Investment banking an overview

INVESTMENT BANKINGINVESTMENT BANKING

Investment bank is an individual or institution which acts

as an underwriter or agent for corporation and

municipalities issuing securities.

Most also maintain brokerage/dealer operations, maintain

markets for previously issued securities, and offer advisory

services to investors. Investment banks also have a large

role in facilitating mergers and acquisitions, private equity

placements and corporate restructuring.

Unlike traditional banks, investment banks do not accept

deposits from and provide loans to individuals. Also called

investment bankers.

Investment BankingInvestment Banking

Investment banking is concerned with the allocation of

financial resources. It works as an intermediary which

deals with how and why money is moved from those who

have it (investors) to those who need it (issuers).

In traditional sense, the role of investment banking is one

of intermediation in resource allocation.

Now-a-days, investment banking is meant include primary

market making, secondary market making, trading,

corporate restructuring, financial engineering, advisory

services, merchant banking, investment management,

consulting, clearing, research, internal finance and

information services.

Investment BankingInvestment Banking

Although investments banking and merchant banking

often are used interchangeably in Bangladesh, in the

USA merchant banking is used to denote only a very

small segment of investment banking activities.

Originally, merchant banks were established in the UK

to provide special service to the merchants. Gradually,

its activities expanded quite significantly over time.

History of Investment History of Investment BankingBanking

Glass-Steagall Act 1933

The modern concept of “Investment Bank” was created in the Glass-Steagall act (Banking Act of 1933). Carter Glass, Senator from Virginia, believed that commercial banks securities operations had contributed to the crash of 1929, that banks failed because of their securities operations, and that commercial banks used their knowledge as lenders to do insider trading of securities.Passed During the Great Depression

Glass Steagall Act separated commercial banking

from investment banking


Since then, investment banking had been narrowly

defined as those financial services associated with the

issuance or floatation of new (mainly corporate)

securities.

This definition confines its activities to primary market

making for securities.

At a little broader level, investment banking is also

understood to include secondary market making.


Controversy over Glass Steagall

Prof. George Benston showed that unregulated banks

have lower failure rate.

Other countries (Germany, Switzerland) have always

allowed universal banking

In 1990s, regulators nibbled away at Glass Steagall by

allowing commercial banks to engage in certain

securities operations


Graham-Leach Act 1999

President Clinton November 1999 signs Graham-

Leach Bill which rescinded the Glass-Steagall Act of

1933.

Consumer groups fought repeal of Glass-Steagall

saying it would reduce privacy. Graham-Leach calls for

a study of the issues of financial privacy

Permits Banking-Insurance-Securities Affiliations


Mergers among Commercial Banks, Investment Banks & Insurance Companies

Travelers’ Group (insurance) and Citicorp (commercial

bank) 1998 to produce Citigroup, on anticipation that

Glass-Steagall would be rescinded. Brokerage Smith

Barney

Chase Manhattan Bank (commercial bank) acquires JP

Morgan (investment bank) (2000) for $34.5 billion

UBS Switzerland buys Paine Webber (brokerage) 2000

Credit Suisse buys Donaldson Lufkin Jenrette

(investment bank) 2000


Investment Bank

Revenue Generating Activities Support Activities

Primary Market Making Corporate Finance Municipal Finance Treasury & Agency Finance

Clearing

Research

Internal Finance

Information Service

Secondary Market Making Dealer Activity Brokerage Activity

Trading Speculation Arbitrage

Corporate Restructuring Expansion Contraction Ownership and Control

Financial Engineering Zero Coupon Securities Mortgage-backed Secu. Asset-backed securities Derivative Securities

Other Activities Advisory Services Investment Management Merchant Banking Venture Capital Consulting

Functions of IB

Investment Banking IndustryInvestment Banking Industry

Relatively few firms dominate the market.

Oligopolistic competition.

Types of Investment BankingTypes of Investment Banking

Types by Size

• Bulge Bracket–(special bracket): Largest

investment banking firms with goodwill. Often their

names are printed larger and bolder on the public

offering announcements (called tombstones).

2. Major Bracket – They are the middle-sized firms

existing at the second tier.

3. Submajors and regionals – They are the small firms

existing at the third tier.

Types by Range of Service

1. Full Service Shops – provide full range of

investment banking services. Vary in their strengths.

Some are largely issuer-driven, some are largely

investor driven, some are essentially trading

organizations and some are primarily warehouses

(retail brokerage firms with large investor base).

2. Boutiques (also called specialty shops) –

specialize in just a few services.

Types of Investment BankingTypes of Investment Banking

Investment Banking vs. Commercial BankingInvestment Banking vs. Commercial Banking

In the USA, the Banking Act of 1933 (Glass-Steagall Act) prohibited the commercial banks to perform investment-banking activities. The main objective of this separation was to restrain the commercial banks from undertaking risky activities that may go against the interest of depositors.

However, because of the advancement of risk management, the prohibitions on securities underwriting had been relaxed. They were allowed to underwrite municipal general obligation bonds, industrial bonds and some corporate issues.

Now-a-days, both investment banks and commercial banks became players for the new range of services (as the Act did not restrict commercial banks to perform these functions).

These services include swaps, structured solutions (to solve financial problems), the Fed fund market, repurchase agreements (repos) etc.

In Bangladesh, commercial banks can perform the functions of investment banks.

Investment Banking vs. Commercial BankingInvestment Banking vs. Commercial Banking

Investment Banking vs. Financial EngineeringInvestment Banking vs. Financial Engineering

• Financial engineering is the lifeblood of financial innovation and a cornerstone of modern investment banking.

• Finance has been transformed from descriptive discipline to an analytical one.

• Financial Engineering can be defined as the development and the creative application of financial technology to solve financial problems, exploit financial opportunities, and to otherwise add value.

Security Market InstrumentsSecurity Market Instruments

• Fixed Income Instruments

• Equity Instruments

Fixed-Income InvestmentsFixed-Income Investments

• Contractual payment schedule• Recourse varies by instrument• Bonds

– investors are lenders– expect interest payment and return of principal

• Preferred stocks– dividends require board of directors approval

Savings AccountsSavings Accounts

• Fixed earnings• Convenient• Liquid• Low risk• Low rates• Certificates of Deposit (CDs)

- instruments that require minimum deposits for specified terms, and pay higher rates of interest than savings accounts. Penalty imposed for early withdrawal

Money Market CertificatesMoney Market Certificates

• Compete against Treasury bills (T-bills)

• Minimum $10,000

• Minimum maturity of six months

• Redeemable only at bank of issue

• Penalty if withdrawn before maturity

Capital Market InstrumentsCapital Market Instruments

• Fixed income obligations that trade in secondary market

• U.S. Treasury securities

• U.S. Government agency securities

• Municipal bonds

• Corporate bonds

U.S. Treasury SecuritiesU.S. Treasury Securities

• Bills, notes, or bonds - depending on maturity– Bills mature in less than 1 year– Notes mature in 1 - 10 years– Bonds mature in over 10 years

• Highly liquid• Backed by the full faith and credit of the U.S.

Government

U.S. Government Agency SecuritiesU.S. Government Agency Securities

• Sold by government agencies– Federal National Mortgage Association (FNMA or

Fannie Mae)– Federal Home Loan Bank (FHLB)– Government National Mortgage Association

(GNMA or Ginnie Mae)– Federal Housing Administration (FHA)

• Not direct obligations of the Treasury– Still considered default-free and fairly liquid

Municipal BondsMunicipal Bonds

• Issued by state and local governments usually to

finance infrastructural projects.

• Exempt from taxation by the federal government and

by the state that issued the bond, provided the

investor is a resident of that state

• Two types:

– General obligation bonds (GOs)

– Revenue bonds

Corporate BondsCorporate Bonds

• Issued by a corporation

• Fixed income

• Credit quality measured by ratings

• Maturity

• Features

– Indenture

– Call provision

– Sinking fund


• Senior secured bonds– most senior bonds in capital structure and have

the lowest risk of default• Mortgage bonds

– secured by liens on specific assets• Collateral trust bonds

– secured by financial assets• Equipment trust certificates

– secured by transportation equipment


• Debentures– Unsecured promises to pay interest and principal– In case of default, debenture owner can force

bankruptcy and claim any unpledged assets to pay off the bonds

• Subordinated bonds– Unsecured like debentures, but holders of these

bonds may claim assets after senior secured and debenture holders claims have been satisfied

• Income bonds– Interest payment contingent upon earning

sufficient income


• Convertible bonds– Offer the upside potential of common stock and the

downside protection of a bond– Usually have lower interest rates

• Warrants– Allows bondholder to purchase the firm’s common

stock at a fixed price for a given time period– Interest rates usually lower on bonds with warrants

attached• Zero coupon bond

– Offered at a deep discount from the face value– No interest during the life of the bond, only the

principal payment at maturity

Preferred StockPreferred Stock

Hybrid security• Fixed dividends• Dividend obligations are not legally binding, but

must be voted on by the board of directors to be paid

• Most preferred stock is cumulative• Credit implications of missing dividends• Corporations may exclude 70% of dividend income

from taxable income

International Bond InvestingInternational Bond Investing

Investors should be aware that there is a very substantial fixed income market outside the United States that offers additional opportunity for diversification

• Bond identification characteristics– Country of origin– Location of primary trading market– Home country of the major buyers– Currency of the security denomination

• Eurobond– An international bond denominated in a currency not

native to the country where it is issued

International Bond InvestingInternational Bond Investing

• Yankee bonds– Sold in the United States and denominated is U.S.

dollars, but issued by foreign corporations or governments

– Eliminates exchange risk to U.S. investors• International domestic bonds

– Sold by issuer within its own country in that country’s currency

Equity InvestmentsEquity Investments

• Returns are not contractual and may be better or worse than on a bond

Common Stock

– Represents ownership of a firm

– Investor’s return tied to performance of the company and may result in loss or gain

Corporate Finance: Underwriting And Corporate Finance: Underwriting And SyndicationSyndication

Primary market making is one of the basic functions of investment banking.

As primary market maker, the investment bank acts as an intermediary between a business or government enterprise that requires financing and persons or institutions that have funds to invest.

IssuerInvestorsInvestment

Banker

Securities

Corporate Finance: Underwriting And Corporate Finance: Underwriting And SyndicationSyndication

Three Distinct Functions of Investment Three Distinct Functions of Investment BankerBanker

1. Origination: It involves development and registration of securities.

2. Underwriting: It involves purchase of securities from the issuer by the underwriting syndicate for subsequent sale to the public.

3. Distribution: It involves the final sale of the securities to the public.

Factors affecting the Role of Factors affecting the Role of Investment BankInvestment Bank

The precise role of investment bank in origination, underwriting and distribution depends on a number of factors. These include:

i. The type of issuer – Corp., Treasury, Govt Agency, Municipality

ii. Where issued – USA or International– registration/shelf-registration

iii. The type of security– exemption from registration (e.g.,com. paper)

Corporate FinanceCorporate Finance

Corporations issue different types of securities:

- Equity Security – Common stock

- Hybrid Security – Preferred Stock

- Debt Security – Mortgage bond, debenture or notes, commercial papers etc.

Two fundamental ways to intermediate issuers and investors.

- Public Offering, where securities that are issued are offered for sale to the public investor.

- Private Placement, where the securities are placed, through negotiations, in the hands of a small group of sophisticated, usually institutional investors.

Ways to intermediate issuers and investorsWays to intermediate issuers and investors

For making public offering, issuers must satisfy a number of well-defined criteria and in Bangladesh, an issuer has to get the prospectus approved from the Securities and Exchange Commission (SEC).

The public offering process involves a tedious, sometimes complex and time-consuming undertaking that can expose the corporate officers and directors to

financial and even criminal liabilities.


For this reason, issuers employ investment bankers (a) to perform due diligence and

(b) to understand what information investors want and need to know to make a reasonable investment decision.

This is the originating phase. Following this, the investment banker works in the capacities of underwriter and distributor.


Investment Banker’s Role in the IPO Process

Origination Underwriting Distribution

Investment Banker’s Role in IPO ProcessInvestment Banker’s Role in IPO Process

The Public Offering ProcessThe Public Offering Process

1. At the first step, the investment bank negotiates a mandate to “do the deal and prepares the issuance to the satisfaction of the SEC. This part of the process is called origination. The process involves an investigation of the issuer, preparation and filing of required documents, and organization of an underwriting syndicate.

2. In the underwriting phase, the investment banker negotiated, on behalf of an underwriting syndicate, with the issuer for (1) an offering price for securities and (2) the size of the issuance. They must also negotiate the underwriting spread – the difference between the offering price to the public and the proceeds to the issuer. This is also known as the gross spread or underwriting discount.

3. In the distribution phase, an underwriting syndicate and an affiliated selling group distribute the securities to the public. Together, the underwriting syndicate and the selling group constitute the distribution syndicate.

The Public Offering ProcessThe Public Offering Process

OriginationOrigination

Investment banking, particularly primary market making, has long been a very “relationship oriented” business. Corporations used to get the service of the same investment bank.

This has changed in recent years particularly due to the advent of shelf registration. Now-a-days, the preparation of securities for issuance and the subsequent underwriting and distribution of those securities and not strongly linked.

The separation of issuance preparation from underwriting and distribution allows competition among underwriters. This had reduced the floatation cost significantly.

But preparation of issuance is still a very relationship-driven business. Because it requires the investment banker to have detailed knowledge of the firm and its management. This knowledge takes time and considerable energy to develop.

Reasons for approaching investment bankersReasons for approaching investment bankers

(a) Assistance in issuing securities;

(b) Cashing our the shares of a privately held grown up firm;

(c) Acquiring capital to effect a transition of ownership and control –as in the case of the sale of junk bonds to finance an LBO.

(d) Altering the capital structure – the debt-equity ratio. Firms leverage up when earning prospect is high and leverage down when debt load is heavy compared to earning prospect.

Steps for Issuance PreparationSteps for Issuance Preparation

1. First, the investment banker must perform a very thorough investigation of the issuer. This is called due diligence investigation.

2. Second, a primary filing with the SEC may be required.

3. Third, after addressing the concerns of the SEC, a preliminary prospectus is prepared.

4. Then, a second and final filing with the SEC is made. At this point, the origination phase is complete.

Due Diligence InvestigationDue Diligence Investigation

A firm making public offering of securities should make a reasonable effort to disclose to potential investors all material information, otherwise the may be held liable for its absence.

The responsibility for due diligence investigation, together with financial liability, extends to the underwriter as well.

Primary responsibility for the due diligence investigation generally falls on the investment bank that will subsequently manage the underwriting syndicate. This firm is referred to as the lead underwriter, the lead manager, or the boo-running manager.

Often, on or more additional investment bank will share some deal management responsibilities. They are referred to as co-managers.

The potential liability associated with the due diligence investigation compels the investment bankers to dig deep and ferret out all material information. The opinion of Chartered Accountant is an integral part of the process.

The disclosure of information required in this process may lead to a conflict between investment banker and issuing firm. Because, the firm had probably never had to disclose all material information and they have to disclose a great deal of information that they consider confidential and competitively sensitive. Moreover, the investment banker will probably downplay all rosy projections.

The role of investment banker in this process is paradoxical. On the one hand, investment banker represents the firm and is being paid by the firm; it needs to present the firm favorably to preserve the relationship with the firm. On the other hand, the bank is ever conscious of its legal responsibilities and the potential liabilities for misstatement and misrepresentations.

Investment banks are required to perform a reasonable investigation of the issuer. But the definition of the term reasonable investigation is little cloudy.

Due Diligence InvestigationDue Diligence Investigation

The SEC Filing ProcessThe SEC Filing Process

In the USA, it consists of two parts:

1. Preliminary prospectus (or a red herring) – It is the principal document used by investors in evaluating the offering and is the only marketing document used by the underwriters.

2. Exhibits including legal documents and a draft of the underwriting agreement.

Acceptance of the registration by the SEC does not constitute an endorsement of the securities by the SEC.

While the registration process is progressing,

a. An underwriting syndicate is formed.

b. Arrangements are to print the red herring in large quantities for distribution.

c. Share certificates are printed.

d. Roadshows are arranged.

UnderwritingUnderwriting

Three forms:

a. Firm commitment

b. Best Efforts

c. Standby Underwriting

a. Firm commitment: Underwriters guarantee that they will sell a specified minimum quantity of issuance at the offer price. If they fail to sell the quantity, they must take it themselves. - An insurance against issue failure. - The risk is transferred to the underwriter.- The underwriting spread is generally higher.- But the issuer may become biased to make underpricing.

- This may create a natural friction between issuer and underwriter.- Most of the deals are on firm commitment basis.


b. Best Efforts:

Underwriters do not make any guarantee. They simply sell securities.

Unsold securities are returned to the issuer.

c. Standby Underwriting:

Standby underwriting is employed when the issuer makes right offering and uses the underwriter only as a backup for any securities not taken through the right offering.


DistributionDistribution

New issues of securities are distributed through the distribute syndicate. It includes both the underwriting syndicate and the selling group.

The primary purpose of the distribution syndicate is to distribute the securities as quickly as possible.

The speed is important, because between the time of commitment to the offer price and the time of actual sale in the market, the market price may decline. (But benefit cannot be sought from a price rise.)

Faster the distribution, better off the underwriters.

They often try to make the distribution syndicate large. Because if each participant receives a small portion of total issuance, they can participate in many issuances. This makes them diversified across securities and reduces the risk.

Distribution of securities:For the purpose of allocating the revenues from the

underwriting and distribution, the syndicate is divided into three groups:

a. The managers, who sell the majority of shares.b. The preferred group of dealers, responsible for a bulk of the

distribution.c. The non-preferred group dealers.


The lead underwriter is expected place a stabilization bid in the market. (To offer same price for all at least for a time).

Sometimes over-allotment option is given to the underwriter that puts the underwriter in the Green Shoe.

- It allows the underwriter to issue additional shares up to a stipulated amount (usually 5 to 15 percent) if the issue is well received by the market.


Division of RevenuesDivision of Revenues

a. Management Fee: It goes to the managers for their role in preparing the offering. This fee is a partial compensation for due diligence investigation.

b. Underwriting Fee: To cover the miscellaneous costs of underwriting – advertising, legal expense, stabilization expense, postage and others.

The remainder is distributed among the syndicate members based on the their level of participation.

c. Selling Concession: To the syndicate based on the number of shares they are responsible for selling.

Shelf RegistrationShelf Registration

In a shelf registration (or a shelf) the issuer prepares an offering in the usual way, but the filing is good for two years. This is in contrast to traditional registration in which filing is good for a very short period of time.

The firm may issue new securities with a 24 hours notice to the SEC.

The major advantages are:1. It allows the firm to get the costly and time-consuming part

of the issuance process over and done with in one shot.2. It allows the firm to come into the market on a very short

notice in order meet the unexpected needs and to exploit any windows of opportunities that might arise.

In Bangladesh, there is no provision for shelf- registration.

Offshore Markets & Dual SyndicationOffshore Markets & Dual SyndicationThe derivative markets allow a firm to raise money in almost any

country and currency by selling securities to investors and swapping these liabilities into desired currency.

For example, a US firm may sell dollar-denominated bonds in the Eurobond market. If it is not sold in the USA, it does not require an SEC registration in the USA. Later on, seasoned issues can be offered in the USA.

A dual syndication is one in which two separate syndicates are employed – one for distribution in the USA and the other for distribution outside the USA.

Special terms: Yankee bonds: Dollar denominated bonds issued in the USA by

any non-USA firm. Samurais: Yen denominated bonds issued in Japan by non-

Japanese firms. Bulldogs: Sterling denominated bonds issued in the UK by non-

British firms.

Syndication DepartmentSyndication Department

The syndication department of an investment bank is responsible for assembling the underwriting syndicate and for helping to select the selling group in cooperation of the issuing firm.

It maintains close ties with many broker/dealer firms, known collectively as the street.

The syndication department plays an important role in working gout problems and conflicts that occasionally arise between members of syndicate.

Seasoned Public OfferingSeasoned Public Offering

Seasoned public offering is a new offering of securities to the public by a firm that has already issued securities.

Three distinct types of seasoned public offering:

a. Primary seasoned offering

b. Secondary public offering (secondary placement):

c. Combined offering

a. Primary seasoned offering: An offering of a new issue by a firm that has already done an IPO.

Its primary purpose is to raise new capital for the firm.

b. Secondary public offering: A public offering of securities that are purchased by the underwriters directly from the pre-public owners and not from the firm.

Usually used by firm’s founders, other pre-public owners and some post public holders of securities to cash out of the firm.


c. Combined offering: It is partly primary and partly secondary. It is used to both raise new capital for the firm and to cash out some of the pre-public owners.

- Often it is difficult to persuade the investors that the stock is attractively priced when insiders are selling out.

Many underwriters do not handle a public offer that includes the sale of securities by owners.As an alternative, the owners could simply sell in the secondary market through broker/dealer. But this may send a negative signal to the market.


Economy & Finance

Investment banking an overview