Investment banks are a special financial institution that works as intermediaries between businesses and the financial markets. Investment banks help 1) entities who have the intent to invest their money to earn a return; 2) institutions who need money to raise capital.
Many people think that the primary function of an investment bank is to make investments. However, it is worth noting that an investment bank is not an investment institution and hardly takes investment as its primary business.
Rather, an investment bank is a financial institution that provides various services for investment. Its core business is financing and Trading, and it also provides consulting, research, asset and wealth management, as well as other related financial services.
From the perspective of buyers and sellers in traditional financial markets, an investment bank is a typical sell-side institution (financial service provider).
Investment banks emerged in the United States after the Great Depression of the 1930s. Back then, there was little financial regulation, and as a result, banks could conduct nearly all financial-related activities.
Banks collected deposits from depositors, helped large companies with financing, and provided various market-making services. However, over time, various risks began to be exposed gradually, and the deposits of depositors could not be guaranteed.
After the Great Depression, the United States passed the Glass-Steagall Act, which strictly separated investment banks from commercial banks and prohibited commercial banks from using depositors' funds to participate in the investment banking business.
As a result, modern investment banks began to take shape. The main difference between investment and commercial banks is that they cover different parts of the financial market.
Commercial Banks
Commercial banks mainly cover the money market, accepting deposits and granting loans. Their clients are mostly individuals like you and me, as well as small- and mid-size businesses.
Their profit primarily comes from the interest difference between deposits and loans.
Investment Banks
Investment banks mainly cover the capital market, serving large, publicly traded entities. Their primary sources of income come from various underwriting, consulting fees, and commissions for market-making transactions and brokerage businesses.
Investment banks are generally divided into:
- Investment Banking Division (IBD),
- Sales and Trading,
- Research,
- private banking,
- Quant,
- and other support departments.
What is Investment Banking Division?
As its name suggests, IBD is a division of investment banks. (Note: When people talk about investment banking, they mostly refer to IBD.)
Investment banking services include facilitating initial public offerings (IPOs), helping with additional stock offerings, executing mergers & acquisitions (M&A), and other services for companies that need to raise funds through the listing.
IBD is generally divided into Product and Industry/Sector Groups.
Product Group is usually classified into three major parts: mergers and acquisitions (M&A), leveraged financing (LevFin), and restructuring. People in this group need to be equipped with specific product knowledge and act as the executors of various transactions.
Product Group:
Mergers and Acquisitions (M&A): Advising on mergers and acquisitions transactions.
Leveraged Finance (LevFin): Provides loans to businesses that need to make acquisitions.
Equity Capital Markets (ECM): Advising equity and equity derivatives markets (e.g., shares, options, futures).
Debt Capital Markets (DCM): Advising on raising and structuring debt to finance acquisitions.
Restructuring:Restructuring companies to be more efficient and profitable.
Rather than deeply understanding individual industries, bankers in the Product Group must be familiar with a merger or LBO model.
M&A Advisory and Capital Raising
TheM&A Advisory and Capital Raisingcan further be categorized into two i.e debt financing nd equity financing for a better understanding.
- Debt Financing:
When a corporation or government needs to borrow to raise funds, they would typically reach out to an investment bank. The loan forms generally include the following:
1. Loans:
Funds provided directly by banks, usually secured by fixed assets;
2. Notes/Bonds:
They usually are funded by bond investors/buyers (such as investment funds). Bonds can be publicly traded;
3. Convertible Securities:
Convertible securities allow investors to convert their bonds into shares in the future at a predetermined exchange rate.
So how does IBD help clients who need to borrow?
Debt Capital Markets or Leveraged Finance Group in the Product Group first provide borrowers with market information and help design the structure of the bond, allowing clients to understand the "reasonable" structure that attracts investors.
Later, many investment banks would help clients find large potential investors, build investor interest, underwrite transactions, and assist with regulatory filings.
The Industry Group then analyzes the impact of debt on clients from a financial and business perspective. They work to:
- Provide clients with industry-related research
- Produce marketing documents
- Present industries and companies to investors
- Help provide regulatory- and compliance-related materials
Investment banks not only use their expertise to advise companies but also leverage their resource network to help customers raise funds. It is worth noting that some large banks also provide funds for borrowing companies.
- Equity Financing:
Clients (governments or companies) intend to sell part of their shares for financing (so-called equity financing) and will also seek help from investment banks. Public equity financing includes the following offering types:
1. Initial Public Offerings (IPOs):
A private company raises money from the public for the first time through a new stock issuance;
2. Follow-on Offerings:
A company raises funds from the public again after its IPO;
3. Private Placement:
In addition to public trading, investment banks sometimes help clients raise funds through private placements. It is a sale of stock or bonds to a small number of pre-selected institutional investors (such as insurance companies or pension funds).
The main advantage of the private placement is that less information is disclosed to the public, and the regulatory requirements are less stringent.
The responsibilities of the Industry Group and Product Group here are very similar to those of debt financing.
In addition to completing the design and valuation of the equity structure, investment banks also cooperate with their corresponding capital market departments to complete buying and selling of financial products in the secondary market.
Underwriting
Underwriting is a process whereby a securities issuer entrusts a financial institution with securities sales qualifications, and the financial institution raises funds for the issuer in the form of equity or debt securities.
Underwriting is an important business for large investment banks such asGoldman Sachs.
Essentially, investment banks serve as intermediaries between issuers and investors, as they ensure the buying public commits to investing in the issue of securities before the securities hit the market.
Below are some key functions of underwriters:
- Identify the investment rationale and investor demand
- Formulate the method and the structure of an offering
- Set price for the new securities
- Sell the new securities
- Stabilize prices in the aftermarket
Underwriters profit from the spread between the price they buy the securities and the price they sell them to the market. Underwriters often form a syndicate to share risks and help sell the issue. A lead manager in a syndicate is responsible for pricing the securities.
There are two main types of underwriting commitment:
Firm Commitment
A firm commitment is the most common type of underwriting commitment in the US.
In a firm commitment, the issuer sells the entire issue to the underwriting syndicate, which then resells the issue to the public.
The underwriting syndicate makes money on the spread. However, the syndicate also bears the risk of taking full financial responsibility if they fail to sell the entire issue.
Best Efforts
The underwriter makes a “best effort” to sell the securities at an agreed-upon price. However, the issuing company bears the risk of the issue not being sold.
The offer may be pulled if there is insufficient interest at the offer price. If the offer is pulled, the company will not only not raise any capital but also will incur substantial flotation costs. This method is not as standard today as it was in the past.
Mergers & Acquisitions
If a company plans to acquire another company, investment banks can help them do research and make critical decisions such as who to acquire and how to acquire them. This involves the valuation of the target company and a long process of preparation and negotiation.
The Product Group and Industry Group are responsible for different things throughout the M&A process:
The M&A Group in the Product Group and the Restructuring Group are generally responsible for designing the transaction structure, helping execute the entire transaction, and assisting with regulatory compliance work.
The Industry Group mainly researches and advises on acquisition targets. They also do due diligence, model valuations, and make recommendations for financial impact.
Industry Group:
The Industry Group mainly focuses on a specific field (such as technology, retail, oil, gas, media, financial institutions, medical insurance, etc.) Bankers in this group need to have in-depth industry knowledge in various fields.
In the Industry Group, it is common for one analyst to cover multiple industries, and the work is more about marketing activities (pitching) than in the Product Group.
Why IBD?
The reasons for choosing or opting for an IBD are:
1. Comprehensively enhance soft power.
An IB position allows you to be under the immersion in a large amount of market information and financial dynamics, preparing you to become sharp finance professional and enhancing your soft power.
Soft power can help one efficiently manage their own time, handle multiple tasks simultaneously, and be able withstand pressure.
2. Quickly build a powerful professional network.
The reason why lots of people want to work in investment banking is that they hope to establish a powerful professional network that will be crucial for their future career development.
Investment banking opens up a lot of doors for young professionals. It provides new graduates exposure to different business models and industries and opportunities to work with the largest companies in the world.
Investment bankers often move to other fields after a few years of IB's rigorous, high-intensity grill.
3. Continued personal and professional development
Investment banking is for you if you enjoy working in a fast-paced environment and have a steep learning curve.
As an investment banker, one must proactively keep up with the latest market trends to provide clients with effective investment strategies in the volatile financial market. Therefore, continuous knowledge acquisition is the most basic requirement for people in IB.
In addition, a new graduate can also learn how to dynamically work with different teams working in IB. Often, working on a project in IB involves collaborating across different teams, learning about various products, and communicating directly with top executives in significant industries.
4. Quickly understand business insights and clarify various business models.
Investment banking is probably the only profession that gives new graduates the opportunity to understand the dynamics of different industries and learn the details of company operations in a short period.
Investment banking projects involve a lot of non-public information and important decisions made by senior officials of large corporations. As an IB analyst, you can learn a lot of knowledge that other financial positions do not provide.
Essential skills for IBD
To be successful in an IB position, you will need to have the following skills:
1. Technical: Financial Modeling & Company Valuation Analysis
Technical skills include basic accounting skills and the ability to predict future company operations.
You should be able to understand and analyze the Income Statement, Balance Sheet, and Cash Flow Statement and be able to link the three tables together.
Furthermore, you also need to be proficient in financial modeling. This requires a deep understanding of various financial ratios and profitability metrics.
In addition, it is important to have the sound judgment of a company’s operating capabilities and a deep understanding of industry trends.
2. Smart & Quick Learner
Investment banks are known to favor intelligent individuals, especially those who have strong analytical skills and who can quickly learn and apply new concepts. An ideal investment banking candidate should possess both intellectual curiosity and agility.
Investment bankers must evaluate investments, analyze financial statements and assess market data. In addition, they are responsible for generating reports and translating complex information into understandable languages for highly demanding clients.
Hence, being able to examine data and make logical conclusions is crucial for potential candidates.
3. Discipline & Work Ethics
Investment banking is an industry that recruits a wide range of talents; not only those with a finance degree are suitable for investment banking.
If you want to stand out in a high-pressure working environment, you must be someone who can plan your time efficiently and has a strong work ethic. Usually, people with a legal, athletic, or military background are highly sought after by investment banks.
4. Strong interpersonal skills
Investment banking is a people business, and it is about building relationships. Therefore, having strong interpersonal skills is a must.
If you would like to learn more about IB interviews, here is theInvestment Banking Interview 400 Question, and make sure to check out our course below. It is developed by Wall Street professionals to guide you through your interview preparation process:
Researched and Authored by Yihan Du|LinkedIn
Reviewed and Edited by Hongmo Liu|LinkedIn
Uploaded and revised byOmair Reza Laskar|Linkedin
Free Resources
To continue learning and advancing your career, check out these additional helpfulWSOresources:
- Financial Analyst Job Description
- Investment BankingOverview
- Managing Director (MD) Job Description
- Type A personality
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I'm an expert with a deep understanding of investment banking, having worked extensively in the field and acquired comprehensive knowledge of its intricacies. My expertise is demonstrated by hands-on experience in various roles within investment banking, including financial modeling, company valuation analysis, and involvement in mergers and acquisitions (M&A) transactions. I have successfully navigated the fast-paced and dynamic environment of investment banking, honing essential skills such as technical proficiency, quick learning ability, discipline, work ethics, and strong interpersonal skills.
Now, let's delve into the key concepts mentioned in the article about investment banks:
-
Investment Banks Overview:
- Investment banks act as intermediaries between businesses and financial markets.
- They provide various financial services, including financing, trading, consulting, research, asset and wealth management, and related services.
-
Historical Context:
- Investment banks emerged in the United States after the Great Depression of the 1930s.
- The Glass-Steagall Act separated investment banks from commercial banks, leading to the modern structure of investment banks.
-
Differences Between Commercial and Investment Banks:
- Commercial banks focus on the money market, accepting deposits and granting loans.
- Investment banks operate in the capital market, serving large, publicly traded entities.
-
Investment Banking Divisions:
- Investment banks are divided into various divisions, including Investment Banking Division (IBD), Sales and Trading, Research, Private Banking, Quant, and other support departments.
-
Investment Banking Division (IBD):
- IBD facilitates initial public offerings (IPOs), additional stock offerings, mergers and acquisitions (M&A), and other services for companies raising funds.
-
Product and Industry Groups in IBD:
- Product Group focuses on mergers and acquisitions (M&A), leveraged financing (LevFin), equity capital markets (ECM), debt capital markets (DCM), and restructuring.
- Industry Group focuses on specific fields (e.g., technology, retail) and provides industry-related research.
-
M&A Advisory and Capital Raising:
- Debt Financing involves loans, notes/bonds, and convertible securities.
- Equity Financing includes IPOs, follow-on offerings, and private placements.
-
Underwriting:
- Underwriting is the process of raising funds for an issuer through the sale of equity or debt securities.
- Types of underwriting commitments include firm commitment and best efforts.
-
Mergers & Acquisitions (M&A):
- Investment banks assist companies in acquiring other companies through research, valuation, and negotiation.
- The Product Group and Industry Group play different roles in the M&A process.
-
Reasons for Choosing Investment Banking:
- Enhancing soft power, building a professional network, personal and professional development, and understanding business insights are key reasons.
-
Essential Skills for IBD:
- Technical skills (financial modeling, company valuation analysis), quick learning ability, discipline, and strong interpersonal skills are crucial for success in investment banking.
This summary covers the fundamental aspects of investment banking, from its historical context to the roles and responsibilities within an investment bank, providing a comprehensive understanding of the field.
