A Philosophy of Investment Banking
April 3 2007 by Robert Lawrence Kuhn
Investment banking is the business of money. Its primary purpose is to link users of capital with providers of capital, seeking optimum financial efficiency for both. It is the intermediary channel through which capital is distributed efficiently and exchanged effectively. As such, investment banking claims to be capitalism’s critical mechanism for facilitating the resource allocation decisions that epitomize the free market system. To no small degree, investment bankers believe that they fuel the world economy.
But what actually is investment banking? It is transaction oriented, a service business. It manufactures no goods and sells no merchandise, yet it influences virtually all enterprises that manufacture and sell. Its primary asset is financial intelligence, and its primary products are financial advice and financial instruments. Investment banks make things happen, energizing corporations to grow and expand and enrich their shareholders.
Some see investment banking as the indispensable hub of the wheel of commerce, the vital force of companies and industries, the market catalyst of economic productivity. Others consider investment banking-why mince words?-to be a parasitic profession, feeding off the productivity of its clients. Investment bankers, these critics complain, are overcompensated and underproductive, a drag on the system.
I deal with this paradox. My objective is to discern the fundamental nature of investment banking, and thereby ascertain its fundamental worth. The search is for intrinsic value and meaningful contribution, for the deep structure of investment banking. My quest is for “essence”-a philosophy, if you will, of investment banking.
WHAT IS A PHILOSOPHY?
In general, philosophy is the search for sense, meaning, cause, and principle using logical thinking and rigorous thought. Philosophy excavates foundations and stresses being and mechanisms, discerning what things are and how they work. It is an attempt to perceive what things really are, not how they appear to be, and to discern how things really work, not how they appear to work. Philosophy seeks ultimate, irreducible truth.
A philosophy of investment banking may seem pretentious (or worse, silly) surrounded by such towering achievements of human knowledge as the philosophies of science, education, history, law and religion. Philosophy claims to be able to make sense out of any human awareness or endeavor, however massive or minuscule. Perhaps we will find interesting things about the nature of investment banking.
DEFINITIONS OF INVESTMENT BANKING
If we are to lay claim to constructing a philosophy of investment banking, we must begin by introducing some rigor into the process. A philosophy flounders when language wobbles. An incipient philosophy needs verbal precision.
Even within the finance community, the term “investment banking” is used rather loosely. Such usages range from widely inclusive of virtually everything that large Wall Street firms do to narrowly restrictive to only certain conventional investment banking functions, primarily underwriting. Part of the problem is the evolution of the field.
Traditional investment banking was the underwriting of common stock equity and investment-grade corporate bonds. But the financial world has changed dramatically, and investment banking, the key catalyst of the metamorphosis, has widened its scope proportionately. Following are four definitions of investment banking; the order proceeds from the most broad to the most restrictive.
1) Investment Banking as Everything Major Firms Do. All Wall Street activities are encompassed here, including personal financial products and retail investments.
2) Investment Banking as All Capital Market Activities. All capital raising and corporate finance functions are included, such as mergers and acquisitions (M&A), merchant banking, fairness opinions, fund management, venture capital management, investment research, risk management and the like-in addition to traditional underwriting of debt and equity securities. Excluded are consumer markets, retail investments, branch management and the like (but would include market making and institutional securities trading). This definition is my personal preference.
3) Investment Banking as Some Capital Market Activities. Some usages of “investment banking” restrict its connotation to only some capital market activities, stressing underwriting, mergers and acquisitions, fairness opinions and the like. Excluded are money management, trading for their own accounts, research, commodities and some risk management (i.e., trading).
4) Investment Banking as Only Underwriting and Raising Capital. This traditional definition, limited to raising capital for corporations in the public markets and trading securities, is the most restrictive. It is hardly a defensible position today not to include M&A as central to mainstream investment banking.
What is the fundamental basis for investment banking? Why does a free market allow, indeed encourage, the existence of highly compensated financial intermediaries who make markets but not products? Following are areas of high value-added contribution-”worth”-that investment bankers provide for financial markets.
Worth of Underwriting Investment bankers float and trade securities; they set standards and establish prices in the underwriting process, and they broker trades and make markets in the subsequent trading of those securities. As such, investment bankers are the essential intermediary that establishes the market between buyers and sellers. They assure the efficiency of the market by their issuer selection process, due diligence procedures, pricing mechanisms, distribution allocations, supply and demand equilibria, and the like. In syndication, investment bankers distribute the risk of underwriting new securities among various firms; the process is important in that it requires one investment bank to convince its peers of the efficacy of its proposed offering, thus building checks and balances in the system.
Worth of Broker / Dealer / Market Making The trading of securities provides liquidity by enabling the continuous buying and selling of those securities. Such liquidity is vital for giving investors confidence that their investment can be converted into cash easily and quickly, which works to lower the cost of capital for issuers. Investment bankers assure a ready and efficient market for both buy and sell sides; they act as brokers, who are commissioned agents for buyers and sellers (brokers hold no inventory and therefore assume no price risk); dealers, who set bid-and-ask prices for each security they offer for trade (dealers assume a price risk for all securities they hold in inventory); and market makers, who establish (and support) the entire market for a security, normally following its initial public offering.
Worth of Mergers and Acquisitions Investment bankers perform a service greatly desired by both buyers and sellers, helping each to achieve economic goals not attainable as efficiently through any other means. When corporate buyers and sellers have a ready, fluid (“liquid”) M&A market, there is more incentive to build companies (e.g., cashing out is easier and more lucrative) and more opportunity for effective strategic planning (e.g., growth through acquisitions is more practical). The intrinsic worth of hostile takeovers-i.e., assessing and comparing the often competing interests of stockholders and management-is a complex issue. On the one hand, it is disruptive for executives to spend their time devising legal and financial techniques to defend their companies against unwanted suitors. On the other hand, an efficient market demands that inefficient corporate structures should be subject to restructure, and sleepy underperforming corporate managers (e.g., highly paid and perked executives who own little stock in their companies) should be subject to change.
Worth of Merchant Banking / Private Equity When investment banks risk their own capital to facilitate M&A deals, whether as short-term bridge financiers or as long-term equity players, the process enables more companies to be on the market and more deals to get done, thus enlarging the M&A market and making it more liquid and more efficient.
Worth of International Investment Banking By extending financial markets worldwide, investment bankers achieve greater efficiencies in optimizing risk and return for both issuers and investors. (Portfolio Theory explains the benefits of such diversification.) In addition, the internationalization of financial markets supports the globalization of business, the development of third-world countries, and the emergence of new markets.
Worth of Fees and What They Mean The enormous fees that investment bankers make in mergers and acquisitions are often used to question M&A’s value to the economy (e.g., critics contend that when investment bankers churn companies they increase personal fees not industrial productivity). Yet, viewed from another perspective, these admittedly huge fees can demonstrate the desirability of the service. After all, chief executives are not easy marks; they are not in business to overpay; they are not suckers or easily bullied; and most of all they are used to getting what they want. If these seasoned corporate leaders are paying such spectacular sums, who’s to say that they are not getting their money’s worth?
BODY OF PROFESSIONAL KNOWLEDGE
Recognizing and appreciating this knowledge base in investment banking is essential in evaluating its philosophy.
Finance Theory If finance is the intellectual foundation on which investment banking is built, then finance theory supplies the raw materials used in its construction. Knowing why a particular financing technique works is often critical in knowing how to make it work better. Seeing deeply into the structure of financial instruments gives a definite competitive edge. But although finance theory is necessary in investment banking, it is not sufficient.
Financing Experience Experience in financing is part of the knowledge base. The collective record of financial performance from thousands of financings is the firm platform on which to construct future financings. Similarly, a keen sense of the outcomes of innumerable mergers and acquisitions over many years provides insight into how to make current M&A clients more successful. But wide experience in financial transactions, like technical competence (or even brilliance) in finance theory, is also not sufficient.
Business Savvy and Industry Expertise First-rate investment bankers understand general business principles and specific industry fundamentals. They are astute at analyzing companies-say, the changing competitive structure within given industries-and perceiving what it takes for enterprises to be successful within their product/markets. They are expert at articulating a company’s current business requirements with the technical features of various financial instruments in order to formulate and implement the optimum structure for the proposed financing. Likewise, the ability to evaluate senior executives of issuer companies gives critical insights.
Market Savvy and Financing Insight Investment banking is an art as well as a science, and perceptive insight is as important as technical analysis. The best investment bankers just seem to “know” when an underwriting makes sense, and at what time, and at what price. They can discern a hot property, the next big market winner. They also have a nose for the negative; they can sense a problem quickly, whether with the products, markets, systems or management. Traders, dealers and market makers have their own special sense of the world and the markets; they have an instinctive feel when to get in and get out of securities, and they trust their intuition as much as their analysis.
Interpersonal Skills The importance of competence in working with people cannot be overstated. For example, appreciating the psychological subtleties of the deal-making process is often more valuable than knowing the technical aspects of those deals.
CLIENT SERVICE AND PROFESSIONAL INTEGRITY
Primary regard for the client’s interests and welfare is sacrosanct. But doing what is best for the client in the long run is not always what the client thinks is best right now. What clients require may differ from what they request. Investment bankers are financial architects, engineers and physicians. Like good architects, they work intimately with their clients, discerning what is needed even if contradicting what is asked. Like good engineers, they coordinate all aspects of the assignment, insisting on internal consistency among all functions and tasks. Like good physicians, they base their diagnosis strictly on the facts, never biasing their opinion because of client wishes. The only thing more important than serving the client is upholding the profession. It is wrong to subvert the highest investment banking standards, even for the cause of assisting a client. Such subversion undermines the profession and diminishes future service.
Investment bankers design and plan financing mechanisms and then fashion and construct them. Formulating and implementing financial strategies and structures are what they do, and, when they do it properly, everyone benefits.
Dr. Robert Lawrence Kuhn is Senior Advisor, Citigroup Investment Banking, and the author or editor of numerous books in business, finance and science, including The Library of Investment Banking and, most recently, China’s Banking and Financial Markets: The Internal Report of the Chinese Government (John Wiley) and Closer To Truth: Science, Meaning and the Future (Praeger). Previously, Dr. Kuhn was president and co-owner of The Geneva Companies, the largest M&A firm representing privately owned, middle market companies (in 2001 he sold Geneva to Citigroup). Dr. Kuhn has a doctorate in anatomy / brain research from UCLA and a master’s in management from MIT.
I am ever enchanted by George Bernard Shaw’s comparison of the scientist and the philosopher. The scientist is said to learn more and more about less and less, while the philosopher is said to learn less and less about more and more-so that in the end the scientist knows everything about nothing and the philosopher knows nothing about everything.