What is investment banking: all you need to know in 5 minutes
What is investment banking: a short guide to the industry
“So where exactly do you work?”. “Investment banking, you know?”. “Ah, yes, yes sure….is it like..a cashier?”
The amount of times this happened to me is uncountable. Whenever people would hear about investment banking, they would usually assume it a) has something to do with the bank, and b) has something to do with the money. To be fair, both were 100% correct. However, as you can imagine, I neither worked at the cashier desk nor in the call centre.
For all those curious about what the industry is about – a quick cheat sheet on what is investment banking.
What are investment banks about?
Investment banks have nothing to do with places where you keep your money. Most of them don’t take deposits and don’t lend money on interest (exception is so-called universal banks like Barclays or HSBC that operate both as an investment and retail bank). They work primarily with companies and governments (and sometimes filthy rich individuals), assisting them in large and complex financial transactions. Most often they act as a bridge between large enterprises and investors.
What do investment banks do?
The range of services provided by investment banks is very broad. Most of the work however is done in four areas: advice on transactions, raising capital & underwriting securities, sales & trading and equity research.
Advice on transactions
Think of Facebook buying Instagram. Facebook knows the Instagram fits great with its strategy but is not sure how much the company is really worth (that is, how much money it should pay to acquire it and what will be the long-term benefit in terms of addition in revenues, decrease in costs etc). This is exactly where investment banks can help. The bank will go through the process of due diligence to determine the value of the company and assist on the actual deal (drafting the necessary documents, managing the act of sale etc.). Investment bank in this case will work on a buy-side (advising Facebook, the buyer) while another bank may be working on sell side (advising Instagram on how much money they should settle for).
Raising capital & underwriting securities
Think of Toyota planning a launch of a new product (high-tech car) or construction of a new factory in Asia. The company needs money to implement its expansion plan. Investment bank will act as a middle man to help to secure financing (find the necessary money). It can do so in two ways – either borrowing money (raising debt by issuing bonds) or selling some parts of the company (shares) in exchange for money (issuing stock).
Why companies can’t do it themselves? For once, they lack experience and scale to do so quickly and efficiently. They don’t have an exact idea of how much the company is worth, when and how to issue securities or how to ensure the process meets regulatory standards. More importantly, they don’t have access to a wide network of buyers to guarantee a smooth and quick execution of capital raising.
This is the investment bank comes it. The bank performs a complete investigation of the company, its financial statements and future earnings (a process called “due diligence”) and determines a fair (or sometimes not so fair) value of the company. It then prepares a prospectus (essentially a big document) that explains all the benefits and risks to potential buyers, and tells them all they need to know about the company to make a weighted decision. Once this is done prospectus is sent around the multiple buyers (hedge funds, mutual funds, institutional investors and interested parties) and the bank manages the actual process of sale (when and how it is best to issue securities).
Sales & trading
Investment bank matches up buyers and sellers to facilitate the trading of securities (bonds, stocks etc). Usually it would provide services mainly for institutional investors, such as pension or mutual funds, or it can also trade out of its own account. Sales and trading is an essential activity for an investment bank. Recall the earlier example of Toyota. Once the bank underwrites the securities, it has to ensure it can also efficiently distribute them among investors. This when the sales and trading teams kick in. They use their relationships with potential buyers to persuade them to buy securities and efficiently execute the trade.
One of the ways to sustain good relationships with institutional investors is to provide them with valuable expertise. Equity research is just about that. Drawing on its expertise as well as access to proprietary information banks can inform investors about developments in particular company (should they buy or sell shares) or “hot” IPO offers that are just about to come to the market.
Of course the area of investment banks’ activities is much broader. This includes leveraged buyouts, management buy-outs, project finance, asset management, securitised products and so on. These activities, although important, nonetheless are non-core and bring in less revenue as compared to main fields of expertise.
What are the top investment banks?
There is a number of largest investment banks that consistently account for most of the deal flow: Goldman Sachs, JP Morgan, Morgan Stanley, Bank of America Merrill Lynch, Citi (all originally from US), Credit Suisse (Switzerland), Deutsche Bank (Germany), Barclays (UK). These big guys cover nearly all sectors and types of financial services.
There are also smaller, so called boutique, firms – Lazard, Rotschild, CentreView etc. They usually specialise in a specific area of financial serices (Lazard, Evercore, Greehill all focus on M&A and restructuring), specific sectors (Allen & Co in media or Cowen & Cowen in Healthcare) or mid-sized deals / clients (Jefferies & Co, William Blair etc.).
Where are the top investment banks located?
Due to the global nature of business, investment banks of one size or another can be found in every country of the world. Biggest offices of top banks are concentrated in the largest financial hubs: New York, London, Hong Kong, Singapore and Dubai.
How do investment banks earn money?
Like every salesman – investment bank earns money on fees and commissions. That is, all the money flow is entirely transaction driven (no deal – no money).
If the bank manages to sell a company for a $100million – it will get roughly 1% on sale ($1 million in this case). In 2015, for example, the biggest deal of the year – merger of Kraft and Heinz – was advised by Lazard and Centerview, each taking in fees around $60 million and $90 million respectively.
Understandably, with banks relying so heavily on commissions a lot of emphasis is put on relationship building. Higher executives in investment banking are almost never involved in actual valuation or pitch book drafting – their primary responsibility is to manage the clients.
Another important question is how do investment banks manage to sustain high margins. The answer is simple.
The revenues are substantial, and expenses negligible compared to traditional banks. Investment banks do not require hundreds of branches, ATMs or thousands of employees. Huge deals are executed by relatively small teams, which allows banks to keep their costs to the minimum. Even food, travel and hotel expenses for people on the deal are usually paid by the client. Most expenses are associated with staff-intense divisions, such as sales & trading and equity research – and this is why specialised boutiques, such as Lazard, can enjoy a higher margin compared to its larger rivals.
What changed after 2008?
As you might know 2008-2009 was a year of total financial meltdown. Banks were the ones to blame: selling risky products at inflated prices and putting profit before investors interests. Many institutions (such as Lehman Brothers) went bust, others took quite a big hit to their financials. Post-crisis hangover is still there: financial industry is now more heavily regulated, which means less opportuntiesi for investment banks to make money. The volume of transactions also went down as companies became more diligent with their spending. As a consequence – fees went down too and banks went maniac on decreasing expenses by letting go of thousands of employees and eliminating whole departments. And although the environment is gradually improving, it is questionable if investment banks will ever be able to enjoy margins comparable to those before 2008.