Ch05 Banks and Analysts - 3ed

CORPORATE
GOVERNANCE
Kenneth Kim,
John Nofsinger &
Derek Mohr
3rd Edition
Pearson Prentice Hall
CHAPTER 5Investment Banks and Securities Analysts

Chapter Overview
2
Investment banking activities

Criticisms of investment banks
Securities analysts
Potential conflicts of interest that analysts face
Investment Banking Activities
3
Issuing new debt and equity securities

Two methods to issue stock and bonds:
Underwriting
The bank will guarantee that the company will receive a
specific amount of capital.
Best efforts
The bank does not guarantee that the firm will get its
desired amount of capital.
The fee charged is much lower for the best-
efforts method than for underwriting
The Process of Selling Securities
4
Registering securities with the SEC

—The investment bank assists the company in submitting a preliminary
prospectus to the SEC and going through the approval process.
—The investment bank distributes the final prospectus to investors.
Road show—the marketing campaign done by
bankers to generate interest and to market the issue
Through assisting with regulatory filings and sales
of securities, investment bankers are an important
source of information and monitoring of a public
company
Under-priced IPO offerings
5
Investment banks experience greater risk when

underwriting an IPO, as opposed to underwriting
an SEO
Investment banks tend to underprice IPO offerings.
Underpricing IPOs lowers the risk to the
underwriters because underpricing attracts
interested customers willing to take a chance on a
new public firm.
IPOs Issued and Their Average
6
Initial Return from 1980 to 2008
Criticisms of Investment Banks
7
IPO problems
Investment banks are expected to offer quality companies to
investors. However, in the mid- to late-1990s, banks began
to bring inferior companies to the market.
Pets.com initial public offering
In 1999, the firm had only $5.8 million in revenue and reported an
operating loss of $61.8 million
Merrill Lynch launched the Pets.com IPO in February 2000 (raised
$66 million)
Ten months later, Pets.com filed for bankruptcy and folded
Criticisms of Investment Banks
8
(Continued)
Structured deals
Often a firm has trouble raising capital
Investment banks sometimes have been
active participants in helping companies
raise capital by manipulating earnings.
Example: Enron’s partnerships

Securities Analysts
9
Analysts generally fall into two categories:

Buy-side analysts:
Analysts hired by institutional investors
Sell-side analysts:
Brokerage and investment bank analysts
Sell-side analysts are part of the corporate
monitoring system because their recommendations
are made public
Sell-side analyst’s job
10
A sell-side analyst will look at
firm’s operating and financial conditions

firm’s immediate and long-term future prospects
the effectiveness of a firm’s management team
the general outlook of the industry in which a
firm belongs
Sell-side analyst’s job (continued)
11
A sell-side analyst will also
make earnings predictions

Earnings per share (EPS)
make trading recommendation
buy/sell/hold
update the recommendation frequently
Quality of Analysts’ Recommendations
12
Many analysts make “conservative” earnings

predictions
First, companies like to meet or beat earnings
expectations.
Second, analysts rely in part on access to
companies to get information to do a good job at
predicting earnings.
So, analysts may make slightly beatable earnings
predictions (“under promise, over deliver”) to
make companies happy in order to have
continued access to information.
Regulation Fair Disclosure (Reg FD)
13
The SEC imposed Reg FD to prevent firms from

divulging privileged information to any analyst.
Forecasts made by analysts have become less
accurate.
However, forecasts now may possibly become
more honest assessments of future earnings.
Analysts’ ability to recommend stocks
14
Are analysts good at picking stocks?
It is still unclear whether analysts are good at picking

stocks.
Results from older academic studies say analysts are not
good at it.
Results from more recent studies suggest some analysts
are good at it.
But analysts always seem optimistic: during the early
2000s, only 2 percent of all stocks carried a sell
recommendation.
Potential Conflicts of Interest
15
Analysts and the firms they analyze

To make accurate recommendations, analysts need
access to high quality information. The best source
of a firm’s information is the firm itself.
Conflict: It is difficult for an analyst who needs
access to management to turn around and give the
firm a bad rating.
Analysts Working at Investment Banks
16
Analysts working at investment banks and

investment bankers at the same bank are not
supposed to collude or even influence each other
when they are evaluating the same firm.
Conflict: Analysts that work at investment banks
may feel the need to compromise their integrity for
the good of their employer’s investing banking
business (i.e., give good ratings to the bank’s
customers).
New Regulations
17
The Sarbanes-Oxley Act, the NASD rule 2711, and

the NYSE rule 472
Under the new rules, sell-side analysts
Cannot be subject to supervision from

investment banking operations
Cannot have their compensation tied to
investment banking deals
Cannot promise favorable ratings to lure
investment-banking deals
New Regulations (Continued)
18
The “Global Analyst Research Settlement”

A recent study shows that the new rules have
reduced the rating’s bias. However, there still
appears to be some over optimism.
Distribution of Analyst Recommendations Before and
After the Rule Changes, all ratings
19
Pre-Regulations
Post-Regulations
11.7%
4.2%
42.9%
Buy
35.1%
45.5%
Hold
60.7% Sell
Ratings on Firms Issuing Equity by Banking
Affiliated Analysts
20
Pre-Regulations Post-Regulations
2.1% 6.5%
28.3%
Buy
Hold 49.0%
Sell 44.5%
69.6%
Ratings on Firms Issuing Equity by Unaffiliated
Analysts
21
Pre-Regulations Post-Regulations
3.4% 9.2%
32.7% Buy
Hold 48.0%
Sell 42.8%
63.9%
Summary
22
Investment banks are part of the American corporate

governance system
There are some criticisms of Investment Banks
Sell-side securities analysts are also important corporate
governance monitors
There are some conflicts of interests in the system
The SEC has issued some new regulations to solve the
conflicts of interests

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CORPORATE

CHAPTER 5Investment Banks and Securities Analysts

Investment banking activities

Issuing new debt and equity securities

Registering securities with the SEC

Investment banks experience greater risk when

Example: Enron’s partnerships

Analysts generally fall into two categories:

A sell-side analyst will look at

firm’s operating and financial conditions

A sell-side analyst will also

make earnings predictions

Many analysts make “conservative” earnings

The SEC imposed Reg FD to prevent firms from

Are analysts good at picking stocks?

It is still unclear whether analysts are good at picking

Analysts and the firms they analyze

Analysts working at investment banks and

The Sarbanes-Oxley Act, the NASD rule 2711, and

Cannot be subject to supervision from

The “Global Analyst Research Settlement”

Investment banks are part of the American corporate

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