Evaluation of Underwriter Proposals for Negotiated Municipal Bond Offerings

The debate continues about the most cost-effective method of issuing municipal securities. The emergence of online securities marketing will add a new dimension to this debate. Some analysts argue that the competitive sale process is the most advantageous because of the inherent protections of open bidding. Others argue that a negotiated sale produces comparable financing costs and affords issuers considerably more flexibility in the marketing of municipal securities. However, the negotiated sale remains the dominant bond marketing strategy. Thus, it is important for issuers to have tools to accurately and fairly evaluate the actual costs of proposed bond offerings. This paper reviews the techniques that are available for comparing alternative pricing proposals and examines their strengths and weaknesses. It includes a description of a process that issuers of negotiated offerings can use to determine the appropriateness of a proposed pricing along with a description of a computer-based evaluation model. Issuers of municipal bonds can use either of two marketing strategies the competitive sale and the negotiated sale. While there continues to be debate about which strategy is the most cost-effective, negotiated bond sales have become increasingly more common, a trend that is consistent with practices in the corporate bond market. This article describes a process that an issuer of municipal bonds sold by negotiated sale can use to evaluate an underwriter's purchase proposal on the day a bond Evaluation of Underwriter Proposals 436 issue is priced. Various measures that are used to compare the relative costs of bond financing proposals are described. Reliance on net interest cost (NIC), one commonly used measure of relative cost, can lead to improper financing decisions. A better process to evaluate the effective cost of negotiated bond sales that incorporates true interest cost (TIC) and duration is described along with the related computer spreadsheet model. Arranging debt financing through the issuance of municipal bonds is an important business activity for state and local governments, special districts and public authorities. The purpose of this article is to describe a process that an issuer of municipal bonds sold by negotiated offering can use to evaluate an underwriter's purchase proposal on the day a bond offering is approved and priced. The analytical process utilizes true interest cost (TIC), the duration of the bond issue, and a comparison to the relative pricings of other similar bond issues. A computer spreadsheet model is presented that calculates net interest cost (NIC), net present value (NPV), TIC, and duration. The spreadsheet model and the evaluation process described in this article were developed in conjunction with the analysis and marketing of a recent negotiated bond issue by a large Pennsylvania school district. They were useful in determining the lowest cost financing alternative from several proposals submitted by the designated underwriter. Issuers of municipal bonds can use either of two marketing strategies. They are the competitive, i.e., public, sale, or a negotiated, i.e., private, sale. Bond issuers have several methods to evaluate bond purchase proposals submitted by underwriters and other potential buyers. The municipal finance literature describes how such issuers can assess net interest cost (NIC) and true interest cost (TIC), two traditional measures of overall financing cost (Public Securities Association 1990, 180-186; Petersen and McLoughlin 1991, 282-282; and, McLoughlin 1996, 553-554). NIC and TIC are both percentage measures. TIC incorporates the time value of money, an important consideration Evaluation of Underwriter Proposals 437 ignored by NIC. Puelz (1996, 410) summarizes and compares NIC and TIC and includes a description of the net present value method (NPV) that measures the total dollar cost of a bond issue. NPV, like TIC, is a measure that incorporates the time value of money. Bierman (1996) examines NIC, TIC, and NPV, but concludes that an alternate strategy, "none of the above", also called NOTA or the Bierman technique, is a simpler and theoretically correct measure for selecting the least cost financing proposal from a group of competitive bids. The Bierman technique identifies the lowest cost proposal as the one that presents the highest bid. While NIC, TIC, NPV, and the Bierman technique are important measures of relative cost, they do not answer the most important question for an issuer that uses the negotiated sale, i.e., does the underwriter's final pricing proposal, or one of two or more alternatives presented by the underwriter, represent the lowest cost financing option? The traditional measures are inadequate because, on the pricing date for a negotiated offering, the issuer is only considering the proposal, or alternatives, of the designated underwriter or syndicate. The issuer, at that point, does not have financing proposals from competing underwriters. The article begins with an overview of the mechanics of negotiated and competitive municipal bond marketing strategies and the comparative advantages and disadvantages of the two strategies. Various measures that are used to compare the relative costs of bond financing proposals, including a comparison of the relative advantages and disadvantages of the various evaluation methods, are then described. An example shows how reliance on NIC, one commonly used measure of relative cost, can lead to improper financing decisions. The final section describes a better process used to evaluate the effective cost of negotiated bond offerings. I. Bond Marketing Strategies Issuers of municipal bonds can use either of two marketing strategies the competitive and the negotiated. While there Evaluation of Underwriter Proposals 438 continues to be debate about which strategy is the most costeffective, negotiated bond offerings have become increasingly more common. In 1970, 83 percent were sold competitively, and only 17 percent sold by negotiation. By 1994 approximately 80 percent of municipal bonds were sold by negotiation, and only about 20 percent were sold by competitive offerings. This trend in the increased utilization of negotiated municipal bond sales, Leonard (1996, 43) explains, is consistent with practices in the corporate bond market where most bonds are sold by negotiation. Due, in part, to allegations of improper influence peddling involving municipal bond offerings in several jurisdictions, there is heightened interest in the procedures issuers use to market tax-exempt municipal bonds. Concerns about this problem led the Municipal Securities Rulemaking Board (MSRB) to issue Rule G37 in April 1994. This so-called "pay-to-play" rule prohibits municipal securities brokers and dealers from handling negotiated bond offerings for an issuer within two years of contributing directly, or indirectly, to an official of the issuer who can influence the underwriter selection process. These concerns also prompted a number of governments to consider mandating competitive sales for all bond issues. The Securities and Exchange Commission (SEC) and the Internal Revenue Service (IRS) are concerned about procedures associated with new issues and refinancings in the $1.3 trillion municipal bond market (Pare 1995; Beckett 1997). Both agencies have launched intensive probes in several jurisdictions aimed at "pay-to-play" violations and "yield burning" abuses (Connor 1997; Gasparino and Connor 1997; Mysak 1995). Yield burning involves transactions where underwriters overcharge issuers for temporary investments made in conjunction with municipal bond refinancings. The investigations include bond transactions in Massachusetts, Florida, California and New Jersey, and Pennsylvania is now a major focus of the inquiries. The investigations include deals managed by leading underwriters including Prudential Securities, Alex. Brown, New Jersey's First Fidelity Bank, Lazard Freres, Goldman Sachs, and Meridian Capital Markets, now a subsidiary of Core States Bank. These Evaluation of Underwriter Proposals 439 investigations should remind issuers of their responsibilities to follow proper bond marketing procedures and regulations, and to apply improved decision-making techniques that are available for evaluating the costs of underwriter proposals (Puelz and Lee 1989, 153). There is also new research interest in the cost implications of municipal bond marketing strategies. Leonard (1994) reviewed and evaluated the existing literature concerning the cost differential between competitive and negotiated bond marketing strategies. Neither method has proven to be superior in terms of consistently producing lower overall financing costs. In a recent large-sample study of 2,333 municipal bonds sold in 1992, Leonard (1996) concluded that there is no evidence to suggest that financing costs as measured by reoffer yields on negotiated bonds are different from the costs on competitive sales. Similarly, Stevens and Wood (1997) compared the TICs of competitive and negotiated school district bond sales in Pennsylvania during 1993 and concluded that the bond marketing strategy does not systematically influence overall financing costs. In contrast, a study of Oregon bond sales during 1992 and 1993 suggests that, on average, competitive sales result in lower interest costs for issuers compared to negotiated offerings (Simonsen and Robbins 1996, 57). Simonsen and Robbins contend that this finding is consistent with research done in the 1970s and 1980s, which they believe suggests that interest costs are generally lower for competitive municipal bond sales. In related research, Stevens (1997) observes that the negotiated sale may not be a single strategy. Negotiation may represent a range of private sale strategies that are differentiated on the basis of the competitiveness of the underwriter search and selection process. This suggests that some negotiated sales may be equally as competitive as so-called competitive sales. Evaluation of Underwriter Proposals 440 II. Comparison of Competitive and Negotiated Offerings A competitive bond offering involves bid solicitation from potential purchasers, principally underwriters. Puelz (1996, 407) describes it as a public auction where the bonds are sold to the underwriter or other purchaser that offers the highest price, resulting in the lowest financing costs. Because a competitive sale is a time consuming process and many issuers sell bonds infrequently, a financial advisor is often employed to assist with the process (Clarke 1997, 75). The financial advisor's duties include preparation of the preliminary and final official statements, recommending the amount and structure of the bond issue, proposing a sale date, and evaluating the competitive proposals submitted by competing underwriters and investors. Puelz (1996, 405) explains that the key feature of a competitive sale is that the structure of the bond issue, including the principal redemption schedule and coupon interest rates, is determined by the issuer prior to the solicitation of competitive bids for the purchase of the bond issue. A negotiated offering differs from a competitive offering in the method used for selecting the underwriter, the role of the underwriter in the bond marketing process, and the procedures used for determining interest rates and underwriter compensation. In a negotiated offering, the underwriter is selected first, often through the solicitation of competitive requests for proposals (Leonard 1994, 15). In some cases, the underwriter selection process is noncompetitive, e.g., the underwriter selection is based on a previous business or personal relationship with the issuer. In a negotiated offering, the interest costs and other terms of the bond issue, including underwriter compensation, are negotiated between the issuer and the underwriter. The underwriter handles most of the administrative activities associated with the bond issue. In addition, the underwriter often engages in pre-sale marketing activities for the bond issue. Those activities, including making contacts with other potential underwriters and conducting informational meetings Evaluation of Underwriter Proposals 441 with interested investors, are designed to increase investor demand in the forthcoming bond issue, which can result in higher prices and lower financing costs. There are advantages and disadvantages for both competitive and negotiated offerings. Proponents of the competitive sale believe that the inherent protections afforded by the open, competitive nature of the public bidding process lead to lower costs (McLoughlin 1996, 553). The traditional view of the negotiated offering is that it may allow the designated underwriter to commit more resources to the bond marketing process, resulting in higher investor demand and lower financing costs (Leonard 1996, 40). Leonard's (1996, 41) compilation of the advantages and disadvantages of competitive bidding and negotiation cited in the public finance literature is presented in Table 1.