|Leverage for the Environment - A Guide to the Private Financial Services Industry (WRI, 1998, 108 pages)|
Investment banks function as a liaison "agent" between corporations or governments that want to attract investment capital and investors who have money to buy securities. Investment banking covers a wide range of functions within the financial services industry, but generally focuses on equity investments rather than credit extensions. Unlike commercial banks, they tend to have little or no long-term stake in a transaction. Investment banks generate revenue by charging a fee for transactions. The specific characteristics of an investment bank vary based on the legal and regulatory systems of the country where the bank is based. In Japan, the United Kingdom, and the United States, investment banks tend to be independent, publicly traded companies. In continental Europe, investment banks are frequently part of larger financial institutions involved in both investment and commercial banking, and in some cases, insurance as well. Figure 3.1 summarizes four key characteristics of investment banks of particular importance to the public interest community.
Size and Leaders
Because there are various methods of ranking the size of investment banks (assets under management, total deal volume, total profits), it is not possible to provide a single ranking of the largest firms. Among the world's leading investment banks are Morgan Stanley Dean Witter and Co., Credit Suisse First Boston, Citigroup, Merrill Lynch, and Goldman Sachs in the United States, and Nomura Securities in Japan. Morgan Stanley Dean Wither's assets alone totaled US$131 billion in 1996 (1).
For many corporate financial transactions, both parties utilize and are advised by an investment bank. These transactions include initial public offerings (IPOs, described below), mergers and acquisitions, divestitures, liquidations, structured or project finance (described under commercial banking), private placements (the sale of financial instruments to a targeted group of investors), and various forms of asset-backed lending activity (such as the acquisition of new equipment or plants as collateral for a loan).
Investment bankers also manage the buying and selling of stocks, bonds, and other financial instruments for their own portfolio and on behalf of clients; this move into asset management represents a diversification from their traditional role as agents. Another trend in investment banking is securitization, or bundling of assets, to sell in the secondary market.
One of the specialties of investment banks is bringing an IPO of a new financial security to the market. An IPO enables a company to raise new funds, or to cash in private stock for public stock. An IPO may consist of common stock (equity stock that has voting rights, but virtually no security if the firm goes bankrupt), bonds (a legal debt commitment by the issuing company to pay the bondholder a fixed amount of money at a specific time in the future, and often just called "offerings" or "issuances"), or preferred stock (which has some characteristics of both common stock and bonds). The IPO process is managed closely by the investment bank from its inception until the completion of the transaction, which can take from 6 to 24 months. In some cases, the investment bank will acquire a portion of the IPO for its own investment portfolio.
The most common IPOs are bonds issued by companies that are already publicly traded, or by governments seeking to raise additional capital in the international public market. Bonds are traded, with price fluctuations discounted by factors such as maturity dates and credit ratings of the issuing company or government. Bonds are the most commonly issued security in the world and comprise 30 percent of total financing activity on capital markets worldwide (2). However, common stock IPOs are more visible because they represent the selling of a company to the general public for the first time. In the United States, where about half of the world's IPOs take place, approximately 80 percent are for bonds while the remaining 20 percent are common stock IPOs. After the United States, the largest IPO markets based on the total number of new issuances are in Korea (prior to the 1997 Asian crisis), Sweden, and the United Kingdom.
In the United States, the principal regulator of investment banking activity is the Securities and Exchange Commission (SEC). The SEC sets standards for what information must be disclosed about companies that are publicly traded. It is the responsibility of the investment bank to obtain that information as it performs due diligence.
Attention to Environmental Issues
In general, most investment banks focus on environmental issues, if only nominally, in two circumstances: (a) as part of the IPO due diligence and disclosure process when investigating a company's potential liabilities, and (b) when handling transactions related specifically to the environmental services industry (e.g., waste disposal or water treatment). Environmental considerations, such as real estate contamination, are just one of a variety of factors considered during due diligence. The extent of the environmental due diligence process varies enormously depending on the investment bank and type of transaction, and can range from no activity to an extensive analysis of current and future environmental conditions. For U.S. transactions, investment banks have an interest in mitigating environmental problems before submitting a prospectus to the SEC.
Relevance to Developing and Transition Economies
Underwriting government bonds issued by central banks has become big business for investment banks. Many developing and transition countries issue bonds through investment banks to raise capital for major infrastructure development, such as the Three Gorges Dam in China. In turn, individual and institutional investors such as mutual funds and pension funds buy and trade these bonds. In 1997, international bond issues by developing countries reached US$108 billion. Half of those issued were from Latin America, with Brazil alone issuing US$18 billion (3).
Investment banks in developing and transition economies may also play a role in brokering privatizations. In the context of a privatization transaction, shares of a state-owned enterprise such as a water or electric power utility are offered for sale to the public as an IPO. Typically, a government (the seller) enlists the services of an investment bank to design and market the newly available security to domestic and international private investors. Several recent privatizations, particularly in Latin America, have been private placements with pension funds as investors.
Stocks of foreign companies can be offered in the U.S. market through a unique certificate resembling shares called an American Depositary Receipt (ADR). ADRs are receipts for shares that allow U.S. investors to purchase shares of foreign companies on a U.S. exchange. Different numerical classifications of ADRs and GDRs (Global Depositary Receipts) require different levels of disclosure to the SEC. One restricted type of ADR, or RADR, is the 144A transaction, which is the sale of an unregistered security. This type of private placement does not require SEC disclosure. In 1995, four of the top 12 ADRs were privatized telecommunication issuances by developing countries (4).
Most investment banking activity in developing and transition economies is dominated by foreign investment banks and the private sector arms of multilateral development banks such as the World Bank Group's International Finance Corporation (IFC). IPOs are limited to countries that have operational stock markets. In countries without functioning stock markets, investment banking tends to focus on structured or project finance (see Chapter 2, Commercial Banks) or foreign direct investment such as joint venture activity (when an international company partners with a local company to set up an enterprise).
INVESTMENT BANK DIAGRAM
Figure 3.2 illustrates the role of an investment bank in a common stock IPO, which represents the selling of a company to the general public for the first time. A stock IPO is depicted here because of its relative visibility and potential opportunity for leverage. IPOs are usually initiated by the company (corporate client) that wants to sell its common stock to the public. The chief financial officer (CFO) represents the interests of the corporate client during the IPO process. The client firm owners influence the transaction through contact with the CFO.
Initially, the CFO hires an investment bank that understands the industry, and ideally, one that previously has taken a similar firm public. The deal manager scrutinizes the company to determine whether the client and the market are ready for this firm to go public. Occasionally, the decision to take on a corporate client may be referred to senior management. The opinions of leaders within the investment community also can influence a bank's decision to accept a client. Upon acceptance of the corporate client, the bank decides whether it will manage the deal alone or with others (co-lead banks). Most large deals involve multiple investment banks brought into the transaction by the lead bank at various points.
The deal team creates the prospectus (or offering circular) that describes the company and security to be offered. Its contents are determined, through the due diligence process, by internal counsel, in concert with the deal team: the deal manager, financial analysts, technical support, and external advisors/consultants. The documents contain everything an investor needs to know about the company such as its products, markets, finances (including contingent liabilities), legal or regulatory issues, and tax implications. The prospectus is filed with the regulators (SEC in the United States) and then distributed to potential investors.
During the transaction, the deal manager considers the following questions:
· What relevant tax laws affect the company going public?
· Does the company have any historical environmental issues (such as site contamination) that require disclosure?
· Is the timing appropriate for an IPO (e.g., market conditions, government regulations, other competing IPOs)?
The following activities occur concurrently:
· The sell-side analysts evaluate and rate the corporate client to determine the potential price of the IPO shares offered to the market.
· Marketing and salesforce, led by a representative of the deal team, begin to travel and meet with potential investors to explain the transaction (the "roadshow"). These potential investors include corporate clients, private clients, investment houses, pension funds, mutual funds, and sometimes the investment bank's own portfolio.
· For potentially visible or sensitive transactions, external relations may be consulted to ascertain how the transaction will be promoted outside traditional sales channels. Within a few weeks of the selected IPO date, public affairs prepares a press release (a "tombstone").
The offering is made on a particular day with various investor groups buying the company's newly issued stock. All the funds obtained during the IPO sale flow through a third-party trustee/custodial account for legitimization of the flow of funds. The original entrepreneurs or venture capital fund receive a sizable return on their investment to date and may maintain some level of ownership that could result in future profits.
Regulators (SEC in United States) - Policy leverage. The SEC and its counterparts in other countries represent one of the most significant potential avenues to influence investment banks and their corporate clients. Guidelines for the IPO process, including requirements for due diligence, are set and enforced by the SEC as authorized by relevant legislation. Securities regulatory agencies could require disclosure of specific kinds of environmental or other information from corporations seeking to trade their securities in the public market.
Box 3.1 Three Gorges Dam Campaign: Watching Wall Street
Background In 1992, China's National People's Congress approved construction of the Three Gorges Dam, the world's largest dam project From the start, critics have argued that the dam's destructive potential will be just as impressive as its size Specifically, opponents noted that I 8 million people will be uprooted, and that the risk of reservoir-induced seismic activity and of siltation threaten the dam's technical viability Moreover, project costs have ballooned to five times the original figure in six years, which calls into question the financial viability of the project Financing this project has proved to be difficult three bond issues have been canceled due to lack of investor interest In 1994, China formed the State Development Bank (SDB) to help finance infrastructure projects, including Three Gorges In early 1997, a group of six investment banks, Credit Suisse First Boston (CSFB) J P Morgan, Lehman Brothers, Morgan Stanley Dean Witter and Co, Salomon Smith Barney (SSB), and Bank of America underwrote a US$330 million bond issue for the SDB A further bond issue was planned for later that year
Action In late 1997, a group of 46 nongovernmental organizations (NGOs) from 14 countries, led by the International Rivers Network and Friends of the Earth, sent a joint letter to the six bond underwriters, urging that they avoid any further activities in support of the project The letter catalogued the technical, environmental, social, and financial risks associated with the project, and noted that support of the project ran counter to the UNEP Statement by Banks on Environment and Sustainable Development signed by CSFB and SSB, and the Coalition for Environmentally Responsible Economies (CERES) Principles signed by the Bank of America The letter was followed by a media campaign, which named the banks involved in the deal and urged investors not to purchase the SDB bonds
Impact. The second bond issue never materialized The reason for this is difficult to establish because the campaign coincided with the growing financial crisis in Asia Three of the banks - notably those that had formally signed statements of environmental concern - sent responses to the NGO letter CSFB and Bank of America noted that SDB bonds are not targeted exclusively to Three Gorges but to infrastructure projects in general, and stated that they were not aware of a second bond issue for SDB Bank of America pledged not to commit direct support to Three Gorges, but also stated that the bank intends to continue dealings with Chinese financial institutions and those in other developing countries, consistent with their environmental commitments SSB reiterated its commitment to sustainability considerations and offered a list of ongoing activities as evidence of this commitment
Analysis The NGO campaign used reputational leverage to urge disengagement from the Three Gorges project The existence of an intermediary institution - the SDB - made reputational leverage harder to exercise It is difficult to assess the campaign's direct impact on the banks' decisions regarding Three Gorges against the backdrop of the Asian financial crisis However, it is noteworthy that the banks that have made a public commitment to corporate responsibility were also those most responsive to the campaign In the case of those three banks, reputational leverage served as a reminder of their environmental obligations
Sources Information packet compiled by International Rivers
Network Additional information is available online at http://www irn
Client Firm Owners - Bottom-line/Reputational leverage. Owners can influence information in the prospectus as well as the marketing and public relations efforts of the investment bank. If a company has a positive environmental record, owners could use the IPO to get information out to potential buyers and the public about the firm's environmental and corresponding financial value.
Deal Manager - Bottom-line leverage. The deal manager is interested in environmental considerations only to the extent that they affect the offering price of the transaction. Deal managers are usually not concerned about the cost of performing additional environmental analysis within due diligence, but are very concerned if it slows down the transaction or reduces the offering price or liquidity.
Analysts (Financial and Sell Side) - Bottom-line leverage. These analysts are interested in environmental issues only to the extent that they can be convinced that a significant correlation, either negative or positive, exists between a company's environmental and financial performance. Such a correlation could be based on revenue opportunities or cost avoidance.
Internal Counsel - Bottom-line leverage. For legal and managerial reasons, the company and the investment bank grant lawyers enormous power in creating the prospectus. If it were possible to convince lawyers of the financial merits of performing additional environmental due diligence and disclosure, they would be in a position to educate the broader investment banking community. Internal counsel is also a strong entry point for leverage within an investment bank because any communication within the bank coming from counsel receives priority attention.
Technical Support/External Advisors/Consultants - Bottom-line leverage. These experts are the only people with technical environmental knowledge who are involved in investment banking transactions and who can influence what potential environmental liabilities are investigated within the due diligence process. They may also influence what environmental information is included or excluded from the prospectus.
Investors - Bottom-line/Values-based leverage. If individual or institutional members of the investment community can be convinced to value environmental information, and begin to request it, the investment bank, in responding to their customers, will provide the requested information.
1. "World Business." The Wall Street Journal. September 18, 1997.
2. OECD (Organisation for Economic Co-operation and Development). Financial Market Trends. Paris: OECD. March 1998.
3. "Capital Flow to Emerging Market Economies." January 28, 1998. Institute of International Finance.
4. The World Bank. Global Development Finance 1997. Washington DC: The World Bank. p. 15.
Securities and Exchange Commission (SEC): http://www.sec.gov Emerging Markets Companion: http://www.emgmkts.com
USAID web site on public transactions: http://www.info.usaid.gov/test/finance.htm
U.S. Stock Exchange: http://www.nasdaq.com
UNEP Financial Services Initiative on the Environment: http://www.unep.ch/eteu/envr-fin.htm
Bank of New York, Global Equity Investing Depositary Receipt Service: http://www.bankofny.com/adr
Global Investor, American Depositary Receipts: http://www.global-investor.com/adr/index.htm
"ADRs Offer Global Self Determination." Chicago Herald Tribune. November 19-20, 1994.
Anderson, Seth C. Initial Public Offerings. Dordrecht, Netherlands: Kluwer Academic Publishers. 1995.
Chan-Fishel, Michelle. Anatomy of a Deal. A Handbook on International Project Finance. Washington, DC: Friends of the Earth, 1996.
Griffith, Victoria. "Seeking the Right Price." Latin Finance, No. 73, pp. 45-48.
Jenkinson, Tim and Alexander Ljungqvist. Going Public. Oxford, U.K.: Clarendon Press. 1996.
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