Financing Alternatives and Investor Types

Types of Financing Transactions

Investment bankers advise companies on the best way to raise capital. The Series 79 tests your understanding of the available alternatives, their trade-offs, and which types of investors are appropriate for each.

Equity Financing

• IPO (Initial Public Offering): First sale of stock to the public. Requires SEC registration (Form S-1), road show, book building.
• Follow-on (Secondary) Offering: Additional shares offered by an already-public company. Can be primary (new shares, dilutive) or secondary (existing shareholders selling).
• PIPE (Private Investment in Public Equity): A public company sells securities directly to select investors at a negotiated discount. Faster than a public offering, avoids full registration initially.
• Forward Sale: An agreement to sell shares at a future date at a fixed price, often used by utilities and REITs.

Debt Financing

• Investment grade bonds: Lower yield, broader investor base
• High-yield (junk) bonds: Higher coupon, covenant-heavy, used in leveraged transactions
• Convertible securities: Hybrid — debt that can convert to equity, lower coupon than straight debt
• Bank loans (term loans, revolving credit): Private lending, often secured, floating rate

Types of Investors

• Mutual funds: Long-only, regulated under the 1940 Act
• Hedge funds: Flexible strategies (long/short, distressed, arbitrage), accredited/qualified investors, less regulation
• Private equity firms: Buy controlling stakes, use leverage, target long-term value creation through operational improvements
• Venture capital: Early-stage equity investments, high risk/return
• QIBs (Qualified Institutional Buyers): Own/manage $100M+ in securities. Key for Rule 144A private resales.
• Qualified Purchasers: Own $5M+ in investments. Key for Section 3(c)(7) funds.

Organizational Structures

Know the tax and liability implications: C corps (double taxation), S corps (pass-through, ≤100 shareholders), LLCs (flexible), limited partnerships (GP unlimited liability, LP limited), MLPs (publicly traded partnerships, pass-through income), REITs (must distribute 90%+ of taxable income).

Debt vs. Equity — The Trade-Off

The choice between debt and equity financing involves fundamental trade-offs that the exam tests frequently:

• Debt advantages: Tax-deductible interest (tax shield), no ownership dilution, lower cost of capital (senior claim = lower required return), predictable payments
• Debt disadvantages: Mandatory interest payments regardless of performance, covenants restrict operational flexibility, default risk, increased financial leverage
• Equity advantages: No mandatory payments, no default risk, greater operational flexibility, no covenants
• Equity disadvantages: Dilution of existing shareholders' ownership and EPS, higher cost of capital (residual claim = higher required return), dividend expectations

Convertible securities are the hybrid middle ground: lower coupon than straight debt (because of the equity upside), with conversion dilution deferred until conversion occurs.

Investment Strategies — Know the Vocabulary

The exam tests whether you understand common investor strategies:

• Distressed: Buying debt or equity of companies in or near bankruptcy at deep discounts, expecting recovery value
• Risk arbitrage (merger arb): Buying the target in an announced deal and potentially shorting the acquirer, betting on deal completion
• GARP (Growth at a Reasonable Price): Seeking companies with above-average growth but reasonable valuations (moderate P/E, PEG ratio near 1)
• Special situations: Investing around corporate events — spinoffs, restructurings, litigation outcomes
• Deep value: Buying securities trading significantly below intrinsic value with a long time horizon for realization

Primary vs. Secondary Offerings — Critical Distinction

This terminology appears frequently on the exam and is a common source of confusion:

• Primary offering: The company itself issues new shares. Proceeds go to the company. This is dilutive — the share count increases, reducing existing shareholders' ownership percentage.
• Secondary offering: Existing shareholders (founders, PE firms, employees) sell their shares. Proceeds go to the selling shareholders, NOT the company. This is not dilutive to the share count, but it can depress the stock price due to increased supply.
• Combined offering: Many deals include both — the company issues new shares AND existing holders sell. The prospectus clearly separates the primary and secondary components.

Exam trap: "Follow-on offering" and "secondary offering" are NOT synonyms. A follow-on is any offering after the IPO — it can be primary (new shares), secondary (existing holders selling), or both. "Secondary" specifically means existing shareholders are selling.

Hybrid Securities — Beyond Convertibles

The outline references several hybrid structures:

• Convertible bonds: Debt that converts to equity at a predetermined conversion ratio. Lower coupon than straight debt. Conversion is typically at the bondholder's option.
• Convertible preferred stock: Preferred that converts to common at a set ratio. Common in venture capital and PE transactions as downside protection with equity upside.
• Preferred stock with warrants: Preferred shares bundled with warrants (long-term options to buy common stock). The warrants act as an equity "sweetener" for investors.
• Subordinated debt with warrants: Junior debt combined with equity warrants — common in mezzanine financing where lenders want equity upside to compensate for the subordinated position.
• PIK (Payment-in-Kind) notes: Debt where interest is paid in additional securities rather than cash. Used in leveraged transactions when cash flow is tight.

Leveraged Buyout (LBO) — Mechanics and Return Drivers

An LBO is the acquisition of a company using a significant amount of debt financing. The private equity sponsor contributes equity (typically 30-40% of the purchase price) and finances the remainder with debt secured by the target's cash flows and assets.

The Three Drivers of LBO Returns

Key LBO Return Metrics

• IRR (Internal Rate of Return): Annualized return on the sponsor's equity. Typical target: 20-25%+. Highly sensitive to hold period and exit value.
• MOIC (Multiple on Invested Capital): Total equity proceeds / Initial equity invested. A 3.0x MOIC means the sponsor tripled its money. MOIC does not account for time — IRR does.

IRR approximations: 2.0x over 5 years ≈ 15% IRR. 2.0x over 4 years ≈ 19%. 3.0x over 5 years ≈ 25%.

LBO Capital Structure — Layers of Financing

Special Structures

• Revolving credit facility: Flexible short-term liquidity for working capital needs. Drawn and repaid as needed. Not for permanent financing.
• PIK (Payment-in-Kind) debt: Interest accrues and is added to the principal instead of being paid in cash. Preserves near-term liquidity but increases total debt over time.
• Cash sweep covenant: Directs excess free cash flow toward accelerated debt repayment. Protects lenders by deleveraging faster.
• Management rollover: Target management reinvests part of their existing equity rather than cashing out. Acts as a source of funds, reducing the sponsor's required equity contribution.
• Dividend recapitalization: The portfolio company issues new debt and uses the proceeds to pay a cash distribution to the sponsor. Enterprise Value is unchanged, but equity value declines. Improves IRR by returning cash earlier.

Accretion / Dilution Analysis

Accretion/dilution analysis answers: Does the deal increase or decrease the acquirer's earnings per share? This is a central test of whether a transaction creates value for the acquirer's shareholders.

• Accretive: Pro forma EPS is HIGHER than the acquirer's standalone EPS. The deal adds earnings value.
• Dilutive: Pro forma EPS is LOWER than the acquirer's standalone EPS. The deal destroys earnings value.

The Shortcut Tests

Key factor: Even a dilutive deal can become accretive if post-tax synergies are large enough to offset the dilution. The breakeven synergy calculation is a common exam question.

Purchase Price Allocation (PPA) and Goodwill

Under purchase accounting, the acquirer allocates the purchase price to the target's assets and liabilities at fair value:

Goodwill = Purchase Price - Fair Value of Identifiable Net Assets

• Step-ups: If the fair value of assets (PP&E, intangibles) exceeds book value, the difference is a "step-up." Step-ups create higher future depreciation/amortization expense, which reduces pro forma EPS.
• Identifiable intangibles: Customer relationships, brand names, technology, non-compete agreements. These are amortized over their useful lives, creating a non-cash expense that reduces earnings.
• Goodwill impairment: If goodwill is later determined to be impaired (the acquired business is worth less than the price paid), the impairment charge reduces earnings but does not affect cash flow.

Transaction Fee Treatment

Under current GAAP, advisory, legal, and accounting fees are expensed as incurred — they are NOT capitalized into goodwill or the purchase price. This expense reduces net income and retained earnings in the period incurred.

Pro Forma Financial Statements in M&A

After an acquisition, the combined company's financials are presented on a pro forma basis. Key adjustments:

• Target's historical equity accounts are eliminated — common stock, APIC, and retained earnings do not carry over. The purchase price is allocated to assets and liabilities at fair value.
• Pro forma shares outstanding = Acquirer's existing shares + new shares issued to the target (target diluted shares x exchange ratio). Only relevant in stock deals.
• New financing costs — if the deal is debt-funded, the after-tax interest expense on the new debt reduces pro forma earnings.
• Amortization of acquired intangibles reduces pro forma net income. This is a non-cash charge but appears on the GAAP income statement.

Synergies — Revenue vs. Cost

Breakeven synergy calculation: If a deal is $0.25 dilutive to EPS and the acquirer has 100 million shares, the after-tax earnings shortfall is $25 million. To find the required pre-tax synergies, gross up for taxes: $25M / (1 - tax rate).

Exchange Ratios — Fixed vs. Floating

Collars

A collar protects against extreme stock price moves between signing and closing. In a fixed exchange ratio deal, a collar may adjust the ratio if the acquirer's stock moves outside a specified range, preserving a minimum value for target shareholders.

Control Premium

Control Premium = (Offer Price / Unaffected Share Price) - 1

The premium is measured against the target's unaffected stock price — the price before the deal was announced or rumored. Using the 52-week high, the current price (which may be inflated by deal rumors), or any other benchmark will produce an incorrect result.

Typical control premiums range from 20-40% above the unaffected price. The premium on equity value translates into a smaller percentage increase in Enterprise Value if the target has significant debt, because the premium applies to equity only.

Strategic Alternatives — Spin-offs, 338(h)(10), and NOLs

Spin-offs

A spin-off separates a division into an independent public company distributed to existing shareholders. If structured to meet IRC Section 355 requirements, the transaction can be tax-free to both the parent and shareholders — a key advantage over a taxable sale. Spin-offs can unlock value by eliminating a conglomerate discount.

Section 338(h)(10) Election

Allows certain stock purchases to be treated as asset purchases for tax purposes. The buyer receives a stepped-up tax basis in the acquired assets, creating additional depreciation and amortization deductions. The trade-off: the seller may face higher tax liability.

Net Operating Losses (NOLs) in M&A

After an ownership change, IRC Section 382 limits the annual amount of acquired NOLs that can be used. The cap is based on the target's equity value at the time of the change multiplied by the long-term tax-exempt rate. NOLs can improve pro forma accretion by reducing future cash taxes.

Merger of Equals

A structure where two companies of roughly similar size combine in a 100% stock-for-stock transaction. Key characteristics:

• The exchange ratio is typically set near prevailing market values, so the premium is minimal or zero
• Governance is often split (board seats, management roles) to reflect the equal standing of both parties
• Because no significant premium is paid, Merger of Equals transactions can be harder to justify to shareholders who expect a control premium