Investment Banking 101 – What is an investment Bank and what are its functions?

Investment Banking 101 – Investment Bank and its funcions

The Investment Banking firms perform difficult financial tasks such as raising capital through public & private capital markets, managing risk of existing capital or undertaking Mergers and Acquisitions (M&A) related transactions. Apart from this, they provide finance to corporations through direct investments in corporate equity & debt securities, or in form of loans to corporate clients. They also help the government entities in raising funds and manage risk.

Individuals who work in an Investment Banking firm are called “investment bankers” and are generally categorized to work for a specific Product or for a specific Client Group (which focuses on a full range of products that the clients need).

The Investment Banks usually have three major divisions:- Investment Banking Division (which is the core division), the Trading Division and the Asset Management division. Each of the division is explained in detail below:-

1. Investment Banking Division :-

There are two key products offered by the Investment Banking Division, namely – M&A and Capital Markets. The M&A transactions are usually executed by the Client Coverage Group. Although, some Investment Banks have a dedicated M&A group of investment bankers that handle all the M&A transactions. The Capital Market products are further divided into two different products – Debt Capital Markets and Equity Capital Markets. The Capital Market products are offered by the Capital Market Group of the Investment Bank.

Client Coverage Investment Bankers Group :-

Client coverage investment bankers offer a complete range of products that the client requires. The Client Coverage Group is categorized on the basis of different industries which includes – consumer, industrials, healthcare, retail, pharma, financial institutions, real estate, media and telecom, technology and public banks.

Investment Bankers assigned to an industry are experts in that industry and understand the strategic and financing objectives of the companies in that industry. They guide the CEOs and the CFOs on corporate strategic problems such as wealth maximisation of the shareholders by enhancing the value of shares.

The investment bankers assist the companies to evaluate and achieve the optimum level of their capital structure, with an adequate amount of cash and debt on their balance sheet. This usually leads to a capital markets transaction where the company further issues/buybacks equity or debt securities in order to achieve the optimum capital structure.

Thus, the client coverage investment bankers understand a specific industry’s company’s problems and objectives in depth. They offer the complete package of services that are required by a corporation.

Other investment banking services are also be marketed by the client coverage investment banker to the corporations. The other services include risk management, foreign exchange risk management; credit rating and corporate restructuring.

Sometimes the clients of an Investment Banking firm prefer being served by investment bankers who work in their geographical proximity. Therefore, some client coverage investment bankers can be assigned to serve clients based on a geographic coverage rather than based on the type of industry.

Every investment banking firm coordinates the services of an industry-specific and geographic coverage investment bankers so as to meet the client’s preferences.

Capital Markets Group :-

The Capital Markets product group comprises of investment bankers who focus on either Equity Capital Markets or Debt Capital Markets. In a few Investment Banking Firms, both the groups coordinate their activities with each other while reporting to the same head/chief, who oversees all the capital market transactions.

While in most of the investment banks, these two groups report to different individual head/chief and work autonomously. When these capital market groups work as an issuer to raise capital, they work with a team comprised of a client coverage investment banker in conjunction with capital markets investment bankers.

The capital markets investment banker are the ones who execute the capital raising process which involves the following aspects – determining pricing, timing, size/quantity etc. of the transaction. The two divisions of Capital Markets Group is explained below:-

a.) Equity Capital Markets Group :-

Equity Capital Markets (ECM) Group comprises of investment bankers who are experts in issuing common stock, convertible securities, and equity derivatives. Issuing Common stock involves the following types of issuance – Initial Public Offering (IPOs), Follow-on Offerings (for companies that are returning to the capital markets for common stock offerings after issuing an IPO), secondary offerings (for major shareholders of a company who wish to sell large number of common shares and its proceeds are received by the selling shareholders and not by the company), and private placements (that do not require compliances with a regulator).

Issuing Convertible security usually involves issuing various forms of bonds or preference shares, which can be converted (either compulsorily or at the shareholder’s option) into a predetermined number of the company’s common shares. Issuing Equity derivatives helps the companies to raise or withdraw equity capital, or hedge equity risks with the use of options and forward contracts.

Investment Bankers in ECM group work closely with client coverage investment bankers for determining suitable companies to target/market for the equity-related products. After helping companies in deciding their financing goals, ECM group undertakes the responsibility of executing the capital market transaction. This also involves a close coordination with the sales and trading team of the Trading Division to determine the investment demand of their client base, which includes institutional and individual investors.

The ECM group acts as an intermediate between the Investment Bank’s issuing team who want to sell securities of their clients at the highest possible price and the Trading Division’s investing clients who want to buy the securities at the lowest possible price. This creates a challenge that requires considerable dexterity to balance competing interests within the two divisions of the Investment Banking firm.

b.) Debt Capital Markets Group :-

Investment Bankers of Debt Capital Markets (DCM) group focuses on the debt financing for companies and government agencies. Their clients are divided into two major categories – Investment grade and Non-Investment grade issuers. Investment grade issuers have a high credit rating from at least one of the major credit rating agencies. Non-Investment grade issuers have a lower credit rating and their debt offerings are often called ‘high yield bonds’ or ‘junk bonds.’

DCM group investment bankers yet again act as an intermediate between corporate/government clients debt offerings and the investors who purchase these offerings (handled by sales professionals of the Trading Division). Their role is to find the balance between the competing price objectives of issuing clients and investors while facilitating communication and executing the transactions.

Investment Bankers in DCM group work closely with client coverage investment bankers for determining suitable corporate and government clients and help these clients in deciding the timing, maturity, size and other aspects of the debt financing.

Mergers & Acquisitions Group :-

Some of the investment banks have a separate Mergers & Acquisitions (M&A) Group which is independent of the Client Coverage Group. Although, a majority of the investment banks, these two groups are blended. Regardless, most investment bankers specialize in one or more industries. Unlike the Capital Markets Group, which is a combined venture between the Investment Banking Division and the Trading Division at some Investment Banks, the M&A Group is the sole responsibility of the Investment Banking Division of an Investment Bank.

The main products of an M&A Group includes – (1) “sell side” transactions, which involve the sale or merger of an entire company or demerger of a division of a company; (b) “buy side” transactions, which involves purchasing of an entire company or a division of a company; (c) corporate restructuring that focuses on enhancing the shareholders value or dramatically changing a company’s capital structure in order avoid bankruptcy or facilitate a sell-side transaction.

M&A group investment bankers have the strong valuation, analytical and negotiation skills. They usually work directly with a company’s CEO, CFO or corporate development team.

2. Trading Division :-

The Trading Division of an Investment Bank is responsible for the following:-

  • All investment related transactions which involve institutional investors, including financial institutions, investment funds, and the cash management divisions of government and corporations
  • Taking proprietary positions in fixed income and equity products, currencies, commodities, and derivatives
  • Market making and clearing activities on securities exchanges
  • Principal investments made both directly and through managed funds. 

This division typically operates in three different business areas: (1) Fixed Income Securities, Currencies, and Commodities ; (2) Equities ; (3) Principal Investments. At some investment banks, Principal Investments activity is conducted by a different division. Research on economics, fixed income securities, commodities, and equities are also provided by the Trading Division to investing clients.

Fixed Income Securities, Currencies, and Commodities (FICC) :-

Fixed Income, Currencies, and Commodities makes markets/trades in government bonds, corporate bonds, mortgage-related securities, asset-backed securities, currencies, and commodities (as well as derivatives on all of these products).

Some firms are also involved in the provision of loans to certain companies and government. Investment Bankers who work in the client related area of this department are either traders, who price these products and hold them in inventory as a risk position or sales professionals, who market trade ideas and bring prices from the traders to investors to facilitate purchases and sales of the products.

Equities :-

The Equities department makes markets in and trades equities, equity-related products, and derivatives in relation to the bank’s client-related activities. The business generates commissions from executing and clearing client transactions on global stock, option, and futures exchanges. As is the case in FICC, individuals who work in the client related area of Equities are either traders or sales professionals.

Investment banks typically have a Prime Brokerage business that provides bundled services such as securities borrowing and lending, financing (to facilitate leverage), asset custody, and clearing and settlement of trades to hedge fund clients and other money managers. Prime brokers provide fund managers with a centralized location for the clearing of securities, reporting, and financing, while also allowing them to trade with other brokers.

Although initiated as an equity-centric business, Prime Brokerage has expanded its capabilities to many other asset classes (in step with the diversification of strategies employed by hedge funds). A large part of Prime Brokerage related revenue comes from commissions from executing and clearing client trades by the sales and trading professionals in Equities. Other revenue sources include earning spreads on financing and lending activities.

3. Asset Management Division :-

The Asset Management business offers equity, fixed income, alternative investments (e.g., private equity, hedge funds, real estate, currencies, and commodities), and money markets investment products and services to individuals and institutions.

Investments are offered in the form of mutual funds, private investment funds, or separately managed accounts, and are sometimes commingled with the bank’s own investments. Revenues are created principally based on fees that are paid by investors as a percentage of Assets Under Management (AUM), which vary depending on the asset class.

At times, investors pay an incentive fee to the investment bank when returns exceed a predetermined benchmark. Most firms have a Private Wealth Management business organized alongside the Asset Management business, reporting to the same division head. The professionals in the Private Wealth Management business act as advisors to investors, helping them decide how to invest their cash resources. In most cases (but not all), investors will be encouraged to invest in funds managed by the firm’s asset management teams.

Co-Investments in Asset Management Division Funds :-

Investment banks make direct investments in certain funds managed by their Asset Management Division. Within the “Alternative Assets” area of this division, investment banks invest in internally managed funds that focus on (1) private equity ; (2) hedge fund-type investments ; (3) real estate. Investment banks typically invest their own capital alongside the capital of their high net-worth individuals and institutional clients in these funds (and they charge investing clients both management fees and performance fees based on the clients’ AUM). This has become a very large business for some investment banks.

Udit Goswami

A finance enthusiast, Udit Goswami is a Chartered Accountant and an undergraduate from University of Delhi having worked in the field of Mergers & Acquisitions (Tax) for over 3 years.

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