LEGAL SIDEPIECE

Have you ever wondered about the meaning of the terms – ‘Investment banking’ and ‘Investment banker’? In this article, we explain these terms in the simplest manner.

What is Investment banking?

Investment banking is a distinct subset of the banking or financial sector that deals with providing companies, governments and other institutions with capital by offering financial advisory services such as underwriting, mergers and acqusitions (M&A), asset management and other related consultancy services. These investment banks, offer financial advice to their clients doing business in the capital market.

In this regard, the capital market provides capital to corporations through the sale of stocks (equities) or bonds and the investment banks act as the intermediaries between the investors (who are desirous of investing their money) and corporations (who require capital to run their businesses).

Investment banks are popular for offering two services – Underwriting and M & A Advisory services.

Underwriting: This involves raising capital through the sale of stocks or bonds to investors. In providing underwriting services, investment banks help businesses raise capital in the following ways-

• The investment bank acting as the underwriter agrees to buy the entirety of the company’s shares and assumes full financial responsibility for any unsold shares. This provides immediate capital for the business.
• The investment bank as the underwriter undertakes to sell as much of the issued shares as possible at an agreed price but is at liberty to return any unsold shares to the issuing company without any financial liability. In certain circumstances, the investment bank may commit to selling all the issued shares at an offering price and if all the shares cannot be sold off as a lot, the transaction falls through, and the issuing company receives no payment.

M & A Advisory services (Mergers & Acqusitions): M & A advisory deals with helping corporations and institutions identify, evaluate and finalise on the acqusitions of businesses. In offering this service, investment banks leverage their extensive networks and business acumen to find opportunities and negotiate on behalf of their clients.

Transactions involving mergers and acqusitions usually has two sides of the bargain – the buy-side and the sell-side. On the buy-side, involving a company wishing to acquire another company or where a company is offered for sale, the investment banks can provide company valuations that determine the price at which the company may be sold. They also offer advice on the value of the company being acquired as well as the most favourable way to structure the deal.

On the sell-side, involving a company targeted for acquisition, the investment bank can determine a reasonable asking price for the company, and advice their client on favourable or unfavourable structures of the sale.

According to the Corporate Finance Institute, the process of M & A involves – Acquisition strategy> Acquisition Criteria> Searching for Target> Acquisition Planning> Valuing & Evaluating> Negotiation> Due Dilligence>Purchase & Sales Contract> Financing> Implementation.¹

What does an Investment Banker do?

An investment banker is a financial professional who works with an investment bank. Generally, the job role of an investment banker would depend on the department of the investment bank they work in. They could be analysts, business valuers or persons in charge of the administration of the investment bank.

However, the primary function of an investment banker would be to perform the following:

1. Investment bankers facilitate large financial transactions. These transactions may include; structuring an acquisition, merger or sale of a company.
2. An investment banker is also responsible for issuing securities as a means of raising capital. This process involves creating a detailed documentation for the Securities and Exchange Commission (SEC) necessary for a company to go public.
3. The investment banker also helps the client save time and money by identifying the risks associated with a particular project before a company takes further action on the project since they are experts in their field and aware of the prevalent investment trends.
4. Investment bankers also assists with pricing financial instruments and navigating regulatory requirements.²

How do Investment Banks make Profit?

Investment banks make profit by charging a fee for their financial consultancy services. Nevertheless, considering that investment banks primarily focus on underwriting and M & A services, let us consider how they make money from these services.

■ Through Initial public offering (IPO): In this case, the investment bank acting as an underwriter will buy all or much of a company’s shares and subsequently sell these shares to the public at a markup. For example, suppose that BC Ltd wants to go public. The owner of BC Ltd would get in touch with an investment banker we can call Peter. Peter and BC Ltd reach a bargain in which Peter (acting on behalf of his firm) agrees to buy 100,000 shares of BC Ltd for the company’s IPO at the price of $26 per share based on the recommendations of his analyst team. The investment bank would then go ahead to pay BC Ltd the sum of $2.6 million for the 100,000 shares. On the day of the IPO, Peter’s firm sells the shares to the public at a higher price than it paid to make a profit.

Experienced analysts at the investment bank use their expertise to price the stock accurately otherwise an investment banker can lose money on the deal if they have overvalued the shares. This is why investment bankers and their firms take on a high level of risk during an IPO. Following, the above example, if the bank’s analyst has overvalued the shares, resulting in low demand for the shares, the firm might not be able to sell all the shares at the estimated price and would be forced to reduce the price in order to sell-out. Thus, eventhough BC Ltd would still receive $2.6 million, the investment firm could incur a loss on the sale.

Alternatively, Peter’s investment bank, could sell the shares on behalf of BC Ltd and earn a commission on each share.

Through M & A: M & A transactions usually involves two investment banks working on the buy-side and sell-side of the transaction. At the inception of the transaction, both companies may not be certain about the right price and possible benefits or losses of the deal. This would then require that they contact their investment bankers. These investment bankers, in turn, would go through the process of due dilligence to ascertain the value of the company, prepare necessary documents and advice on the right timing of the deal.³

In this transaction both investment banks will make money on commission and the bigger the deal size, the higher the commission the investment bank will earn.

Conclusion

Investment banks are a great resource for start-ups and companies in their early stage of growth because they can offer the best financial advice which would help these category of companies structure their long-term financial goals and position themselves for entry into the public market.

Reference List:

1. Vipond, T. Investment Banking Overview. Corporate Finance Institute <https://corporatefinanceinstitute.com/resources/career/investment-banking-overview/nyc&gt; Accessed 10 March 2024. ↩︎
2. Kagan, J. Investment Banker: What they Do, Required Skills and Examples. Investopedia <https://www.investopedia.com/terms/i/investmentbanker.asp&gt; Accessed 10 March 2024 ↩︎
3. The Economic Times. What is Investment Banking <https://m.economictimes.com/definition/investment-banking&gt; 10 March 2024. ↩︎