An investment bank is a financial services company that acts as an intermediary in large and complex financial transactions. They are almost always present when a company files an initial public offering (IPO) or merges with or is acquired by another company. They also act as brokers for large institutional clients, such as in the case of pension funds. Some well-known investment banks include JP Morgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, Credit Suisse, and Deutsche Bank.
How do they work?
In the simplest of terms, investment banks earn money through fees for the services that they provide. The trading division of the investment bank may also earn a commission based on its market performance. Some banks will have a commercial division, in addition to an investment division, that makes a profit by loaning money to consumers and businesses.
Nowadays, the most important investment banks are typically a section of a larger bank, such as Citibank. These organizations have more resources to spend and capital to give, and also have more connections with the global financial community.
Read our full investment banking guide here: What is Investment Banking?
Scope of Investment Banks
Investment banks are responsible for many different activities. As intermediaries, their client base can extend to hedge funds, government entities, pension funds, corporations, and other institutions. Here is an outline of some of the roles they play:
Public Offerings of Debt and Equity Securities
Investment banks are active in debt capital markets in which corporations and government institutions raise funds by trading debt securities, which may include corporate and government bonds, among others. Essentially, these organizations are borrowing funds from institutional investors and then paying interest. Or, in the case of equity securities, instead of paying interest they sell a percentage of the ownership of the company.
Investment banks also help companies issue public offerings. There are four main types of public offerings: initial public offerings (IPO), IPOs of new securities, public offerings of publicly traded securities, and public offerings of publicly traded securities by company shareholders. In recent years, the line between equity securities and debt has become less distinct and often overlaps.
Private Placements of Debt and Equity Securities
Private placement of securities is an alternative to public offerings because, as the name implies, the company remains private. The organization will raise capital by offering debt or equity securities to a specific group of investors, rather than the general public. Doing so allows these companies to raise capital, diversify their financing, and increase their financial capacity. One advantage of private placements is that the securities are not required to be registered with the Securities and Exchange Commission (SEC), which allows the company to avoid the costs that accompany a public offering.
Mergers and Acquisitions (M&A)
When a company decides to sell to another, an investment bank is often brought in to help manage the change. Investment banks find, facilitate, price, and finance M&A, and help optimize the terms. They may also be involved with leveraged buyouts, company restructuring and recapitalization, and the reorganization of distressed companies.
Financial Advisory/Sponsor Group Finance
Investment banks work with many private funds to offer services like raising capital for general funds, M&A help, the financing of acquisitions, and IPOs of portfolio companies. In general, investment banks help private companies raise capital for various uses.
Fairness opinions are reports that evaluate the facts of different business deals, such as mergers, acquisitions, carve-outs, buybacks, or others. These reports provide a perspective of whether the proposed stock price is fair to the target company.
The fairness opinions of investment banks support M&A, leveraged buyouts, and the restructuring of public companies. They are able to charge high fees because of the importance of providing an independent, defensible, expert statement on values. Also, because there is a significant liability, the investment bank takes on fairly high levels of risk and as such, is compensated generously.
The synthetic financing mechanisms and structure creation roles of investment banks make it possible for companies to allocate capital and implement better risk-return features for both issuers and investors. Securitization is the process through which assets are packaged together into one security and then any cash flow from those assets is used as collateral for the overall package.
Investment banks alleviate risk through swaps, options, and futures, all derivative instruments and essential components of financial markets. Through these instruments, investment banks are able to shift their risk exposure and hedge investment positions.
Swaps are the process through which two corporations exchange currency or interest rates in order to better control the desired risk-return profile or shift their risk exposure. In these kinds of interactions, the investment banks act as intermediaries. They’re used because different organizations have different comparative advantages and this extends to categories of debt instruments in financial markets. Investment banks work to manage risk by combining the expertise of different hedging instruments when developing a strategy for clients.
Investment banks sometimes use their own capital for equity investments with the goal of receiving high returns. This activity is undertaken in order to facilitate a client transaction or purchase securities in an operating company for the firm’s own account.
Public Trading of Debt and Equity Securities
Most investment banks have strong trading capabilities and gain profits by trading for clients and themselves. They may act as brokers, dealers, or market makers. Brokers are agents who are representatives of either the buyer or seller. They have no securities in inventory and therefore, assume no risk. Dealers set the bid-and-ask prices for the securities that they offer for trade. They maintain an inventory of securities and assume some risk because of market volatility. Market makers are responsible for providing liquidity to the markets by strategically placing orders on both sides of a transaction.
Investment Research and Security Analysis
Investment banks have garnered a reputation for expertise in investment analysis. Because of their constant dealings in the market, they have a deep understanding of trading and securities. Bankers use this knowledge to develop underwriting and money management strategies for businesses.
Individuals and corporations with wealth use investment banks to manage it. Investment banks deal primarily with businesses as there are specific wealth management firms for individuals. There are many services in this area including tax planning, investment services, and estate planning.
In addition to the traditional financial products like stocks and bonds, investment banks will also deal with others. These include private equity, real estate, arbitrage, and international trade. The banks develop these proprietary products and sell them.
Investment banks help raise money for governments at all levels: national, state, county, and municipal. They also work with national governments in the privatization of assets.
International Investment Banking
Due to the increasingly international nature of financial markets, investment banks are often involved in deals across multiple countries. They finance international market searches for the lowest cost of capital and the highest possible returns. Recently, a lot of this research has been done in emerging markets, where there is an enormous opportunity for growth.
Underwriting Public Offerings
The foundation and classic service of investment banking is public offerings of debt and equity securities. Investment banks typically handle IPOs with one of two approaches: firm commitment or best efforts.
The firm commitment approach means that the managing investment bank and any syndicate partners will agree to buy all of the shares at the negotiated price. The underwriter will then resell the shares to clients to make a profit. In this instance, the underwriter bears the entire risk of the shares’ pricing and the total amount of profit raised.
In contrast to a firm commitment approach, best efforts involve an agreement between an investment bank and a company that wants to sell its securities. The bank purchases enough shares for the client and may act as an underwriter to sell the shares to the general public. This approach limits the risk that the underwriter is taking on, as well as their potential profits. It is most often used when the market conditions are not ideal or when the deal is especially risky.
The Underwriting Process
Underwriting is the process where a bank raises money for its client through equity or debt securities. There are many different functions, procedures, and requirements involved but the critical steps are outlined below:
- A company has an interest in raising capital and chooses an underwriter.
- The underwriter and/or bank performs a preliminary analysis of the issue structure and pricing of the securities.
- The underwriter conducts a due diligence review.
- The underwriter and its counsel do a legal and accounting analysis and prepare all necessary documents.
- The registration statement undergoes a preliminary compilation.
- The registration statement is submitted to the Security and Exchange Commission (SEC)
- The preliminary prospectus is circulated to prospective investors and meetings are held for the description of the company and its securities.
- Any comments provided by the SEC are received and responded to.
- The company and underwriter undergo final pricing negotiations and sign the underwriting agreement.
- Any final registration statements are filed with the SEC.
- The SEC approves the final registration statements and declares the issue effective.
- Any press releases and/or tombstone advertisements are completed and the bank/underwriter and company close and settle.
Investment banking is a complex and competitive industry and though we have covered some of the roles that the organizations play, there are many others. Here are several more articles to get you started on your investment banking journey:
- 37 Free Resources to Break Into Investment Banking
- Wealth Management vs. Investment Banking: Key Differences and Career Prospects
- Top 10 Investment Banks in the World
- An Expert's Guide to Resumes: 5 Tips to Make You Stand Out
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