Investment Banking- Overview

IntroductionIB is not a straightforward thing to explain, but lets start by stating that its NOT investing, NOR banking.

It is really the raising of capital (money companies need to help their business grow) on behalf of clients by buying and selling securities.

It can be said that IB is the EVOLVED form of Merchant Banking.

DefinitionThe dictionary of banking and finance defines investment bank as A bank which deals with the underwriting of new issues and advices corporations on their financial affairs.The SEBI(Merchant Bankers) Rules 1992 define merchant banker as A person who is engaged in the business of issue management either by making arrangement regarding selling ,buying ,or subscribing to securities as manager , consultant ,advisor or corporate advisory services in relation to such issue management.

Thus Investment banks are essentially financial intermediaries who assist their clients in raising capital either by underwriting their shares or bonds or by acting as an agent in the issuance of securities.Please note that Investment banking isnt one specific service or function. It is an umbrella term for a range of activities including underwriting, selling & trading securities, providing financial advisory services, such as mergers & acquisition advice, IPO advisory and managing assets.

History & Emergence Merchant Banking practices adopted in USA evolved into the better equipped current form of Investment Banks.

For the purpose of study we can divide the evolution process of IB into 3 main phases:

Period prior to 1929 Period from 1929-19331933 onwards

Period prior to 1929The end of World War ll broke the back bone of Commercial Banking in USA and they were preparing for an economic recovery.It was expected that American companies would shift their dependence from commercial banks to the stock & bond markets wherein the funds were available at lower cost and for longer periods of time.In order to have a presence in the capital markets, Commercial banks started to acquire Stock Broking Businesses

The stock and bond market boom of the 1920 was an opportunity that banks could not miss. But since they could not underwrite and sell securities directly, they owned security AFFLIATES through holding companies.However the compartments were not maintained in a water tight fashion.While the boom lasted, Investment Banking Affiliates made huge profits as underwriting fees.Eventually the stock market got over heated with investment banks borrowing money from parent banks in order to speculate in the banks stocks, mostly for short selling.

The bubble ultimately burst in October 1929 wiping out millions of dollars of bank depositors funds and bringing down with it banks such as the Bank of United States.

Period between 1929-1933In order to restore the confidence in the banking & financial system, several legislative measures were proposed, major being the BANKING ACT 1933 ( popularly known as the Glass-Steagall Act)It restricted commercial banks from engaging in securities underwriting and acting as agents for others in securities transactions.These activities were segregated as the exclusive domain of Investment Banks.

On the other hand, investment banks were barred from deposit taking and corporate lending, which were considered the exclusive business of commercial banks.

As a result of the passage of this Act, a separate group from J.P. Morgan set up Morgan Stanley Investment Bank while J.P. Morgan itself continued as a Commercial Bank.

Birth of Universal BanksIn order to reach the current state, Investment Banks have undergone several phases of transformations, which has broken down the water-tight compartments to a great extent.The Gramm-Leach Bailey Act 1999 has legalized for a bank to have both commercial & investment banking.A Universal Bank thus means co-existence of commercial banking (lending activity)with investment banking (investment & distribution activity).

Investment BanksCommercial BanksHelp their clients in raising capital by acting as an intermediary between the buyers & sellers of securities.Do not take deposits from customersEarn underwriting commissionAre engaged in the business of accepting deposits from customers and lending money to individuals & corporatesCan legally take deposits from the customers.Earn interest on loans granted to their customers

Investment v/s Commercial Banks

Do not own the securities & only act as an intermediary for smooth transaction of buying and selling securities.

Own the loans granted to their customers.

Role of Investment BanksInvestment banks help companies and governments and their agencies to raise money by issuing and selling securities in the primary market. They assist public and private corporations in raising funds in the capital markets (both equity and debt)as well as in providing strategic advisory services for mergers, acquisitions and other types of financial transactions.

Investment banks also act as intermediaries in trading for clients. Investment banks differ from commercial banks, which take deposits and make commercial and retail loans. In recent years, however, the lines between the two types of structures have blurred, especially as commercial banks have offered more investment banking services

Investment banks may also differ from brokerages, which in general assist in the purchase and sale of stocks, bonds, and mutual funds. However some firms operate as both brokerages and investment banks; this includes some of the best known financial services firms in the world.

In the strictest definition, investment banking is the raising of funds, both in debt and equity, and the division handling this in an investment bank is often called the "Investment Banking Division" (IBD). However, only a few small firms provide only this service. Almost all investment banks are heavily involved in providing additional financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.

More commonly used today to characterize what was traditionally termed "investment banking" is "sell side." This is trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e. underwriting, research, etc.).The "buy side" constitutes the pension funds, mutual funds, hedge funds, and the investing public who consume the products and services of the sell-side in order to maximize their return on investment. Many firms have both buy and sell side components

Organizational Structure of an Investment Bank An investment bank is split into the so-called Front Office, Middle Office and Back Office.

Front OfficeInvestment Banking is the traditional aspect of investment banks which involves helping customers raise funds in the Capital Markets and advising on mergers and acquisitions. Investment bankers prepare idea pitches that they bring to meetings with their clientswith the expectation that their effort will be rewarded with a mandate when the client is ready to undertake a transaction.

Once mandated, an investment bank is responsible for preparing all materials necessary for the transaction as well as the execution of the deal, which may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.

Investment ManagementThe professional management of various securities (shares, bonds etc) and other assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) orprivate investors (both directly via investment contracts and more commonly via collective investment schemes, mutual funds) .

Sales & Tradingis often the most profitable area of an investment bank.responsible for the majority of revenue of most investment banks In the process of market making, traders will buy and sell financial products with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales forcewhose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales desks then communicate their clients' orders to the appropriate trading desks, who can price and execute trades, or structure new products that fit a specific need.

Researchis the division which reviews companies and writes reports about their prospects, often with "buy" or "sell" ratings. While the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. In recent years the relationship between investment banking and research has become highly regulated, reducing its importance to the investment bank.

Structuringhas been a relatively recent division as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities

Middle Office Risk Managementinvolves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent 'bad' trades having a detrimental effect to a desk overall.

Another key Middle Office role is to ensure that the above mentioned economic risks are captured accurately (as per agreement of commercial terms with the counterparty) correctly (as per standardized booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution). In recent years the risk of errors has become known as "operational risk" and the assurance Middle Offices provide now include measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation

Back OfficeOperations involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While it provides the greatest job security of the divisions within an investment bank, it is a critical part of the bank that involves managing the financial information of the bank and ensures efficient capital markets through the financial reporting function. The staff in these areas are often highly qualified and need to understand in depth the deals and transactions that occur across all the divisions of the bank.

TechnologyEvery major investment bank has considerable amounts of in-house software, created by the Technology team, who are also responsible for Computer and Telecommunications-based support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading platforms. These platforms can serve as auto-executed hedging to complex model driven algorithms.

Revenue-Generating ActivitiesPrimary Market MakingCorporate FinanceMunicipal FinanceSecondary Market MakingDealer ActivitiesBrokerage ActivitiesTradingArbitrageProprietaryCorporate RestructuringExpansionContractionOwnership and Control

Financial EngineeringZero Coupon SecuritiesMortgage-Backed-Securities Derivative ProductsOther Revenue-Generating ActivitiesInvestment Management (Asset Management))Merchant Banking (Private Equity and Venture Capital)ConsultingTransaction Banking (Prime Brokerage)

Types of Investment BanksGrad Nav has classified the hundreds of investment banks that operate in the UK into three groups:

Multinational banks

Mid-market banks

Boutiques

Multinational banks

Multinational banks are the big, well-known global financial institutions.

They are major players in the financial markets and can be sub-classified into three further categories:

Universal banksPure-play investment banksAdvisory houses

Universal banks are universal because they are active in all the departments you can find in an investment bank, plus they also have a retail or commercial banking division.

Pure-play investment banks are also active in all the departments found in an investment bank, but do not have a major retail or commercial banking division.

Advisory houses focus on the Banking business areas of investment banking. They provide advice to clients seeking to buy or sell companies or raise capital.

Mid-market playersMid-market players are often not technically "banks" as they dont have retail and commercial banking arms.Instead they focus on providing investment banking services to small-cap and mid-cap clients.Accountancy firms such asDeloittehave many different departments, obviously focusing on the activities you normally associate with accounting firms like audit and tax, but they also provide M&A advice to small and mid-sized companies.

BoutiquesBoutiques are small firms focusing on a specific niche, help their clients in equity and debt raising activities. Aboutique investment bankis a smallinvestment bankthat specializes in some aspect ofinvestment banking, generallycorporate finance, Of those involved in corporate finance, capital raising, mergers and acquisitionsandrestructuringandreorganizationsare their primary activities

A small financial firm that provides specialized services for a particular segment of the market. Boutique firms are most common in the investment management or investment banking industries. These firms may specialize by industry, client asset size, banking transaction type or by other factors to address a market not well addressed by larger firms.

Chinese WallsPotential conflicts of interest may arise between different parts of a bank, creating the potential for financial movements that could be market manipulation. Authorities that regulate investment banking (the FSA in the UK and the SEC in the US) require that banks impose a Chinese wall which prohibits communication between investment banking on one side and equity research and trading on the other.

Functions of Investment BanksIssue of an IPO

Merger & Acquisitions

Private Placements

Financial Restructuring

Issue of an IPOThe very first time a company chooses to sell equity, this offering of equity is transacted through a process called Initial Public Offering of stock.Through the IPO process, stock in a company is created and sold to the public. After the deal stock sold in India is traded on a stock exchange such as the NSE or BSE.Bankers to one of the largest IPOs in Indian history, the Rs. 12000 crores IPO of Coal India Limited included Citigroup, DSP Merrill Lynch, Morgan Stanley, Deutsche Bank, Enam Financials & Kotak Mahindra Capital Company.

From an Investment banking perspective, the IPO process consists of these 3 major phases:Hiring the Managers: the first step for a company wishing to go public is to hire managers for its offering.The choice depends on the past transaction experience, the fee quotes, the valuation the bank promises to fetch for the companys offering etc.The selection also depends on whether the issuer would like to see its securities held more by individuals or by institutional investors ( i.e. Investment Bankers distribution expertise).Often, the selection process is a two-way affair, with the reputable IB choosing its clients at least as carefully as the company would choose the I.Banker

.When there are multiple managers, one investment bank is selected as the Lead or Book-running manager. The lead manager always appears on the left of the cover of the prospectus, and it plays a major role throughout the transaction.Due Diligence and Drafting :Once the managers are selected, the second phase of the process begins.For Investment Bankers on the deal this phase involves understanding the companys business as well as possible scenarios ( called due diligence)

Marketing: The third phase of an IPO is the marketing phase. Once the approval comes on the prospectus, the company embarks on a road show to sell the deal.A road show involves meeting potential institutional investors interested in buying shares in the offering.Typical road shows last from two to three weeks, and involve meeting numerous investors, who listen to companys presentation and then ask scrutinizing questions.

Mergers & AcquisitionsRepresenting the TargetSell side representation comes when a company asks an Investment Bank to help it sell a division, plant or subsidiary operation.The work involved in finding a buyer includes writing a selling memorandum and then contacting potential buyersRepresenting the AcquirerThe advisory work itself is straightforward: the IB contacts the firm their client wishes to purchase, attempts to structure an offer for all parties and make the deal a reality.

Private PlacementsA Private Placement differs little from a public offering aside from the fact that private placement involves a firm selling stock or equity to private investors rather than to public investors.Also a typical Private Placement deal is smaller than a public transaction.

Financial RestructuringWhen a company cannot pay its cash obligations-for example when it cannot meet its bond payments or its payments to other creditors (vendors) it goes bankrupt.In a situation like this, it can choose to simply shut down operations and walk away. On the other hand it can also restructure and remain in business.What does it mean to restructure? The process can be thought of as two-fold: financial restructuring & organisational restructuring.

Restructuring from a financial viewpoint involves renegotiating payment terms on debt obligations, issuing new debt & restructuring payables to vendors.Bankers provide guidance to the firm by recommending the sale of assets, issuing of special securities such as convertible stock & bonds etc.Restructuring bankers must work within a legal framework- the Bankruptcy Code-and hence must have a more in-depth legal understanding than other bankers.

Organizational Restructuring involves a change in management, strategy and focus.I-bankers with expertise in reorgs can facilitate and ease the transition from bankruptcy to viability.

Risk comes from not knowing what you are doing. Warren Buffett