What Is Investment Banking?
The term investment banking often conjures up images of suave bankers.
You can almost see images of hectic trading, computers clattering and a lot of money at stake.
So the question is how exactly you will define investment banking?
In very simple terms, it is an advisory service primarily for capital raising.
This is a specific branch of the bigger banking sector aimed at capital creation.
However, the banks do not target creating capital for themselves.
This capital creation is for other companies, governments and the like.
Investment banking includes underwriting debt as well as equities.
Helping sale of securities and facilitating mergers is also part of the profile.
They undertake investment activities for individual investors as well as organizations.
Many times, you see investment banks guiding investors about the placement of stocks.
Most times, these investment banking segments are part of the larger banking network.
But unlike retail banks, they do not take in deposits.
They are purely into financial and investment-related services.
Some of the best-known investment banks include
- Morgan Stanley
- Goldman Sachs
- Bank Of America Merrill Lynch
- JPMorgan Chase
- Deutsche Bank
So it will not be wrong to say that they are involved in large-scale financial operations.
These banks essentially undertake financial transactions.
So whether you are trying to ascertain the worth of a company or a new issue, investment bankers help.
They are essentially associated with all types of fundraising on behalf of their clients.
It can involve any type of security issue for the same.
This capital raising can be on behalf of any corporates or individual.
Yes, private investors also use the investment banking route for their investment needs.
Investment banking is also necessary to identify risks involved.
Every investment needs careful analysis and risk assessment.
Investment Banking Primarily For Capital Raising
You can, therefore, understand that the term investment banking is quite broad-based.
You already know that capital raising is their primary role.
Now, this capital raising can be done via a new issue or a secondary issue.
But many corporates or firms may also choose to go via the debt route.
So that will include debt issuance by investment banks on behalf of clients.
So they may also look at bond underwriting depending on the need.
Guiding corporates with new issues is a pretty comprehensive role.
Most investment banking firms help their clients in pricing the new issue.
Pricing of the stocks or bonds that are going to be issued is crucial.
Often the investor response to the issue is directly linked to the pricing.
If the new issue is priced too low, you may not raise sufficient capital.
If the issue is raised too high, this may lead to a tepid response.
Moreover, it can also have a bearing on the overall business valuation.
A new issue also includes a host of legal formalities.
It has to comply with a series of legal provisions and other norms.
Again, this too is an investment banker’s job to smoothen out the process.
So all in all, investment banking includes every formality with regards to raising capital.
As a result, this ambit includes even potential restructuring and spin-offs.
The risks associated with a particular’s issue are also their responsibilities.
This is important because there is no foolproof guarantee for any type of issuance.
However, when corporates are going for it, they need to be aware.
The investment bankers analyze the associated problem areas and even offer solutions.
So if you are looking at capital issuance, it is impossible without roping in investment bankers.
When you think of investment banking, underwriting new issues is the most instant connection.
However, as we mentioned, new issuances are not just limited to stocks and equities.
Investment banking firms also underwrite bonds.
So in this case, they become the intermediary between the buyer and the seller.
The investment banker becomes the underwriter for the new bonds.
So in effect, they take up the risk of the new issuance from their clients.
The bond issuer may be a corporate or even government.
The resale of the bonds to the dealers and retail investors involve a certain profit quotient.
That is primarily the impetus or incentive for the investment banks.
This difference in the price they bought from the issuer and the price they sold to the investor is the underwriting spread.
It can differ based on the market conditions, the premium associated and economic provisions.
As an underwriter, they also furnish necessary documents to the SEC or the regulatory officials.
They also play a crucial role in creating a group or syndicate.
The risk of the issue is then spread out amidst the group.
Needless to mention that this often improves the acceptability of the new issuance.
It improves the scope of selling a lot better.
It creates scope for perhaps even selling the whole of the new issue.
Sometimes, investment bankers may only market the issue and not underwrite it.
But these are a variety of permutation and combination that go with any new issuance.
The bottom line is just like in a new stock issuance; a bond issuance also is an inseparable part of investment banking.
An effective new issue and a positive response are deeply dependent on the investment banker.
In many ways, they take the new issue to its natural conclusion and successful fundraising.
Role Of Investment Banking In Research & Rating
However, investment banking is not limited to mere security issuance.
I am sure you understand that any new issuance is a function of a lot of factors.
It takes into account a variety of other elements to undertake proper capital issuance.
Now research is an inseparable part of this entire chain.
On an average, every investment banking firm has a separate research wing.
Their primary role is the assessment of various companies.
They research the financial performance and the earnings growth.
Based on these they then issue guidance about investing in a firm.
I am sure you have seen ratings on stocks.
For example, when Citi comes out with a ‘buy’ rating on X stock, what does it mean?
Well, it essentially means that Citi has analyzed the financial performance of the stock.
It has also looked at the operational details and earnings performance.
Based on that they have decided on a specific fair price for a stock.
Now let’s assume, stock X is trading at a 10% discount to this rate.
So they have decided that it is time to buy stock X.
Now, this is a crucial role as well.
Many times, both retail and private investors base their investment on the basis of these ratings.
The assumption here is that these investment bankers have undertaken thorough research.
Most times investment banks also issue a detailed report in support of their rating decision.
This, in many ways, helps investors understand their investment rationale.
Based on this, individual investors often decide on their key portfolio allocations.
Therefore investment banking plays a crucial role in determining individual investment patterns.
So research and rating is another key role played by the investment banking firms.
They help investors formulate qualitative investment decisions with the long-term bearing.
Mergers & Acquisitions
Investment banking firms are also closely associated with mergers and acquisitions.
Though in many ways, this is an extension of the broad capital raising exercise, there are many differences.
Overall the dynamics of mergers and acquisitions are distinctly different from a new issuance.
The company that is likely to take over has to be careful about the valuation they are offering.
Are they offering too much for a company?
Is it possible to get a company with similar fundamentals at a lower rate?
All of these are very important considerations.
Moreover, it is also important to undertake a due diligence of the firm they are acquiring.
What are the parameters they need to judge a firm or how exactly will a company represent value?
Most often corporates assign investment banks the role of a mediator.
They, therefore, undertake due diligence on behalf of the client and also decide on a valuation.
If the firms are listed, the deal gets even tougher.
The impact on the shareholders also needs to be analyzed.
The investment banking firm undertakes all these elements of the entire take over the project.
They even look at the options for investors in securing proper approvals.
So, all in all, they facilitate a smooth takeover and glitch-free share transfer.
They, therefore, play the role of a mediator.
Proprietary Trading Activities Under Investment Banking
That said, investment banking does not suffice in just rating a stock.
These banks also engage in select proprietary trading activities too.
After all, they play a key role in often making and breaking the markets.
They are involved in healthy and active trading of a variety of financial instruments.
The idea is to profit from every trade and add to their growing kitty.
Their choice of financial instruments is primarily dependent on the market conditions.
They trade in a large number of tools including stocks and bonds.
They may also actively trade in derivatives.
Just like an average investor, their choice of investment tools is a function of market forces.
As a result, you will see them buying and selling a whole range of market offerings.
However, they have huge funds at their disposal.
Unlike, average retail investors, their trades are never small.
Whether they are selling or buying, it is undertaken in huge quantities.
As a result, this has a huge bearing on the market.
When one investment bank sells or buys a certain stock or a bond, it offers cues to other investors.
They look at it as an indicator of the market condition.
Many times, they mimic the move in hopes of better profit.
The logic is investment bankers have a whole range of information at their disposal.
They have keenly analyzed every stock or bond they take a position in.
So if they are selling or buying something, there is sufficient mettle in it.
But remember investment bankers are also operating with a profit motive.
So as an average investor looking at them for direction, it is better to tread with caution.
Do not forget the fundamentals of your investment principles either.
That will help in clocking better gains.
By now, I am sure you have understood the wide range of services these bankers operate in.
It will be unfair to simply club them under one head.
It is true that they play a key role in fundraising.
But the overall ambit and quality of their activity are significantly far-reaching.
This is exactly why they play a key role in managing investments.
In fact, most investment banks offer a range of investment products.
The idea is to optimize the value of money and maximize the profit.
They also offer advisory services to their clients.
Be it the corporates or high net-worth individual investors, investment banking is all wealth management.
They counsel the clients on the best investment route forward.
Needless to mention that this is also based on in-depth market research they undertake.
Most investment banking firms have a separate department to analyze the economic conditions too.
As a result, the investment advice that they offer is pretty comprehensive.
It seeks to undertake a holistic view of the overall market condition.
In many ways, it is an appropriate reflection of the core market sensibilities.
So the investment advice that they offer often determines the market direction.
Traditionally they have also managed funds on behalf of many high net-worth individuals.
The idea has been effective fund allocation at the right time.
Given the large chunks of investment they undertake, they play a crucial role in the market.
As a result, you will often see corporates turning to investment bankers for advice.
This is not just geared at planning capital raising but also developmental models.
The idea is that most times investment bankers have their finger on the pulse of the market.
As a result, they are often best positioned to offer a direction for future.
Investment Banking Examples
However, all this chat about investment banking is in the realms of theoretical concepts.
But practical understanding is crucial for in-depth knowledge.
So let us use an example to understand how an investment banking firm operates.
Needless to mention that there are many avenues of their operation.
For the sake of simplicity, let us look at their most basic function.
We all know fundraising is closely linked with investment banking.
Let us assume that XYZ, a software major is planning to offer a fresh issue.
They are looking at raising money via a public listing.
So the founder of XYZ then approaches ABC investment bank for assistance.
Mr “F” working on behalf of his investment bank strikes a deal with the founder of XYZ firm.
After careful analysis and considering various business dynamics, they decide on an issue size and price.
So the investment bank then pays the money for the complete issue offering to XYZ firm.
Now they file for a listing and complete all legal documentation.
Initially, they raise the price over the fair value they decided.
But the response is not very good.
Let us assume; they only sold 30% of the shares.
So now they lower the prices even below the fair value level.
So the investment bank completes the deal at a lower value than what they paid to XYZ.
We can say that ABC investment bank overvalued XYZ firm’s potential.
So the investment bank booked the loss.
However, the brighter side is that in reality, you have more than one underwriter.
So in case of a loss, the blow to individual participants is far lesser.
In case the stock is undervalued, the scope of profit is equally large.
So that is the risk that the investment bank is taking.
Investment banking is, therefore, a multifaceted operational exercise.
From arranging funds to new issuances and rating stocks, they are closely linked with every element of financing and investment.
They play a crucial role in creating avenues of sound investment.
At the same time, you can rely on investment bankers for quality financial and economic analysis.
However, that said, private equity is not the same as investment banking.
The business model for investment banking is distinctly different.
Private equity firm is primarily a pool of investors.
In comparison, a pool of advisors makes investment banking firms.
They counsel their clients and provide comprehensive investment solutions.
If as a corporate, you are looking for a one-stop shop for your financial needs, contact an investment banking firm.