An Overview of the Private Equity Distressed Debt and Restructuring Markets Kelly Deponte, Partner, Probitas Partners

Total Page:16

File Type:pdf, Size:1020Kb

An Overview of the Private Equity Distressed Debt and Restructuring Markets Kelly Deponte, Partner, Probitas Partners 17 An Overview of the Private Equity Distressed Debt and Restructuring Markets Kelly DePonte, Partner, Probitas Partners Distressed debt and restructuring investing is a small but These factors make the sector complex, and this chapter is growing sector of the private equity market, one with several meant to provide a general overview of issues that are covered unique characteristics: in depth in a number of the other chapters. • In a private equity market that is becoming increasingly INVESTMENT STRATEGIES AND DEFINITIONS global, it is one where local laws and regulations still have a significant impact. For many investment strategies, Before covering how the market has developed, it would be local bankruptcy laws and their practical application are useful to define the investment strategies that are prevalent in tremendously important – though for global companies the the market. It needs to be said that the “pure” strategies question of which bankruptcy law applies is not always described below are useful for discussion purposes, but that straightforward. many funds utilize hybrid strategies in some form of combi- • Hedge funds are a significant competitor in the sector. nation. Recently, hedge funds have begun to compete with private equity funds for transactions on a limited basis. In the Distressed Debt Trading Distressed Debt sector, however, hedge funds have been At its simplest, Distressed Debt Trading involves purchasing significant competitors for years, especially for funds pursu- debt obligations trading at a distressed level – for example at ing Distressed Debt Trading strategies. 40% of par value – in anticipation of reselling those securities • Within the sector, fund managers pursue greatly divergent over a relatively short period of time at a higher level, gener- investment strategies. The investment strategies used by ating a trading profit. Distressed Debt traders are looking for fund managers in the sector (described in further detail in investment opportunities in which they believe the debt obli- the Investment Strategy sector below) are very different gations are fundamentally mispriced and will rebound in and require diverse skill sets to execute successfully. value. The holding period on an individual security is usual- • Investment opportunities in the sector are counter-cyclical ly weeks, sometimes days, and the size of a particular position to the general economy. Established private equity sectors is not directly relevant.This is the most liquid of these invest- such as buyouts, venture capital, and mezzanine investment ment strategies, and in part for that reason hedge funds are are not totally dependent upon general economic cycles, but major players in this sector. their returns are generally positively correlated to econom- ic trends; a strong economy in general helps generate strong Distressed Debt: Active/Non-Control returns and a weak economy hurts returns. The reverse is Active/Non-Control strategies are substantially different true of Distressed Debt and Restructuring Funds, as a weak from Trading strategies in that their goal is to accumulate economy generates in general increased investment oppor- significant positions in companies that are likely to go tunities. through, or are in, a bankruptcy restructuring process. The 18 The Guide to Distressed Debt & Turnaround Investing goal is to gain a position of influence in that restructuring a Restructuring focused fund or at other times taking the process in which the value of securities – and indeed the lead themselves. This most often occurs when they have par- nature of the end securities exchanged – is negotiated in ticular industry or country expertise (as was the case with bankruptcy in order to maximize returns. This complex Ripplewood and J.C. Flowers in the Shinsei Bank transac- process necessitates a longer holding period than in Trading, tion in Japan) though in general buyout funds avoid restruc- as well as larger, more concentrated portfolio positions. turing transactions especially if the company is already in bankruptcy. Distressed Debt: Control In this strategy,the fund manager builds a controlling position Lastly, though not private equity funds per se, there are also in the fulcrum distressed security in a bankruptcy proceeding opportunistic real estate funds that are focused on distressed in order to effectively buy control of the target company transactions, and several firms such as Cerberus and Lone through the bankruptcy process, either alone or as part of a Star got their start in this area before broadening their man- syndicate. With this strategy, the distressed debt position is in dates into corporate investments as well.The dynamics of the many respects the start of a much longer process, as after the distressed real estate market are somewhat similar to the pri- fund manager wins control of the target he acts very much as vate equity market, though the economic cycles and the types a buyout fund manager would, controlling the company and of assets are quite different. turning it around in order to maximize profitability. THE ROLE OF BANKRUPTCY LAW Restructuring or Turnaround Restructuring or Turnaround funds target companies in dis- In most Distressed Debt and Restructuring funds, deep tress but buy them utilizing equity, sometimes purchasing knowledge and experience in bankruptcy law and its process- them before an expected bankruptcy and other times in the es are key to success.Though it can be argued that Distressed bankruptcy process. Their goal – much as it is for Distressed Debt Trading strategies may be driven more by market psy- Debt: Control funds – is to get control of companies in dis- chology and trading dynamics, in all the other strategies tress cheaply and then restructure them. This strategy also knowledge of the law and its practical workings is crucial. requires detailed knowledge of local bankruptcy law in a sim- Also key is the fact that - as is discussed in other chapters of ilar manner to the distressed debt strategies. this book - the details of bankruptcy regulation can differ tremendously country by country. Success in one legal envi- Few funds follow any one of these strategies in a pure man- ronment under a specific set of regulations does not set a ner. For example, both Distressed Debt: Active/Non-Control template that can be automatically duplicated in another and Distressed Debt: Control managers use smaller trading jurisdiction. positions for reconnaissance purposes, sometimes building them up further into core positions and at other times liqui- The starting point for any discussion of legal ramifications in dating the position in order to move on to another target. Distressed Debt and Restructuring strategies is Chapter 11 Even restructuring funds that normally do not deal in dis- of the U.S. bankruptcy code, adopted in 1978. This provision tressed debt have occasionally taken control positions of the code for the first time put real stress on reorganizing a through debt instead of equity. company so it could continue to operate instead of focusing on liquidating a company. The intention of the law was to In addition, a number of regular buyout funds will on occa- both ease impacts on stakeholders like company employees sion do turnaround transactions, at times in a syndicate with and suppliers by having a revitalized if restructured company Chapter Title 19 still in operation, and to provide debtors with at least the opposed to liquidation was a necessary first step in the creation potential for a higher level of recuperation on defaulted secu- of the Distressed Debt and Restructuring Market, the other rities than would be possible in a liquidation. key item necessary was a supply of transactions that were attractive and presented a critical mass of opportunities neces- With real reorganization mechanisms in place, it began to be sary to get investors to devote time and attention to the sector. practical to try to take control of companies through the bankruptcy process. Liquidity preference (see the attached Until the 1980s, the supply of Distressed Debt was provided table) became not just relevant in the liquidation of a compa- by “Fallen Angels” – debt instruments that had originally ny but crucial in control of a restructuring. The “fulcrum been issued by investment grade obligors whose credit stand- security” in a restructuring would be the instrument likely to ing and repayment ability had fallen. Though there was a control the future of the company – with the size of overall constant supply of this type of paper as individual companies potential losses determining which investment securities got into financial trouble in all sorts of economic environ- would be wiped out and which might be converted into com- ments, the supply was actually rather low – and a number of mon equity controlling the reorganized firm. these Fallen Angels were so badly troubled that liquidation was still preferable to restructuring. TABLE 1 – SIMPLIFIED PREFERENCE STRUCTURE The 1980s, however, saw the creation of a new type of debt Secured Debt market – the high yield new issuance or “junk bond” market – in which highly levered companies issued non-investment Senior Debt grade paper with high coupon levels reflecting the increased Subordinated Debt financial risk inherent in their capital structures. Finance the- Preferred Stock ory touted by Michael Milken of Drexel Burnham Lambert and others enticed investors to purchase these bonds on the Common Stock basis that a diversified portfolio of high yield obligations was an attractive investment as the increased yield was attractive For a number of years the U.S. stood alone with this approach net of anticipated losses on defaults. Issuance of these bonds to bankruptcy, but as these changes took hold other countries was also driven by another group on the rise – Leveraged began to consider and then adopt this approach. However, Buyout Funds – that used these bonds to help buy targeted the U.S. market is still the most advanced in this area, espe- companies. cially as regards tried and true processes and methods of applying the regulation.
Recommended publications
  • Initial Public Offerings
    November 2017 Initial Public Offerings An Issuer’s Guide (US Edition) Contents INTRODUCTION 1 What Are the Potential Benefits of Conducting an IPO? 1 What Are the Potential Costs and Other Potential Downsides of Conducting an IPO? 1 Is Your Company Ready for an IPO? 2 GETTING READY 3 Are Changes Needed in the Company’s Capital Structure or Relationships with Its Key Stockholders or Other Related Parties? 3 What Is the Right Corporate Governance Structure for the Company Post-IPO? 5 Are the Company’s Existing Financial Statements Suitable? 6 Are the Company’s Pre-IPO Equity Awards Problematic? 6 How Should Investor Relations Be Handled? 7 Which Securities Exchange to List On? 8 OFFER STRUCTURE 9 Offer Size 9 Primary vs. Secondary Shares 9 Allocation—Institutional vs. Retail 9 KEY DOCUMENTS 11 Registration Statement 11 Form 8-A – Exchange Act Registration Statement 19 Underwriting Agreement 20 Lock-Up Agreements 21 Legal Opinions and Negative Assurance Letters 22 Comfort Letters 22 Engagement Letter with the Underwriters 23 KEY PARTIES 24 Issuer 24 Selling Stockholders 24 Management of the Issuer 24 Auditors 24 Underwriters 24 Legal Advisers 25 Other Parties 25 i Initial Public Offerings THE IPO PROCESS 26 Organizational or “Kick-Off” Meeting 26 The Due Diligence Review 26 Drafting Responsibility and Drafting Sessions 27 Filing with the SEC, FINRA, a Securities Exchange and the State Securities Commissions 27 SEC Review 29 Book-Building and Roadshow 30 Price Determination 30 Allocation and Settlement or Closing 31 Publicity Considerations
    [Show full text]
  • Stock in a Closely Held Corporation:Is It a Security for Uniform Commercial Code Purposes?
    Vanderbilt Law Review Volume 42 Issue 2 Issue 2 - March 1989 Article 6 3-1989 Stock in a Closely Held Corporation:Is It a Security for Uniform Commercial Code Purposes? Tracy A. Powell Follow this and additional works at: https://scholarship.law.vanderbilt.edu/vlr Part of the Securities Law Commons Recommended Citation Tracy A. Powell, Stock in a Closely Held Corporation:Is It a Security for Uniform Commercial Code Purposes?, 42 Vanderbilt Law Review 579 (1989) Available at: https://scholarship.law.vanderbilt.edu/vlr/vol42/iss2/6 This Note is brought to you for free and open access by Scholarship@Vanderbilt Law. It has been accepted for inclusion in Vanderbilt Law Review by an authorized editor of Scholarship@Vanderbilt Law. For more information, please contact [email protected]. Stock in a Closely Held Corporation: Is It a Security for Uniform Commercial Code Purposes? I. INTRODUCTION ........................................ 579 II. JUDICIAL DECISIONS ................................... 582 A. The Blasingame Decision ......................... 582 B. Article 8 Generally .............................. 584 C. Cases Deciding Close Stock is Not a Security ...... 586 D. Cases Deciding Close Stock is a Security .......... 590 E. Problem Areas Created by a Decision that Close Stock is Not a Security .......................... 595 III. STATUTORY ANALYSIS .................................. 598 A. Statutory History ................................ 598 B. Official Comments to the U.C.C. .................. 599 1. In G eneral .................................. 599 2. Official Comments to Article 8 ................ 601 3. Interpreting the U.C.C. as a Whole ........... 603 IV. CONCLUSION .......................................... 605 I. INTRODUCTION The term security has many applications. No application, however, is more important than when an interest owned or traded is determined to be within the legal definition of security.
    [Show full text]
  • The Importance of the Capital Structure in Credit Investments: Why Being at the Top (In Loans) Is a Better Risk Position
    Understanding the importance of the capital structure in credit investments: Why being at the top (in loans) is a better risk position Before making any investment decision, whether it’s in equity, fixed income or property it’s important to consider whether you are adequately compensated for the risks you are taking. Understanding where your investment sits in the capital structure will help you recognise the potential downside that could result in permanent loss of capital. Within a typical business there are various financing securities used to fund existing operations and growth. Most companies will use a combination of both debt and equity. The debt may come in different forms including senior secured loans and unsecured bonds, while equity typically comes as preference or ordinary shares. The exact combination of these instruments forms the company’s “capital structure”, and is usually designed to suit the underlying cash flows and assets of the business as well as investor and management risk appetites. The most fundamental aspect for debt investors in any capital structure is seniority and security in the capital structure which is reflected in the level of leverage and impacts the amount an investor should recover if a company fails to meet its financial obligations. Seniority refers to where an instrument ranks in priority of payment. Creditors (debt holders) normally have a legal right to be paid both interest and principal in priority to shareholders. Amongst creditors, “senior” creditors will be paid in priority to “junior” creditors. Security refers to a creditor’s right to take a “mortgage” or “lien” over property and other assets of a company in a default scenario.
    [Show full text]
  • In Re Security Finance Co
    University of California, Hastings College of the Law UC Hastings Scholarship Repository Opinions The onorH able Roger J. Traynor Collection 11-12-1957 In re Security Finance Co. Roger J. Traynor Follow this and additional works at: http://repository.uchastings.edu/traynor_opinions Recommended Citation Roger J. Traynor, In re Security Finance Co. 49 Cal.2d 370 (1957). Available at: http://repository.uchastings.edu/traynor_opinions/526 This Opinion is brought to you for free and open access by the The onorH able Roger J. Traynor Collection at UC Hastings Scholarship Repository. It has been accepted for inclusion in Opinions by an authorized administrator of UC Hastings Scholarship Repository. For more information, please contact [email protected]. 370 IN BE SECURITY FINANCE CO. [49 C.2d [So F. No. 19455. In Bank. Nov. 12, 1957.] In re SECURITY FINANCE COMPANY (a Corporation), in Process of Voluntary Winding Up. EARL R. ROUDA, Respondent, V. GEORGE N. CROCKER et at, Appellants. [1] Corporations-DissolutioD.-At common law a corporation had no power to end its existence; the shareholder.- could surrender the charter, but actual dissolution depended on acceptance by the sovereign. [2] ld.-Voluntary Dissolution-Judicial SupervisioD.-The su­ perior court has jurisdiction to supervise the dissolution of a corporation by virtue of Corp. Code, § 4607, only if the cor­ poration is "in the process of voluntary winding up," and the corporation is in the process of voluntary winding up only if a valid election to wind up has been made pursuant to § 4600. [3] 1d.-Volunta17 Dissolution-Rights of Shareholders.-Share­ holders representing 50 per cent of the voting power do not have an absolute right under Corp.
    [Show full text]
  • Bain Capital Distressed and Special Situations 2019 (A), LP
    COMMONWEALTH OF PENNSYLVANIA PUBLIC SCHOOL EMPLOYEES’ RETIREMENT SYSTEM Public Investment Memorandum Bain Capital Distressed and Special Situations 2019 (A), L.P. High Yield/Private Credit Commitment James F. Del Gaudio Senior Portfolio Manager April 22, 2019 COMMONWEALTH OF PENNSYLVANIA PUBLIC SCHOOL EMPLOYEES’ RETIREMENT SYSTEM Recommendation: PSERS Investment Professionals, together with Hamilton Lane Advisors, L.L.C. (“Hamilton Lane”), recommend the Board commit up to $200 million to Bain Capital Distressed and Special Situations 2019 (A), L.P. (the “Fund”, or “DSS 19”). Bain Capital Credit, LP (“Bain” or the “Firm”) is seeking to raise their third dedicated distressed and special situations fund, DSS 19, which will focus on global special situations opportunities and distressed securities, targeting $3 billion in commitments. Firm Overview: Bain Capital Credit, LP, an affiliate of Bain Capital, LP, is a leading global credit specialist. The Firm was formed as Sankaty Advisors in 1998 by Jonathan Lavine, Managing Partner and CIO, based on the idea that one could successfully apply the same level of rigorous analysis developed in Bain Capital’s Private Equity business to credit investing. With approximately $39 billion in assets under management as of January 1, 2019, Bain Capital Credit invests across the full spectrum of credit strategies, including leveraged loans, high-yield bonds, distressed debt, direct lending, structured products, non-performing loans (“NPLs”), and equities. Bain Capital Credit currently has 297 employees in
    [Show full text]
  • Frequently Asked Questions About Initial Public Offerings
    FREQUENTLY ASKED QUESTIONS ABOUT INITIAL PUBLIC OFFERINGS Initial public offerings (“IPOs”) are complex, time-consuming and implicate many different areas of the law and market practices. The following FAQs address important issues but are not likely to answer all of your questions. • Public companies have greater visibility. The media understanding IPOS has greater economic incentive to cover a public company than a private company because of the number of investors seeking information about their What is an IPO? investment. An “IPO” is the initial public offering by a company • Going public allows a company’s employees to of its securities, most often its common stock. In the share in its growth and success through stock united States, these offerings are generally registered options and other equity-based compensation under the Securities Act of 1933, as amended (the structures that benefit from a more liquid stock with “Securities Act”), and the shares are often but not an independently determined fair market value. A always listed on a national securities exchange such public company may also use its equity to attract as the new York Stock exchange (the “nYSe”), the and retain management and key personnel. nYSe American LLC or one of the nasdaq markets (“nasdaq” and, collectively, the “exchanges”). The What are disadvantages of going public? process of “going public” is complex and expensive. • The IPO process is expensive. The legal, accounting upon the completion of an IPO, a company becomes and printing costs are significant and these costs a “public company,” subject to all of the regulations will have to be paid regardless of whether an IPO is applicable to public companies, including those of successful.
    [Show full text]
  • Preventing Nuclear Catastrophe: Making the Case for Investors and the Private Sector to Work Towards Reducing the Risks of Nuclear Weapons
    Preventing Nuclear Catastrophe: Making the Case for Investors and the Private Sector to Work Towards Reducing the Risks of Nuclear Weapons David Epstein, CFA The Cross Capital Initiative | July 2020 Acknowledgements We would like to acknowledge the folks who we interviewed for our ongoing work, along with others who were helpful. (Please note that inclusion of a name should not be taken as an indication that the person has read or endorses the report.) This report was made possible by funding from and in collaboration with N Square. Erika Gregory – Director, N Square Chris Gadomski – Lead Analyst, Nuclear, Morgan Matthews – Deputy Director, N Square Bloomberg New Energy Finance Gretchen Hund – Former Director, PNNL Elizabeth Talerman – CEO, Nucleus Christopher Bidwell – Senior Fellow, Federation Shazeeda Bhola – Strategist/Designer, Nucleus of American Scientists Clare Albers – Nucleus Lauren Borja – Stanton Nuclear Security Franz Busse – Sr. VP of Tech. Systems, Banjo Postdoctoral Fellow, Stanford Tom Freke – Senior Editor, Bloomberg News Michelle Dover – Director of Programs, Elaine Hagan – Assoc. Dean @ UCLA Anderson Ploughshares Fund and Exec. Dir. of Price Center Rob Du Boff, CFA – ESG Analyst, Bloomberg Will Freas – Prog. Coord., Venture Accelerator Intelligence @ UCLA Anderson Nickolas Roth – Senior Fellow & Director, Ben Solomon – Founder/Managing Partner, Stimson Center’s Nuclear Security Program Fedtech Brian Finlay – President/CEO, Stimson Center Jack Fernandes – CEO/Founder, Regenica Unmesh Sheth – Founder, SoPact Biosciences
    [Show full text]
  • List of All Fees for the Securitytrustsm Reloadable Visa® Prepaid Card Issued by Republic Bank of Chicago, Member FDIC, Pursuant to a License from Visa U.S.A
    CARDHOLDER AGREEMENT List of all fees for the SecurityTRUSTSM Reloadable Visa® Prepaid Card issued by Republic Bank of Chicago, Member FDIC, pursuant to a license from Visa U.S.A. Inc. All Fees Amount Details Monthly usage Monthly Fee is $7.95. The Monthly Fee is waived for the first 60 days Monthly fee $7.95 after the initial load. The Monthly Fee is also waived if you receive direct deposits of $500.00 or more every 35 days. Add money Fee of up to $5.95 may apply when reloading your Card at Retail Locations, including Green Dot® and Visa ReadyLink reload agents. This Cash reload $5.95 fee is charged by the reload agent and is subject to change. Reload locations may be found at www.insightvisa.com. Fee of up to 5% of the amount of a check loaded through third party 5%, $5.00 applications may apply, subject to a $5.00 minimum. Service is subject to Mobile check load minimum third party terms and conditions. This fee is charged by a third party and is subject to change. Spend money Per purchase transactions None No fees are assessed for domestic purchase transactions. Bill pay available when you log in to your account at Bill payment None www.insightvisa.com. There is no charge to complete a bill pay transaction. There is no charge to originate or receive transfers between your Card Card to card transfer None and another Insight-branded or SecurityTRUSTSM-branded Card. Get cash You will not be charged a fee for cash withdrawals at “in-network” ATMs.
    [Show full text]
  • •Central Securities Depository •Creating Stock •Corporate Actions •Clearance and Settlement •Fixed Income Issues •M
    ® LIFE CYCLE OF A SECURITY explores the role of central securities depositories in the United States and global capital markets, with a particular focus on the part The Depository Trust Company (DTC) plays in launching new securities issues and providing the essential services that security issuers require. The guide explains the process of creating and dis tributing stocks and bonds in the primary and secondary markets,- the details of clearing and settling retail and institutional transac tions, and the sophisticated infrastructure that enables the seamless- payment of dividends and interest, smooth management of tender offers and other corporate actions, and essential risk protection in an increasingly global environment. LIFE CYCLE OF A SECU RITY LIFE CYCLE OF A SECU RITY If trading volume between countries WHAT’S AN justifies it, CSDs are frequently linked INTERNATIONAL CSD? Central Securities Depositories electronically, and have accounts with There are currently two International The certificate stops here. each other, so that securities can be Central Securities Depositories (ICSDs), both moved electronically between them. In located in Europe: Clearstream Banking in most cases, payment for those securities Luxembourg and Euroclear Bank in Belgium. In the quest to attract capital and make shares that an issuing corporation offers is usually handled between the trading Initially created to accommodate the their economies more vibrant, most for sale in one or more countries in addi- firms’ settlement banks rather than expanding market in Eurobonds—bonds countries with active capital markets tion to its home market. This approach through the CSD, though some CSDs issued in a different currency and sold in have central securities depositories allows the corporation, working with a are equipped to handle both transfer a different country than that of the issuer, (CSDs) to provide the custody and local depositary bank, to raise capital in and payment.
    [Show full text]
  • Risk Disclosures by Asset Class
    Risk Disclosures by Asset Class Contents Alternative ............................................................................................... 3 Bank Loans .............................................................................................. 3 Commodities ............................................................................................ 3 Emerging Markets .................................................................................... 3 Emerging Markets Bonds .......................................................................... 4 Europe Stock ............................................................................................ 4 Fixed Income - Fixed Income ................................................................... 5 Fixed Income - Short Term Bond .............................................................. 5 Foreign..................................................................................................... 6 Foreign Large Blend ................................................................................. 6 Foreign Large Growth ............................................................................... 6 Foreign Large Value ................................................................................. 7 Foreign Small/Mid Blend .......................................................................... 7 Hedge Fund of Funds ................................................................................ 7 High Yield................................................................................................
    [Show full text]
  • Glossary of Bond Terms
    Glossary of Bond Terms Accreted value- The current value of your zero-coupon municipal bond, taking into account interest that has been accumulating and automatically reinvested in the bond. Accrual bond- Often the last tranche in a CMO, the accrual bond or Z-tranche receives no cash payments for an extended period of time until the previous tranches are retired. While the other tranches are outstanding, the Z-tranche receives credit for periodic interest payments that increase its face value but are not paid out. When the other tranches are retired, the Z-tranche begins to receive cash payments that include both principal and continuing interest. Accrued interest- (1) The dollar amount of interest accrued on an issue, based on the stated interest rate on that issue, from its date to the date of delivery to the original purchaser. This is usually paid by the original purchaser to the issuer as part of the purchase price of the issue; (2) Interest deemed to be earned on a security but not yet paid to the investor. Active tranche- A CMO tranche that is currently paying principal payments to investors. Adjustable-rate mortgage (ARM)- A mortgage loan on which interest rates are adjusted at regular intervals according to predetermined criteria. An ARM's interest rate is tied to an objective, published interest rate index. Amortization- Liquidation of a debt through installment payments. Arbitrage- In the municipal market, the difference in interest earned on funds borrowed at a lower tax-exempt rate and interest on funds that are invested at a higher-yielding taxable rate.
    [Show full text]
  • Can Underwriters Profit from IPO Underpricing?
    Footloose with Green Shoes: Can Underwriters Profit from IPO Underpricing? Patrick M. Corrigan† Why are green shoe options used in initial public offerings (IPOs)? And why do underwriters usually short sell an issuer’s stock in connection with its IPO? Are underwriters permitted to profit from these trading po- sitions? Scholars have long argued that underwriters use green shoe options together with short sales to facilitate price stabilizing activities, and that U.S. securities laws prohibit underwriters from using green shoe options to profit from IPO underpricing. This Article finds the conventional wisdom lacking. I find that underwriters may permissibly profit from IPO under- pricing by pairing purchases under a green shoe option with offshore short sales. I also find that underwriters may permissibly profit from IPO over- pricing by short selling the issuer’s stock in the initial distribution. The possession of a green shoe option and the ability to short sell IPOs effectively makes underwriters long a straddle at the IPO price. This posi- tion creates troubling incentivizes for underwriters to underprice or over- price IPOs, but not to price them accurately. This new principal trading theory for green shoe options and under- writer short sales provides novel explanations for systematic IPO mispric- ing, the explosive initial return variability during the internet bubble, and the observation of “laddering” in severely underpriced IPOs. This Article concludes by charting a new path for the regulatory scheme that applies to principal trading by underwriters in connection with securities offerings. Consistent with the purpose of preserving the integrity of securities markets, regulators should address the incentives of under- writers directly by prohibiting underwriters of an offering from enriching themselves through trading in the issuer’s securities.
    [Show full text]