Investment Banking- Overview

Introduction
IB is not a straightforward thing to explain,
but lets start by stating that its NOT
investing, NOR banking.
It is really the raising of capital (money
companies need to help their business grow)
on behalf of clients by buying and selling
securities.
It can be said that IB is the EVOLVED form of
Merchant Banking.

Definition
The dictionary of banking and finance

defines investment bank as A bank

which deals with the underwriting of new
issues and advices corporations on their
financial affairs.
The SEBI(Merchant Bankers) Rules 1992
define merchant banker as A person
who is engaged in the business of issue
management either by making
arrangement regarding selling ,buying
,or subscribing to securities as
manager , consultant ,advisor or
corporate advisory services in relation to
such issue management.

 Thus Investment banks are essentially financial

intermediaries who assist their clients in raising
capital either by underwriting their shares or
bonds or by acting as an agent in the issuance
of securities.
Please note that Investment banking isnt one
specific service or function. It is an umbrella
term for a range of activities including
underwriting, selling & trading securities,
providing financial advisory services, such as
mergers & acquisition advice, IPO advisory and
managing assets.

History & Emergence

Merchant Banking practices adopted in
USA evolved into the better equipped
current form of Investment Banks.
For the purpose of study we can divide the
evolution process of IB into 3 main phases:
Period prior to 1929
Period from 1929-1933
1933 onwards

Period prior to 1929

The end of World War ll broke the back bone
of Commercial Banking in USA and they were
preparing for an economic recovery.
It was expected that American companies
would shift their dependence from
commercial banks to the stock & bond
markets wherein the funds were available at
lower cost and for longer periods of time.
In order to have a presence in the capital
markets, Commercial banks started to
acquire Stock Broking Businesses

 The stock and bond market boom of the 1920 was

an opportunity that banks could not miss. But since
they could not underwrite and sell securities
directly, they owned security AFFLIATES through
holding companies.
However the compartments were not maintained in
a water tight fashion.
While the boom lasted, Investment Banking
Affiliates made huge profits as underwriting fees.
Eventually the stock market got over heated with
investment banks borrowing money from parent
banks in order to speculate in the banks stocks,
mostly for short selling.

 The bubble ultimately burst

in October 1929 wiping out
millions of dollars of bank
depositors funds and
bringing down with it banks
such as the Bank of United
States.

Period between 1929-1933

In order to restore the confidence in the
banking & financial system, several legislative
measures were proposed, major being the
BANKING ACT 1933 ( popularly known as the
Glass-Steagall Act)
It restricted commercial banks from engaging
in securities underwriting and acting as agents
for others in securities transactions.
These activities were segregated as the
exclusive domain of Investment Banks.

 On the other hand, investment banks were

barred from deposit taking and corporate
lending, which were considered the exclusive
business of commercial banks.
As a result of the passage of this Act, a
separate group from J.P. Morgan set up Morgan
Stanley Investment Bank while J.P. Morgan itself
continued as a Commercial Bank.

Birth of Universal Banks

In order to reach the current state, Investment
Banks have undergone several phases of
transformations, which has broken down the
water-tight compartments to a great extent.
The Gramm-Leach Bailey Act 1999 has legalized
for a bank to have both commercial &
investment banking.
A Universal Bank thus means co-existence of
commercial banking (lending activity)with
investment banking (investment & distribution
activity).

Investment v/s Commercial Banks

Investment Banks
Help their clients in
raising capital by
acting as an
intermediary between
the buyers & sellers of
securities.
Do not take deposits
from customers
Earn underwriting
commission

Commercial Banks
Are engaged in the
business of accepting
deposits from customers
and lending money to
individuals & corporates
Can legally take
deposits from the
customers.
Earn interest on loans
granted to their
customers

 Do not own the

securities & only act
as an intermediary for
smooth transaction of
buying and selling
securities.

Own the loans granted

to their customers.

Role of Investment Banks

Investment banks help companies and
governments and their agencies to raise
money by issuing and selling securities in the
primary market.
They assist public and private corporations in
raising funds in the capital markets (both
equity and debt)
as well as in providing strategic advisory
services for mergers, acquisitions and other
types of financial transactions.

 Investment banks also act as intermediaries in

trading for clients. Investment banks differ
from commercial banks, which take deposits
and make commercial and retail loans.
In recent years, however, the lines between
the two types of structures have blurred,
especially as commercial banks have offered
more investment banking services

 Investment banks may also

differ from brokerages, which
in general assist in the
purchase and sale of stocks,
bonds, and mutual funds.
However some firms operate
as both brokerages and
investment banks; this
includes some of the best
known financial services firms
in the world.

 In the strictest definition, investment banking is

the raising of funds, both in debt and equity,
and the division handling this in an investment
bank is often called the "Investment Banking
Division" (IBD).
However, only a few small firms provide only
this service. Almost all investment banks are
heavily involved in providing additional financial
services for clients, such as the trading of
derivatives, fixed income, foreign exchange,
commodity, and equity securities.

 More commonly used today to characterize what

was traditionally termed "investment banking" is
"sell side." This is trading securities for cash or
securities (i.e., facilitating transactions, marketmaking), or the promotion of securities (i.e.
underwriting, research, etc.).
The "buy side" constitutes the pension funds,
mutual funds, hedge funds, and the investing
public who consume the products and services of
the sell-side in order to maximize their return on
investment. Many firms have both buy and sell
side components

Organizational Structure of an Investment

Bank
An investment bank is split into the so-called Front Office, Middle Office and Back
Office.

Front Office
Investment Banking
is the traditional aspect of investment banks which
involves helping customers raise funds in the
Capital Markets and advising on mergers and
acquisitions. Investment bankers prepare idea
pitches that they bring to meetings with their
clients
with the expectation that their effort will be
rewarded with a mandate when the client is ready
to undertake a transaction.

 Once mandated, an investment

bank is responsible for
preparing all materials
necessary for the transaction
as well as the execution of the
deal, which may involve
subscribing investors to a
security issuance, coordinating
with bidders, or negotiating
with a merger target.

 Investment Management
The professional management of various
securities (shares, bonds etc) and other assets
(e.g. real estate), to meet specified investment
goals for the benefit of the investors. Investors
may be institutions (insurance companies,
pension funds, corporations etc.) or
private investors (both directly via investment
contracts and more commonly via collective
investment schemes, mutual funds) .

 Sales & Trading

is often the most profitable area of an investment bank.
responsible for the majority of revenue of most investment
banks
In the process of market making, traders will buy and sell
financial products with the goal of making an incremental
amount of money on each trade. Sales is the term for the
investment banks sales force
whose primary job is to call on institutional and high-net-worth
investors to suggest trading ideas (on caveat emptor basis) and
take orders. Sales desks then communicate their clients' orders
to the appropriate trading desks, who can price and execute
trades, or structure new products that fit a specific need.

 Research
is the division which reviews companies and writes
reports about their prospects, often with "buy" or
"sell" ratings. While the research division generates
no revenue, its resources are used to assist traders
in trading,
the sales force in suggesting ideas to customers,
and investment bankers by covering their clients.
In recent years the relationship between
investment banking and research has become
highly regulated, reducing its importance to the
investment bank.

 Structuring
has been a relatively recent division as
derivatives have come into play, with highly
technical and numerate employees working
on creating complex structured products
which typically offer much greater margins
and returns than underlying cash securities

Middle Office
Risk Management
involves analyzing the market and credit
risk that traders are taking onto the
balance sheet in conducting their daily
trades, and setting limits on the amount of
capital that they are able to trade in order
to prevent 'bad' trades having a
detrimental effect to a desk overall.

 Another key Middle Office role is to ensure that the

above mentioned economic risks are captured
accurately (as per agreement of commercial terms
with the counterparty) correctly (as per
standardized booking models in the most
appropriate systems) and on time (typically within
30 minutes of trade execution).
In recent years the risk of errors has become
known as "operational risk" and the assurance
Middle Offices provide now include measures to
address this risk. When this assurance is not in
place, market and credit risk analysis can be
unreliable and open to deliberate manipulation

Back Office
Operations involves data-checking trades that
have been conducted, ensuring that they are not
erroneous, and transacting the required transfers.
While it provides the greatest job security of the
divisions within an investment bank,
it is a critical part of the bank that involves
managing the financial information of the bank
and ensures efficient capital markets through the
financial reporting function. The staff in these
areas are often highly qualified and need to
understand in depth the deals and transactions
that occur across all the divisions of the bank.

Technology
Every major investment bank has considerable
amounts of in-house software, created by the
Technology team, who are also responsible for
Computer and Telecommunications-based
support. Technology has changed considerably
in the last few years as more sales and trading
desks are using electronic trading platforms.
These platforms can serve as auto-executed
hedging to complex model driven algorithms.

Revenue-Generating Activities
Primary Market Making
Corporate Finance
Municipal Finance
Secondary Market Making
Dealer Activities
Brokerage Activities
Trading
Arbitrage
Proprietary
Corporate Restructuring
Expansion
Contraction
Ownership and Control

 Financial Engineering
Zero Coupon Securities
Mortgage-Backed-Securities
Derivative Products

Other Revenue-Generating Activities

Investment Management (Asset Management))
Merchant Banking (Private Equity and Venture
Capital)
Consulting
Transaction Banking (Prime Brokerage)

Types of Investment Banks

Grad Nav has classified the hundreds of
investment banks that operate in the UK
into three groups:
Multinational banks
Mid-market banks
Boutiques

 Multinational banks
Multinational banks are the big, well-known global
financial institutions.
They are major players in the financial markets and can
be sub-classified into three further categories:
Universal banks
Pure-play investment banks
Advisory houses
Universal banks are universal because they are active
in all the departments you can find in an investment
bank, plus they also have a retail or commercial banking
division.

 Pure-play investment banks are also active in all the

departments found in an investment bank, but do not
have a major retail or commercial banking
division.
Advisory houses focus on the Banking business
areas of investment banking. They provide advice to
clients seeking to buy or sell companies or raise
capital.

 Mid-market players
Mid-market players are often not technically "banks" as
they dont have retail and commercial banking arms.
Instead they focus on providing investment banking
services to small-cap and mid-cap clients.
Accountancy firms such asDeloittehave many
different departments, obviously focusing on the
activities you normally associate with accounting firms
like audit and tax, but they also provide M&A advice to
small and mid-sized companies.

 Boutiques
Boutiques are small firms focusing on a specific
niche,
help their clients in equity and debt raising activities.
Aboutique investment bankis a smallinvestment
bankthat specializes in some aspect ofinvestment
banking, generallycorporate finance,
Of those involved in corporate finance, capital
raising, mergers and
acquisitionsandrestructuringandreorganizationsare
their primary activities

 A small financial firm that provides specialized

services for a particular segment of the market.
Boutique firms are most common in the investment
management or investment banking industries. These
firms may specialize by industry, client asset size,
banking transaction type or by other factors to address
a market not well addressed by larger firms.

Chinese Walls
Potential conflicts of interest may arise between
different parts of a bank, creating the potential for
financial movements that could be market
manipulation. Authorities that regulate investment
banking (the FSA in the UK and the SEC in the US)
require that banks impose a Chinese wall which
prohibits communication between investment
banking on one side and equity research and
trading on the other.

Functions of Investment Banks

Issue of an IPO
Merger & Acquisitions
Private Placements
Financial Restructuring

Issue of an IPO
The very first time a company chooses to sell equity,
this offering of equity is transacted through a process
called Initial Public Offering of stock.
Through the IPO process, stock in a company is created
and sold to the public. After the deal stock sold in India
is traded on a stock exchange such as the NSE or BSE.
Bankers to one of the largest IPOs in Indian history,
the Rs. 12000 crores IPO of Coal India Limited included
Citigroup, DSP Merrill Lynch, Morgan Stanley, Deutsche
Bank, Enam Financials & Kotak Mahindra Capital
Company.

 From an Investment banking perspective, the IPO process

consists of these 3 major phases:
Hiring the Managers: the first step for a company wishing
to go public is to hire managers for its offering.
The choice depends on the past transaction experience, the
fee quotes, the valuation the bank promises to fetch for the
companys offering etc.
The selection also depends on whether the issuer would like
to see its securities held more by individuals or by
institutional investors ( i.e. Investment Bankers distribution
expertise).
Often, the selection process is a two-way affair, with the
reputable IB choosing its clients at least as carefully as the
company would choose the I.Banker

 .When there are multiple managers, one investment

bank is selected as the Lead or Book-running manager.
The lead manager always appears on the left of the
cover of the prospectus, and it plays a major role
throughout the transaction.
Due Diligence and Drafting :
Once the managers are selected, the second phase of
the process begins.
For Investment Bankers on the deal this phase
involves understanding the companys business as
well as possible scenarios ( called due diligence)

 Marketing:
The third phase of an IPO is the marketing phase. Once
the approval comes on the prospectus, the company
embarks on a road show to sell the deal.
A road show involves meeting potential institutional
investors interested in buying shares in the offering.
Typical road shows last from two to three weeks, and
involve meeting numerous investors, who listen to
companys presentation and then ask scrutinizing
questions.

Mergers & Acquisitions

Representing the Target

Representing the Acquirer

Sell side
representation comes
when a company asks
an Investment Bank to
help it sell a division,
plant or subsidiary
operation.
The work involved in
finding a buyer
includes writing a
selling memorandum
and then contacting
potential buyers

The advisory work

itself is
straightforward: the IB
contacts the firm their
client wishes to
purchase, attempts to
structure an offer for
all parties and make
the deal a reality.

Private Placements
A Private Placement differs little from a public
offering aside from the fact that private
placement involves a firm selling stock or
equity to private investors rather than to
public investors.
Also a typical Private Placement deal is smaller
than a public transaction.

Financial Restructuring
When a company cannot pay its cash
obligations-for example when it cannot meet its
bond payments or its payments to other
creditors (vendors) it goes bankrupt.
In a situation like this, it can choose to simply
shut down operations and walk away. On the
other hand it can also restructure and remain in
business.
What does it mean to restructure?
The process can be thought of as two-fold:
financial restructuring & organisational
restructuring.

 Restructuring from a financial viewpoint

involves renegotiating payment terms on debt
obligations, issuing new debt & restructuring
payables to vendors.
Bankers provide guidance to the firm by
recommending the sale of assets, issuing of
special securities such as convertible stock &
bonds etc.
Restructuring bankers must work within a legal
framework- the Bankruptcy Code-and hence
must have a more in-depth legal understanding
than other bankers.

 Organizational Restructuring involves a change

in management, strategy and focus.
I-bankers with expertise in reorgs can
facilitate and ease the transition from
bankruptcy to viability.
Risk comes from not knowing what you are
doing. Warren Buffett