Equity Capital Markets

What is Equity Capital Markets (ECM)?

Equity Capital Markets (or ECM) is a financing group in the investment bank that deals with equity capital raising, from origination to structuring to distribution. ECM is most well known for helping corporates with the issuance of equity/stock – whether through primary offerings (Initial Public Offerings or IPOs for companies looking to list) or secondary market issues. Services that fall into the domain of ECM include:

Initial Public Offerings
Seasoned Public Offerings/Follow-On Offerings
Secondary Offerings (a major shareholder wants to divest a large block of shares in-part or in-whole)
Subscription Receipts
Instalment Receipts
Rights Issues
Private Placements
Private Investment in Public Equity (PIPE)
Hybrids
- Preferred Shares
- Convertible Bonds
- Mandatory Convertibles
- Mandatory Convertible Preferred
- Hybrid Capital (also DCM)

Within the bank, ECM is split into origination and syndication/distribution. ECM is rightfully seen as a financing or underwriting business where it must involve banks with a balance sheet that can underwrite the equity issuance or lend towards equity take out (a bridge). There are a lot of teams within the investment bank that the layman does not consider that are associated with an equity issuance that Bulge Brackets have – they need to have equity research analysts to cover the stock, equity sales, traders to support liquidity and the relationships with their private banking arms and clients.

However, elite boutiques such as Evercore or Lazard will offer independent equity capital markets advisory – with banks such as Klein & Co. being a part of the largest IPOs in history such as Saudi Aramco. This is becoming more and more comment as corporates look to manage conflicts of interest for balance sheet banks, who also make considerable fees from their buy-side clients.

Equity Capital Markets Origination

Origination (originating deals) is more closely aligned with classic investment banking and is responsible for pitching for equity issuance. This team will speak to why it makes sense to issue equity based on market multiples for valuation, investor appetite and general strategy.

When investment bankers say equity capital markets, they are generally referring to origination. Syndication will often be called Equity Syndicate.

Origination will also provide advice on what the best structure or product is best – for instance, a straight equity issue or a convertible bond – and offer indicative numbers for pricing, timing and how the market may react. Similar to the investment banking coverage teams, equity capital markets origination will also be split into industry verticals such as oil & gas or healthcare.

When not involved with execution, ECM origination offers support via shareholder analysis and advice on repurchases and other ideas related to equity via an ECM update.

Equity Capital Markets Syndication

Once equity is issued, it ideally is spread out in a liquid market at the right price. The syndication team is in constant correspondence with syndication desks at other investment banks and maintains relationships with the institutional and retail investors who eventually purchase the shares. This desk is also responsible for making sure that the issue goes smoothly and that the price is stable – an exercise that evaluates daily trading volume, market reception and investor demand.

Investors want a piece of hot new issues (such as Facebook or Alibaba), so the syndication desk must figure out an appropriate amount to allocate based on subscriptions to institutional investors as well as to retail brokerage channels (Dean Witter, Smith Barney) for investment advisors (IAs) to further distribute within their client portfolios.

Equity Capital Markets Salaries and Exit Opportunities

Compensation will entail standard investment banking base ($70,000 – $90,000 starting as an analyst) but a smaller bonus of 75%-100% of salary.

Exit opportunities are abundant for equity capital markets professionals. As with DCM bankers, ECM bankers can lateral to investment banking. Equity sales and equity research are more options for ECM bankers if they prefer to stay on the sell-side. There are also numerous options on the buy-side, with many funds requiring equity analysts.

Primary Markets versus Secondary Markets

Equity offerings marketed by an investment bank can be via primary market or secondary market. A primary market offering is when the company is the seller of shares – cash proceeds from the offering will go into company coffers. Assuming that there are existing shareholders, as the stock is issued from treasury and therefore increasing the numbers of shares outstanding, this is dilutive to current owners of the stock.

A secondary market offering is when a shareholder of a company offloads some or all of their shares that are already exchanging hands in the broader market. As the company itself is not involved in the transaction and no new shares are issued (existing shares are exchanged), existing shareholders are not diluted.

Both primary and secondary offerings will lead to greater shareholder diversity as it will be a large holder or group of large holders divesting their shares to the public market.

The Initial Public Offering

An IPO is a major step in the corporate life cycle and the full process usually lasts 3-6 months which takes up a large swath of company management time. Investment bankers are the most important cog in the machine that involves lawyers, accountants (tax and audit), consultants (who will usually provide an industry overview for prospective investors) and financial printers (Donnelly Financial Solutions or Merrill).

Investment bankers, usually led by the lead underwriter, will help decide on when (timing of IPO), where (forum shopping – the pros and cons of each exchange) and other important decisions.

The timing of issuance is important – does it have to compete for liquidity with other major issuance that buy siders want to subscribe to? Doubly so if it is a competitor in the same industry. Alternatively, bankers may also not want to price around their fiscal year if they have already met their targets (ha-ha).

The relationship banker in investment banking coverage will handle the prospectus writing and sizing – ECM will comment on the feasibility and assist in marketing and execution. They will also help decide the equity story and how to message it to new investors. Through lunches with equity research analysts and potential anchor clients, banks should know what they are looking for in the sector in order to garner a favorable valuation and communicate that effectively.

Decisions that need to be made include what stock exchange the company should list on. Each exchange’s rules and the securities law of each country differ. For marquee floats (recent examples include the IPOs of Alibaba and Saudi Aramco), exchanges will pitch companies on why they should list in a specific jurisdiction. The banker will advise on the following questions:

Should the company list in the US or Canada (NYSE or NASDAQ? TSX? Should the company dual list and trade on both?) – and what are the ramifications of each? The US allows for a deeper investor pool, but it depends on appetite at the moment. What kind of dual class share structures are allowed? What kind of reporting requirements are there?

The actual IPO needs to be syndicated – the advising investment bank can help decide on the following:

What banks should be in the equity syndicate?
What kind of execution allows for the best pricing?
Where will the stock go after it floats?
Which buy side clients should be targeted and who should anchor the investment? Which ones are actually long term money and who will simply dump their allocation afterwards?
From discussions with syndicate and their feedback from core clients, where should this issue price?

Usually, equity issuances are underpriced, which allows for the stock to pop afterwards, boosting investor sentiment (and encouraging investors to participate in IPOs to begin with). By “leaving some money on the table”, companies can make sure the offer size is filled and covered many times over (banks will pro-rata allocate to investors if this is the case) – usually if there is an exit, they have already made a lot of money already and are crystallising value at an attractive multiple (private markets are where the smart money is).

In corporate finance class in MBA school, underpricing is essential in order for orders to be fully subscribed – however if the stock doubles in the first day, it also means that a lot of money may have been left on the table for the exiting investors. A good ECM desk should ideally target a pop in the share price of 5-10% consistently so that both new investors and exiting investors are happy.

There may also be a greenshoe or over-allotment option of ~15% should the issue be oversubscribed, and more stock can be issued (also applicable for seasoned offerings – sometimes mentioned as the issue has “room to grow”).

Interestingly enough, an equity issue may not have proceeds going to the corporate itself, but rather it is an exiting shareholder divesting their stake. If that is the case, the company will not be able to use the funds for corporate purposes – it doesn’t affect the company (other than the incremental cost of filing and reporting publicly). A good example of this was the Government of Ontario floating Hydro One.

The lead bank for an IPO tends to be where an investment banker has a relationship early and pushes corporate banking to provide credit support until (and after issuance). Another prerequisite in being a lead bank is to have the bank’s equity research division cover the stock, as that provides exposure and marketing for the firm.

The titles that banks compete over for ECM are the same as for DCM – Sole Bookrunner, Joint Bookrunner, etc.

Seasoned and Follow-On Offerings

Firms make undertake seasoned or “follow-on” offerings once they are already publicly traded. Similar to an primary market IPO, this is a firm issuing new equity from their treasury – as such they dilute the ownership of existing shareholders.

However, while an IPO is a rigorous process that takes a long period of time consulting with lawyers and securities regulators and marketing the stock to potential investors, once a firm is known to the market, seasoned market issues require much less of a marketing effort and are more easily priced given that there is already active price discovery on exchanges.

Equity Offering Processes

Whether a seasoned offering or a secondary market issue for a public stock for a large shareholder, the seller of the equity may choose from a number of processes to get rid of their stock. Given that seasoned offerings can be quite large, they have price risk – especially for stocks that are illiquid/have low trading volumes.

Historically, a core business for investment banks has been the underwriting of securities. Companies that wanted to equity would sell the stocks they wished to sell to an investment banker at a discount to the current market price and for a fee. The fee was for arranging the process while the discount was to help the investment bank selling the stock to not take a loss on the stock. However, should the stock sale not clear the market, the investment bank could be stuck with stock they did not want or take a loss if the stock fell below the discount.

Today, the largest Bulge Bracket investment banks still take full underwriting risk, but the most sophisticated and prestigious companies are no longer willing to give a heavy discount for the sale and would prefer to keep the pricing and clearing risk for a lower total fee so to not dilute shareholders. This has led to a bifurcation of processes, with underwritten deals being joined by agency deals where the investment bank is purely a broker and does not face price risk.

Read more about block sales in this post:

Block Sales

Firm Commitment, Bought Deal or Fully Underwritten

This is the least risky method for the equity seller (and most risky for the investment bank) but the most expensive. The underwriting investment bank purchases the shares from the company at a fixed price before marketing the issue to the market. The money to the company is guaranteed based on this fixed price.

The discount to current trading price must be wide to compensate investment bankers for taking on the selling risk. Banks generally prefer when there is a shareholder base that already is well acquainted with the stock that they can offload to quickly as the company is not brought out for an extensive marketing road show like for the IPO. However, if the equity issue tanks, banks can lose money.

The benefit for corporates that choose this avenue to sell shares is certainty. The dollar value received is known and timing is quick, as this is negotiated between the seller and the banks subject to any conversations with its counsel. Also, with the pricing risk with banks and no need to sell to new investors, it is less distracting for the operations of the company as management focuses on the firm.

Agency Deals for Equity

With agency deals, the price risk stays with the company. The investment banks have their pulse close to the market and will have an idea of where an issue will price. They build up a book of investors to allocate shares for sale given a price range.

Depending on how engaged the company wishes to be, this can be a smaller or larger process, with smaller processes having equity distributed to investors that already know the company’s story while a larger process may require a large marketing effort where management is brought out to new investor geographies to answer analyst questions. Ideally, a big marketing effort derisks the stock for new investors and generates more demand for the company, bettering the realized price. However, the company will not know what price it will sell at and how big the total size they can sell is until they sell.

Two common methods are Best Efforts and All-or-None. With a best efforts arrangement, the investment bank tries to sell as many of the shares at the fixed price as possible. However, the investment bank is allowed to return shares that do not clear. With an All-or-None arrangement, if investment bankers cannot build a book of investors that covers the whole deal, the deal is not launched.

Preferred Equity

Preferred shares (or “prefs”) are hybrid securities that have fixed income characteristics but also equity content. They are similar to fixed income in the way that they have a par value (usually $25 per share) and pay out a distribution. Preferred shareholders do not have voting rights and do not get to participate in the upside of the company.

Preferred shares may have their dividends suspended should the financial position of the company be compromised. If they are cumulative preferred shares, all accrued dividends that have not been paid during the suspension must be paid out before common shareholders can start receiving dividends again.

From a cost of capital perspective, preferred shares are less attractive than debt for common equity holders because the interest must be higher than the debt due to them ranking lower on the capital structure while preferred dividends are not tax deductible – although their tax treatment varies by jurisdiction.

However, preferred shares are favored by retail investors (institutional investors find far less favor with preferred shares compared with common shares or fixed income) for investment grade companies. Given the affinity for preferred shares by a less sophisticated and yield hungry investor base, sometimes corporates can get away with paying a low preferred dividend while not compromising their credit ratings when they need money and additional debt would put them in a delicate situation with the rating agencies.

Preferred shares have their own credit ratings – P-1, P-2, P-3, P-4, and P-5. P-3 is the investment grade cusp equivalent and the market is not receptive to preferred shares below P-3 in terms of new issuers.

Rate Reset Preferred Shares

RR Prefs pay a fixed dividend for 5 years before they “reset”, whereby the holder of the preferred share has the option of a new fixed rate based on the benchmark government rate at that time or switch to a variable rate dividend permanently. As they are floating rate instruments, they are relatively more rate sensitive during the beginning of a reset period but not very rate sensitive near the end. Assuming the credit quality for the underlying company is acceptable, these will generally not deviate far from par.

Financial institutions have a special type of rate reset prefs called Non-Viability Contingent Capital (“NVCC”). These will convert into common equity to shore up the capital of the financial institution if the domestic financial regulator under certain circumstances.

Floating Rate Preferred Shares

As the name implies, floaters pay variable rate dividends and are not very interest rate sensitive, but may get blown out if the underlying credit is poor.

Perpetual Preferred Shares

These preferred shares pay a dividend at the same rate with no maturity date. They are very interest rate sensitive.

Convertible Debentures

There are various ECM products with an embedded conversion option – that is the right but not the obligation to convert the security into a certain number of common shares. The most common ones are convertible bonds and convertible preferred shares, but technically, any financial instrument could have a conversion option.

Convertible debt is characterized as a subordinated fixed income instrument with a conversion option that kicks in after a certain time period. However, holders of convertible debt may not want to convert once the option is “in-the-money” as they continue to enjoy the coupon until conversion is forced. The issuer will have debt on their books and known interest payments for a limited period, where the interest payments are tax deductible.

Convertible bonds are junior to other bonds, so for credit agreements and bond indentures, they usually do not count against maintenance covenants. However, credit rating agencies treat them purely as debt.

A convertible makes sense when the convertible issuer wants to issue delayed equity more cheaply than a direct common share issuance while enjoying cheaper debt for the time being as the conversion premium means that investors are willing to accept a lower yield on the note. Given that the convertible does not hurt leverage metrics, the convertible becomes a much more attractive option versus debt.

A convertible bond that has seen the underlying equity fall far below the conversion price whereby the conversion option is effectively worthless is called a busted convertible. It will trade more or less in line with a straight bond (normal bond) for the company.

Shareholder Analysis for Equity Capital Markets

ECM will disseminate shareholder analysis to corporates to shed light on who the primary investors are and what strategies they follow. If certain shareholders are missing, let’s say a dividend index, ECM can speak to the rules that must be followed to broaden shareholder acceptance (raise your dividend once a year).

They can also compare the holdings vs peers (for instance, these US fund managers hold Suncor but not Canadian Natural Resources – could they be served by doing a tour with Blackrock, PIMCO and T.Rowe?) and find out how to better communicate the company’s story and alleviate investor fears.

Looking at whether funds are underweight or overweight a stock compared to the index or another relevant benchmark can also be used in reverse as feedback for the company’s current strategy. Does something need to be derisked before people look to buy?

Top Shareholders for Equity

In a shareholder analysis update, the investment bank will often list the top 10 or top 25 shareholders. This can be easily pulled from a data source such as Factset or Bloomberg (OWNH <GO>), which in turn lists the source of the data as many asset managers have to report their holdings.

From there, the investment bank can segment the shareholder base into relevant categories such as investor type, investor geography, investor mandate, and whether or not investors are activist threats (shareholder activism).

Investor Type – Institutional, Retail, Insider
Investor Geography – Canada, US, International
Fund Mandate (Institutional) – Growth, Value, Special Situtations
Institution Type – Hedge Fund, Mutual Fund, Index Fund, Pension
Passive versus Active Investing – Indexing to Benchmark or Active Security Selection (stock picking)
Shareholder Activism – Shareholders with activist history versus passive shareholders

Investment banks will also outline which investors are buying and which are selling, as well has how big the flows are so that the company can plan to appease or defend. Investment banks may offer strategy and tactics for how to market to certain investors depending on what they have historically liked to see.

Activist Shareholders

Shareholder activism has become more newsworthy of late with famous hedge fund managers such as Bill Ackman (Pershing Square), Carl Icahn, David Einhorn (Greenlight Capital), Barry Rosenstein (Jana Partners) and Dan Loeb (Third Point) taking aim at companies and demanding change (by kicking out the Board of Directors and bringing in their own people).

Beyond these widely reported proxy battles, shareholder activism represents a real threat when the stock performance has not been top quartile (or relatively poorly compared to industry peers). Reasons for complaint can include the stock trading at a lower multiple (General Motors – Greenlight), management excess (Third Point – Sotheby’s), return of capital ideas (Icahn demanding a dividend from Apple), or sub-optimal capital structure.

If a known activist shareholder takes on a material shareholding, an investment bank may be hired by management or the board of directors to advise on how to deal with the situation.

Equity Capital Markets Update

ECM will be continuously putting out data on issue volume, where things priced, how many times covered demand was – etc. For every industry, they will have an assortment of tables and pies that illustrate appetite for equity issuance.

Given this, they will provide indicative numbers for where a company would price should it issue, depending on the size and other considerations. ECM will be in charge of their own league tables which showcase their bank’s performance (fiddling around with Bloomberg or other data provider criteria to make sure they are first or second).

On the converse, ECM will also offer commentary on repurchases and the merits of a Normal Course Issuer Bid (NCIB) or Substantial Issuer Bid (SIB) as well as providing a walkthrough of execution schedules should they take on a mandate – accretion/dilution analysis will be conducted by primary investment banking coverage.

Timing an Equity Issuance

ECM will comment on when it is a good time to issue equity. Generally, when equity markets are robust with investor appetite, valuations are frothy and stock markets are rising, the window is more attractive as it minimizes dilution to existing shareholders (which the corporate owes a fiduciary duty to). Issuers also want more certainty on price, so turbulent market movements or high volatility is not desirable. A good compromise on both of the above are times when several industry peers have already issued successfully – for resource companies in mining and oil & gas, one healthy issue usually leads to a string of issues.