What is an Investment Bank

Introduction:

An investment bank's primary role is to act as an intermediary between a corporation and the financial markets. They advise clients (corporations, governments, and other financial institutions) on important strategic decisions such as: issuing stock through and IPO, debt financing, derivative products, or M&A transactions. Due to the size of the transaction’s investment banks advise on, although their services require only a small percentage fee, these investment banks still earn billions in annual revenue. For example, let’s say an investment bank charged 1% fee of AOLs $182 billion acquisition of Time Warner for its advisory services, that investment bank would receive $1.82 billion from that one transaction they advised on!

Case Scenario:

To paint a clearer picture of what they do, let us think of a hypothetical transaction that an investment bank may advise on. Let’s say Coca Cola wants to buy another beverage company. They may want to do so to diversify their product range or benefit from additional knowledge of drink production. Coca Cola may go to an investment bank, who will start looking for companies. They may find a few companies who fit Coca Cola’s criterion and will start meeting with these target companies. They may pick one company who fits the acquisition strategy best and begin working on predicting the future benefits and costs of the acquisition. When deciding the valuation of the acquisition, banks will spend a lot of time on ‘financial modelling’ which tries to capture a fair price for the target company. Many different techniques are used for this financial modelling such as ‘DCF’ analysis or ‘Comparable’ analysis. Once negotiations have taken place and management teams are happy, the deal will go through, and the two firms will integrate. This is what happened when Coca Cola bought Innocent Smoothies in 2013 for about £100 million and is an example of a mergers & acquisitions (M&A) deal. However, banks offer a variety of other services as well.

The variety of services a given investment bank offers depends on its size. For example, a bank such as JP Morgan who are the largest bank by market capitalisation and have over 1,600 managing directors will offer just about any service you can think of. These are called bulge bracket or full-service investment banks. On the other end of the spectrum, we have smaller investment banks which specialise in a small range of services. These are called boutique investment banks. For example, Torch Partners, who have a grand total of just 6 managing directors, are a very small bank specialising in M&A advisory within the technology sector.

Services offered by investment banks:

Full-service bulge bracket investment banks, like JP Morgan, will offer the following services: raising capital, M&A, sales & trading, equity research and asset management.

Considering these in turn:

• Raising capital is where a bank may help a company raise money through, for example, debt or listing themselves on a stock market. They may want to do so to expand existing operations, or to acquire another company.

• M&A is what we saw with the Coca Cola example - companies merge with or acquire other firms to benefit from accelerated growth, economies of scale and expertise sharing.

• Sales & trading is where investment banks facilitate the buying & selling of securities such as shares in a company, corporate bonds, or more complicated financial products such as collateralized debt obligations (CDOs) which were roundly blamed for the 2008 financial crisis.

• Equity research is where investment banks will provide advice to, say, a teacher pension fund on whether or not to buy a specific stock.

• Asset management is similar to equity research however, the bank will actively purchase investments on behalf of clients instead of just advising them on investments.

Conclusion:

Although we have touched on the type of client’s investment banks offer services to, you may still be wondering who is paying these investment banks. Investment banks mainly advise companies, governments, hedge funds, pension funds and other financial institutions. For example, an investment bank may help a state-owned pension fund for teachers in Chicago decide what securities will yield the highest returns, or what company a major private equity fund should acquire. These advisory services yield very high revenues for investment banks, such as JP Morgan who raked in $115 billion in 2019.