Investment Banks Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Unlike consumer banks, investment banks offer services that primarily deal with the restructuring of business ownership, including initial public offerings, mergers and acquisitions, leveraged buyouts, securitization, and private placements. In the sense that most people think of it, an investment bank is not a bank at all—insofar as it does not act as a lender or depository, but rather as a middleman and consultant. Most of an investment bank’s income comes from fees.

As a business becomes more successful, it is usually to its benefit to become a corporation (having originated as a partnership or proprietorship, most of the time). Most of the corporation’s stock is owned by the core of the company—its founders and various key employees—but a fast-growing company will need to expand beyond the funding capacity of those stockholders. Usually the first source of outside funds is obtained through private placements. These are stock issues that are extremely restricted and cannot be resold by their initial purchasers, and therefore do not have to be registered with the Securities and Exchange Commission (SEC). Nonregistered private placements are limited to 35 nonaccredited purchasers and an unlimited number of accredited investors, including the officers of the company, wealthy individuals, and institutional investors like banks, corporations, pension funds, and so on.

The next step in funding is to seek support from a venture capital fund, a private limited partnership that pools money from a group of (usually) institutional investors. The venture capitalists managing these funds are usually very knowledgeable in a particular industry, and limit their activity to that sector—the transportation industry, for instance, or food and beverages, or dotcoms.

IPOs

An initial public offering (IPO) of stock, which can then be traded on the secondary markets, may follow the venture capital stage. This is the principal activity of investment banks: helping companies go public. Investment bankers act as intermediaries to sell stock to their clients (a similar mix to the sort of investors interested in private placements), and help to determine the stock’s initial offering price, based on various factors and comparisons to similar companies and the performance of their IPOs. Once the stock has been sold, the investment bank assigns an analyst to maintain investors’ interest in it, regularly issuing reports on the stock’s prospects.

During an IPO, an investment bank can underwrite the issue or work on a best-efforts basis. When underwriting the issue, the bank purchases all of the offered stock and resells it itself, to guarantee that the company raises the money it seeks. This is usually the case. In a best-efforts sale, the bank makes no guarantees, only agrees to do what it can. From time to time, an underwriting investment bank misjudges the initial offering price, and is stuck with stock it cannot sell; it must pay the business within four days, while other investors have 10 days to pay for their stock. That is the risk the investment bank takes, and encourages them to thoroughly investigate the business going public—which, in turn, acts as a filter to encourage healthy business and healthy stock.

Since the New Deal created the Securities and Exchange Commission in 1933, investment banking services have been subject to significant regulation. All interstate public offerings over $1.5 million fall under SEC jurisdiction, and state agencies generally have relevant regulations of their own. Newly issued securities must be registered 20 days before their IPO, providing critical information to the government. After registration, representatives of the company and the investment bank go on a “road show,” making presentations to institutional investors to explain the merits of their company. The investment bankers will gauge investors’ interest in the stock at various prices, as part of the process of determining the initial offering price; if there are more interested investors than shares to go around, the price will usually be increased before the IPO. From time to time, the road show may lead to withdrawing the registration altogether, if there is too little interest in the company. During this period, nothing can be disclosed that is not already in the SEC’s registration forms, a situation that invites a lot of spin. This quiet period lasts until 25 days after the IPO.

Mergers And Other Activities

Another area in which investment banks are involved is in mergers—when two or more businesses combine into one business with management drawn from all the constituent businesses, more or less equally—and acquisitions, when one business assumes control of or absorbs another. Stockholders can respond to these situations in various ways, depending on the specifics; if a company becomes too diversified through the results of a merger or acquisition, there is typically a fear that it is no longer strong enough in its field, no longer specialized—a jack of all trades and master of none, when what stockholders want to invest in is mastery. (Stockholders love diversity, but in their portfolios, not the individual companies they invest in.) Ideally, what stockholders want to see from a merger or acquisition is synergy: when the whole becomes greater than the sum of its parts, because of economies of scale, tax benefits, financial benefits, increased efficiency, and increased market power. The Justice Department’s antitrust division regulates mergers and acquisitions to protect consumers, and keeps an especially close eye on them when the involved businesses are large or dominant in their industries.

Another investment bank activity is the leveraged buyout, in which a publicly held company is purchased in whole by an allied group of investors—which generally includes the company’s senior management, and may include outside investors who provide the necessary capital—and is then taken private. Leveraged buyouts may be motivated by the desire to take the company in directions that stockholders would consider too risky or otherwise undesirable, or as a way to remove current management. They are less common when the stock market is healthy (making a leveraged buyout more expensive).

Lastly, securitization is the transformation of a debt instrument into a publicly traded financial instrument, making it more liquid because of its ability to be bought and sold in open market. Home mortgages can be pooled, for instance, and used as collateral to issue bonds. Investment banks help to securitize debt instrument assets ranging from mortgages to automobile loans, credit card balances, and student loans.

History

Investment banking has a long history in the United States, originally involving the exchange of government and railroad-issued bonds. By the time of the Civil War, the American securities market had become more sophisticated, in response to the large amount of money changing hands thanks to the successes and changes of the Industrial Revolution, the so-called robber barons, and the various tycoons of industry like Andrew Carnegie. The Union funded its side of the war with the first mass-marketed securities (war bonds), and investment banks continued the practice after the war’s end. J. P. Morgan opened a banking house in New York principally to deal in gold, foreign currency, and securities, and later organized a syndicate to replenish the country’s gold reserve by issuing government bonds.

Before the Great Depression, most commercial banks offered some investment-banking services, but banking mismanagement was blamed as one of the several causes of the Depression. New Deal banking reforms required banks that participate in the Federal Reserve System to abandon the securities market by 1934, and prohibited certain members of securities firms from acting as officers of commercial banks. Many banks thus broke their investment banking services off into separate companies.

Once the Depression had been weathered, banking stayed stable until the 1970s, when inflation led to a series of bank failures and lengthy deregulation of many commercial bank activities. The 1999 Financial Services Modernization (FSM) Act allowed for the mergers of commercial banks, securities firms, and insurance companies, more or less repealing the earlier New Deal legislation, which soon led to the creation of companies like Citigroup (via a merger of Citicorp with Traveler’s Insurance, which itself owned Salomon Smith Barney, an investment bank). The Citigroup merger actually took place a year before the FSM Act, which was passed in time that Citigroup was not required to get rid of any of its services (there would have otherwise been a grace period in order to avoid radical overnight restructuring).

In 2008 the U.S. government intervened to prevent Bear Stearns from filing for bankruptcy. Later, it declined to bail out Lehman Brothers, which filed for Chapter 11 bankruptcy protection. Like other financial institutions then, Lehman Brothers had souring real estate investments and confronted tight credit markets.

Bibliography:

Eugene F. Brigham and Joel F. Houston, Fundamentals of Financial Management (South-western, 2009);
Michel Fleuriet, Investment Banking Explained: An Insider’s Guide to the Industry (McGraw-Hill, 2008);
Maretno Harjoto, Donald J. Mullineaux, and Ha-Chin Yi, “A Comparison of Syndicated Loan Pricing at Investment and Commercial Banks,” Financial Management (v.35/4, 2006);
Mathew A. Hayward, “Professional Influence: The Effects of Investment Banks on Clients’ Acquisition Financing and Performance,” Strategic Management Journal (v.24/9, 2003);
Thomas Liaw, Investment Banking and Investment Opportunities in China: A Comprehensive Guide for Finance Professionals (Wiley, 2007);
Thomas Liaw, The Business of Investment Banking: A Comprehensive Overview (Wiley, 2005);
Tom Lott, Vault Career Guide to Investment Banking (Vault, 2008);
Alan D. Morrison, Jr., and William J. Wilhelm, Investment Banking: Institutions, Politics, and Law (Oxford University Press, 2008);
Joshua Rosenbaum and Joshua Pearl, Investment Banking: Valuation, Leveraged Buyouts, and M&A Sale Process (Wiley, 2009);
Wiegler, “Banking with a Green Conscience: The Story of America’s First All-Green Investment Bank,” Engineering and Technology (v.3/11, 2008).

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