Investing

What Is Investment Banking?

There is no end to the number of people and businesses that encourage you to invest on a yearly basis. Saving and investing go hand in hand, and both are encouraged if you want to have any hope of securing your financial future.

Once you get into the world of investments, you can’t avoid encountering investment banks. Investment banking is a staple in the process, so it’s important for you to understand what makes it so important.

As you know, the point of investing is to make a return. If you invest $50 into anything, your aim is not to have the same $50 that you invested. While that is the case with saving, the idea with an investment is that there should be value added. Therefore, your $50 should become a greater value, such as $60 or $100.

This is where investment banking comes into the mix. This banking sector has a tunnel focus on the creation and accumulation of capital and wealth for investors. These investors can be private individuals, companies, and even the government.

Note that a bank is not an investment bank because it has an investment banking division. These divisions only provide limited services compared to a full investment bank, which provides a much more comprehensive spread.

This banking sector is known for being one of the most complex areas in existence. Be that as it may, the services being provided can all be placed under six main categories, which are covered below.

All the information provided answers the questions surrounding the functions of an investment bank and everything that goes into executing them.

Underwriting and Capital Raising

You can think of this service as a middleman role. Companies routinely want to offer new securities to the public. This is usually done to raise funds for a new project, to clear debt, to fund an acquisition, or to retire older bonds.

Since this process is not direct, an investment bank is typically hired by the company that wants to make the offer to the public. When this bank comes in, there isn’t just an automatic jump to the sale.

There’s an assessment process during which the investment bank does pricing, underwriting, and sale of new bonds. The outcome of this tends to be based on how valuable the business is versus the level of risk that is associated with it.

Bonds aren’t the only things that investment banks assist with under this service category. Other securities, such as stocks, also come into the mix. These are offered via an initial public offering (IPO) or via any public offering thereafter.

There is a level of security attached to the process for the issuer. This is because the investment bank doesn’t wait until the securities hit the market before pulling buyers in. In fact, these banks get the public to commit to the purchase of a certain number of units before the securities hit the market.

Multiple investment banks typically try to get in on the securities, since they want them for customers. Therefore, the banks tend to negotiate a comfortable price for the purchase.

Once the purchase is made, the investment banks can then resell the securities to their customers, as well as the public. Of course, this means that the issuing firm gains capital from the arrangement, which works out as a win for all parties involved.

Mergers and Acquisitions (M&A)

There have been a lot of consolidation agreements between corporations over the years. While it wasn’t a very lucrative service initially, investment banks profit immensely by offering advice during M&A processes.

The investment bank can play the role of an advisor on either side of the M&A fence. The first possibility is that the bank comes in to advise the target business, which is usually a potential seller. This is known as sell-side engagement.

There is also the reverse scenario in which the investment bank is an advisor to the acquiring business. In this case, the bank must perform due diligence. This is a process that aims to provide the buyer with all the information necessary to protect its interests. There’s always an information gap where the acquirer and the target are concerned. The buyer doesn’t know much about the target, while the target has all the information. Additionally, the target wants the buyer to close the deal, so hiding negative information is a possibility.

The investment bank’s role here is to reduce the information gap by gaining the required information. The buyer can then decide if going through with the deal is feasible from an informed standpoint.

Due diligence comes in several forms, which all come together to provide a wealth of relevant information. The process contains the following areas:

  • Operational due diligence: This involves looking into the seller’s operational workflow as it is, as well as the expected impact from the acquisition.
  • Tax, legal, and accounting due diligence: As the name suggests, this is a review of tax, accounting, and legal data surrounding the seller.
  • Business due diligence: This area focuses on analyzing the seller’s customers, products, industry, and shareholders.
  • Financial due diligence: An analysis is done of the seller’s financial projections and financial history.

There are also special cases, such as buyouts, takeover defense, and hostile takeovers, in which companies can also seek advice from investment banks.

Sales & Trading

The sales and trading division of an investment bank is responsible for security trading facilitating. These securities are usually underwritten by the bank into the secondary market.

Investment banks trade securities for institutional investors. Such investors include pension funds, mutual funds, hedge funds, and university endowment. Not only do the banks bring buyers and sellers together, but they also make sales and purchases using their accounts, which helps to facilitate trade further. By doing so, they establish a pseudo marketplace, which lends itself to better movement of securities and more favorable pricing. The investment banks also charge a commission for such services, which means that there is another source of profit.

The efficient distribution of securities is a requirement for the investment bank to be considered a viable underwriter. This is the reason that investment banks have a sales force. The idea is to persuade buyers to purchase the securities by forming corporate relationships, while efficient trade execution is also promoted.

The sales arm of the investment bank is tasked with communicating with institutional investors. These investors are provided with all the necessary information surrounding securities. Additionally, the firm’s research analysts and traders depend on the sales force to provide both liquidity and timely information to clients.

The final piece of the puzzle is the traders who are responsible for making purchases and sales for the institutional clients. They also do so for the firm using their knowledge of the market and how favorable the conditions may be. Trades are done with institutional investors, commercial banks, and investment banks.

Commercial and Retail Banking

This wasn’t always a service offered by investment banks because it was prohibited by law. For 67 years, The Glass-Steagall Act prevented commercial banks and investment banks from overstepping certain boundaries where service offerings were concerned. They were distinct entity types that were only allowed to offer distinct services.

Investment banks could do institutional brokerage, M&A advice, and underwriting of securities. Commercial banks, on the other hand, could do saving and checking accounts, lines of credit, and loans.

When this law was repealed, the banks got the freedom to offer services that were previously labeled illegal. This is the reason for things like investment banking divisions in commercial banks. The whole financial services industry, which consists of investment banks, commercial banks, securities brokerages, and insurers, got the green light to offer all financial services.

Therefore, you can now find retail brokerage being offered by investment banks. This means that private investors are welcome. Instead of just institutions, individuals can throw their hats into the mix.

Naturally, the removal of such barriers meant that extended offerings would be accompanied by institutional consolidations. Many of the biggest mergers between businesses in the financial services industry were only possible and sought after because of the law repeal.

Asset Management

Some companies hire investment banks to perform the function of asset management. This means that all or part of these companies’ portfolios become externally managed.

There are two main objectives when an asset manager is brought in. The first is that of appreciation. It is expected that asset values should increase with the professional touch of an investment bank. Additionally, the experience factor that the bank has should go a long way in mitigating risk.

Note that this service is not available to everyone because of the financial barrier to entry. There is a minimum required investment, which means that corporations, wealthy individuals, and governments tend to make up the client base.

An investment bank needs to put the right foot forward as close to every time as possible. This means that there should be an innate ability to effectively decide what investments should be made or avoided. Doing this adequately results in the progressive growth of a client’s portfolio.

Of course, there’s more than just experience at play here. There is a lot of research and analysis that goes into making these predictive decisions. Some of the activities used here are company official interviews, statistical analysis, and historical analysis. Anything that can meet the requirement of asset appreciation is fair game.

Equity Research

An investment bank typically has an equity research division that is responsible for providing the necessary stakeholders with reports, recommendations, and analytical data on potential investment opportunities.

Though the process is very intensive, the end goal is to be able to definitively tell investors whether the recommended action is to buy, sell, or hold an investment.

The sales force and the trading teams get much of their information from the equity research team. Since this information governs important decisions, the underlying techniques must provide high-quality and timely data.

Most of the work done by equity research analysts revolves around the generation of reports. There is a constant publishing process, as there are tight and numerous deadlines that need to be met. These reports tend to include information on forecasts, valuation, recommendations, historical reviews, management overviews, and industry research.

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