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Investment Bank: What It Is, How It Works, and Major Examples

ByTheMost

Jan 30, 2024
Investment Bank: What It Is How It Works and Major ExamplesInvestment Bank: What It Is How It Works and Major Examples

Investment Bank: What It Is How It Works and Major Examples

Investment banks are well recognized for acting as middlemen between corporations and financial markets. They assist firms in issuing stock in an initial public offering (IPO) or additional stock offering. They also arrange debt funding for businesses by locating large-scale investors in corporate bonds.

An investment bank is a financial services firm that operates as a middleman in large and sophisticated financial transactions. An investment bank is typically involved when a young firm prepares to launch its initial public offering (IPO) or when a corporation combines with a competitor. It also serves as a broker or financial adviser to large institutional clients, such as pension funds.

Global investment banks include JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, Credit Suisse, and Deutsche Bank.

Many of these names offer storefront community banking and divisions catering to high-net-worth clients’ investment needs.

The Key Takeaways

  • Investment banks specialize in advising corporate clients on sophisticated financial transactions such as IPOs and mergers.
  • Modern investment banking is often a division of a larger financial company, such as Citibank or JPMorgan Chase.
  • A ‘Chinese wall’ is intended to keep investment banking activities distinct from the company’s trading division to avoid conflicts of interest.

How an Investment Bank Works 

Investment banking is a specialized branch of banking that assists people or organizations in raising cash and providing financial consulting services. They operate as mediators between security issuers and investors, assisting new enterprises to go public.

The advisory division of an investment bank receives a fee for its services. The trading segment earns commissions based on market performance. As previously stated, many retail banking sections generate revenue by lending money to individuals and businesses.

Investment banking professionals may work as financial consultants, traders, or salespeople. An investment banking career is rewarding but usually comes with long hours and high stress.

The Intermediary Role

Investment banks are well recognized for acting as middlemen between corporations and financial markets. That is, they assist firms in issuing stock in an initial public offering (IPO) or additional stock offering. They also arrange debt funding for businesses by locating large-scale investors in corporate bonds.

The investment bank’s advisory role begins with pre-underwriting counseling and continues after the securities are distributed.

The investment bank is in charge of verifying a company’s financial accounts and preparing a prospectus that outlines the offering in detail to investors before the securities are offered for purchase.

Clients of investment banks include corporations, pension funds, other financial institutions, governments, and hedge funds.

Size is an asset for investment banks. The more contacts the bank has in the global financial community, the more probable it is to earn from connecting buyers and sellers, particularly in one-of-a-kind transactions.

Investment bank operations are typically separated into three major functions.

Financial Advisors

As a financial counselor to major institutional investors, an investment bank may offer strategic guidance on a wide range of financial issues.

They achieve this mission by combining a detailed awareness of their client’s goals, industries, and worldwide markets with the strategic vision required to identify and assess short- and long-term opportunities and challenges.

Mergers and Acquisitions

Facilitating mergers and acquisitions is an important part of an investment bank’s activity.

An investment bank analyzes the value of a potential acquisition and assists in negotiating a reasonable price for it. It also helps to structure and facilitate the acquisition, making the transaction run as smoothly as feasible.

Research

Investment banks include research divisions that evaluate companies and provide studies on their prospects, sometimes with buy, hold, or sell recommendations. This research may not create revenue immediately, but it does benefit its traders and sales department.

The research division also gives investment advice to outside clients who can complete a deal through the bank’s trading desk, resulting in revenue for the bank.

Research preserves an investment bank’s institutional knowledge in credit research, fixed-income research, macroeconomic research, and quantitative analysis, all of which are used internally and externally to advise customers.

Criticism of Investment Banks

Investment banks advise external clients in one division while trading their own money in another. This is a potential conflict of interest.

To prevent this, investment banks must establish a “Chinese wall” between divisions. This symbolic barrier is intended to prohibit sharing information that might allow one side or the other to unfairly profit at the expense of their clientele.

What Is Investment Banking?

Investment banking is a type of banking that handles large, sophisticated financial transactions like mergers and IPO underwriting. These banks can raise funds for businesses in a variety of ways, such as underwriting the issuing of new securities by a corporation, municipality, or other entity. They may oversee a company’s first public offering (IPO). Investment banks also offer assistance on mergers, acquisitions, and reorganizations.

In essence, investment bankers are professionals who understand the present investing situation. They guide their clients through the difficult world of high finance.

Understanding Investment Banking

Investment banks underwrite new debt and equity securities for all types of firms, assist with securities sales, and handle mergers and acquisitions, reorganizations, and broker trades for institutional and private investors. Investment banks also advise issuers on the offering and placement of stock.

Many significant investment banking systems are linked with or subsidiaries of larger banking organizations, and several have become household names, including Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank.

Generally speaking, investment banks help with large, complex financial deals. If the investment banker’s client is considering an acquisition, merger, or sale, they may advise on how much a firm is worth and how to organize the transaction. Investment banks’ activities may also involve issuing securities as a means of obtaining money for the client groups and creating the documentation for the United States Securities and Exchange Commission (SEC) required for a firm to go public.

In theory, investment bankers are experts with their finger on the pulse of the current investing climate, so businesses and institutions turn to investment banks for advice on how to best plan their growth because investment bankers can tailor their recommendations to the current state of economic affairs.

Regulation and Investment Banking

The Glass-Steagall Act was implemented in 1933, following the 1929 stock market disaster, which resulted in huge bank failures. The law’s objective was to segregate commercial and investment banking activity. The combination of commercial and investment banking activity was deemed extremely dangerous and may have exacerbated the 1929 catastrophe. This is because, when the stock market plummeted, investors hurried to withdraw funds from banks to meet margin calls and other obligations, but some banks were unable to comply since they had also put their client’s money in the stock market.

Before the passage of Glass-Steagall, banks could redirect regular depositors’ monies into speculative activities such as equity market investment. As such operations got increasingly lucrative, banks increased their speculative bets, eventually placing depositors’ assets in danger.

The Glass-Steagall Act, however, was repealed by Congress in 1999 because some in the financial sector deemed its provisions too harsh. The Gramm-Leach-Bliley Act of 1999 effectively removed the distinction between investment and commercial banks. Since the repeal, most large banks have resumed their combined investment and commercial banking businesses.

Initial Public Offering (IPO) Underwriting

Investment banks act as intermediaries between a firm and investors when it wishes to issue stock or bonds. The investment bank can help with pricing financial instruments to optimize revenue and navigate regulatory restrictions.

When a company goes public, an investment bank will frequently purchase all or a large portion of its shares straight from the company itself. Following this, as a proxy for the company conducting the IPO, the investment bank will sell the shares on the market. This makes things considerably easier for the corporation because it effectively outsources the IPO to the investment bank.

Furthermore, the investment bank stands to profit because it will often price its shares at a premium to what it originally bought for it. In doing so, it accepts a significant level of danger. Although professional analysts utilize their skills to price the stock as correctly as possible, the investment bank may lose money on the transaction if it discovers that it has overvalued the stock, as it will frequently have to sell the stock for less than it paid for it.

Example of Investment Banking

Global investment banks include JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, Credit Suisse, and Deutsche Bank. Many of these names also provide storefront community banking and have divisions dedicated to the investment needs of high-net-worth clients.

Suppose Pete’s Paints Co., a chain that sells paint and other items, wants to go public. Pete, the owner, contacts José, an investment banker working for a larger investment business. Pete and José reached an agreement in which José (on behalf of his firm) agreed to purchase 100,000 shares of Pete’s Paints for the company’s IPO for $24 per share, which the investment bank’s analysts determined after careful consideration.

The investment bank pays $2.4 million for 100,000 shares and, after filing the necessary papers, begins selling the stock at $26 per share. However, the investment bank is unable to sell more than 20% of the shares at this price and must lower the price to $23 per share to sell the remaining shares.

The investment bank earned $2.36 million on the IPO agreement with Pete’s Paints, calculated as (20,000 x $26) + (80,000 x $23) = $520,000 + $1,840,000 = $2,360,000. In other words, José’s firm lost $40,000 on the transaction because it overestimated Pete’s Paints.

Investment banks frequently compete with one another for IPO projects, forcing them to raise the amount they are ready to pay to secure the contract with the company going public. If competition is exceptionally strong, this might have a significant impact on the investment bank’s profitability.

In most cases, however, more than one investment bank will be underwriting securities in this manner. While each investment bank has less to gain, they will also have less risk.

Underwriting Services in Investment Banking

Underwriting is the process of raising funds by selling stocks or bonds to investors (for example, an IPO) on behalf of corporations or other entities. Businesses require money to run and grow, and bankers assist them in obtaining that money by promoting the company to potential investors.

There are typically three types of underwriting:

  • Firm Commitment: The underwriter pledges to buy the entire issue and bear full financial responsibility for any unsold shares.
  • Best Efforts: The underwriter agrees to sell as many of the issue as feasible at the agreed-upon price, but may return any unsold shares to the issuer without financial obligation.
  • All-or-none: If the entire issue cannot be sold at the offering price, the transaction is terminated, and the issuing business receives no payment.

Once the bank begins promoting the offering, the following book-building processes are done to price and close the transaction.

M&A Advisory Services

Mergers and acquisitions (M&A) advisory is the process of assisting corporations and institutions in identifying, evaluating, and completing company acquisitions. This is an important function in i-banking. Banks use their considerable networks and relationships to identify opportunities and facilitate negotiations on their clients’ behalf. Bankers provide advice on both sides of M&A deals, representing either the “buy-side” or the “sell-side”.

Here’s an outline of the step mergers and acquisitions procedure.

Banking Clients

Investment bankers help a wide spectrum of clients with their capital raising and M&A needs. These clients may be located anywhere in the world.

Investment banks’ customers include:

  • Governments: Investment banks cooperate with governments to obtain funds, trade securities, and acquire or sell crown enterprises.
  • Corporations: Bankers assist both private and public corporations in going public (IPO), raising additional capital, growing their operations, making acquisitions, selling business units, doing research for them, and providing general corporate finance guidance.
  • Institutions: Banks collaborate with institutional investors, who handle other people’s money, to assist them in trading securities and doing research. They assist private equity firms in acquiring and exiting portfolio companies through strategic sales or IPOs.

Investment Banking Skills

I-banking work necessitates extensive financial modeling and appraisal. Analysts and Associates at banks spend a lot of time in Excel, constructing financial models and utilizing various valuation methods to advise customers and complete transactions, whether for underwriting or M&A.

Investment banking requires the following skills:

  • Financial modeling: Creating several financial models, including 3-statement, DCF, LBO, and others.
  • Business valuation: Using several valuation approaches, including similar company analysis, precedent transactions, and DCF analysis.
  • Pitchbooks and presentations: Create pitchbooks and PPT presentations from scratch to pitch ideas to potential clients and gain new business (refer to CFI’s Pitchbook Course).
  • Transaction documents: CFI offers a library of free transaction templates, including a confidential information memorandum (CIM), investment teaser, term sheet, confidentiality agreement, and data room setup.
  • Relationship management: Working with existing clients to successfully finish a deal and ensure their satisfaction with the service delivered.
  • Sales and business development: Meeting with prospective clients to pitch ideas, support their work, and provide value-added advice can lead to new business.
  • Negotiation: Assisting clients in maximizing value creation by influencing buyer-seller negotiations.

Careers in Investment Banking

Getting into i-banking is quite difficult. There are substantially more applicants than positions, with ratios as high as 100:1. For more information on how to get into Wall Street, check out our guide to acing an investment banking interview.

In addition, have a look at our example of real interview questions from an investment bank. It is also beneficial to attend financial modeling and valuation classes as part of your interview preparation.

The most popular job titles (from most junior to senior) in i-banking are:

  • Analyst
  • Associate
  • Vice President
  • Director
  • Managing Director
  • Head, Vice Chair, or another special title

What Do Investment Banks Do?

Generally speaking, investment banks help with large, complex financial deals. If the investment banker’s client is considering an acquisition, merger, or sale, they may advise on how much a firm is worth and how to organize the transaction.

Essentially, their services include underwriting new debt and equity securities for all types of firms, assisting with securities sales, and facilitating mergers and acquisitions, reorganizations, and broker transactions for institutions and private investors alike. They may also issue securities to raise funds for their clients and prepare the necessary US Securities and Exchange Commission (SEC) papers for a firm to go public.

Full-service banks provide these services:

  • Underwriting: Capital raising and underwriting groups connect investors and firms seeking to raise funds or go public through the IPO process. This function serves the primary market, often known as “new capital”.
  • Mergers & Acquisitions (M&A): Providing advisory services to buyers and sellers and overseeing the entire M&A process.
  • Sales & Trading: Matching buyers and sellers of securities in the secondary market. In investment banking, sales and trading units represent clients and trade the firm’s cash.
  • Equity Research: The equities research group’s “coverage” of securities assists investors in making investment decisions and facilitating stock trading.
  • Asset Management: Managing investments for institutional and individual investors in various investment types.

Who are the Main Investment Banks?

The major banks, commonly known as the bulge bracket banks in investment banking, are:

  • Bank of America Merrill Lynch
  • Barclays Capital
  • Citi
  • Credit Suisse
  • Deutsche Bank
  • Goldman Sachs
  • J.P. Morgan
  • Morgan Stanley
  • UBS

What Is the Role of Investment Bankers?

Investment banks hire individuals to help firms, governments, and other entities plan and manage huge projects, saving their clients time and money by spotting project hazards before they move forward. In theory, investment bankers should be professionals who understand the present investment climate. Businesses and institutions consult investment banks for guidance on how to best plan their growth. Investment bankers adjust their advice based on their experience and the current status of the economy.

What Is an Initial Public Offering (IPO)?

An initial public offering (IPO) is the process of selling shares of a private company to the public in a new stock issuance. A firm can raise funds from public investors by issuing shares. To conduct an IPO, companies must meet the conditions specified by exchanges and the SEC. Companies use investment banks to underwrite their initial public offerings (IPOs). The underwriters are involved in all stages of the IPO, including due diligence, document preparation, filing, marketing, and issuance.

How do investment banks make a profit?

Investment banks commonly engage in market-making activities to generate revenue by increasing liquidity in the stock market or other marketplaces. A market maker presents a quote (buy price and sale price) and receives a tiny commission, known as the bid-ask spread from the difference between the two prices.

What is the structure of an investment bank?

Investment banks are often split up into three main parts: the front office, middle office, and back office. The front office is where the bank generates revenue. Its three main divisions are investment banking (I-banking), sales and trading, and investment research.

What are the steps in investment banking?

  1. Develop an acquisition/exit strategy.
  2. Connect to the buyer or seller.
  3. Conduct a valuation analysis.
  4. Begin negotiations.
  5. Assist with due diligence.
  6. Lead the closing and settlement of final terms.

What is the difference between a bank and an investment bank?

The distinction between commercial banking and investment banking is that investment banks often raise capital by selling assets (such as stocks and bonds). Commercial banks employ consumer deposits to fund loans and mortgages, and the interest on those loans produces profit for the bank.

What is the difference between a commercial bank and an investment bank?

Commercial banks serve small businesses and consumers with ordinary banking needs, whereas investment banks serve institutional investors and larger corporations.

Why is it called an investment bank?

The goal of investment banks is to raise funds for their corporate clients. Capital can be in the form of equity (from investors) or debt. Emphasizing the first, they are called investment banks.

In Conclusion

Investment banks such as Goldman Sachs and Morgan Stanley are regularly mentioned in conversations about the financial market, emphasizing their prominence in the financial world. In general, investment banks help clients with large, sophisticated financial transactions. This involves underwriting new debt and equity securities, assisting with the sale of securities, and facilitating mergers and acquisitions, reorganizations, and broker transactions. Investment banks may assist other organizations in raising funds by underwriting initial public offers (IPOs) and preparing the papers necessary for a firm to go public.

 

 

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