After reading The Accidental Investment Banker by Jonathan Cree, I decided my first blog on investment banking and corporate finance was due.
From my understanding of investment banking, many people simply don’t understand it. Is it banking? Is it investing? Is it Gordon Gecko in the movie Wall Street or is he a trader? What is the difference between an investment banker and an equity trader? What do investments bankers actually do?
One finance degree short of an answer, it took me a fair while to truly come to grips with the concept of investment banking. However, now that I have, I feel the short summary below will give a very good indication to those considering a career in investment banking or those wishing to understand investment banking better.
What is investment banking and what do investment bankers do?
As companies grow, they need capital. In many cases, in order to raise capital and for other related advisory services, companies go to investment banks. Investment banks provide a range of services relating to the raising of capital and act as advisors to the world’s corporate leaders…
Now, some more detail. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds.
Investment banks primarily provide the following services:
- Financial and strategic planning advice to companies.
- Creating and issuing stock and bond offerings to either private investors or the public typically through an IPO.
- The underwriting (guaranteeing) of such offerings.
- Mergers and Acquisitions advise
- Sales and trading
- Market making
- Research functions
Thus if you are considering a career in investment banking, you need to think critically about which section would suit you best. I have found the Vault Guide to Investment banking and the Wetfeet Insider guide to Investment banking particularly useful in this endeavour.
Capital Raising and Underwriting Services
In order to raise capital for companies, investment banks issue and sell those clients’ stock, debt or some related financial instrument. The investment bank then advises the client on a reasonable price through a number of company valuation and testing mechanisms that I will discuss in a later blog.
At this point, the investment bank buys the securities and sells them to investors either privately or through a public offering of shares. The investment bank makes its money on what is known as the ‘spread’ which is the difference between the price it pays the client for the securities (the underwritten price) and the price at which it resells the securities.
Financial Advisory Services
Investment banks advise companies, government entities, and other institutions
about their financial strategies and the most effective use of the financial markets. One of the most common and publicised service is mergers and acquisitions advice where investment banks advise companies on appropriate M & A targets, strategies, company valuation and the bidding process.
Other financial advisory services include investment strategies, international business advice and corporate options strategy formulation advice.
Sales and Distribution
It is difficult to be an investment bank if you cannot sell the securities that you are underwriting. In fact, they would be in a particularly illiquid position if they had underwritten 70% of the newly issued shares in a company but had not distribution channels or method of selling them. The majority of the underwritten securities are sold to institutional investors such as pension funds, money management firms, mutual funds, and other large-quantity buyers. The institutional sales role advises these investors and typically establishes these important relationships through travelling, hand-holding and significant Schmoozing according to the Vault Guide that I referred to earlier.
Many investment banks also have or are considering adding a retail sales force of stockbrokers to target individual investors but this business is more typical of broking and is not traditionally associated with investment banking.
“To be an effective underwriter, an investment bank must have a wide distribution network and a knowledgeable sales force that can consistently find buyers for all of the stocks, bonds, and other financial instruments that the I-bank underwrites.”
Trading and Market-Making Services
Most investment banks actively trade securities in the stock market to support the institutional and retail sales efforts thereby providing liquidity (cash) and market prices to their investors.
As a result, when an investment bank decides to market a particular stock, they typically stand ready with their own (underwritten) capital to buy and sell the stock at the publicly traded prices. A firm can make a market either on the exchange floor for listed stocks or on its own trading desk for over-the-counter stocks. Traders typically focus on one group of stocks at a time, often becoming specialists in a particular industry.
Finally, most investment banks require a research division to complement their advisory services. This division focuses on the latest company news, economic trends, and potential opportunities in order to maximise opportunities for both the investment banks and its clients.
This research role used to play an important role in the underwriting process but in recent times investment banks have faced public and regulatory outcries over conflicts of interest that can arise as a result of investment bankers and researchers working together. In order to end the legal scrutiny over their operations, investment banks are now attempting to outline the separation between their banking and research arms similar to the ‘Chinese wall’ approach of many prominent law firms.
I will be writing many more blogs on investment banking in the future with the next blog to focus on buy-side vs sell-sell investment banking.