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Table of Contents
- How do Investment Banks operate the largest economic system in the world?
- Difference between Commercial banks and Investment banks
- IPO(Initial Public Offering)
- Security Underwriting
- Types of Underwriting-
- Investment bank's role in mergers and acquisitions (M&A)
- If the bank is selling the securities, there are many responsibilities of the investment bank, including-
- If the investment bank is buying securities for a client. It has other responsibilities like-
- Investment banks' role in Restructuring and Reorganising the company
- Ethics in Investment Banks- The Chinese Wall
- How did the Chinese wall first come into place?
How do Investment Banks operate the largest economic system in the world?
One of the most lucrative industries in finance is investment banking. In 2020 investment banks recorded 2200 crores of revenue, which was only for India. Investment banking might sound tricky to a common person. But not only a common man but even bankers and associates with financial backgrounds find investment banking to be complex and, at times, intimidating. Major investment banks include Goldman Sachs, JPMorgan Chase, and Credit Suisse. So, what is an investment bank, and how did it originate?
The origin of Investment Banks in the 19 century, investment banking first appeared in America. During the civil war, there was a major change in the American economy. In 1861, a financier in Philadelphia, James Cooke, established the first investment bank in America to help the governments in the civil war. So the US government became the Investment bank's first client. The American economy was growing so fast that commercial banks could not afford to finance the big projects of mines, railways, and heavy industries. Therefore, the government started providing bonds to investment banks, which would be bought by other investors who then financed these projects. The investment bank was paid a fee to connect the investors with the bigger projects. The investment bank acted as a middleman for big industries and investors. One might feel that commercial banks have the same process, but it's not completely true.
Difference between Commercial banks and Investment banks
The main difference between commercial banks and investment banks is the clients they cater to.
Investment banks deal with large business corporations and even government projects, whereas commercial banks deal with day-to-day small private business clients. Commercial banks provide foreign exchange, loans, commercial mortgages, and acquisition-related financing. These are all basic cash management services. Through the interest they charge, they are profitable. Whereas investment banks take larger risks by choosing to help in providing large capital to huge organizations and startups with higher risks. They issue stocks and advise clients who wish to trade their business. They earn large amounts of fees for these services. They help them decide on a merger or an acquisition wisely.
The major difference between the two banks is in size and their performance measure. The investment bank's performance depends on the stock market's highly variable performance. Commercial banks depend on their credit demand or loans and overall economic growth.
Investment bankers provide a wide spectrum of clients with capital raising and M&A advice. They may be found anywhere in the world.
Investment banks' clients include:
1. Governments – Investment banks work with government projects to raise money, trade securities, and buy or sell crown corporations.
2. Corporations – This is the most common field of interest for investment banks to work. These corporations include private and public companies, which help them go public through IPOs; they raise capital, grow their businesses, make acquisitions, sell business units, and provide corporate financial advice through thorough research and analysis.
3. Institutions – Banks also work with private institutional investors who manage other people's money to guide them through trading securities and by providing research on the trade markets. Additionally, they collaborate with private equity firms to help them acquire portfolio companies and sell their business by either doing an IPO or selling to a strategic bidder.
IPO(Initial Public Offering)
When a company reaches out to an investment bank (underwriter) to make a public offering of their now-private company, therefore, to help the company gain shareholders, the bank issues an IPO, which stands for initial public offering. It is, in a way, first offering the company's shares or stocks to the investment bank and later to the public. A large business has many partners, and the investment bank is its first partner. When a company or business reaches out to an investment bank to issue its IPO, the bank will analyze its business plan, the profits, and its future, and it will try to examine every aspect of the business. They take these measures before deciding if they are interested or profitable in working with the company. When the bank finds the company's business and IPO valuable, the investment bank wishes to work with the company and then try to be its book-runner or the underwriter.
Often a company with greater potential and size will have many investment banks interested in issuing IPOs for it. This leads to a "bake-off" situation where many investment banks pitch their services to the company so that the company chooses them for their IPO. Often, not very large companies have to select joint book runners— which is more than one head underwriter. It has many banks as its head which underwrite the company and act as an advisor.
For example, in January 2011, 7 banks underwrote Tata steel's plan to raise funds. As a result, the banks decided to issue IPOs for the unsold share of the company. The 7 banks were Kotak Mahindra Capital Co. Ltd, Citigroup Global Markets India Pvt. Ltd, Deutsche Equities India Pvt. Ltd, HSBC Securities, and Capital Markets (India) Pvt. RBS Equities India Ltd, Standard Chartered Securities (India) Ltd, and SBI Capital Markets Ltd's parent State Bank of India.
When the bank decides to work with the company, a negotiation process will start, during which the company settles many issues, which include the details of the IPO, what assistance the bank will provide before and after the IPO, and the money or fee the bank will receive for their services. The process starts by writing the letter of intent which includes all the details about the company and the banks' agreement.
The banks will form a syndicate or a group if the company requires more than one investment bank. They will provide their financial advice until the end of the period when the company is the bank's client. The bank will have its role as a financial advisor. It will develop many plans of execution for financial services. It will provide a better offer and strategy for the company's IPO. It will help to provide a better investment thesis, a written document that includes information about the investment, analyses the business's value, and evaluates its potential profits.
This thesis is used by the investment bank when they offer their IPO to investors. They also develop a valuation framework and finally price the offering, after which the bank will try to buy all or most of the company's stocks at a lower price and sell it to the public shareholders in the stock market. The process of selling the private securities of the company to the public is known as security underwriting.
It is the process by which investment banks would raise investment capital from buyers for bigger corporations and even governments by issuing securities. The securities are in the form of stocks or bonds. Security is a financial asset or instrument which has a cost and value. It is tradable and has properties of ownership.
In simple words, investment banks buy the issues from a company and sell them to potential investors at a profitable price. Investment banks' biggest service is underwriting share issues.
Types of Underwriting-
1. Firm Commitment Underwriting: This is the most common underwriting arrangement known to the public. According to this underwriting method, the investment bank buys their client's company's security issues or stocks and bonds. And then, the bank sells it for a profitable price to potential investors. However, the responsibility to sell the entire issue lies in the hands of the investment bank. So, if any of the issues fail to be sold, they will remain in the hands of the bank itself. Until and unless they find an investor interested in buying the bank's acquired issues. Therefore it is very risky for an investment bank to buy issues. Because of this, they only work with top bankers who are experts in stock trading and have in-depth knowledge of the stock market. Also, the banks do not deal with or buy every issue. They are caring for their trades and choose their clients wisely. In this type of risky underwriting, the banks charge a higher fee.
2. Best Effort Underwriting: An investment bank will frequently sell securities in this manner. In this method, the investment bank uses its decades-old network and sources to sell the securities of its client. Every trader or investor is in contact with investment banks. So the investment banks know all the potential investors willing to buy the securities for their clients. The investment bank does its best to find the most appropriate investor. So the investment is legally obligated to use all of its network and connections to sell the securities of the issuing company. However, if the investment bank cannot sell any securities, the investment banker would not be forced to hold on to the remaining or all of the securities for themselves. Instead, they can easily return the securities to their client.
3. All or None Underwriting: It is an arrangement between investment banks and the clients in which they sign a deal of either selling all of the company's securities at a decided price or, if they fail to do so, having to return the entire issue to the issuer. As its name suggests, the bank has to either sell all of its security or none of it.
So this is why investors and the company do not buy or sell their securities directly. Instead, they prefer investment banks because they take the risk of selling the shares. If they fail to find interested investors, they must keep some or all of the shares themselves. So they are seen as risk-takers. But not only do investment banks take these risks, but commercial banks are also risk-takers.
Investment bank's role in mergers and acquisitions (M&A)
Investment banks find themselves in any of the two positions of either buying or selling the company. Merger and acquisition may be used interchangeably, but they are a bit different when a company buys all of the other companies for itself and becomes the owner of the bought company. It is called an acquisition. For example, Walmart's purchase of Flipkart entered the Indian market. Walmart was competing with Amazon in the bidding war, paying $16 billion for a 77 percent interest in Flipkart.
This helped Walmart to compete with Amazon in one of its key markets (India). On the other hand, when two firms become a partner of each other by combining both of their companies into one entity and operating as an individual company, this is known as a merger. For example, when two of India's largest media companies, Zee Entertainment Enterprises Limited (ZEEL) and Sony Pictures Networks India (SPNI), agreed to a multibillion-dollar merger.
As we know, big firms do not wish to indulge in buying and selling their companies or a part of them on their own. They need advisors and a middleman to take the risk to provide the best deal. So they reach out to the most trusted investment banks.
Investment banks have several strategic methods and procedures to provide a successful M&A. The bank's main objective while selling the company in an M&A is to provide the highest possible valuation. The bankers try to find the best prospects and are commissioned for their services, from 1% to 2% of the sale value. The percentage might look small, but dealing with these large trading companies can amount to millions. The banks pre-decide the fee for M&A, which is in the percentage of the total capital raised. It can be anywhere between 3%-10%.
In the case of IPOs, the main task of an investment bank is to evaluate its possible value and to calculate if it is worth any possible acquisition. Also, the banks settle their negotiations at a fair price. An investment bank also helps structure and facilitate the acquisition so the deal is finalized quickly and efficiently.
In an M&A, the role of the investment bank depends on whether the bank is representing itself as the seller of a company or representing its client as a buyer that advises and helps a prospective acquirer.
If the bank is selling the securities, there are many responsibilities of the investment bank, including-
* The bankers help their clients by providing the best valuation to their company. In addition, they keep track of the perfect timing in the stock market to sell their issues.
* They understand the company's potential and apply their knowledge of the client to build a portfolio for their securities. They use different means to advertise the issues of the company. They also compete with other banks if there is a clash of potential investors for similar securities.
* The investment bank has a large network of investors. With the help of this network, they try to identify and contact the best potential buyers but also hold meetings and provide strategic discussions and information to interested parties.
* The bank starts a formal bid process for the company; it provides the best bids and selects the most profitable buyer.
* It sets up due diligence and is a primary liaison between the sellers and buyers.
* The bank represents itself as the head advisor of the issuer. And acts as a middleman for selling the issues.
* And lastly, the bank may be selling the company's securities, but it is related to both the buyer and seller; therefore, it tries to satisfy both by negotiating the deal's final terms.
If the investment bank is buying securities for a client. It has other responsibilities like-
* They try to meet their client's expectations by providing them with a potential target company that comes under their area of expertise and interest.
* They set a preliminary valuation for the securities suitable for the buyer.
* They build the most efficient bidding strategies which will profit their client.
* They help to draft proposed terms of purchase.
* They identify any issues in the diligence process and try to avoid or mend those problems.
* The bankers try to understand their client's business models and analyze their financial structure to determine the proper transaction of the securities. If they require financing, it is the bank's responsibility to provide them with the best means of financing.
* Lastly, the bank negotiates the deal's final terms with the seller.
Investment banks' role in Restructuring and Reorganising the company
As mentioned before, Investment banks play the lead role of advisor for the company. They analyze the company's financial structure to assess its present and future assets. When a company faces a stressful financial situation where it is not making enough property to fulfill its debt or is on the verge of bankruptcy, it reaches out to investment banks for advice.
Investment banks play two roles the debtor (company) and the creditor. The bank is the head of the two parties, so it can simultaneously assess them. It helps the company by managing its finances, whereas it also helps the creditors who have put their money into the debtor's company. An investment bank's advice for financial stability consists of two strategies: restructuring and reorganizing the company.
By restructuring, we mean that if a company faces a debt crisis, then the bank will advise the company to rearrange or restructure its assets to pay off its debts. For example, a company may turn its debt into stocks so its bondholder or creditor would receive assets in place of its debt. In this way, the bank changes the company's structure by assessing its securities for its financial benefit.
The bank, as an advisor, also helps the company to build strategies to improve the company's performance. The bank will reorganize the business models by holding long meetings with the company's associates to find solutions to promote the company's financial growth. The bank advises changing the company's roles and models to help its financial crisis. For example, consider a corporation experiencing a financial downturn in a specific industry. In that case, the bank will advise a better alternative to help those losses, and often they will bring a more profitable solution.
The investment banks' process of restructuring and reorganizing is often misunderstood as the last means of survival for the company. A profiting company can also seek investment banks' restructuring and reorganizing strategies to improve their operations. The banks also help to predict the company's future as they calculate its present minor stress, which might blow up in the future. An investment bank can help build a solid business model for a company with a minimum financial crisis and more profits.
Proprietary Trading or Prop Trading is a form in which investment banks are mainly involved. When the bank trades stocks, bonds, commodities, or other financial securities for its purpose, it will use its own money to buy the company's securities, unlike its other role where it buys and sells issues for its clients and earns a fee over it.
The bank is the sole beneficiary of its trade and exchange in prop trading. There are no clients involved in buying or selling the securities. This enables the bank to earn all its profits from trading rather than just the commission it receives for processing trades for its clients.
The banks have the advantage of executing prop trading for themselves; due to their institution, the bank has market information and expertise to benefit their trades.
Banks and other financial entities do this kind of trading to benefit from surplus earnings. In this trading, the banks receive 100% of the profits. Another advantage is that the bank has advanced modeling and trading software which help them in stock marketing.
Prop trading banks use merger arbitrage, index arbitrage, global macro-trading, and volatility arbitrage to maximize their returns and profits. Proprietary traders have access to sophisticated and advanced software. They also have a lot of internal expert information to help them make critical decisions even though prop trading is risky as it deals with the investor seeking maximum profits.
Prop traders and hedge funds were one of the primary causes of the 2008 financial catastrophe. Therefore, The Volcker rule was introduced to control prop trading, which regulated the operation of brokers in trading. Another concern was avoiding the conflicts of interest that arose between the bank and its clients, who were the investors. The prop trading mainly benefited the bank, so its clients were more cautious with the prop trading of the bank as it had all the information of its investors. Such conflict of interest was looked after through the Chinese wall.
Ethics in Investment Banks- The Chinese Wall
The investment banks' role as a middleman between the buyer and seller of the stocks raises a conflict of interest. Information is power; it can benefit the person and harm them. The bank acts as a mediator between the two parties and profits from their trades. The trading deals of private companies with the public significantly affect the banks' business interests. To keep non-public information confidential within the bank itself is a matter of ethics in the stock business. This ethical code stands among the members of the bank itself and the investors. The information is separated and protected through a virtual barrier known as the Chinese wall. While the wall concept exists in other industries and professions like journalism, law, insurance, computer science, reverse engineering, and computer security, it is most famously associated with the financial services sector, especially the stock market.
How did the Chinese wall first come into place?
During the early 1930s, the stock market crash of 1929 was partly due to price manipulation and trading on inside information. As a result, Congress passed the 1933 Glass- Steagall Act (GSA), which demanded the separation of commercial and investment banking activities (investment banks, brokerage firms, and retail banks). This Act's main intention was to prevent the existing conflicts of interest between the bank's self-interest and its client's interests.
For example, a banker trying to recommend clients to buy those shares of a new company whose IPO is also issued by the same investment bank itself. The Glass-Steagall Act sought to establish a workplace where a single bank could engage in its business practices of ethically selling and buying by separating the inside information within its departments instead of requiring businesses to provide research or investment banking services for their benefit.
The investment banks have helped the country build extensive infrastructure and industries. They are the primary beneficiaries who build the country's economy on a large scale. Large business transactions affect not just a company or group of individuals who hold large companies but also the country's whole economic market. Investment banks work internationally, and countries' economies depend on each other. Therefore the banks extensively depend on the stock markets. Investment bankers take high risks and work at least 16 hours daily to track their transactions. Investment banks not only enlarge the existing industries but it is hoped that they will have a major role in bringing new industries to the world. They play a major role in providing capital to emerging industries, especially new sustainable industries of alternative energy projects. The investment banks had helped build the country in the past by offering their service to the rails, mines, and heavy industries during the civil war. It will again revolutionize the economic industry of the world by bringing new industries to the market.
Frequently Asked Questions
Investment Banks are important because of the services that they provide to their clients which play an important role in the economy. Their services like Merger and acquisition help the firms to expand their businesses in the world. Investment banks help companies to raise funds which allow them to get capital access. Also, Investment banks provide various investment opportunities to investors and creditors.
IPO means initial public offering. When any large company which is unlisted or it can be a small company makes either a first issue of securities or offer for sale of its existing securities or both for the first time to the public is called an Initial Public Offering (IPO).
Investment banks provide a number of services which include, issuing IPO, merger and acquisition, proprietary trading, restructuring and reorganizing the company.
Investment banks often find themselves with information which can conflict with each other’s interests. To keep non-public information confidential within the bank itself is a matter of ethics in the stock business. This ethical code stands among the members of the bank itself and the investors. The information is separated and protected through a virtual barrier known as the Chinese wall.