Investment banks facilitate flows of funds and allocations of capital. They are financial intermediaries, the critical link between users and providers of capital. They bring together those who need money to invest (e.g., corporations that build factories and buy equipment) with those who have money to invest (e.g., institutions that manage money for pension plans), and they make the markets that allocate capital and regulate price in these financial transactions (i.e., who gets how many dollars, with what terms and at what cost).
Investment banking is a dynamic industry characterized by flux and transformation. Financial instruments have grown more complex as financial intermediaries have become more competitive. Blizzards of innovative instruments have swept financial markets. Boundaries among diverse financial institutions have blurred. Barriers between international financial markets have eroded. And amplifying the complexity and the competition, financial markets, firms, products and techniques are merging and melding.
It is in this volatile environment that investment banks of all sizes and strategies struggle with change. Investment banking, long simply synonymous with the domestic underwriting and market making of corporate equity and debt securities, has expanded dramatically in past decades: new functions (e.g., the prominence of mergers and acquisitions, M&A), new products (e.g., risk management mechanisms such as swaps), new techniques (e.g., securitization of illiquid receivables), new international exchanges (e.g., importance of Hong Kong in addition to New York, London and Tokyo), new financial markets (e.g., China), and new muscle (e.g., private equity, hedge funds and merchant banking).
What services can investment bankers provide, and how can senior executives use investment banks to their firms’ advantage?
Strategies of Investment Banks
Investment banks enable issuers to raise capital (i.e., enterprises that sell or “issue” securities for cash) and investors to place capital (i.e., individuals or institutions that buy or invest in those securities) in the most reasonably efficient manner for both: the lowest overall cost of capital for issuers and the highest ratio of return-to-risk for investors. Designing financial instruments that ever more closely match these opposite desires of issuers and investors is the hallmark of the industry.
Whether debt or equity, all capital has a cost and issuers want to raise capital at the lowest possible overall (all-in) cost. The cost of debt is its interest rate, repayment schedule, covenants, and the like. The cost of equity is the dilution of current stockholders relative to the money raised. The cost of capital is directly related to the overall value of the firm as determined by the market capitalization and to the apparent risk of the firm as determined by both competitive business (product-market) and financial structure (leverage, debt/equity). Investors, naturally, want to achieve the highest overall return commensurate with a given level of risk. By arranging monetary transactions, exchanges and relationships among economic entities, investment banks make the capital markets more efficient. Matching the highly specific profiles of myriad issuers and investors is the special capability that investment banks offer.
Scope of Investment Banks
Following are fourteen activities of investment banks. They can be allocated into categories such as “Corporate Finance,” “Capital Markets,” “Wealth Management / Private Client,” “Alternative Investments,” and the like.
Public Offerings of Debt and Equity Securities
There are four general types of public offerings: 1) Initial public offerings (IPOs) of securities issued by companies that have never before issued any public securities (normally common stock is the first security to be issued in an IPO); 2) Initial public offerings of new securities that companies that are already public have not before issued (e.g., a new class of convertible debt security); 3) Further public offerings of securities that are already publicly traded (e.g., the issuance of additional common stock when its price is sufficiently high so that cost of capital is sufficiently low); 4) Public offerings by company shareholders of securities that are already publicly traded (e.g., when an original large shareholder, say a private equity fund, wants to cash out its position).
In the past we could cleanly differentiate debt and equity securities and put them into separate categories. Investment grade corporate bonds were distinct from high-yield (“junk”) bonds. Today the old distinctions are fuzzy. Debt and equity are more points on a continuum than boxes on a chart. Junior subordinated zero-coupon convertible debentures can be thought more equity than debt and dutch-auction preferred stock can be thought more debt than equity. Geography, as well, is no longer a constraint: Companies can reach anywhere in the world to lower their cost of capital.
Private Placements of Debt and Equity Securities
Private placement is the selling of securities to investors without the regulatory requirements of public offerings. The regulations defining private placements are complex and the securities and investment vehicles offered are numerous. Ranging from corporate equities to real estate interests, privately placed securities carry a higher return than similarly structured securities that can trade in the public markets. The loss of liquidity enhances risk and therefore requires a proportionally higher return.
Mergers and Acquisitions (M&A)
This is the front-page stuff – the huge acquisitions, takeover battles, hostile attacks and fierce defenses. But it’s not all war. The vast majority of M&As are friendly. Investment bankers seek to optimize price and terms, so that the “best price” may not be the highest price for client sellers (all cash or confidence in closing may be more important) nor the lowest price for client buyers (certainty of getting the deal done may be more vital). Investment banks find, facilitate, price, and finance mergers and acquisitions. Also included in M&A are leverage buyouts by private equity, the restructuring and recapitalization of companies, and the reorganization of troubled companies.
Financial Advisory / Sponsor Group Finance
Financial advisory services have grown dramatically as investment banks work with the large number of private funds – hedge funds and private equity – that have mushroomed in recent years and control hundreds of billions of dollars. Services include (i) raising of capital for general funds, (ii) M&A acquisitions, (iii) financing acquisitions, (iv) IPOs of portfolio companies owned by the funds (when appropriate) and (v) M&A of these companies (when IPOs are not appropriate). Investment banks like to involve themselves with hedge funds and private equity since they are transaction oriented, generate huge fees and are in perpetual deal mode.
Fairness opinions support M&A, leveraged buyouts and restructurings for public companies. Providing an independent, defensible, expert statement on values and the “fairness” of those values is an essential part of any such public transaction. Investment banks command what may seem to be exorbitantly high fees for giving fairness opinions, considering the number of hours worked (and the amount of paper produced). The reason is the significant liability the investment bank assumes, which can be realized both in the courts via shareholder suits and in industry reputation. In fact, major investment banks do not like to provide fairness opinions – the risks are too high for the fees – but generally do so only to serve important clients.
Structured Finance / Securitization
The creation of synthetic financing mechanisms and structures makes possible allocations of capital with better risk-return features for both issuers and investors. This is generally achieved by instruments that (i) pool assets, (ii) allocate liabilities into different “trenches” (with different risk-return profiles), and (iii) are contained within an independent legal entity.
Securitization is the process by which formerly illiquid assets, mostly small consumer receivables of all kinds (e.g., home mortgages, automotive loans, credit card receivables), can be liquefied by their being “rolled up” into large, publicly tradable securities with improved risk-return for both issuers and investors. (Such innovations exemplify investment banking’s contribution to financial markets.)
Securitized obligations are sophisticated in design and often require statistical analysis and sensitivity testing of key criteria (e.g., default rates, prepayment profiles, interest rate sensitivity, tax changes, etc.). For example, a change from forecasted rates of prepayment (e.g., due to interest rate declines and the resulting refinancing of older, higher-rate mortgages) can result in shocking differences in returns from initial expectations. (Principal itself can suffer significantly.)
Other kinds of structure finance include project finance, which is used to fund large-scale enterprises such as power plants and infrastructure.
Hedging positions in interest rates, foreign currency exchanges and commodity positions through swaps, options and futures are an essential building block of financial markets. Swaps are the mechanism by which two or more parties exchange their debt obligations in order to control more precisely each party’s desired risk/return profile. Swaps work because different entities have different comparative advantages when pricing different categories of debt in different financial markets. Parties of dissimilar credit ratings or financing needs can exchange their obligations (e.g., from shorter term to longer term and vice versa) in order to optimize their financial strategy and structure. Risk management groups combine expertise in diverse hedging instruments to develop a complete hedging strategy for enterprises.
Merchant banking is the commitment of an investment bank’s own capital to equity-level investments and participations, seeking very high returns. Such commitment of capital is made for two general purposes: 1) to facilitate a client transaction (i.e., a bridge loan until permanent financing is obtained); or 2) to purchase securities in an operating company for the firm’s own account (i.e., whether 100% ownership by the investment bank, in partnership with a client, or as the manager of an LBO[BP1] fund). Bridge loans are highly profitable, combining commitment fees, placement fees, high interest rates,and equity kickers.
Public Trading of Debt and Equity Securities
Most large investment banks maintain strong trading capabilities, which is a significant though volatile profit center – profits are made both from commissions generated by trading for clients and from capital appreciation generated by trading for the firm’s own account. Investment banks act as brokers, dealers, and/or market makers (which can differ for different securities). In addition to traditional stocks and bonds, money market instruments and commodities (e.g., gold, silver, coffee, crude oil, various metals, various foods), investment banks create “synthetic securities” (e.g., striped Treasuries, interest only and principal only instruments), which by appealing to different investors, enhance the risk-return for all.
Brokers are commissioned agents who represent either buyers or sellers and work much as do real estate agents; they carry no securities in inventory and therefore assume no risk in price variation or interest-charge. Dealers set bid-and-ask prices for each security they offer for trade; by maintaining an inventory of securities, dealers assume a price risk since the market may go up or down during the time they hold the securities. Market Makers establish (and support) the entire market for a security on either side of a transaction. Brokers and dealers are regulated by the various exchanges of which they are members and the National Association of Securities Dealers (NASD), which is the self-regulating organization to which they all belong.
Investment Research and Security Analysis
For decades, the research capabilities of an investment bank’s security analysts were often the firm’s most prestigious and visible strength. (More recently, M&A, IPOs, LBOs, and private equity / hedge funds have usurped the limelight.) Indeed, many investment banks used the reputation derived from their investment analysis expertise to develop underwriting and money management businesses. Typical subdivisions are Global Equities and Fixed-Income. Today, after various scandals and prosecutions, investment banks must enforce strict compartmentalization between their corporate finance and investment research departments (the so-called “Chinese Wall”).
The accumulation of vast wealth by institutional investors (i.e., pension and insurance funds), and by rich and super-rich individuals, has made money management a vital business. (For individuals, the departments are called “private banking” or “private client.” ) Investment banks compete with one another, and with large commercial banks and specialized money management firms in accumulating assets under management. Hundreds of billions of dollars are at stake.
The investments in financial products other than exchange-traded stocks and bonds have become a huge business, such as private equity, real estate, arbitrage, international, and the like. The development of funds under management, including private equity and hedge funds, has increased dramatically, and investment banks both develop their proprietary products and sell others.
Public / Government Finance
The raising of money for governments (“sovereigns”) at all levels: national governments, state governments, county and municipal governments. Also included is working with national governments in the privatization of government assets.
International Investment Banking
“Globalization” is the byword of investment banking. Financing has become a multi-market search for the lowest cost of capital for issuers, and a 24-hour-a-day quest for the highest return for investors. Growth is highest in emerging markets, the opportunities for investment, underwriting and M&A are extensive, and all major investment banks have significant presence in many countries.
Both issuers and investors seek the optimum level of risk for a given level of return. Such optimizations cover the uncertainties and volatilities of interest rates, currency exchange rates, credit availability (for users of capital), credit instability (for providers of capital) and equity investments. Optimum risk for a given return, or conversely optimum return for a given level of risk, is achieved by using techniques of finance theory such as hedging and diversification. The international expansion of one’s investment horizons allows more efficient optimization procedures for both issuers and investors – i.e., investment portfolios can be diversified more widely, thereby expanding their risk/return frontier and achieving higher efficiency.
Underwriting Public Offerings
The public offering of debt and equity securities is the foundation of investment banking. Although the term “underwriting” seems to imply an absolute guarantee that the managing investment bank and its syndicate members (i.e., the underwriters) will be legally bound to purchase the securities from the issuing company, the real world is more complicated. Regarding an initial public offering, there are really only two approaches that an investment bank can take: firm commitment or best efforts.
A “firm commitment” means that the managing investment bank and its syndicate will agree to buy the entire issue at a negotiated price. The underwriters will then resell these shares to its clients, making as its profits the previously negotiated “spread,” which is the difference between the “gross proceeds” paid by the public and the “net proceeds” given to the issuer. This means that the underwriters bear the entire risk of per share pricing and the amount of total proceeds raised. (It should be stressed that a “firm commitment” is often not as “firm” as it sounds. A firm commitment only becomes absolutely firm on the offering day itself (or the night before) just before the issue “goes effective,” which is the moment when the SEC gives its final approval. Until then the “firm commitment” is not firm, no matter who promises what to whom. (Even then the underwriting agreement is not perfectly firm; it has various “outs,” for market disturbances, acts of God, and the like.) Furthermore, all the marketing of the issue has already been done; the “road shows” have been conducted and the underwriting syndicate members know which of their clients are committed to buy how many shares. They know if the issue is oversold or undersold and can make final adjustments to price accordingly. The bottom line is that when investment banks give firm commitments they have little uncertainty.
A “best efforts” relationship is where the investment bank uses its expertise as structurer in designing the issue and as marketer in selling the issue. This means that the underwriters bear no risk in the deal, leaving to the issuing company all the uncertainty of per share pricing and the amount of total proceeds to be raised.
The Underwriting Process
The underwriting process is a formal process involving many simultaneous functions, procedures, requirements and activities. Following are some of the critical steps: company interest and underwriter selection, preliminary analysis of issue structure and securities pricing, due diligence reviews by underwriters and their counsels, legal and accounting analysis and document preparation, preliminary compilation of the registration statement, submission of registration statement to the Security and Exchange Commission (SEC), circulation of preliminary prospectus to prospective investors, information meetings (“road shows”) in major cities for describing the company and its securities, receive and respond to SEC comments, final pricing negotiations and signing the underwriting agreement, final registration statement filed with the SEC, SEC approval declaring the issue effective, press releases and tombstone advertisement, closing and settlement.
Investment banks are at the center of business and finance, and all senior executives, irrespective of their direct responsibilities, need to understand what they do and how they do it.