What is investment banking? The ultimate industry overview

Understanding investment banking

Investment banks assist in issuing new debt and equity securities, facilitate securities sales, aid in mergers, acquisitions, and reorganizations, and broker trades for institutions and private investors. They also advise issuers on stock offerings.

Numerous major investment banking systems are part of larger banking institutions or subsidiaries, with well-known names like Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank leading the industry.

In general, investment banks support significant and intricate financial dealings. They offer guidance on valuation and deal structuring for clients exploring acquisitions, mergers, or sales. Additionally, investment banks may assist in raising funds through securities issuance and prepare SEC documentation for companies aiming to become publicly traded. In principle, investment bankers are seasoned professionals who closely monitor the current investment landscape. Businesses and institutions rely on investment banks for advice on strategic development, as these bankers can customize their recommendations based on the prevailing economic conditions.

Investment banking and regulation

The Glass-Steagall Act, passed in 1933 following the 1929 stock market crash, aimed to prevent large-scale bank failures by segregating commercial and investment banking activities. This separation was viewed as crucial because the intertwining of these activities was seen as risky and potentially exacerbating financial crises, as seen in 1929 when banks struggled to honor withdrawals due to investments in the stock market.

Prior to Glass-Steagall, banks could use retail deposits for speculative ventures like stock market investments, which grew increasingly profitable but also endangered depositors' funds.

However, some in the financial sector found the Act's restrictions burdensome. Consequently, in 1999, Congress repealed Glass-Steagall through the Gramm-Leach-Bliley Act, effectively ending the separation between investment and commercial banks. This repeal allowed major banks to resume combined operations, encompassing both investment and commercial banking activities.

Illustration of investment banking

Imagine Pete's Paints Co., a hardware and paint supply chain, wants to go public. Pete, the owner, partners with José, an investment banker at a larger firm. They agree that José's firm will buy 100,000 shares of Pete's Paints at $24 per share for the IPO, a price determined by the investment bank's analysts.

The investment bank pays $2.4 million for the shares and begins selling them at $26 per share. However, only 20% of the shares sell at this price, prompting a reduction to $23 per share for the rest.

Ultimately, the investment bank makes $2.36 million from the IPO with Pete's Paints [(20,000 × $26) + (80,000 × $23) = $520,000 + $1,840,000 = $2,360,000]. This results in a $40,000 loss due to overvaluation.

Competition among investment banks for IPO projects can lead to higher prices paid to secure deals, potentially impacting profitability. Multiple banks often underwrite securities, reducing individual risk but also potential gains.

Understanding the responsibilities of investment bankers

Investment banks hire professionals who assist corporations, governments, and other entities in planning and overseeing significant projects. Their role involves identifying potential risks associated with projects upfront, ultimately saving clients time and money. Ideally, investment bankers are seasoned experts well-versed in the current investment landscape. Businesses and institutions seek their advice to strategize their growth effectively. Investment bankers tailor their recommendations based on their expertise and the prevailing economic conditions.

Understanding Initial Public Offerings (IPOs)

An initial public offering (IPO) is when a private company offers shares to the public for the first time, raising capital from public investors. To conduct an IPO, companies must meet exchange and SEC standards. Investment banks are hired to underwrite IPOs, handling all aspects from due diligence to marketing and issuance.

Underwriting an Initial Public Offering (IPO)

In essence, investment banks act as intermediaries between companies and investors during stock or bond issuance. They help in pricing financial instruments for optimal revenue and in navigating regulatory frameworks.

During an Initial Public Offering (IPO), an investment bank typically purchases a significant portion or all of the company's shares directly, then sells them on the market as the company's representative. This simplifies the IPO process for the company, essentially outsourcing it to the investment bank.

Additionally, the investment bank aims to profit by pricing shares above its initial purchase cost. However, this strategy involves substantial risk, as the bank may incur losses if it overvalues the stock and has to sell it below the purchase price. Despite employing skilled analysts to accurately price stocks, there's still a potential for financial loss in such scenarios.