Bought Out Deals in Investment Banking

Whenever a company wants to go public, they generally appoint investment bankers to be the intermediaries. However, in some cases, investment bankers are looking to make a higher return. They are also willing to take more risks in order to earn that higher return. Over the years, investment banks have devised a strategy wherein they can be more involved in the IPO process and hence can earn a higher return from the same. This process is called a “bought out deal.” In this article, we will understand what a bought out deal is and how it works.

What is a Bought Out Deal?

A bought deal is a type of Initial Public Offering deal. It is a two-pronged process. In this process, instead of going public directly, the company sells its stock to a private investor with the understanding that this private investor will ultimately take the company public within a predetermined period of time. Nowadays, bought out deals are not commonly seen in the market. However, during the nineties, these deals were commonplace.

Now, in most cases, the private party that first buys these shares and then resells them to the public is the investment banker. In case of such issues, investment bankers end up acting as the principal instead of the agent. These deals have several advantages as well as disadvantages. Some of these details have been listed in the article below.

Example of a Bought Out Deal

A company wants to sell its shares. It is projected that the market value of the shares will be $1. However, the company needs money immediately. Also, the company is not very sure about whether the IPO will be successful. In such cases, they might consider selling the entire issue to the investment banker at $0.75. If the banker is able to sell for more than $0.75, they stand to make money, or else they will face a net loss.

Bought Out Deal from the Point of View of the Selling Company

Companies tend to opt for bought out deals because of certain specific advantages and disadvantages that these deals have to offer. The details have been listed below:

  • In the case of bought deals, the selling company is assured of the funds from the very first day. This means that the uncertainty, as well as the time required for the public issue to take place, is greatly reduced. The selling company gets money on the spot. The entire risk associated with the stock issuing process is eliminated.

  • In the case of a bought deal, the issuing company does not have to pay upfront compensation. Instead, the investment bank earns its compensation as a difference between the purchase and sale price of its shares. This reduces the cash outlay required for the IPO process.

  • The main disadvantage for the issuing company is that it has to compromise in terms of price. The investment bankers who invest in these shares are commonly looking to get deep discounts when they buy the entire issue before it reaches the market. Since the entire process is risky, a significant risk premium has to be paid out. This eats into the proceeds which are raised from the IPO. This is the reason that fewer big companies ever use the bought out deal process.

  • The promoters of the issuing company also run the risk of a hostile takeover with bought out deals. This is because after bought out deals, the investment banks end up holding large amounts of stock in the company. They are often in a position to collude with the competitors and induce a hostile takeover. This is the reason that trust is an important factor while choosing a partner as far as bought out deals are considered.

Bought Out Deal from the Point of View of Investment Bankers

Not all investors provide their investors with bought out deals. This is because these deals have some specific risk-reward characteristics which may not be suitable for all banks. Some of these characteristics have been listed below:

  • As mentioned above, the underwriters are able to make a handsome return on their investment. This is because the issuing company provides a substantial discount during the sale. The investment bankers know the exact time frame in which they are going to take the company public. They can work out a good internal rate of return on the basis of the investment and the time frame for which the money will be locked.

  • Investment bankers know how to create a positive public relations campaign for a company in order to increase the prices of the shares. Hence, they are able to buy low, raise the prices, and earn a handsome return on their investment.

  • The only problem that the investment banker faces is that there is always a risk the banker may not be able to resell the issue at a higher price. In some cases, due to adverse macroeconomic events, they may not be able to sell the issue at all. It is for this reason that their capital might end up getting stuck in these shares for a long time. Investment bankers typically want to earn a high return on equity. This is the reason that they factor in the risk and charge an upfront premium.

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Investment Banking