Day 8
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Transcript of Day 8
- Classification of Investment Banks:o Equity capital markets – ECMo Debt Capital Markets – DCMo Currency & Commodities – FICC(Fixed Income Currency & Commodities)o Valuation Advisoryo Tax Advisoryo M&A and Restructuring Advisoryo Credit rating Advisoryo Private Equity, Venture Capital & Hedge Fundso Sales, Trading, Brokerage, Risk Managemento SWF – Sovereign Wealth Fund o PMS – Portfolio Management Services
- Incomeo Fee Basedo Fund Based (Risk)
- Type of IB’so Bulge Bracket – big – full o Boutique IB’s ( Most of Indian Banks are these as they do not provide all the above
services)-
- Note on IPO Processo Why do firms exist?
Sir Ronald Coase –Industry Organization - Transactional Cost Economics Facilitates exchange – profit Need for exchange of products or services
o Problems with Capital Market Information Asymmetry Adverse Selection / Moral Hazard Function of Intermediaries –is to Reduce transaction cost – improve
efficiency IBs Add to volatility of the market IBs bring in efficiency of the market
Absence of arbitrage leads to efficient marketso Fresh Water Economics & Salt Water Economics
Fresh Water Economics says leave it to the market forceso To Raise Capital
The Firm requires capital for its expansion Bank Based to Market Based Go to Market – Unlock the Value
o Firms which are listed Price Discovery – Daily Market Price
o Firms which are yet to be listed Locked Value – Unlock the value
o IPO Sell the stake to another investor Easy entry and exit
- Case – Manipal Leisure & Business travels Limited (MLBLT)o Authorized share capital of 100Mn shares of Rs 10 eacho Issue, Subscribed, Paid – Up – 60Mn shares of 10/Eacho Additional Capital Requirement : 200 MNo Value Per Share – 50
o No. of shares to be issued : 200/50 = 4 Mno How many shares to be offered
Valuation Current Market Price Done by a IB Third Party
o Incorporation : MOA, AOA; Capital clause : Authorized Share Capitalo Post Issue Paid up capital = 500 Mn =100
The new issue: 10 Mn =10/500 = 2%o The Present issue constitutes 2% on a fully diluted basiso Pre-Money and Post – Money = Investment made by the PE
Session 3
Offer for Sale
Fresh issue
Promoters: 93% share capital; public holding: 0%
Closely held company
Offered fresh issue: to raise capital for the firm: equity route
How many shares to be offered
The amount required for the company: general purpose; specific purpose
Factors that would impact the shares to be offered:
Amount required Value per share
Issue less number of shares: better valuation
Valuation representatives:
a) 52 week trading rangeb) The PV of forecast from dalal street analystsc) Sum of the parts (SOTP)d) DCF
468 crores: 390 to 430
Issuer would like to charge a higher premium
Pre-SEBI era: CCI – Controller of Capital Issues: Regressive
Fixed Price Mechanism – How much premium to be charged – Formula given by CCI used for calculating the price
Post 1992: SEBI; BOOK BUILDING and Free pricing mechanism
Issuer, GCBRLM (Global coordinators & book building lead managers), institutions – decide the price
Investment appetite decides the price band – auction
Auction:
English auction Dutch Auction French Auction
Post SEBI: Price dependent on demand and supply
HIGHER VALUATION: Discover the value
If there is higher valuation: issuer will offer less number of shares – to reduce dilution
Exiting investors: VC/ Promoters group – purpose is to unlock the value
All public sector are owned by government and the signatory for the same is the President.
Road Shows; Planned meeting – marketing the offer
The valuation should go up when the company is moving from closely held to widely held
Merits of going for an IPO; why do firms go for an IPO?
Exit Options:
The company goes public: fresh issue + offer for sale – MHRIL The VC/PE can sell the stake to a strategic or financial investor: Strategic investors often pay
a premium ( ex snapdeal wanting to buy flipkart or tata buying jaguar to move into new market), but sometimes the company might not agree to going for this route
The promoter can buy back
IPO – primary equity offering – first time
FPO – secondary equity offering –
Corporate Actions: Public Issue, Rights issue, convertibles, bonus, ESOPs, M&As, CAPEX Against issue of equity, buy back (large cash holdings); Acquisitions
SESSION 4
The share capital is altered: increases, decreases
1. IPO – Additional Cash, change in no. of shares, change in net worth2. FPO – same as above3. RIGHTS - same as above4. BONUS – No additional cash, increase in no. of shares, no change in net worth (Adjustment
between paid up capital and reserves, capitalizing the reserves)5. SPLIT (RATIO ADJUSTMENT) – no additional cash, increase in no of shares, no change in net
worth6. ESOP – (add cash, change in no of shares, increase in net worth)7. CONVERSION OF PREFERENCE DEBT INTO EQUITY – (no cash, reduction in debt, increase in
shares, increase in net worth)
8. CAPITAL EXPENDITURE- (no change in cash, increase in equity shares, increase in net worth, increase in FA)
9. BUY BACK (decrease)
If you bought 100 shares at the time of the first public issue of Infosys in 1993, did not buy any additional shares or sell shares, what will be the number of shares today?
Wealth maximization.
93- 100 shares
94 – 200 shares
97 – 400 shares
99 – 1600 shares
04 – 6400 shares
06 – 12800 shares
14 – 25600 shares
15 – 51200 shares
Session 51. IPO – related calculations2. Rights Issue – theoretical value of a right, options to the shareholder – what is the impact
on the wealtha. Accept the rights and buy the rights sharesb. Sell the rightsc. Reject the rights
3. CCD Prospectus4. INDIGO Prospectus5. INFIBEAM IPO (First ecommerce co. to announce IPO)6. Motilal Oswal IPO, Note on IPO – Quiz in the next visit7. PE & VC Investment related calculations8. Introduction to M&As
BOLD – Syllabus
PE & VC Investments
The firm requires funding
Firm is expecting an amount of investment from the PE
PE will take an equity stake
How much stake to be offered?
If the valuation is high for the firm, the stake to be offered to be is low
If required rate of return from the PE is high (IRR), the amount of investment will be less for a given stake
1. Motilal Oswal2. Flipkart3. Term Sheets (Prospectus in PE business)
M & A:
Acquiring Firm – Buying Firm
Target Firm – Selling Firm
Acquiring Firm – Buying Firm – Build vs Buy – Green field vs Brown field; Organic vs Inorganic
Target Firm – Selling Firm – Sell vs Continue
Buying Firm:
Cost of building vs Cost of buying
Replacement Cost
Market Value of the firm
Market Value of the firm < Replacement Cost: Buy
When does a firm become a takeover target: MV/RC < 1 – TOBIN’S Q < 1: TAKEOVER TARGET
Expected Synergies: Revenue, cost, overall business -
Operating synergies – Economies of Scale (EOS1) & Economies of Scope (EOS2)
ECONOMIES OF SCALE: Larger the volume of operation, less than average cost per unit
ECONOMIES OF SCOPE: Using same common infrastructure, sell multiple products & services
FINANCIAL SYNERGIES – Larger Balance Sheet, More borrowing capacity, higher collateral, less cost of debt
Acquiring Firm – purchase
Target firm – sale
How much the acquiring firm has to offer to the target firm & in what form?
Conduct valuation for the target firm
Different Models of Valuation: Listed Firm or Unlisted
Valuation of both acquiring & target is required
Valuation of the two entities required in a stock based acquisition
Session 6
Two firms: Acquiring Firm & Target Firm
Acquiring Firm: Freeport McMoran – Metals & Minings
Target Firm: Phelps Dodget – Metals & Mining
How the acquiring company offers Target Company?
1. Entirely stock based acquisitions2. Entirely cash based (TATA)3. Combination of cash & stock (FCX)
1 share of Target Company – x shares of the acquiring company
1 share of target company = x rs.1 share of target company = x rs + x shares of acquiring company No of shares outstanding for acquiring and Target Company at the time of acquisitionValue per share at the time of acquisitionMarket capitalization of the two firms
No. of shares outstanding for Acquiring & target company at the time of acquisitionValue per share at the time of the acquisition
Market capitalisation of the firm
Read:FCX will acquire all of the outstanding common shares of Phelps Dodge for a combination of cash and common shares of FCX for a total consideration of $126.46 per Phelps Dodge share, based on the closing price of FCX stock on November 17, 2006. Each Phelps Dodge shareholder would receive $88.00 per share in cash plus 0.67 common shares of FCX. 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. The cash portion of $18 billion represents approximately 70 percent of the total consideration. In addition, FCX would deliver a total of 137 million shares to Phelps Dodge shareholders, resulting in Phelps Dodge shareholders owning approximately 38 percent of the combined company on a fully diluted basis. The boards of directors of FCX and Phelps Dodge have each unanimously approved the terms of the agreement and have recommended that their shareholders approve the transaction. The transaction is subject to the approval of the shareholders of FCX and Phelps Dodge, receipt of regulatory approvals and customary closing conditions. The transaction is expected to close at the end of the first quarter of 2007. FCX has received financing commitments from JPMorgan and Merrill Lynch to fund the cash required to complete the transaction. After giving effect to the transaction, estimated pro forma total debt at December 31, 2006, would be approximately $17.6 billion, or approximately $15 billion net of cash.
Total offering made to PD (target firm) = 25.9 billion cash & stockNo. of shares of PD x offering per share = 26000 mnOffering made per share = 126.46 = cash + stock = 88 + 0.67 stock of FCXOffering made per share = 88 cash + 38.46 stock38.46 = 0.67 shares of FCXValue per share of FCX = 38.46/0.67 = 57.4 USD/share
No. of shares outstanding post acquisition = pre acquisition no. of shares + shares offerd to the target company% ownership offered (fully diluted) = 37%Number of shares offered for 37% ownership = 137 millionTotal no. of shares post acquisition = 137/0.37 = 360 millionTotal no. of shares pre acquisition = 360-137 = 223 million (FCX pre acquisition)Market capitalisation of the acquiring firm = 223 million * 57.4 = 13 billion approx..
When companies participating in the acquisition are from same sector it is called a horizontal merger
Total offering = 25900 mnPer share offering = 126.46No. of shares of PD = 25900/126.46 = 204 mn shares outstandingMarket price per share (current) for PD = 126.46/1.30 = 97.27 per shareMarket cap of PD = 204 * 97.27 = 20 billion approx.
Observation: Size does not matter in an M&A transaction if the capital markets are at a matured stage
The financing can be arranged without much difficulty
Mode of funding: internal accounts + raise debt + raise preference or convertibles
Pecking Order Hypothesis:
Bridge loan: temporary
An initial step in this financing was the joint commitment by JPMorgan and Merrill Lynch to a combined $6 billion bridge loan prior to approval of the merger. FCX announced on March 15 the pricing of a total of $17.5 billion in debt financing for the Phelps Dodge acquisition, including $6 billion in high-yield senior notes offered in the public debt market (the bridge loan would be drawn down only if this public offering failed) and $10 billion in senior secured term loans. In addition, a $1.5 billion senior secured revolving credit facility was provided, which was to be undrawn at closing. The initial press release indicated an offering of “approximately 35 million shares of common stock” and 10 million shares of mandatory convertible preferred stock at $100.00 per share.
223 million shares – existing
1. Shares offered to PD – 137 mn2. New issue of equity – 47.15 mn3. Convertible pref. stock – 28.75 – 1.63 & 1.36
Session 7Recap:
1 share of Target Company – x shares of the acquiring company
1 share of target company = x rs.1 share of target company = x rs + x shares of acquiring company No of shares outstanding for acquiring and Target Company at the time of acquisitionValue per share at the time of acquisitionMarket capitalization of the two firms
No. of shares outstanding for Acquiring & target company at the time of acquisitionValue per share at the time of the acquisitionMarket capitalisation of the firm
Read:FCX will acquire all of the outstanding common shares of Phelps Dodge for a combination of cash and common shares of FCX for a total consideration of $126.46 per Phelps Dodge share, based on the closing price of FCX stock on November 17, 2006. Each Phelps Dodge shareholder would receive $88.00 per share in cash plus 0.67 common shares of FCX. 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. The cash portion of $18 billion represents approximately 70 percent of the total consideration. In addition, FCX would deliver a total of 137 million shares to Phelps Dodge shareholders, resulting in Phelps Dodge shareholders owning approximately 38 percent of the combined company on a fully diluted basis. The boards of directors of FCX and Phelps Dodge have
each unanimously approved the terms of the agreement and have recommended that their shareholders approve the transaction. The transaction is subject to the approval of the shareholders of FCX and Phelps Dodge, receipt of regulatory approvals and customary closing conditions. The transaction is expected to close at the end of the first quarter of 2007. FCX has received financing commitments from JPMorgan and Merrill Lynch to fund the cash required to complete the transaction. After giving effect to the transaction, estimated pro forma total debt at December 31, 2006, would be approximately $17.6 billion, or approximately $15 billion net of cash.
Total offering made to PD (target firm) = 25.9 billion cash & stockNo. of shares of PD x offering per share = 26000 mnOffering made per share = 126.46 = cash + stock = 88 + 0.67 stock of FCXOffering made per share = 88 cash + 38.46 stock38.46 = 0.67 shares of FCXValue per share of FCX = 38.46/0.67 = 57.4 USD/share
No. of shares outstanding post acquisition = pre acquisition no. of shares + shares offerd to the target company% ownership offered (fully diluted) = 37%Number of shares offered for 37% ownership = 137 millionTotal no. of shares post acquisition = 137/0.37 = 360 millionTotal no. of shares pre acquisition = 360-137 = 223 million (FCX pre acquisition)Market capitalisation of the acquiring firm = 223 million * 57.4 = 13 billion approx..
When companies participating in the acquisition are from same sector it is called a horizontal merger
Total offering = 25900 mnPer share offering = 126.46No. of shares of PD = 25900/126.46 = 204 mn shares outstandingMarket price per share (current) for PD = 126.46/1.30 = 97.27 per shareMarket cap of PD = 204 * 97.27 = 20 billion approx.
Observation: Size does not matter in an M&A transaction if the capital markets are at a matured stage
The financing can be arranged without much difficulty
Mode of funding: internal accounts + raise debt + raise preference or convertibles
Pecking Order Hypothesis:
Bridge loan: temporary
An initial step in this financing was the joint commitment by JPMorgan and Merrill Lynch to a combined $6 billion bridge loan prior to approval of the merger. FCX announced on March 15 the pricing of a total of $17.5 billion in debt financing for the Phelps Dodge acquisition, including $6 billion in high-yield senior notes offered in the public debt market (the bridge loan would be drawn down only if this public offering failed) and $10 billion in senior secured term loans. In addition, a $1.5 billion senior secured revolving credit facility was provided, which was to be undrawn at closing.
The initial press release indicated an offering of “approximately 35 million shares of common stock” and 10 million shares of mandatory convertible preferred stock at $100.00 per share.
223 million shares – existing
4. Shares offered to PD – 137 mn5. New issue of equity – 47.15 mn6. Convertible pref. stock – 28.75 – 1.63 & 1.36
The TED spread is the difference between the interest rates on interbank loans and on short-term U.S. government debt ("T-bills"). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.
Eurodollar is one of the least regulated market and yet one of the most competitive. Why?
Regulation has a cost.
Profile of the market: issuer and investor – information asymmetry
PE market:
Regulation cost is reduced Information asymmetry is low Reduced regulation and hence deal closes faster.
Similarly in Eurodollar:
Investors are banks & hence better informed.
Session 10Break –up fee: COMPANY A is negotiating with company B and Almost close to complete the deal. A C appears & offers a higher price to B If B decides to accept the offer of C. C has to pay a break-up fee to A.
Fairness Opinion: Second opinion about valuation of the company
Using comparables, the valuation of the target:
Trading comps – developed based on the market price Transaction comps – based on the precedent transactions
How to derive P/E multiple theoretically
Po = Do * (1+g) = BV * ROE
Ke-g
Po/Eo = (1-b)*(1+br)
Ke - br
Po/Bo = (Eo /Bo)* (1-b) * (1+br) = r * (1-b) * (1+br)
Ke-br Ke-br
Here, r= ROE
Session 12Capital Markets – public, private
M&A – FCX-PD, P&G, Gillette
Deal Structure, role of IBs, valuation issues
Leveraged Buyout
KKR
Acquisition using heavy amount of debt
Acquisition + Leverage – LBO
FCX – Strategic Buyer
P&G – Strategic Buyer
Inorganic Growth
KKR – Buying out dollar general – Dollar store
KKR – Buying out – RJR NABISCO – Tobacco + Food Business
Junk Bond Market – LBO – Michael Milken – Junk Bonds King
KKR like firms – Financial Investors
PE player – Financial Investor
Enter with an investment
Exit at a higher multiple
100 – 300/500/600
Dollar General – in profits – some trouble
RJR NABISCO – in profits – some trouble
BARBARIANS AT THE GATE
Any firm in trouble - Valuation – undervalued – takeover target
Strategic Investor/ Financial Investor
Synergies – converted into value in the long run
Agency theory – owner management conflict – corporate governance
Shareholder Value Creation
Agency Theory –
Owners are principals & Managers are Agents
Michael C Jensen
Eugene Fama
Williamson
Ronald Coase
Financial markets – invisible hand
Targets: RJR NABISCO – tobacco + food business
Problems – Fixable
1. ROA – Down2. Inventory Turnover – Down
Low Capital Expenditure to Sales Ratio – 7%
Low NWC to Sales Ratio - Low
LBO Target
Finance the target with heavy debt low equity
Buy the entire equity & make the firm delisted – going private
Buy back – reverse book building
Control of the financial investors
Repay the debt over a period of time
The target has fixable problems – Fix them
Improve the performance metrics
Improved free cash flow available to pay debt
FCFF available from the target – reduce the debt – increase the equity – exit with a higher multiple
Alpha Seekers – PE/HF
Market Neutral Investors
RECAP AS ON 18TH OCTOBER 2015:
1. CAPITAL MARKETS- PUBLIC & PRIVATE2. M&A’S- FCX- PD; P&G- GILLETTE3. DEAL STRUCTURE, ROLE OF IB’S, VALUATION ISSUES
LEVERAGED BUYOUT
1. ACQUISITIONS USING HEAVY AMOUNT OF DEBT2. ACQUISITIONS+LEVERAGE LBO3. FCX AND P&G ARE STRATEGIC BUYERS, IN THE SAME LINE OF BUSINESS AND IS NOT
INTENDED TO EXIT4. BOTH INTEND TO HAVE INORGANIC GROWTH, HAVING SYNERGY IN OPERATIONS
EXPANDING THE GEOGRAPHIC COVERAGE5. FOR LBO, KKR IS NOT BRINGING ANY RESOURCES OTHER THAN CASH, NO VALUE ADDED IN
SYNERGY6. KKR- BUYING OUT DOLLAR GENERAL- DOLLAR STORE7. KKR- BUYING OUT- RJR NABISCO – TOBACCO+ FOOD BUSINESS8. LBO’S ARE MOSTLY POPULAR IN USA- RAISING RISKY DEBT9. JUNK BOND MARKET- LBO- MICHAEL MILKEN- JUNK BOND KING10. KKR LIKE FIRMS- FINANCIAL INVESTORS
a. ENTER AN INVESTMENT WITH A TARGET IRRb. EXIT AT A HIGHER MULTIPLEc. 100- 300/500/600
11. BARBARIANS AT THE GATE12. DOLLAR GENERAL- IN PROFITS- SOME TROUBLE13. RJR NABISCO- IN PROFITS- SOME TROUBLE14. ANY FIRM IN TROUBLE- VALUATION IS AT STAKE- UNDERVALUED- BECOMES A TAKEOVER
TARGET15. UNDER THE SIGHT OF STRATEGIC INVESTOR/FINANCIAL INVESTOR16. FINANCIAL INVESTOR WILL TAKEOVER ADD SOME VALUES AND EXIT AT RIGHT TIME17. SYNERGIES- CONVERTED INTO VALUE IN THE LONG RUN18. AGENCY THEORY- OWNER MANAGER CONFLICT- CORPORATE GOVERNANCE-
SHAREHOLDER’S WEALTH CREATION19. AGENCY THEORY
a. OWNERS- PRINCIPALb. MANAGERS- AGENTS
20. IMPORTANT ADVANTAGE OF LBO’S IS IT REDUCES AGENCY CONFLICTS21. MICHAEL C JENSEN, EUGENE PHARMA, WILLIAMSON, RONALD COASE THEORIES DEAL WITH
THIS ISSUES22. FINANCIAL MARKETS- INVISBLE HAND- M&A- FAILED FIRMS WILL BE TAKEN OVER BY
SUCCESSFUL FIRMS
23. CCD IPO ISSUE:
24. TARGETS- RJR NABISCO- TOBACCO+ FOOD BUSINESS25. PROBLEMS: FIXABLE
a. ROE- DOWNb. ITR- DOWN
26. FOLLOWING MAKES LBO TARGETa. LOW CAPITAL EXPENDITURE TO SALES RATIO- 7%
i. MAYBE ALREADY HAVE BUILT ENOUGH CAPITALb. LOW NWC TO SALES RATIO
27. HOW LBO OPERATES?a. FINANCE THE TARGET WITH HEAVY DEBT LOW EQUITYb. BUY THE ENTIRE EQUITY AND MAKE THE FIRM DELISTED- GOING PRIVATEc. BUYING BACK- REVERSE BOOK BUILDING
28. CONTROL OF THE FINANCIAL INVESTOR INCREASED29. REPAY THE DEBT OVER A PERIOD OF TIME30. FIX THE PROBLEMS OF THE TARGET WHICH HAS FIXABLE PROBLEMS
31. IMPROVE THE PERFORMANCE METRICS32. TARGET- IMPROVE THE FREE CASH FLOW AVAILABLE TO PAY DEBT33. FCFF AVAILABLE FROM THE TARGET- REDUCE THE DEBT34. INCREASE THE EQUITY VALUE- EXIT AT HIGHER MULTIPLE35. EXAMPLE- BAIN CAPITAL MITT ROMNEY, COMPETING IN US ELECTIONS36. ALPHA SEEKERS- AIM TO GENERATE RETURNS GREATER THAN THE MARKET, IRRESPECTIVE
OF HOW THE FIRM IS OPERATING
37. LBO OBJECTIVE: PAYDOWN DEBT DURING HOLDING PERIODa. INITIAL ACQUIRED FOR 8.0x LTM EBITDA OF $125b. FUTURE: SOLD FOR 8.0x LTM EBITDA, REFER LBO MODELLING FROM BOOK
38. TASKS:a. USING COMPS ARRIVE AT EQUITY VALUE PER SHARE OF A COMPANYb. PERFORM VALUATION OF KKR- RJR LBO
Session 13LBO:
1. What is an LBO?Cash Based acquisition funded by large amount of debt at varying interest rates and with different kinds of debt structures.
i. FCX-PD (a kind of LBO)ii. KKR-DG
iii. KKR-RJR NABISCO
2. What are the characteristics of typical LBO candidate?a. The firm is not doing well? ROI, ITR, ATRb. Firm has lot of asset built-up: Fixed assets, brands, WCc. The assets can be disposed-off, can be used as collateral d. Asset Strippinge. The firm is undervalued in the marketf. The shareholder group is not diverse
3. What is the business model of a buyout firm?a. Identify a target with LBO characteristicsb. Have access to sources of fundingc. The target has a potential value if turned aroundd. Infuse large amount of debt into BSe. Pay the existing owners through cash and delist the target (This is done to gain free
ride with regards to decision making like getting rid of emotionally attached businesses etc)
f. Improve the target’s performance – generate free cash flow – g. Deliver the target over a period of time – increase the value of equity – exit h. Exit: take the firm public & go for OFS (offer for Sale) – or sell a part or whole of the
firm to another buyout firm – to another strategic investor for a better premiumi. Reason for exiting coz a buyout firm is a financial investor and hence would like to
exit at the end of your investment horizon.
Increase Value by:
Only by deleverage EBITDA expansion EBITDA expansion, multiple expansion , deleverage
Price = EPS * P/E
EPS represents performance & P/E represents perception –get paid to talk
CAPEX equals Depreciation only for firms that already have a lot of asset built-up and is not technology oriented so does not need constant upgrade. Then all you are left with is maintenance CAPEX which can be met with cash available. If you have growth capex then you have to improve cash flows a lot. IF you only have maintenance CAPEX to bother with then all you have to do is improve the turnover to improve the free cash flows.
Call transcriptsCFO’s PresentationCommunication cost to capital marketsAll these are done to improve the P/E expansion by improving perception about the firm
Debt Capital Markets
Types of Debt: Public capital markets/ Private Capital Markets – Term Loan Private Placement
Interest Rates: Fixed / Floating
Location: Domestic, International, Euro, Global
Convertibility: FC, PC, NC
Bonds with call & Put
Credit Rating Advisory
Valuing Debt Instruments and working on the yield Curve
Understanding & interpreting the yield curve
Yield Curve as leading indicator
Yield Curve: Yield vs maturity – shape:
1. Normal Yield Curve:Short Run Interest Rates < Long- Run Interest rates
2. Inverted Yield Curve:Short-Run Interest rates > Long-run Interest rates
3. Flat Yield Curve
Term Premium:
Yield = base rate + term premium
Liquidity preference/ Expectations/ Preferred Habitat/ Segmentation Theory
Yield to value a bond:
1. Yield to maturityFace Value: 10000Maturity: 8Coupon: 9%YTM: 10% (Intermediate coupons are reinvested at YTM till N)Value: Price (1, 2, 3, 4, 5)
Checklist:
Yield Curve interpretation – shape & direction: shape as a predictor of future economic outlook
Parallel shift in the yield curve Yield pick up
DB research division
In-house research division
A trade in a direct fashion – trading
Advising: a client; in-house trading desk monetise the idea or information
Information: Arbitrage – relative value trades is nothing but finding out arbitrage in the bond markets
Arbitrage is a short run phenomenon
Relative value trade: arbitrage derived from yield curve data
Boot strapping model
Cubic spline model
Affline model
NSE uses NS model: Nelson-Siegel Model (ZCYC): ZCYC – Zero Coupon Yield Curve
9th November:
Recap:
ECM: Primary/IPO/Offer for sale
Public capital markets, Pvt capital markets
MOFSL case, Indigo, CCD
M&A: FCX-PD, PG-Gilette; LBO-RJR-KKR; Dollar General-KKR
The revenue model for IBS
FICC: Fixed Income, Currency, commodity
DB Relative Value Trades: ZYCC Using Boot Strapping
NSE: Nelson Siegel Model For ZCYC
Actual Yield Vs Predicted Yield: Trading Strategy
INTEREST RATE SWAP:
An Agreement between two parties
To exchange interest on a notional principal
Fixed rate for floating rate
Objective:
a) To transform a liability from FL to fixed or vice versa
b) To reduce the borrowing cost
Questions:
1. What is the requirement for BFG & Rabobank?2. What is the IRS structure designed by the IB?3. What will be the all-in-cost to BFG, if it enters into IRS?
BFG:
- INDUSTRIALS USA- LOSSES- BBB RATING FALL- 50 MILLION USD FUND- MT TO LT- PREFERABLE INTEREST FIXED- 12.50%
RB:
- DUTCH AG BANK- POSITIVE PROFILE- 50 MN USD FUNDS- AAA RATED- EURO DOLLAR MARKET- RATE APPLICABLE : L+25- FLOATING RATE PREFERED MODE
INTERMEDIARY:
- MARKET MAKER- BENEFIT FROM FEES & ARBITRAGE PROFIT SPREAD- FACE LIQUIDITY & COUNTERPARTY RISK
INTEREST RATE SWAP:
- REDUCE THE BORROWING COST
- FACILITATE CONVERSION FROM FIXED TO FLOATING AND VICE VERSA
AAA (1) BBB (2)FIXED RATE 10% 12%FLOATING L+50 L+100REQUIRED FLOATING FIXEDALL INTEREST COST L-25 11.25 % (12- 0.75)
- FIRST CASE HAS DIFFERENCE OF 200 BP- SECOND CASE HAS 50 BP DIFFERENCE- OVERALL TRANSACTION INVOLVES 150 BP(QSD- QUALITY SPREAD DIFFERENTIAL), IF SHARED
EQUALLY WILL HAVE: (IF NO INFO, MAY NOT SHARE EQUALLY)o BENEFITS FROM IRSWAP:
75 BPS IN FLOATING AND 75 BP IN FIXED MODE- A IS HAVING BOTH COMPARATIVE AND ABSOLUTE ADVANTAGE OVER B BUT MORE BENEFIT
IN FIXED RATE MARKET- B IS PAYING MORE IN BOTH THE MARKETS AND PREFERS FLOATING MARKETS- 1 GOES TO FIXED RATE MARKET AT 10% BORROWING HAVING COMPARATIVE ADVANTAGE- 2 GOES TO FLOATING RATE MARKET AT L+100 RATE
10% FLOATING RATE L+100
FIXED RATE
- AT 1: INFLOW EQUALS OUTFLOW- L-25 = 10% - (10.25%) +L -> ONLY CONDITION WHICH SATISFIES THE EQUATION. HENCE
FIXED RATE ARRIVING AT 1 = 10.25%- FOR 2: 11.25 = L+ 100 – L + 10.25
INCLUSION OF INTERMEDIARY:
SL NO FEES COST INTERMEDIARY REVISED RATE1 L+50-75 15 L+50- 602 12-0.75 15 12.00- 0.60
- BECAUSE OF INTERMEDIARYo AT 1:
OUTFLOW : 10% & L INFLOW: 10.10 FLOATING RATE
o AT 2: OUTFLOW: L+100 & FLOATING RATE OF 10.40 INFLOW AT L
PARTY 1 PARTY 2
1 PAYS FIXED AT FIXED AND GETS FIXED FROM 2. 2 PAYS FLOATING AND GETS IT FROM 1
PARTY 1 INTERMEDIARY PARTY 2
- BFG HAS FLOATING RATE AND NEEDS TO TRANSFORM IT TO FIXED RATE LIABILITY AND OBJECTIVE SHOULD BE IT IS LESS THAN DIRECT MARKET TRANSACTION AROUND 12 TO 13%
- RB TRANSFORM A FIXED RATE LIABLITY INTO A FLOATING RATE LIABILITY AT A COST LESS THAN L+25
- HENCE IT FACILITATES TWO THINGSo TRANSFORMATION o REDUCTION OF COSTS
CASE TRANSFORMATION:
5.5 MN (11% OF 50) 11% 11%
L+50
L- X L- X
- L+50 BPS – (L-X) +11%= 11% + (50+X)= 11.5% + X- FOR RB: 11% - (11%) + L-X = L-X
WHAT IS MAXIMUM VALUE OF COST?
- BFG: X CANNOT BE GREATER THAN 100 BPS AS OVERALL RATE REQ IS 12.5%- RG: X CANNOT BE MORE THAN 100 BPS (INCLUDING OTHER COSTS PAID BY RG)
RaboBank has a competitive advantage in both the fixed and floating markets. But Rabo has a comparative advantage in the fixed rate market & BFG has a comparative advantage in the floating rate market. So, RB goes to fixed rate market and BFG to floating rate market.
Next day:
Alternate market for investment
- The capital is available with firms or high net worth individuals- There is a need to generate above market returns and market neutral returns- Alpha seeking behaviour : PE, VC, HF- alpha services- High levels of RISK and high levels of return
Expectations of moderate to high levels of IRR
- Short investment windows- Quick entry and exit- Expansion of multiples- Active participation in start-up and mezzanine funding
1 INTERMEDIARY 2
Valuation industry
- Investments of PE- Valuations are quite high: Real estate, Dotcom, E-Com- Market correction- Valuations are justified as long as the investor is able to exit at a better price
with a premium
Valuation
- Implied value=Investment amount/ stake is critical so is the IRR
VALUATIONS ARE JUSTIFIED AS LONG AS THE INVESTOR IS ABLE TO EXIT AT A BETTER PRICE
Strong Tech Platform- Investment
Marketing in Form Structure
Logistics – India Past
Pref. Merchandising – Banking Network – COD – e-trailing Co.
Aggregation + Investing
Supplier Fulfilled means: This means that this trip is listed by a supplier on the website. It will be executed by the supplier and Thrillophilia is a booking and ticketing partner for it.
E-Com Model
- Strong technology platform- requires high investment- Market traffic doesn’t increase linearly, needs strong infra to withstand- Marketing Infrastructure- Strong logistics- Payment mechanism (strong contributors)- For last mile delivery in rural areas, partnering with India Post- Logistics- GMV= Aggregation + Inventory
Innovations on Wall Street
1. ML for EK- 6 plan vanilla products2. SB design of IR’s for BGF and RB
- Reduce the cost of borrowing by a few basis points- Exploit the arbitrage opportunities even at the minutest level in the form
interest rate differentials
CDO (Collateralized Debt Obligations) & CDS (Credit Default Swaps) Financial weapons of mass destruction
Wall street- Greed is good
- There is a continuous pressure from the clientele to deliver consistent profits- Arbitrage opportunities are gradually disappearing- Global connectivity of markets and financial globalization/ democratization of
markets- If there is capital available it is equally accessible to all investors
o To meet client’s requirements o To meet their proprietary trading objectives
- HFT- High frequency trading
- Alpha generating- returns irrespective of market movements1. Futures, Options, Swaps, Floors, Collars, CAPS2. Currency swaps, interest rate swaps, zero coupon swaps3. Spread trading strategies4. CDO/CDS family
- Objectives:o Liquidity generationo Generating profit out of arbitrage
CDO exercise:
1. Expenses:a. DO1: 80 million X (L+70 BPS)b. DO2: 10 mn x 9%c. IRS: 80 mn X 8%
2. Income: a. Collateral: 100 mnb. Rate: 11%c. Value: 11 mnd. IRS: 80 mn x L
3. Equation:a. 100mn X 11% + 80 mn X L – ( 80 mn* (L+70) + 10 mn X 9% + 80 mn X
80%):b. Which equals:
= 11+ 80 L – 80 L- 0.56 - 0.9 -6.4= 3.14 mn gross return to equity tranche/ Sponsoring – SPV
c. Less: Collateral Management expense: 0.5d. Net return by sponsor: 10e. Net return to equity investor: 0.264
(Difference between interest income on collateral and interest expense on Debt obligations)
f. ROE: 26.40%
4. Assumptions:a. No defaultb. No prepayment
Investment Banks help clients to generate funds and to restructure, to manage funds/ portfolio and to face the market fluctuations with risk management instruments and to innovate financial products.
Portfolio: Investment
Typical fund management consists of building a portfolio/Initial NAV/ Track the portfolio/ how the NAV is changing and what are the return
Investment Banking: Intermediation POV
Equity/Debt/PE/VC/HF
Portfolio Beta = Market Beta
Cash + Beta + Alpha = is the return you get from the hedge funds
Inside Job
RISK TAKERS – Continuous search for positive returns – innovation –exploiting arbitrage
HF industry
How hedge funds are different from mutual funds?
Total cost of funding: Cost of money + Intermediation Cost + Regulation
GRC: Governance+ Risk+ Compliance – Cost
Amaranth Advisors LLP
6 Billion USD in 30 days
Hedge funds are alpha seeking or market neutral firms
Fee – 2/20
Betting on energy futures
MtoM
LTCM – convertible bond arbitrage
Amaranth
Ending Value = Initial Investment * (1+return on investment)Assumption made: Beta of sector same as sector shares in the portfolioSectoral index return = portfolio return for sectorCash assumed to remain sameUnlisted Bonds remain same
Listed bonds valued at market value at current yieldHolding Period Return = (CF + Cap appreciation)/initial investment*100
Expense ratio = total expenses/ (average of initial value & ending value)
DRI-dividend reinvestment plan means dividend calculated on face value is used to buy addl units on NAV on dividend date to reinvest.
Bonus ratio if 1:6 means 1 new unit for 6 exiting unitsAddl units under bonus plan = existing units / 6 if bonus ratio is 1:6