How Investment Bankers Think
March 9 2007 by Robert Lawrence Kuhn
Just to survive, investment bankers must be both smart and savvy, and to prosper they must be extraordinarily smart and savvy. Business executives can learn key principles of business and finance by examining how the best investment bankers think-a sophisticated system of reasoning and procedure that generates consistent, high-quality financial output. In addition, we explore the personality of investment bankers-what makes them tick?
PRINCIPLES OF INVESTMENT BANKING
The way of thinking in investment banking can be described by the following six categories: financial maximization; financial optimization and cost/benefit analysis; independent judgment and due diligence; financial innovation and new product development; capital allocation and efficient utilization; and client service and development. The first two are client-centered, the third and fourth are market-centered, the fifth is both client and self-centered, and the sixth is largely self-centered.
Financial maximization seeks to get the most while giving the least. In underwriting public offerings, this means achieving the lowest cost of capital for issuers and the best risk/return ratio for investors. The lowest cost of capital for equity issuers results from the highest market capitalization (which is the current value of all the company’s equity computed by multiplying the total number of outstanding shares by the current market price per share); the lowest cost of capital for debt issuers results from the lowest interest rate and most flexible covenants. The best risk/return ratio for equity investors is achieved by the lowest market capitalization; the best risk/return ratio for debt investors is achieved by the highest interest rate and strictest covenants. Investment bankers are usually on both sides of security transactions, and as such the market is cleared between issuers and investors at a rational intersection point between issuer cost of capital and investor risk/return.
Obtaining the lowest cost of capital is the holy grail of investment banking. Raising the most net-net dollars for the least all-in costs is the key criterion, and around this icon does the entire profession dance. The maximization mechanism works by investment bankers choosing and/or designing highly specific financial instruments tailored to each highly specific financing situation.
The financial maximization process is quantitative (i.e., algorithms, spreadsheets and mathematical simulations), a numerical determination of how return can be maximized and cost minimized. This is basic business, the way of the economic world, and it epitomizes investment banking thinking when representing clients in financial transactions. By being analytical, the process of financial maximization encourages the development of innovative financial instruments.
Financial Optimization and Cost-Benefit Analysis
Financial optimization seeks the ideal financial structures and mechanisms given specific conditions. Such thinking takes both a short-term and a long-term perspective, seeking to balance the sometimes conflicting pressures between the two poles. The process is partly qualitative, a non-numerical determination of economic efficiency and best choices.
Investment bankers analyze all aspects of a client’s company and formulate those financial strategies and implement those financial structures designed to produce the most effective overall outcome. Aspects that must be scrutinized include business as well as financial elements. Financing is one part of an enterprise’s operations, and internal consistency among all parts is essential.
Note that optimization is not maximization in that what is “best” may not always be what is “most.” For example, if the least expensive financing requires a maturity or covenants not consistent with business requirements it is not optimal even though it is maximal. Another example is the setting of security prices in an initial public offering; if prices are too high and the aftermarket becomes weak, investors will sour on the company and sit out future financings, thus raising the long-term cost of capital.
Financial optimization can be considered a cost-benefit analysis, which compares relative value between the pros and the cons of alternatives. Developed for situations where numerical analysis is not relevant (e.g., government agencies and eleemosynary organizations), cost-benefit analysis can be an effective technique for discerning optimization in situations where numerical analysis is relevant.
Independent Judgment and Due Diligence
Independent judgment establishes the credibility of investment bankers, and due diligence is a primary expression of this independence. Confidence is the primary building block of investment banking; without such trust on both sides financial transactions cannot occur.
Investors realize that when investment bankers represent issuers they are committed to obtaining the best possible transaction for their clients (“best” usually meaning “most”). But these investors must also be able to rely on the statements and presentations that the investment bankers make regarding the issuer. For the system to work, investors must believe that everything material that the investment bankers state to be true is in fact true; investors must be able to trust the reasonable veracity of what investment bankers present. (In this context, investment bankers differ from attorneys in representing their clients.)
Due diligence is the process by which investment bankers validate the claims of their own clients. For example, in preparing an underwriting, investment bankers must make reasonable efforts in examining all material aspects of the client’s company, however laborious or complex or expensive the process. Such detailed checking is required by law.
What would happen to an investment bank that gets a better deal for its issuer clients than the facts would justify? That investment bank would sustain competitive loss, not achieve competitive gain. Not only would the investment bank suffer severely as an underwriter but it might also be exposed to legal liability.
A similar requirement for proper due diligence applies in mergers and acquisitions. If an investment bank makes exaggerated claims for its client seller, it risks ruining its credibility in future transactions and thereby losing its comparative strength in attracting new clients.
Financial Innovation and New Product Development
Financial innovation is a prime characteristic of the way of thinking in investment banking. In former decades, underwriting had little variety; stocks and bonds were “plain vanilla,” each having largely similar features. But the plethora of new financial instruments changed the old world forever. And, once started, such change cannot be contained.
Today, innovation is a major competitive weapon of investment banks. Each tries to upstage the others in bringing to market more focused and more efficient instruments for its clients. Client service is certainly a motivation here, but the primary impetus is the investment bank’s own reputation.
Capital Allocation and Efficient Utilization
The adequate availability and efficient use of capital is a recurring theme of modern finance, and investment bankers apply this fundamental principle both to client companies and to themselves. The availability of capital is critical for the successful implementation of all corporate strategies. Client companies need sufficient capital to finance their businesses, whether for fixed assets (e.g., plant and equipment), working capital (i.e., receivables and inventories), or building the company (e.g., marketing and advertising, research and development). Investment banks need sufficient capital to support their underwriting, securities dealing, and merchant banking functions.
The efficient use of capital is the central mediator of the financial markets. Capital is allocated to where it will produce the highest returns for the lowest risks, i.e., the optimal risk/return relationship. Regarding client companies, investment bankers always want to understand the “use of proceeds”-i.e., how the monies that are generated from the underwriting will be employed in the business. Issuers must be able to demonstrate that their use of proceeds will generate sufficiently high returns to justify the investment, certainly well in excess of the cost of that capital. (No investor wants to watch his or her invested money sitting idly in Treasury Bills-investors can earn Treasury returns themselves, with full control and no risk.)
Regarding the investment banks themselves, the same efficient use of capital is required. In recent years, investment banks have been scrambling to increase their capital bases in order to compete effectively, especially in firm commitment underwritings, trading for its own account in the world securities markets and merchant banking. Yet, returns on that capital must exceed significantly the cost of that capital. In bull markets for underwriting, trading and merchant banking, the returns are appropriately high and heavy capital is essential. However, when these markets turn down, the returns decline rapidly since the capital base is so high. When returns on capital fail to approach the costs of capital, this can mean that there may be too much capital in the company.
Client Service and Development
Investment banks are service organizations, and as such, attending to clients is the highest good. In most investment banking transactions there are many organizations and individuals involved, but no matter the complexity, the best investment bankers never forget who are their clients and what are their needs.
Clients may be issuers or investors depending on the power relationships in a given market. Clients are those with the independent power to generate opportunities for making money in a financing situation. Power is critical here, because given the specific condition, such power may reside with either the issuer or the investors.
Blue-chip, investment-grade companies or hot initial public offerings draw in their own investors and issues are sold (and oversold) rapidly; the clients here are the issuing companies and investment banks compete to offer these issuers the best services. In the high-yield market, on the other hand, power often resides with the investors, those institutions that buy below-investment grade paper. Generally, there is more investor demand in the investment-grade market and more issuer demand in the high-yield market.
PERSONAL ATTRIBUTES OF INVESTMENT BANKERS
The personal attributes of investment bankers can be explored in three categories: natural abilities and learned skills, attitudes and ethics, and coping with professional tension.
Natural Abilities and Learned Skills
It is an historical truism that those professions perched on the highest strata of society, and/or enjoying the largest relative proportion of society’s material benefits, attract the best and brightest members of that society. In points past, such a profession might have been the priesthood, the military, or the foreign service. Today, worthy or not, investment banking makes claim for the honor. This is not intended as an absolute value judgment (i.e., I do not assert that investment banking should occupy the highest strata); the dubious question of intrinsic social superiority or relative moral position is not the issue. The only point here is that where investment banking stands in our socio-economic system is a fact.
By providing very large compensation packages, investment banking is no exception to the historical rule of attracting the smartest and most ambitious young members of society-in this case, the graduates of America’s leading business schools. Many critics lament the consequences of this magnetic draw, claiming that since investment banking promotes more paper shuffling than product productivity, the smarter the bankers the more shufflings will occur. The fact that investment banking has attracted the best and brightest has energized the field with high competitive energy and rapid dynamic change. The best and brightest are creative and innovative as well as dedicated and ambitious.
As discussed above, there is a substantial body of knowledge that undergirds investment banking, but there are a myriad ways to achieve its mastery-and personality is often as important as intellect in the process. Having an intuitive sense for people and relationships is as important as having an inherent capacity for numbers and formulas. For example, those with the ability to bring in new clients (called “rainmakers”) are highly prized and rewarded. Knowing what to do is one thing; having the opportunity to do it is something else. You cannot show your stuff without getting the chance. Winning the assignment comes first: You must get the business before you can show your brilliance. So whereas technical competence may get the highest score, personal charisma gets you into the game.
There are different sets of skills that can lead to success in investment banking-technical, insightful, personal and managerial-skills that are neither complementary nor mutually exclusive. Though few are gifted in all four areas, many investment bankers show strengths in several.
Technical Technical types analyze financial situations and develop financial instruments. The paragons are the so-called “quants,” those mathematicians and scientists who have migrated to Wall Street (drawn by the tingle of tough competition and the heat of hot dollars). Computer technology has changed dramatically how Wall Street works, from market arbitrage to back office administration. Quants, those who specialize in quantitative analysis, are the new gurus on the old Street.
Insightful Insightful types see behind numbers and beyond technical analysis. They are often creative in spirit and enjoy innovating new concepts and products. They devise fresh financial instruments, and they add novel “bells and whistles” to transform ordinary products into special products. They find unrecognized M&A candidates, and they devise fascinating ways to make doable M&A deals that others think undoable. They are the ones with the sixth sense of market savvy, making the best trades with the right timing. Admittedly, insightful investment bankers have a tendency to ignore facts; but this weakness is also their strength. Ideas fly with high frequency. But insight is optimized when analysis is not slighted. They do the analysis, then have the confidence to leap beyond the logic.
Personal Personal types are the leaders of the investment banking world. They lead by “making it rain,” by developing client relationships and bringing in the business. They have high charisma; they attract people by their often magnetic personalities. They also lead by shaping the system, by influencing the people and events of the internal environment.
Managerial Managerial types run the organizations. They maintain the delicate balance between the high-ego, individual investment bankers and the collective authority needed to assure conformity with corporate goals. Managing investment banks-and investment bankers-is more like running an opera company or academic department than a traditional manufacturing or service corporation. Not only do you have all the conventional business problems, you also have the added aspect of managing prima donnas. Managers of investment banks work to focus the independent dynamism of investment bankers toward achieving corporate goals.
Attitudes and Ethics
Professions are characterized by specific standards of performance and codes of behavior to which members must conform. Such standards and codes serve to unify diverse aspects of the field. It is difficult to examine attitudes and ethics in investment banking except in the context of controversy. But the import of ethics must supersede its fractious recent history and intense media attention. Ethics is a prime building block of investment banking. Ethics generates confidence, and without the confidence of clients, investment banking cannot exist.
Coping with Professional Tension
Like law and medicine, investment banking is a profession where providing the best service to clients is the highest good. But investment banking is also a business, the business of finance, where money is not only used to keep score but it is also the product and service being sold. Furthermore, the money is massive, moving it around seems easy, the financial leverage is enticing-and investment bankers control the whole process. This atmosphere causes a certain tension to develop, a tension perhaps unique to investment banking.
Client service and private benefit can conflict. Though present in all professions, such strain can become exceedingly intense in investment banking. Why the greater problem here? The prime reason is the huge stakes and the competitive environment. The pie is so spectacularly large that even a small piece translates into grand personal compensation. And in the world of investment bankers, perhaps more than in any other profession, public status and personal success are judged in terms of compensation comparisons with peers.
Progressing further, many investment bankers would envision themselves as entrepreneurs, where personal productivity and creativity should lead to professional advancement and personal wealth. This desire, like most human emotions, has both upside and downside. The upside is enhanced individual effort; the downside is increased conflict of interest. Coping with such professional tension-resolving the conflicts that surely appear-is vital.
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.