Investment Banking

Financial intermediaries, an important part of the financial system, have evolved with the purpose of lowering transaction costs and allowing small savers and borrowers to benefit from the financial markets. One solution to the problem of high transaction costs provided by financial intermediaries is to pool the funds of many investors together so that they can take advantage of economies of scale, which is the reduction in transaction costs per dollar of investment as the size of transactions increases. The presence of economies of scale in financial markets helps to explain why financial intermediaries have developed and have become such an important part of our financial system.

There are two fundamental ways that new financial claims can be brought to the market: direct or indirect financing. In the indirect credit market, commercial banks are the most important participants; in the direct market, investment banks are the most important participants. Investment banks are firms that specialize in assisting businesses and governments sell their new security issues (debt or equity) in the primary markets to finance capital needs.

A generation ago, we had merchant banks operating in a few developed countries, now they have been renamed as investment banks following the US nomenclature. In modern usage merchant banking is occasionally used for the subset of investment banking businesses concerned with using the bank’s capital to facilitate a transaction such as engaging in mergers and acquisitions.

Universal banks are institutions that are allowed to accept deposits, make loans, underwrite securities, engage in brokerage activities, and sell and manufacture many other financial services such as insurance.

Investment-banking firms have three distinctive primary market functions in financial structure and these are as follows:
• bringing new securities to market,
• deal making in the mergers and acquisitions,
• advising corporations.

Investment banking firms occasionally engage in originating securities. As an originator, the investment bank tries to identify corporations that may benefit from a security sale. Once an agreement is reached between an investment bank and an issuer, the investment bank makes a detailed study (called due diligence) of the corporation. This means that they are required to diligently search out and disclose all relevant information about an issuer before securities are sold to the public, or the underwriter can be held responsible for investor losses that occur after the issue is sold.

A syndicate is a group of investment banking firms, each of which buys a portion of the security issue.

The prospectus acts as a marketing tool as the firm tries to persuade investors to apply for shares.

The most important types of offering in the sale of new securities can be classified as initial public offering or unseasoned offering, secondary common stock offering or seasoned offering, and bond offering.

There are several different types of arrangement between the investment banking firm and the corporation in security offerings. Sometimes the financing takes the form of a private placement in which the securities are sold to a tiny number of large institutional investors, such as life insurance companies or pension funds, and the investment- banking firm receives a fee. On other occasions, it takes the form of a public offering, where securities are offered to the public.

When an investment-banking firm buys the securities from the issuer and takes the risk of selling the securities to investors at a lower price, it is referred to as an underwriter.

There is also a phenomenon known as underpricing. Stocks are typically sold to investors at an offering price that is, on average, about 15 percent below the closing price of the stocks after the very first day of trading. This implies that underwriters deliberately (and consistently) sell stocks to investors for merely six-sevenths of their value.

The structure of a bought deal is as follows:
• The lead manager or a group of managers offers a potential issuer of debt securities a certain bid to purchase a predetermined amount of the securities with a fixed interest (coupon) rate and maturity.
• The issuer is given a day or two (maybe even only a few hours) to accept or reject the bid. If the bid is accepted, that means the underwriting firm has bought the deal.

The aim in an IPO is to fully subscribe the issue. A fully subscribed issue is one where all of the securities available for sale have been spoken for before the issue date. Issues of securities may also be undersubscribed. That means the sales agents have not been able to generate enough interest in the security among their clients to sell all of the securities by the issue date. An issue may also be oversubscribed, and that means there are more offers to buy than there are securities available.

Investment bankers serve both acquirers and target corporations. Acquiring corporations require help in locating attractive corporations to pursue, soliciting stockholders to sell their stocks in a process called a tender offer, and raising the required capital to complete the transaction. Target corporations may hire investment bankers to help avoid undesired takeover attempts.

Poison pills have to be approved by a majority of stockholders. Often stockholders stand against poison pills because they see them as benefiting only management.

The expected cash flows are the core of the valuation process. Two cash flows must be estimated:
1. the cash flows of the acquired corporation as a stand-alone business,
2. the additional cash flow that the acquiring corporation can generate if it purchases the business

Investment banking firms commonly suggest that the corporation could benefit from revising its ownership structure. It may recommend a carve-out, in which the corporation would sell one of its units to new stockholders through an IPO. The proceeds of the IPO go to the parent company.

Some firms, widely known as boutique investment banks, specialize in a few activities, such as advising companies on financing issues and mergers, but does not raise finance for the firm, or underwrite, or engage in securities trading.

The portion of the fee or commission allocated to research and advising services is called soft dollars. When one area in the corporation, such as an investment advisor, uses client commissions to buy research from another area in the corporation, it receives a benefit because it is relieved from the need to produce and pay for the research itself. Therefore, advisors using soft dollars face a conflict of interest between their need to obtain research and their customers’ interest in paying the lowest commission rate available.