An investment bank is a special division of a bank or a financial institution that aids large and complex financial transactions for companies, governments, and other entities. Investment banking is a very wide and subjective phenomenon, and it can be structured in different ways. In this article, we will take a holistic approach and try to understand each service that an investment bank provides.
Types of Investment Banking Services
Following are the services provided by investment banks:
We can put underwriting as one of the main business segments of an investment bank. Underwriting is a service through which investment banks raise open market capital for corporations and governments. An entity uses the underwriting service of an investment bank when it wants to launch an initial public offering (IPO) in the primary market.
In their role as an underwriter, investment banks first plan the entire public issue. It understands the necessary capital requirement, why the client wants to raise the capital, etc. Secondly, it studies the market conditions. This stage analyses market conditions, target market, and investor’s risk-taking capacity, sensitivity, economic and political conditions, etc. Finally, on the basis of all this analysis, the investment bank structures the public issue and launches it.
In a majority of transactions, as an underwriter, the investment bank commits to invest some percentage of its capital in the public issue if the issue is not fully subscribed. This is mainly to create investors’ confidence in the public issue. It is very important that the investment chooses its client wisely for providing underwriting services. This is mainly because it is expected that the bank commits its capital. In fact, this step has become even more important now as high-growth start-ups, which may or may not have thorough financial stability, are increasingly raising equity capital through an IPO. A proper cost-benefit analysis is necessary. Let’s take an example to understand this better.
Jane Software, a Silicon Valley high growth start-up, needs capital of USD 100,000.00 to fund its expansion plans. It decides to explore the option of an initial public offering (IPO). It approaches Deutsche Bank (an investment bank) to advise and underwrite the IPO. Deutsche Bank analyses Jane Software’s financial statements, expansion plans, management capability, market scenario, and investor capacity. As everything is satisfactory, it agrees to underwrite the IPO. On the advice of Deutsche Bank, Jane Software decides to issue 10,000 shares of USD 10.00 each. Also, Deutsche Bank agrees to underwrite 30% (or 3000 shares) of the IPO. The IPO receives purchase requests for 8000 shares which means it goes under-subscribed by 20%. Here Deutsche Bank’s liability is limited to its 30% underwriting agreement, i.e. –
80% of 3000 underwritten Deutsche Bank shares are subscribed
so, 2400 shares are subscribed
Therefore, Deutsche Bank has to buy the remaining 600 shares (3000 – 2400) by investing USD 6000.00 of its capital in the IPO.
Now suppose on the IPO opening day, Jane Software shares open at USD 12.00 per share. Then Deutsche Bank can sell its 600 shares for USD 7200.00 and make a profit of USD 1200.00. However, if the share opened at USD 8.00, then it may have to decide to sell the stock at a loss or hold up the capital until its shares reach a profitable price.
Regardless, Deutsche Bank will charge an underwriting fee as a percentage of the value of the IPO, i.e., USD 100,000.00
Mergers & Acquisitions (M&A) Advisors
One can say that mergers and acquisitions are the heart and soul of investment banking. Mergers itself have a very wide scope. There are various types of transactions that come under M&A namely – Mergers, Acquisitions, Tender Offers, Leverage Buyouts, Consolidations, etc. This makes the role of investment banks as M&A advisors very wide.
There are two entities involved in an M&A transaction, one is the buy-side company and another is the sell-side company. Each side hires its own investment banks as advisors to get the maximum value for their shareholders.
As a buy-side M&A advisor, the investment bank analyzes if the merger or acquisition that its client wants is actually viable for the client’s business or not. If viable, it creates an M&A strategy and calculates the value of the company that the client wants to buy. Naturally, both the parties of the M&A transaction will not come up with the same valuation and terms. So investment banks also help in negotiating the deal with the opposite party.
Investment banks charge a percentage of the value of the M&A deals as advisory services. Any M&A deal goes in multimillion dollars in value. Thus this is a very high paying business for an investment bank.
In a research by KPMG, it has been found that historically two-thirds of all M&A transactions actually lose value in the stock market. Therefore we can understand the precarious nature of these transactions.
Sales, Trading & Corporate Broking
Under sales and trading, the primary function of an investment bank is to facilitate the buying and selling of securities and other financial instruments between the investment bank and large institutional clients or high net-worth investors. Here the investment banks approach large clients to suggest profitable trading ideas. They conduct and complete the trade on behalf of their client, and charges commission or brokerage from buying and selling.
It is important to note that the transactions done by investment banks are very different from those done by the brokerage houses. These transactions are different in two ways. Firstly, the investment banks only entertain large investors, who have the capacity to make high-value transactions while brokerage houses offer its services to even a small investor. Secondly, the flow of the transaction of an investment bank is that the investors trade on the advice of investment banks, whereas in brokerage houses the brokers usually instrument the transactions as the investors ask them to.
In recent years the investment banks have started making its own financial products to pitch to the investors. The products can be a mix of equities, equities plus debts, or a mix of all securities such as equities, debt, commodities, and derivatives.
Also, the investment banks help investors in hedging risks through derivative trading.
Asset Management Services
Asset management is another very lucrative business for investment banks. In many cases, investment banks serve as personalized asset managers to their clients. Clients of an investment bank for their asset management services include large insurance companies, government provident fund departments, and the likes. Investment banks create an efficient portfolio for their client which yields maximum returns for a certain risk that the client is ready to bear. It is obvious that in such cases the assets under management is very large, and investment banks charge a commission which is a percentage of the asset under management.
Research is not the main profit center for the investment banks, but it is necessary to support the other profit-making divisions. Most investment banks host an in-house research department where analysts work on research of equities and other securities. The equity research helps the sales and trading department to come up with high-profit trading ideas. The investment banks hire high-quality buy-side and sell-side analysts to come up with extremely precise equity valuation.
Furthermore, investment banks also do high-quality research in the areas of macroeconomics, market scenario, political scenarios, credit analysis, and other quantitative analysis. This aids all the other profit-making divisions of investment banks in making a precise informed decision. For example, it is important to have thorough credit analysis before making an investment for underwriting services, or it would be fruitful to understand the market scenario and macroeconomic factors before deciding the best timing to launch an initial public offering.
Thus we can conclude that investment banking services are large and complex but is a very lucrative business.
Continue reading – How to become an Investment Banker?