Investment Banking

Investment banks raise capital for businesses. They make the capital markets more efficient by arranging the exchange of money between different economic groups. Also they help corporations and government agencies raise capital by selling securities to investors, and on the other side of the transaction they help investors find vehicles where they can safely invest their capital in the most efficient manner and at the lowest cost. Investment banks are experts at creating financial instruments that match up the opposing interests of issuers and investors.

Investment banks provide a wide range of services—from underwriting a public offering of securities and trading in securities, to advising corporations on mergers, restructuring, acquisitions, and divestitures. Most of an investment bank’s income is earned from fees or commissions earned on the sale of securities and also from trading activities.

Once limited to arranging the public sale of debt or equity securities through underwriting, investment banks have a vastly expanded role today. In recent decades the activities of investment banks have come to include advising corporations on mergers and acquisitions, risk management, wealth management, private placements, and proprietary trading.

Primary activities of investment banks still fall into three different categories: corporate finance, capital markets, and wealth management for private clients. The bread and butter for most investment banks, or where they make their money, is mostly in their trading activities and securities underwriting by managing an issuer’s initial public offering (IPO) or follow-up offerings of additional securities. Underwriting an IPO for a hot new company—Facebook is a good example—gets a lot of headline-grabbing attention, but most IPO’s are routine affairs that don’t attract anywhere near that amount of interest.

Wall Street firms are extremely creative in coming up with new products that slice and dice a securities offering and carve out entirely new markets for these offerings. Years ago, a bright line distinction existed between debt and equity securities. Today that distinction is fuzzier as many classes of securities, convertible bonds, or certain types of preferred stock, for instance, have both debt and equity features. Structured finance deals, which pool large portfolios of home mortgages, credit card loans, and even commercial mortgages, are a big part of the business today. This is generally done by creating marketable securities that pool assets, allocate the liabilities into different investment pools (called “tranches”) with different risk characteristics, and sell the securities through an independent legal entity. The securitization process makes possible better allocation of capital and distributes ownership risks through a larger group of investors. Investment bankers see the structured finance/securitization business as a lucrative source of fee income, largely from the advisory fees charged to the issuing companies, the investors in structured finance deals, or both parties.

Mergers and acquisitions (M&A) are front-page, headline-grabbing deals. The huge takeover battles of the late 1980s—the RJR Nabisco hostile takeover by KKR put M&A deal-making in the spotlight—but it’s not all hostile tender offers and defensive battles. Most M&A deals are friendly affairs arranged on terms amicable to both sides. Investment bankers seek ways to optimize transactions—that is, negotiating the best price everyone can live with. That price may not be the highest price sellers are willing to offer or the lowest bid price but something in between. Investment bankers search out, facilitate, and price leveraged buyouts by private equity firms, arrange the restructuring and recapitalization of companies exiting lines of business, and reorganize troubled companies emerging from bankruptcy.

Financial advisory service is another big segment of the investment banking business. Advisory services have grown dramatically along with the growth in hedge funds and private equity funds managed or advised by investment banks. Advisory services include raising capital for investment funds, financing acquisitions, and handling the initial public offerings of portfolio companies owned by hedge funds or private equity funds. Investment bankers like the advisory business because the deals generate hefty fees, and the deal pipeline in private equity transactions can stretch out for months in a major investment bank.

Other important investment banking services are risk management, merchant banking, and proprietary trading of debt and equity securities. Risk management involves taking hedging positions in interest rates, foreign currencies, commodities, and financial instruments through swaps, options, and futures. Swaps are negotiated in the over-the-counter market or traded through an organized futures and options exchange. These transactions work because the parties to a deal often have dissimilar credit ratings and financing needs. Both sides can effectively structure a deal that meets their financing requirements and risk tolerance. An investment bank’s risk management group applies its expertise in many different financial instruments to develop a hedging strategy that best matches a client’s needs.

The trading desk in an investment bank is a sizable, though volatile, profit center. There is huge upside potential when a shrewd market bet pays off. On the other hand, profits can evaporate overnight in a market sell-off. Trading profits are made both from commissions from trading on behalf of clients and also from capital gains from securities held in the firm’s own account (also known as “proprietary trading”). Investment banks can work as brokers (who buy or sell according to client instructions), dealers (who act as principal and take an ownership stake), or market makers (who try to maintain stable prices in a security or market, depending on what’s being traded).

Besides stocks and bonds, investment bank trading desks actively trade money market instruments, precious metals and commodities, junk bonds, credit swaps, and so forth—almost any product where they can find a buyer. The explosive growth of alternative investment—private placements, hedge funds, and similar investments—opened entirely new trading opportunities in the last 15–25 years.

Investment bankers are especially talented at taking off-the-shelf, plain vanilla securities, tweaking them a little, and whipping up customer demand through their trading desks or broker-dealer affiliates. A good example here is the zero-coupon mortgage bond. By “stripping” off the interest coupons from ordinary bonds, the banks developed an entirely new class of securities. These IO (interest only) or PO (principal only) strips appealed to investors who wanted to own either bond interest payments or bond principal, but not both, depending on their outlook on interest rates and market trends.

Finding new market opportunities like IO or PO strips plays on one of the investment bank’s most visible strengths—its securities analysis and research team. Many investment banks use their research group’s stock-picking and research expertise to develop underwriting, private client wealth management, and money management businesses. The research team also plays an advisory role in the mergers and acquisitions side of the firm. Typical subdivisions are Global Equity and Fixed Income research. Today, an investment bank’s research units maintain an arms-length relationship with the finance and sales side of the bank—the so-called “Chinese wall” between corporate finance and investment research to avoid the appearance of any conflicts of interest. Numerous scandals dating to the dot-com bust of 2000 and the Great Recession (December 2007 to June 2009) and subsequent prosecutions require investment banks to vigorously enforce this in-house compartmentalization.

Wealth management is a burgeoning business sector, an outgrowth of the vast accumulation of private wealth over the last 30 years. Wealth management units service the needs of big institutional clients (pension funds, endowments, and foundations) and also very wealthy individuals. The departments serving private clients are typically referred to as the “private banking” or “private client” units of the bank. Wealth management units compete for market share with trust companies, trust departments of commercial banks, and investment management firms. Billions of dollars are at stake in this business.

Beyond the borders of the U.S. domestic market is the international investment banking market. Globalization is a watchword in the world of multinational corporations, development banks like the World Bank, and emerging market countries. Growth is highest in emerging markets in Asia and South America, which presents extensive M&A and underwriting opportunities. All major investment banks have a presence in the developed markets (Europe, Australia) and the developing markets worldwide.