To most people, investment banking is a big mystery - they know it’s important, but they aren’t really sure why. It’s like some finance mojo that no one really needs to know about unless you’re a banker. Or to put it differently, the term is a combination of two words that separately make perfect sense but together create confusion. This guide will help you understand what investment banking really is and what investment banks actually do.
When we talk banking, we talk banks and when we talk investment we mean the creation of capital for a defined purpose. Put together, investment banking is a segment of a banking that helps organizations, companies and - less frequently - individuals raise capital and provide financial consultancy services to them. Broadly speaking, investment banks assist in large, complicated financial activities. They employ investment bankers who help corporations plan and manage large projects, and identify potential risks.
In theory, investment bankers are experts in their field who have their finger on the pulse of the current investing climate. Companies decide to consult investment banks for advice on how best to plan their future investments and business decisions, as investment bankers can tailor their recommendations to the present state of the global economy and various economic affairs.
Investment Banking Activities and Products:
- Mergers and Acquisitions (M&A) - advisory on sale, merger and purchase of companies. Investment banks help facilitate mergers and acquisitions where they play the role of “Financial Brokers” and help companies find suitable acquisition targets or suitable buyers for their companies.
- Initial Public Offerings (IPOs) - a company selling itself to the public. Investment banks either buy all the available shares at a price estimated by their experts and resell them to the public or sell shares on behalf of the issuer and take commission on each share. It may also include creating the documentation for the Securities and Exchange Commission necessary for a company to go public.
- Leveraged Finance - lending money to firms to finance acquisitions.
- Equity Capital Markets - advice on equity and equity-derived products (shares, options, futures, swaps). Investment banks also provide guidance to issuers regarding the issue and placement of stock. Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments so as to maximize revenue and with navigating regulatory requirements.
- Debt Capital Markets - advice on raising and structuring of debt to finance acquisitions
- Restructuring - improving the structures of a company to make it more profitable or efficient.
- Financing Large Projects - funding of massive projects, such as building giant bridges or power plants, that usually require enormous amounts of cash up front. The need for upfront cash is so great it may outstrip the lending capacity of traditional banks, or it may be too risky for them. That’s where investment banks can come in. Investment banks gather cash by selling securities to investors with excess money looking for a chance at a good return.
- Offering Asset Management and Brokerage Services - collecting money from clients and helping those clients put the money to work in a way to generate returns, either by selecting individual stocks or by putting them into a mutual fund
So how do investment bankers make money ? Commissions (1% to 10% of the transaction value) make up a great deal of their profits. Just think about how much Investment Bankers may have made in the Facebook, Twitter or Alibaba IPOs! Brokerage and Underwriting Services also create profits as well as creating collateralized products, proprietary trading and dark pools.
Often, when a company holds its Initial Public Offering (IPO), an investment bank will buy all or much of that company’s shares directly from the company. Subsequently, as a proxy for the company holding the IPO, the investment bank will sell the shares on the market. This makes things much easier for the company itself, as they effectively contract out the IPO to the investment bank.
Moreover, the investment bank stands to make a profit, as it will generally price its shares at a markup from the price it initially paid. However, in this case, the investment bank is under a substantial amount of risk. Though experienced analysts at the investment bank use their expertise to accurately price the stock as best they can, the investment bank can lose large sums of money if they initially overvalue the stock since they will often have to sell the stock for less than they initially paid for it.
This example illustrates one of the activities that investment banks indulge in. Think of Amazon recently buying Whole Foods Market. Amazon is not sure how much Whole Foods Market is really worth and what will be the short term and long-term benefits in terms of projected streams of revenues, and costs. Goldman Sachs went through the process of due diligence to determine the real value of the company, settle the deal by helping Amazon prepare necessary documents and advising it on the appropriate sizing and timing of the deal.
In this scenario, Goldman Sachs works on the buying side and Evercore is working on the selling side to help Whole Foods Market. The bigger the deal size, the more commission the bank will earn. In this $13.7 billion acquisition deal, Goldman stands to receive $30 million to $35 million in advisory fees, while Evercore stands to receive $40 million to $50 million, according to estimates.
Investment banking as an industry is currently showing signs of shifting trends. Investment banks are going from broad general financial institutions that could offer anything under the sun to more specialized ones, focusing their talents on specific industries instead. Moreover, the advent of financial technology is changing the scene, pushing investment banks to integrate fintech solutions and rely more on technology. A report by Boston Consulting Group“ recently stated that “enormous opportunity exists from the collaboration of established capital markets players such as investment banks with young FinTech companies, but the potential is far from being realized.”
Digitalization through AI, big data, blockchain, mobile technologies, interactive platforms, AR and VR is fast changing the way business is conducted across all financial sectors, including investment banking. It should come as no shock that these changes will absolutely cause turbulence and disruption to the future of investment banking and to the banks themselves. The financial institutions that will be able to best adapt to the emerging technology trends will see greater productivity, higher levels of innovation and overall superior business performance.