Chapter 6: Investment Banking

Introduction

Financial intermediaries, an important part of the financial system, have evolved with the purpose of lowering transaction costs and allowing small savers and borrowers to benefit from the financial markets. One solution to the problem of high transaction costs provided by financial intermediaries is to pool the funds of many investors together so that they can take advantage of economies of scale, which is the reduction in transaction costs per dollar of investment as the size of transactions increases. The presence of economies of scale in financial markets helps to explain why financial intermediaries have developed and have become such an important part of our financial system.

Overview of Investment Banking

Investment-banking firms are best known as intermediaries that help corporations raise funds. However, this definition is too narrow to accurately explain the many valuable and complicated services these firms provide. Despite its name, an investment bank is not a bank in the ordinary sense; that means, it is not a financial intermediary that takes in deposits and then lends them out, but in countries where there is no legislation commercial banks provide investment banking services as part of their daily range of business activities. Countries where investment banking and commercial banking are combined have what is called a universal-banking system. Universal banks are allowed in most European countries. Universal banks are institutions that are allowed to accept deposits, make loans, underwrite securities, engage in brokerage activities, and sell and manufacture many other financial services such as insurance.

Investment-banking firms are mostly involved in security market operations. They employ ‘analysts’ whose job is to study corporate movements and identify corporations as over or under-valued, or as high-growth and low-growth, high-risk and lowrisk, etc. The results of the research are served to clients who are often managers of mutual funds. Sometimes investment-banking firms act as ‘market makers’ in equity or bond markets.

Investment-banking firms and their role in the financial system is very important. For example, executives go to investment-banking firms when contemplating a once-in-a-career business move, such as buying another firm. They do not have the knowledge and skill set themselves to be able to cope with the regulations, the raising of finance or the tactics to be employed, so they apply to the specialists at the bank who regularly undertake these tasks for client companies. Another area where executives need specialist assistance is in raising money by selling bonds or stocks. Investment banking firms also assist companies in managing their risks.

One characteristic of investment banking firms that distinguishes them from brokers and dealers is that they usually earn their income from fees charged to clients rather than from commissions on stock trades. These fees are usually set as a fixed percentage of the dollar size of the deal being made.

In conclusion, investment-banking firms have three distinctive primary market functions in financial structure and these are as follows:

• bringing new securities to market,
• deal making in the mergers and acquisitions,
• advising corporations.

Bringing New Securities to the Market

The main business of investment banking is raising debt and equity financing for corporations or governments. This involves originating the securities, underwriting them, and then placing them with investors. When a corporation has an intention to borrow or raise funds, it may decide to issue long-term debt or equity instruments. It then generally gives the job to an investment banking firm to make the issuance easier and subsequent sale of the securities.

Preparation for Public Offerings

Investment banking firms occasionally engage in originating securities. As an originator, the investment bank tries to identify corporations that may benefit from a security sale. Once an agreement is reached between an investment bank and an issuer, the investment bank makes a detailed study (called due diligence) of the corporation. This means that they are required to diligently search out and disclose all relevant information about an issuer before securities are sold to the public, or the underwriter can be held responsible for investor losses that occur after the issue is sold. The investment bank uses this information to determine the best means of raising the needed funds.

The investment bank is obviously taking a huge risk at this point. One way that helps it to reduce the risk is by forming a syndicate. Then each firm in the syndicate is responsible for reselling its share of the securities. A syndicate is a group of investment banking firms, each of which buys a portion of the security issue.

Investment banking firms advertise upcoming securities offerings with ads called tombstones in business journals. One major and carefully regulated piece of information is the prospectus, which shows the issuer’s detailed finances and must be provided to each buyer of the security. The prospectus acts as a marketing tool as the firm tries to persuade investors to apply for shares. The content and accuracy of this highly important document are the responsibility of the directors not the regulators. Regulators’ approval implies only that the information presented is timely and fair.

Types of Offerings

The most important types of offering in the sale of new securities can be classified as initial public offering or unseasoned offering, secondary common stock offering or seasoned offering, and bond offering.

An initial public offering (IPO) or unseasoned offering is a common stock offering issued by corporations that had not previously issued common stock to the public. A secondary common stock offering or seasoned offering is an offering of common stock that had been issued in the past by the corporation. One of the problems investment banking firms face with IPOs is how to price them, since they are securities that have never been traded. In secondary common stock offerings, there is no prior market price on which to base the offering price. For traditional bond offerings, the gross spread mostly is even lower than for a secondary common stock offering.

Public Offerings Practices

There are several different types of arrangement between the investment banking firm and the corporation in security offerings. Sometimes the financing takes the form of a private placement in which the securities are sold to a tiny number of large institutional investors, such as life insurance companies or pension funds, and the investment-banking firm receives a fee. On other occasions, it takes the form of a public offering, where securities are offered to the public. A public offering might be a best efforts or firm commitment practice: in the case of a best efforts public offering, the investment-banking firm does the best it can do to place the securities with investors and is paid a fee that depends, to some extent, on its success and in the case of a firm commitment public offering, the investment-banking firm agrees to buy the securities from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price. An investment banking firm makes a profit that is equal to the difference between the price at which it sells the securities (offer price) and the price it pays (firm commitment price) the issuer. This difference is called the gross spread, or the underwriter discount. If for any reason it is not able to sell the securities, it ends up owning them itself. When an investment-banking firm buys the securities from the issuer and takes the risk of selling the securities to investors at a lower price, it is referred to as an underwriter.

The fee earned from underwriting a security is the difference between the price paid to the issuer and the price at which the investment-banking firm reoffers the security to the public. This difference is called the gross spread, or the underwriter discount. Numerous factors affect the size of the gross spread. Two major factors are the type of security and the size of the offering. There is also a phenomenon known as underpricing. Stocks are typically sold to investors at an offering price that is, on average, about 15 percent below the closing price of the stocks after the very first day of trading. In a private placement, securities are sold to a limited number of investors rather than to the public as a whole.

Variations in the Offering Process

Variations in the United States, the Euromarkets, and foreign financial markets include the bought deal for the underwriting of bonds, the auction process for both bonds and stocks, and a rights offering for underwriting common stock.

The structure of a bought deal is as follows:

• The lead manager or a group of managers offers a potential issuer of debt securities a certain bid to purchase a predetermined amount of the securities with a fixed interest (coupon) rate and maturity.
• The issuer is given a day or two (maybe even only a few hours) to accept or reject the bid. If the bid is accepted, that means the underwriting firm has bought the deal.

Another variation for underwriting securities is the auction process. The auction form is mandated for certain securities of regulated public utilities and many municipal debt obligations. The sales function of an investment bank is divided into institutional sales and retail sales. Retail sales involve selling the securities to individual investors and companies that purchase in small quantities. Investment banking firms must also attempt to satisfy the institutional investors that may invest in the IPO. The higher the price institutional investors pay for the stock being issued, the lower the return they earn on their investment when they sell the stock. The longer the investment-banking firm holds the securities before reselling them to the public, the greater the risk that a negative price movement will cause losses.

Deal Making in Mergers and Acquisitions

Mergers and acquisitions are practices that fall under the investment banking segment. Beginning in the 1980s, mergers and acquisitions (M&A) became one of the most important and highly profitable business activities for investment banking firms. Firms with powerful M&A departments compete intensely for the highly profitable activity of corporate mergers or acquisitions. Investment banking firms act on behalf of corporate clients in identifying firms that may be suitable for merger. Large fees are charged for this service.

A merger happens when two businesses come together to form one new company. Both firms are behind the merger, and corporate officers are usually selected so that both companies contribute to the new management team. Shareholders turn in their share for share in the new firm.

In an acquisition, one firm acquires ownership of another firm by buying its shares. Often this process is friendly, and the firms agree that certain economies and synergies can be captured by combining resources. Sometimes, a firm suffering financial stress may even seek out a company to acquire them. At other times, the firm being bought may resist. Resisted acquisitions are called hostile.

In these cases, the acquirer attempts to buy sufficient shares of the target corporation to gain a majority of the seats on the board of directors. Then board members are able to vote to merge the target corporation with the acquiring corporation. Investment bankers serve both acquirers and target corporations.

Categories of M&A

Investment banking firms provide four categories of M&A services for which they earn fees:

1. First, investment-banking firms help corporations identify M&A candidates that match the acquiring corporation’s needs.
2. Second, the investment-banking firm does all of the analysis necessary to price the deal once an acquisition candidate corporation is located.
3. Third, the investment banking firms work with the acquiring corporation management, provide advice, and help them negotiate the deal.
4. Finally, once the deal is complete, investmentbanking firms assist the acquiring corporation in obtaining the funds to finance the purchase. These activities range anywhere from arranging bank loans to arranging bridge financing, underwriting the sale of equity or debt, or arranging a leveraged buyout (LBO) deal.

Advising Corporations

Valuation, strategy, and tactics are the key aspects of the advisory services offered by an investment-banking firm.

Investment banking firms commonly suggest that the corporation could benefit from revising its ownership structure. It may recommend a carve-out, in which the corporation would sell one of its units to new stockholders through an IPO. The proceeds of the IPO go to the parent company. Alternatively, an investment-banking firm may advise the corporation to spin off a unit by creating new stocks representing the unit and distributing them to existing stockholders. Alternatively, an investmentbanking firm might recommend that a corporation engage in a divestiture, in which it sells one or more of its existing divisions that suffered recent losses. That means the investment-banking firm may receive a fee for advising and another fee for finding buyers of the divisions that are sold. Investment banks also commonly serve as sole advisors as well as makers of mergers. In addition, investment-banking firms are making increasing inroads into traditional bank service areas such as small-business lending and the trading of loans. Other activities of investment banking firms include the management of pension and endowment funds for businesses, colleges, churches, hospitals, and other institutions.

Some firms, widely known as boutique investment banks, specialize in a few activities, such as advising companies on financing issues and mergers, but does not raise finance for the firm, or underwrite, or engage in securities trading.