Investment Bank Business Model

• Securities include stocks and bonds, and a stock offering may be an initial stock offering (IPO).
• Underwriting is the procedure by which an underwriter brings a new security issue to the investing public in an offering. The underwriter guarantees a certain price for a certain number of securities to the company (client) that is issuing the security (in exchange for a fee). Thus, the issuer is secure that they will raise a certain minimum from the issue, while the underwriter bears the risk of the issue.

Learn More → Investment Banking Primer

Raising Capital and Security Underwriting

Investment banks are middlemen between a company that wants to issue new securities and the buying public. So when a company wants to issue, say, new bonds to get funds to retire an older bond or to pay for an acquisition or new project, the company hires an investment bank. The investment bank then determines the value and riskiness of the business in order to price, underwrite, and then sell the new bonds. Banks also underwrite other securities (like stocks) through an initial public offering (IPO) or any subsequent secondary (vs. initial) public offering. When an investment bank underwrites stock or bond issues, it also ensures that the buying public – primarily institutional investors, such as mutual funds or pension funds, commit to purchasing the issue of stocks or bonds before it actually hits the market. In this sense, investment banks are intermediaries between the issuers of securities and the investing public.  In practice, several investment banks will buy the new issue of securities from the issuing company for a negotiated price and promote the securities to investors in a process called a roadshow. The company walks away with this new supply of capital, while the investment banks form a syndicate (group of banks) and resell the issue to their customer base (mainly institutional investors) and the investing public. Investment banks can facilitate this trading of securities by buying and selling the securities out of their own account and profiting from the spread between the bid and the ask price.  This is called “making a market” in a security, and this role falls under “Sales & Trading.”

Gillette wants to raise some money for a new project. One option is to issue more stock (through what’s called a secondary stock offering).  They’ll go to an investment bank like JPMorgan, which will price the new shares (remember, investment banks are experts at calculating what a business is worth).  JPMorgan will then underwrite the offering, meaning it guarantees that Gillette receives proceeds at ($share price * newly issued shares) less JPMorgan’s fees.

Then, JPMorgan will use its institutional salesforce to go out and get Fidelity and many other institutional investors to buy chunks of shares from the offering. JPMorgan’s traders will facilitate the buying and selling of these new shares by buying and selling Gillette shares out of their own account, thereby making a market for the Gillette offering.

Mergers and Acquisitions Advisory Services (M&A)

You’ve probably heard of the term “Mergers and acquisitions” or M&A.  It’s an important source of fee income for investment banks as the fee margin structure is substantially higher than most underwriting fees). This is why M&A bankers are some of the highest paid and highest profile bankers in the industry. As a result of much corporate consolidation throughout the 1990’s M&A advisory became an increasingly profitable line of business for investment banks. M&A is a cyclical business that was hurt badly during the financial crisis of 2008-2009, but rebounded in 2010, only to dip again in 2011. In any event, M&A will likely continue to be an important focus for investment banks.

JP Morgan, Goldman Sachs, Morgan Stanley, Credit Suisse, BofA/Merrill Lynch, and Citigroup, are generally recognized leaders in M&A advisory and are usually ranked high in M&A deal volume . The scope of the M&A advisory services offered by investment banks usually relates to various aspects of the acquisition and sale of companies and assets such as business valuation, negotiation, pricing and structuring of transactions, as well as  procedure and implementation. Investment banks also provide “fairness opinions” – documents attesting to the fairness of a transaction. Sometimes firms interested in M&A advice will approach an investment bank directly with a transaction in mind, while many times investment banks will “pitch” ideas to potential clients.

When an investment bank takes on the role of an advisor to a potential seller (target), this is called a sell-side engagement.  Conversely, when an investment bank acts as an advisor to the buyer (acquirer), this is called a buy-side assignment.  Other services include advising clients on joint ventures, hostile takeovers, buyouts, and takeover defense.

When investment banks advise a buyer (acquirer) on a potential acquisition, they also often help to perform what’s called due diligence to minimize risk and exposure to an acquiring company, and focus on a target’s true financial picture. Due diligence basically involves gathering, analyzing and interpreting the target’s financial information, analyzing historical and projected financial results, evaluating potential synergies and assessing operations to identify opportunities and areas of concern. Thorough due diligence enhances the probability of success by providing risk-based investigative analysis and other intelligence that helps a buyer identify risks – and benefits – throughout the transaction.

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Sample Merger Process: Transaction Timeline

Week 1-4: Strategic Assessment of Possible Transaction

The Investment Bank will identify potential merger partners and confidentially contact them to discuss the transaction. As potential partners respond, the Investment Bank will meet with potential partners to determine if a transaction makes sense. Follow-up management meetings with serious potential partners to establish terms

Weeks 5-6: Negotiation and Documentation

• Negotiate Definitive Merger and Reorganization Agreement
• Negotiate Pro Forma Composition of Board of Directors and Management
• Negotiate Employment Agreements, as required
• Ensure Transaction Meets Requirements for a Tax-Free Reorganization
• Prepare Legal Documentation Reflecting Results of Negotiations

Week 7: Board of Directors Approval

The Client’s and Merger Partner’s Board of Directors Meet to approve the transaction, while the Investment Bank (and the investment bank advising the Merger Partner) both deliver a Fairness Opinion attesting to the “fairness” of the transaction (i.e., nobody overpaid or underpaid, the deal is fair). All definitive agreements are signed.

Weeks 8-20: Shareholder Disclosure and Regulatory Filings

Both companies prepare and file appropriate documents (Registration Statement: S-4), Schedule Shareholder Meeting. Prepare filings in accordance with antitrust laws (HSR) and begin preparing integration plans.

Week 21: Shareholder Approval

Both companies hold Shareholder Meeting to approve transaction

Weeks 22-24: Closing

The merger, acquisition, or reorganization formally closes, with the agreed upon shares (and/or cash consideration) issued.

Sales and Trading Division (S&T)

Institutional investors such as pension funds, mutual funds, university endowments, as well as hedge funds use investment banks in order to trade securities.  Investment banks match up buyers and sellers as well as buy and sell securities out of their own account to facilitate the trading of securities, thus making a market in the particular security which provides liquidity and prices for investors.  In return for these services, investment banks charge commission fees. In addition, the sales & trading arm at an investment bank facilitates the trading of securities underwritten by the bank into the secondary market.

Revisiting our Gillette example, once the new securities are priced and underwritten, JP Morgan has to find buyers for the newly issued shares.  Remember, JP Morgan has guaranteed to Gillette the price and quantity of the new shares issued, so JP Morgan better be confident that they can sell these shares. The sales and trading function at an investment bank exists in part for that very purpose. This is an integral component of the underwriting process – in order to be an effective underwriter, an investment bank must be able to efficiently distribute the securities. To this end, the investment bank’s institutional sales force is in place to build relationships with buyers in order to convince them to buy these securities (Sales) and to efficiently execute the trades (Trading).

Sales Division

A firm’s sales force is responsible for conveying information about particular securities to institutional investors.  So, for example, when a stock is moving unexpectedly, or when a company makes an earnings announcement, the investment bank’s sales force communicates these developments to the portfolio managers (“PM”) covering that particular stock on the “buy-side” (the institutional investor). The sales force is also in constant communication with the firm’s traders and research analysts to provide timely, relevant market information and liquidity to the firm’s clients.

Trading Division

Traders are the final link in the chain, buying and selling securities on behalf of these institutional clients and for their own firm in anticipation of changing market conditions and upon any customer request. They oversee positions in various sectors (traders specialize, becoming experts in particular types of stocks, fixed income securities, derivatives, currencies, commodities, etc…), and buy and sell securities to improve those positions. Traders trade with other traders at commercial banks, investment banks and large institutional investors.. Trading responsibilities include: position trading, risk management, sector analysis & capital management.

Equity Research Division

Traditionally, investment banks have attracted equity trading business from institutional investors by providing them with access to equity research analysts and the potential of being first in line for “hot” IPO shares that the investment bank underwrote.  As such, research has traditionally been an essential supporting function to equity sales and trading (and represents a significant cost of the sales & trading business)

Retail Brokerage and Commercial Banking

From 1932 until 1999 there was a law called The Glass-Steagall Act, which said that commercial banks can lend money, extend lines of credit, and open checking and savings accounts, while investment banks can underwrite securities, advise on M&A, and provide institutional brokerage services. Under the Glass Stegall Act, commercial banks and investment banks had to limit their respective activities to those which traditionally fell under those respective labels.

Late 1999 saw the repeal of the Depression-era Glass-Steagall Act, marking the deregulation of the financial services industry. This now allows commercial banks, investment banks, insurers, and securities brokerages to offer one another’s services. As such, many investment banks now offer retail brokerage (retail meaning the customers are individual investors rather than institutional investors) as well as commercial lending. For example, today you can open a checking account with JP Morgan via its Chase brand, while JP Morgan offers investment banking services and asset management.

Until 1999, one financial institution providing all of these services under one roof was technically not allowed (although many post-enactment loopholes basically neutered the law long before 1999). It is not an understatement to say that deregulation has transformed the financial services industry, with the repeal paving the way for mega-mergers and consolidation in the financial services industry. In fact, many blame the repeal of the Glass-Steagall as a contributing factor to the financial crisis in 2008-9.

History of Investment Banking

Undoubtedly, investment banking as an industry in the United States has come a long way since its beginnings. Below is a brief review of the history:

• 1896-1929: Prior to the great depression, investment banking was in its golden era, with the industry in a prolonged bull market.  JP Morgan and National City Bank were the market leaders, often stepping in to influence and sustain the financial system.  JP Morgan (the man) is personally credited with saving the country from a calamitous panic in 1907. Excess market speculation, especially by banks using Federal Reserve loans to bolster the markets, resulted in the market crash of 1929, sparking the great depression.
• 1929-1970: During the Great Depression, the nation’s banking system was in shambles, with 40% of banks either failing or forced to merge. The Glass-Steagall Act (or more specifically, the Bank Act of 1933) was enacted by the government with the intent of rehabilitating the banking industry by erecting a wall between commercial banking and investment banking. Additionally, the government sought to provide the separation between investment bankers and brokerage services in order to avoid the conflict of interest between the desire to win investment banking business and duty to provide fair and objective brokerage services (i.e., to prevent the temptation by an investment bank to knowingly peddle a client company’s overvalued securities to the investing public in order to ensure that the client company uses the investment bank for its future underwriting and advisory needs). The regulations against such behavior became known as the “Chinese Wall.”
• 1970-1980: In light of the repeal of negotiated rates in 1975, trading commissions collapsed and trading profitability declined.  Research-focused boutiques were squeezed out and the trend of an integrated investment bank, providing sales, trading, research, and investment banking under one roof began to take root.  In the late 70’s and early 80’s saw the rise of a number of financial products such as derivatives, high yield an structured products, which provided lucrative returns for investment banks.  Also in the late 1970s, the facilitation of corporate mergers was being hailed as the last gold mine by investment bankers who assumed that Glass-Steagall would some day collapse and lead to a securities business overrun by commercial banks. Eventually, Glass-Steagall did crumble, but not until 1999. And the results weren’t nearly as disastrous as once speculated.
• 1980-2007: In the 1980s, investment bankers had shed their stodgy image. In its place was a reputation for power and flair, which was enhanced by a torrent of mega-deals during wildly prosperous times. The exploits of investment bankers lived large even in popular media, where author Tom Wolfe in “Bonfire of the Vanities” and movie-maker Oliver Stone in “Wall Street” focused on investment banking for their social commentary. Finally, as the 1990s wound down, an IPO boom dominated the perception of investment bankers. In 1999, an eye-popping 548 IPO deals were done – among the most ever in a single year — with most going public in the internet sector. The enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999 effectively repealed the long-standing prohibitions on the mixing of banking with securities or insurance businesses under the Glass-Steagall Act and thus permitted “broad banking.” Since the barriers that separated banking from other financial activities had been crumbling for some time, GLBA is better viewed as ratifying, rather than revolutionizing, the practice of banking.

Financial Crisis (Post-2008)

The greatest global financial crisis since the Great Depression was triggered in 2008 by multiple factors including the collapse of the subprime mortgage market, poor underwriting practices, overly complex financial instruments, as well as deregulation, poor regulation, and in some cases a complete lack of regulation.    Perhaps the most substantial piece of legislation that emerged from the crisis is the Dodd-Frank Act, a bill that sought to improve the regulatory blind spots that contributed to the crisis, by increasing capital requirements as well as bringing hedge funds, private equity firms, and other investment firms considered to be part of a minimally regulated “shadow banking system.” Such entities raise capital and invest much like banks but escaped regulation which enabled them to over-leverage and exacerbated system-wide contagion. The jury is still out on Dodd-Frank’s efficacy, and the Act has been heavily criticized by both those who argue for more regulation and those who believe it will stifle growth.

Investment Banks BHCs Conversions: Goldman Sachs Example

“Pure” investment banks like Goldman Sachs and Morgan Stanley traditionally benefited from less government regulation and no capital requirement than their full service peers like UBS, Credit Suisse, and Citi. During the financial crisis, however, the pure investment banks had to transform themselves to bank holding companies (BHC)  to get government bailout money.  The flip-side is that the BHC status  now subjects them to the additional oversight.

Industry Prospects Post-Crisis

Investment banking advisory fees in 2010 were $84 billion globally, the highest level since 2007. Although the official scorecard isn’t in, based on press releases from the largest financial institutions, 2011 will see a significant decline in fees. The future of the industry is a highly debated topic.  There is no question that the financial services industry is going through something pretty significant post-crisis.  Many banks had near-death experiences in 2008 and 2009, and remain hobbled.  2011 saw much lower profitability for many of the largest financial institutions. This directly impacts bonuses for even the entry level investment banker, with some pointing to smaller fractions of ivy league graduating classes going into finance as a harbinger of a fundamental shift . That being said, those trying to break into the industry will find that compensation is still high compared to other career opportunities.  Also, the job function of an M&A professional has not dramatically changed, so the professional development opportunities haven’t changed.