bankers’ involvement in bankruptcies: Chandler Act;investmentbank/mutualfund cross holdings/mgmt: ICA 1940.Q3.Disclosure of information to investors is another recurring theme in U.S. regulationof the securities industry.Provide examples of disclosure required by U.S.regulations.A.Securities Act of 1933: investors must receive financial and other significantinformation about a company offering securities for public sale; ’34 Act: periodicreporting of information by companies with publicly traded securities; ICA 1940:investment companies must disclose financial condition and investment policiesto investors; Sarbanes-Oxley: greater disclosure of off-balance sheettransactions, disclosure and reconciliation of non-GAAP financial measures;global research settlement: disclosure of potential conflicts of interest betweenthe research department and the investment banking department.Q4.What is therole of statesin the U.S.in regulating investment banks?A.Only anti-fraud matters.Q5.What type of U.S. securities offerings do not need to be registered with the SEC?A.Private offerings to limited number of persons or institutions; offerings of limitedsize; intrastate offerings; securities of municipal, state and federal governmentsQ6.What is a “Red Herring”?A.A “Red Herring” is a preliminary registration statement that has been filed withthe SEC and which carries a front-page statement (written with redink) whichcautions prospective investors that the SEC has not approved the registrationand sales cannot be completed until a “final” registration statement is declaredeffective by the SEC and is delivered to investors. Red Herrings are provided bysales people to their prospective clients to educate, rather than to be used as afinal sales document.Q7.Before an SEC registration statement is declared effective, companies (or theirunderwriters) that sell stock or are deemed to be promoting the sale of stock have asecurities law problem. What is this problem called and what are its consequences?A.Gun jumping. The company must withdraw the issuance until the SEC is satisfiedthat no fraud or manipulation has occurred. The company may also be requiredto pay a fine.

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Q8.What are the “Risk Factors” in a prospectus? Why are they important to the issuerand to the investor?A.Risk Factors are disclosures about potential problems the company mayencounter, including possible losses, unpredictable revenue, capacityconstraints, reliance on suppliers, technological change, competition, litigationregulation, customer mix, etc.i.Issuer: The issuer must list every reasonable risk in order to meet fulldisclosure requirements of securities laws and to therefore have adefense in case they are sued by shareholders if the company’s shareprice drops.ii.Investors: Investors should read these disclosures to ensure that theyunderstand all relevant risks before making decisions regarding purchaseof securities.Q9.What is the significance of the Gramm-Leach-Bliley Act of 1999 in relation to thesecurities industry?A.The Gramm-Leach-Bliley Act, in essence, repealed the Glass Steagall Act of 1933and allowed the creation of financial holding companies that could participate inboth commercial and investment banking, a practice formerly separated by theGlass-Steagall Act. This act paved the way for conglomerate, multi-serviceproviders such as Citigroup and JP Morgan and permitted the convergence ofbanking, insurance and securities businesses.Q10.What are some securities regulations in place in the U.K., Japan and China thatmirror U.S. regulations?A.Japan and China: Originally separated the functions of commercial andinvestment banks (these changes happened within a much shorter time framefor China). Later, like the U.S., those restrictions were eliminated. Also, variousJapaneselaws requiring disclosure and internal controls in public companieswere similar to those in the U.S.TheU.K. also has an SRO system like the U.S.Chinainstitutedanti-fraudandinsider trading rulesin 2005 similar to those inthe U.S.Q11.What are some major differences between the regulatory frameworks of the fourcountries covered in this chapter?A.One main difference is the U.S. has somewhat fragmented and decentralizedsecurities regulatory bodies,whereas in the other three countries, securitiesregulation is centralized.Q12.Compare the regulatory bodies ofthe four countries covered in this chapter.A.TheFinancial Supervisory Agency in Japan, theFinancial Services Authority inU.K., and the China Securities Regulatory Commissionare the sole financial

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regulators in those countries. In the U.S., the two main regulators are the Fedand the SEC. In addition, entities such as the Commodity Futures TradingCommission and the FDIC also have regulatory powers.Q13.What does the Dodd-Frank Act of 2010 mainly focus on?A.This Act mainly focused on protecting consumers, ending “too big to fail”bailouts, improving coordination between various regulatory agencies,identifying systemic risk early, creating greater transparency for complexfinancial instruments and providing greater transparency for executivecompensation.Chapter 3–FinancingsQ1.What type of securities offerings do not need to be registered with the SEC?A.144A private placements to QIBsQ2.List the three types of bank participants in an underwriting syndicateand their coreresponsibilities, in order of compensation received, from high to low.A.Lead bookrunners; co-managers; selling groupQ3.W hat are league tables and why are league tables important in investment banking?A.Record of underwriting volume and M&A advisory volume. They keep score onwhich investment banks are completing the most and largest volume oftransactions, giving them a marketing advantage in soliciting new business.Q4.Describe the function of the equity capital markets group, including the two majordivisions they directly work with and the two types of clients they indirectly workwith.A.They are an intermediary between the trading division and the investmentbanking division, providing information regarding the equity market, includingpricing, structure and timing advice to corporate issuers of equity andconvertible securities. Their indirect clients are corporations and, through equitysales colleagues, institutional and high net worth investors.Q5.Describe the unique process utilized by Google in its IPO, intended advantages andpotential disadvantages.A.Google utilized a Dutch auction where the highest bid that allows a company tosell all the shares it wants to sell is the price at which all shares are sold. Acomplex software program was written to meet Google’s requirements for totaltransparency andGoogle had the right to increase or decrease the sharesoffered and the price range of acceptable share bids from investors.

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i.Advantages: obtain higher offering price; enable greater “retail” investorparticipation; smaller first day gains; similarity to Google’s full businessmodel.ii.Disadvantages: winners curse–pushing price too high, reducing demandand dropping share price; poor participation by large institutionalinvestors; more volatile trading; disgruntled investment bankers. Inhindsight, Google’s Dutch auction actually resulted in minimal retailparticipation since Google did not allow selling concessions to retailbrokers.iii.In addition, with little input on pricing from institutional investors,Google’s IPO was arguably underpriced as it experienced an 18% gainduring the first day of trading.Q6.What is a shelf registration statement and what securities can be included in it?A.An S-3 registration with the SEC that enables issuers to sell either debt, commonshares, preferred shares or warrants anytime during a 2-year period, without anyregulatory delays, as long as the issuer keeps its financial statements updated(through 10-Qs) and material information is made available to the public.Q7.Whymight ayounger high-techcompanyselect equity over debt when raisingcapital?A.These companies tend to have a smaller asset base, less stable cash flows, andgreaterneedsfor funding. An equity raise offers the company more financialflexibility.Q8.A BBB-/Baa3 rated company is looking at acquiring a smaller (but sizeable)competitor. Discuss considerations the company should take into account whendeciding whether to fund the acquisition with new debt, equity, or convertiblesecurities.A.The company needs to look at what debt will do to leverage ratios and whetherthat would lead to a potential ratings downgrade. On the equities side, thecompany needs to determine how much potential dilution there is to currentequity holders if the transaction is paid with stock (the analysis should take intoconsideration potential synergies from the transaction).Convertibles should beconsideredif the company wants a lower coupon bond financing (with dilutionrisk) or (through a mandatory convertible) a potentially less dilutive equityoffering.Q9.Suppose a company issues a $180 million convertible bond when its stock is tradingat $30. Assuming it is convertible into 5 million shares, what is the conversionpremium of the convertible?

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A.$180 million / 5 million shares = $36. $36 / $30 = 1.2➔20% conversionpremiumQ10.How many shares will beissued by a convertible issuer if conversion occurs for a$200 million convertible with a conversion premium of 20%, which is issued whenthe issuer’s stock price is $25? (show your calculation).A.$25 x 1.20 = $30. $200,000,000 / $30 = 6,666,667 sharesQ11.Why did the SEC delay declaring Google’s IPO registration effective?A.An interview with the CEOwas published during the quiet period precedingpricing of the company’s IPO.Q12.Provide seven reasons that an investment bank might give to support their advicethat a private company should “go public”.A.The seven reasons include:i.Access to a vast, continuing source of capitalii.Liquidity and non-cash compensation for employees (give employeesstock or options to incent existing employees and find newemployees)iii.Wealth creation–principals can sell their shares in a secondary offeringiv.Prestigev.Create an acquisition currencyvi.Increase confidence in suppliers and creditorsvii.Liquidity for investorsQ13.List six characteristics of companies that are good targets for an equity issuance.A.The characteristics include:i.In favor sector, strong stock performance or supportive equity researchii.Large insider holdings or small float/illiquid tradingiii.Overly leveraged capital structureiv.Strategic event: finance an acquisition or large capital expenditurev.Sum of the parts analysis indicates hidden valuevi.Need more investor focus based on a roadshow and additional researchQ14.How does a negotiated (best efforts) transaction differ from a “bought deal”?A.In a negotiated transaction, the lead underwriter will “explore” the appropriateprice for a securities offering based on input from prospective investors,resulting in the issuer taking price risk. In a bought deal, the lead underwritercommits a firm price to the issuer, resulting in the underwriter taking all pricerisk in relation to a resale to investors.Q15.What are some methods used by investment banks to help equity issuers mitigateprice risk during the marketing process?A.Accelerated offering, block trade, over the wall offering, green shoe optionQ16.Explain what a “green shoe” is.

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A.Green shoe is the industry term for a 15% overallotment option: the name camefrom a company with this name that was the first user of this option.Overallotments are created to provide price support for stock in a new offering:the underwriter sells moreshares in the offering than the issuer originally agreesto sell, creating a “short” position.Q17.When a company has agreed to a green shoe, who does the underwriter buy sharesfrom if the share price drops? Who do they buy shares from if the share priceincreases?A.If, after issuance, the share price drops, the underwriter can stabilize the price bybuying stock from investors to cover the short. If the share price increases, theunderwriter can buy up to 15% more shares at the offered price from the issuerto coverthe short, utilizing the green shoe option.Q18.Calculate the investment bank’s fees and profit for a 5 million share equity offeringat $40/share, with a 15% green shoe option (fully exercised) assuming a 2% grossspread,assumingthe issuer’s share price decreases to $38/share after the offering.A.Total fees and short profit of $3.5 million:-Investment bank (IB)sells 5 million shares @ $40/share = $200 million inproceeds.-IBshorts 750,000 shares at $40/share = $30 million in proceeds.-IBbuys back 750,000 shares at $38/share and pays $28.5 million to cover itsshort.-$30 million-$28.5 million = $1.5 million in short-related profit.-Fee of 2% on the $200 million issuance = $2 million-Total fees and short profit of $3.5 millionQ19.What is the tradeoff for having a stabilizing green shoe option in a common equityoffering?A.Additional dilution from the extra sharesChapter 4–M&AQ1.Provide definitions for strategic buyers and financial buyers in a prospective M&Atransaction.A.Strategic buyers are companies in the same industry as the target companiesthat they attempt to acquire. The acquirer has a permanent investment horizonin mind and identifiable synergies and strategic benefits. Financial buyers areLBO funds (and occasionally hedge funds) that target companies to acquirebased on the use of leverage and cost cutting, as opposed to synergies, as thevehicle to derive value from the investment. These buyers usually have a 20%IRR objective and an exit strategy within three to seven years.

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Q2.Why have strategic buyers traditionally been able to out bid financial buyers inauctions?A.Strategic buyers are able to capture synergies that financial buyers cannot. Costsynergies lead tolowerexpenses and margin expansion. Revenue synergies leadto top line growth andusually, profit growth. Both of these increase future cashflow projections which lead to higher valuations.Q3.Why are revenue synergies typically given less weight than cost synergies whenevaluating the combination benefits of a transaction?A.Revenue synergies are more difficult to estimate and capture. Requires a lotmore assumptions than costsynergies.Q4.In the U.S., if an M&A transaction is relatively large within its industry, what is thename of the regulatory filing that is probably necessary before the transaction canbe consummated? Which agency is it filed with? How long is the waiting periodafter a filing is made? What is the name of the European regulator that may berelevant in an M&A transaction?A.Hart-Scott-Rodino (HSR) filing. This is filed with the Federal Trade Commission(FTC), which is part of the Justice Department. There is a 30-day waiting periodfollowing filing. The European Commission (EC) is the relevant Europeanregulator for M&A transactions.Q5.Assume an acquiring company’s P/E is 15x and the target company’s P/E is 11x. Isthe acquirer more or less likely to use stock as the acquisition currency? Why?A.Stock-accretive transaction. Stock at 15x is a more valuable currency.Q6.What is a potential risk of trying to complete a stock-based acquisition duringperiods of high market volatility?A.If fixed exchange ratiodeal, significant fluctuations in share prices could lead tohigh variations in the final economic value of the deal; if floating exchange ratiotransaction, a down market could lead to more shares issued to pay for thetransaction, thereby diluting existing shareholders more.Q7.Assume an investment bank has provided a fairness opinion on a proposed M&Atransaction. Does this mean the board should go ahead and approve thetransaction?A.Maybe. The fairness opinion only states that the deal is “fair from a financialpoint of view”. It does not review the deal on the merits of its strategicrationale.Q8.Why mighta board want to includea “go-shop” provisioninthe merger/purchaseagreement?A.It helps protect the board against shareholder lawsuits relating to Revlon Duties.Q9.When is a break-up fee paid? What is the normal fee as a percent of equity value?

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A.A break-up fee is paid if an M&A transaction is not completed because a targetcompany walks away from the transaction after a merger or sale agreement issigned. The fee is usually set at 2-4% of the target company’s equity value.Q10.Under what circumstances would an investment bank hold a public auction in anattempt to help sell a company?A.When the company to be sold is unlikely to be damaged or disrupted by thepublic process, and the investment bank expects difficulty in finding a buyerwithout a public auction. This process is designed to obtain the highest offer.Q11.List the four principal alternative methods for establishing value in an M&Atransaction.A.Discounted cash flow analysis; publicly-traded comparable company analysis;comparable transaction analysis; leveraged buyout analysisQ12.Of the major valuation methods which one(s) are based on relative values? …onintrinsic values? …on ability to pay?A.Relative:comparable company/transaction; intrinsic: DCF; ability to pay: LBOQ13.Suppose you are the sell-side advisor for a multinationalhousehold andpersonalproducts manufacturerand marketer that sells primarily to the mass consumermarkets. The analyst on your deal team prepares the following comparablecompanies analysis. Which, if any, of the companies in the list would you potentiallyremove from the analysis?A.P&G may be too big; Prestige may be too small; McBride only sells in Europe(and may be too small)Q14.Which valuation method tends to show the lowest valuation range? Why?A.Comparable companies–no control premium. DCF w/no synergies can also belowQ15.Which of the followingcompanies would make a better LBO target, and why? (a) adiversified manufacturer of consumer snack products or (b) a manufacturer ofComparable Companies Analysis$ in billionsLocationMarket CapEnterpriseValue (EV)LTMRevenueLTMEBITDALTM EBITDAMarginEV /RevenueEV /EBITDAAlberto Culver Co.U.S.$2.4$2.3$1.5$0.211.2%1.5x13.1xBeiersdorf AGGermany$15.9$15.1$8.0$1.214.6%1.9x12.9xChattem Inc.U.S.$1.4$1.7$0.4$0.129.4%4.4x15.1xChurch & Dwight Co.U.S.$3.9$4.2$2.1$0.315.6%2.0x12.7xColgate-Palmolive Co.U.S.$42.8$41.9$13.4$2.921.8%3.1x14.4xHenkel KGaA Nvtg PrfGermany$21.6$26.2$19.3$2.513.0%1.4x10.5xMcBride PLCU.K.$0.3$0.9$1.2$0.18.7%0.8x9.2xPrestige Brands Holdings Inc.U.S.$0.4$1.0$0.3$0.131.5%3.0x9.6xProcter & Gamble Co.U.S.$232.2$268.1$77.9$18.924.3%3.4x14.2xReckitt Benckiser Group PLCU.K$38.1$41.3$10.3$2.726.1%4.0x15.4x

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factory automation equipment for car makers, agricultural equipment and otherheavy machinery.A.(a)–more stable cash flows; lower capital expenditures.Chapter 5–TradingQ1.When might an investment bank declineparticipationin an underwritingand why?A.When the perceived risks of participation outweigh the expected underwritingfees. One possible risk is if the trader believes demand for new securities fromthe issuer is lower than the contemplated issuance size. Alternatively, theinvestment bank could have severalpotentialunderwritingcommitmentsatonce, and needs to ration the regulatory capitalthat must beset aside.Finally,the firm could decline because of reputational concerns or problems foundduring due diligence.Q2.How do professionals in sales, trading and research work together?A.Research provides investment ideas to sales, who contacts the bank’s investingclients with specific trade ideas based on research’s recommendations. Shouldthe client decide to go ahead with the trade, sales works with traders to executethe trade.Q3.Describe what Prime Brokerage is, including four principal products in this area andthe generic name of the financial institutions that are targeted for this business.A.Prime Brokerage is a Trading Division business area that focuses on hedge fundsand provides the following products: lending and clearing securities; marginloans; securities trading; securities processing and clearing; global securitiescustody and trustservices; cash management and asset administration.Q4.Explain traders’ market-making function.A.The traderprovides bid and offer pricesto the bank’s investing clients that wantto sell or buy a specific security that the bank covers. This provides clients withdependable liquidity on those stocks covered by the bank (could be securitiesunderwritten by the bank or just those the bank elected to cover).Q5.Why would a prospective issuer prefer tohire as underwriteran investment bankthat has traders already active in its security?A.By already being active in a security, the bank may have a better understandingof who the potential investors are and may have already developed arelationship with those investors. As a result, the bank may be able to bettergauge overall market sentiment and demand for the new issuance.Q6.FICC is one of the main Divisions in an Investment Bank.What does FICC stand for?Other than during 2007 and 2008, how does this division typically rank from aprofitability point of view, compared to other Divisions? What happened during

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these two years and which part of the FICC Division was most responsible for thisoutcome?A.Fixed Income, Currencies and Commodities. FICC is typically the most profitableDivision. However, during 2007 and 2008, there were huge losses in this Divisionfrom significant investments and underwriting in subprime mortgage securitiesand, to a lesser extent, from bridge loans and off-balance sheet liabilitiesassociated with SIVs.Q7.Why might a high short interest ratio be potentially misleading with respect to theopinions of market participants regarding a particular stock?A.A largeportion of the short interest reported for some companies is due tohedge funds taking short positions in order to hedge share price risk on sharesthat underlie the convertible securities they hold.This short interest does notconvey a bullish view on the stock since it relates to hedging the convertible.Q8.An investor lends 10,000 shares of ABC fortwomonthswhen the stock is at $50andrequires 102% cash collateral.The market interest on cash collateral is 4.0%. Therebate rate on ABC shares is 2.5%. Calculate thecombined profit for the stocklender and investment bank.A.10,000 x $50x 102%= $510,000cash collateral. $510,000 x (4% / 6) = $3,400➔market interest. $510,000 x (2.5% /6) = $2,125➔rebate amount.$3,400-$2,125 = $1,275.Q9.What risks do investors take on when buying on margin?A.If the value of the investor’s collateral drops, the investor must depositadditional cash, or other collateral. In the case of a precipitous drop in the valueof the collateral, investors may be forced to liquidate assets at below marketvalue prices in order to meet the margin calls of investment banks.Q10.Howweresenior tranches of a CDO able to obtain investment grade credit ratingswhensome ofthe underlying assetswerenon-investment grade?A.Rating agencies, issuers and investorsbelieved that risk can be decreasedthrough the diversification of theassets underlying the CDO and that by slicingthe CDO into tranches, the risk of a pool of assets is stratified. The most seniortranche is able to receive investment grade rating because the lower tranchesabsorbthe initial losses.Q11.A domestic airline based in the U.S. has placed a large $10 billion order for newairplanes with French aircraft manufacturer Airbus. Delivery is scheduled in fouryears. Payments are staggered based on a percentage of completion rate.The U.S.airline believes the Euro will appreciate against the Dollar during this time frame.How can the U.S. airline hedge currency risk related to this purchasewith aninvestment bank?

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