Investment banking is probably even bigger than you think.
It was responsible for funding many of the world’s original trade expeditions, the first canals and railroads, the first motorways, and virtually all of the world’s biggest companies.
Whenever there is a good entrepreneur idea that lacks capital, it is usually investment banking - in some form - which decides whether the idea is good enough to fund.
This is an extremely important dynamic that essentially impacts on everything: from funding mortgages to college education and retirement plans. You simply cannot live your life without being affected in some manner by investment banking.
In this guide, we look at the industry from top to bottom, at times building on some of the feedback that DealRoom has received from the investment banking companies that use its platform.
We begin with a definition…
What is investment banking?
Investment banks are financial institutions that seek to profit from the flow of money between different actors (e.g. between companies, between companies and lenders, between companies and investors, between companies and the stock market, etc.).
There are essentially four ways in which they achieve this:
- Financial advisory (particularly in mergers and acquisitions)
- Subscription (i.e. IPOs)
- Fundraising and investment
- Market creation
Below, we will look at each of these in turn
What do investment banks do?
1. Financial Advisory
Investment banking is at the heart of the M&A industry.
As noted elsewhere in DealRoom articles (biggest M&A challenges), M&A transactions are highly complex affairs that need experts to get them over the line.
Investment bankers fill this knowledge gap, providing deal advisory services that ensure deals get through. And by all accounts, they’re extremely good at fulfilling this role: Investment banking fees for dealmaking in 2021 have already surpassed the US$100 billion mark.
Subscription (or ‘underwriting’) is the second biggest money spinner for investment banks. It refers to the process of investment banks undertaking to guarantee payments to companies in the event of losses, usually in the initial public offering process.
This essentially involves an investment bank telling a company:
“if you go public, we’ll ensure that you receive a certain amount of money for the equity that you’re offering,”
thus removing the risk for the companies, incentivizing a public listing, and creating huge opportunities for investment banks to profit from the IPO.
3. Fundraising and Investment
If a company doesn’t want to sell out entirely, but needs to raise capital, it usually turns to an investment bank for fundraising and investment.
Once more, as experienced intermediaries in this field, investment bankers help companies to pitch their message to investors, showing them how the company, project, or venture, is worth investing in.
As part of this process, the investment bank will help the company with its valuations and financial projections to begin the marketing process.
4. Market Creation
Even high quality assets can face a lack of liquidity.
Using this logic, in certain cases, investment banks become market makers (hence, ‘market creation’), ensuring buyers have somebody to buy from and sellers have somebody to sell to, with the spread - the difference between the buying and the selling price - being where the investment bank makes its money.
The less liquid the market, the bigger the spread, the bigger the opportunity for the investment bank to profit on each transaction.
There are the four principal roles of investment bankers.
However, as a general rule, whenever there is good money to be made in the corporate world, investment bankers won’t be far away.
Other ways in which they generate revenue include industry research, sales and trading (of debt and equity), and proprietary investments.
You begin to see why the definition of investment banking in this article stated that these institutions seek to profit from the flow of money.
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Investment banks versus retail banks
What makes investment banks any different from retail banks (i.e. traditional main street banks)?
This is an important distinction. The deposits held by retail banks - the savings of millions of families among them - are protected by the Federal Deposit Insurance Corporation (FDIC).
Furthermore, under international banking conventions, retail banks have to meet certain deposit conditions (i.e. less risky assets on their balance sheets).
Investment banks on the other hand, have lesser regulatory burdens. It is assumed that their clients are more sophisticated than those of retail banks, and they have increased flexibility to make risky assets.
Of course, their reputation is on the line.
While a retail bank might only be as good as its customer service, deposit rates, or online banking services, an investment bank is really only as good as the cash that it generates for its clients and investors.
Categories of investment banks
In broad terms, there are three kinds of investment banks - denominated by size and the breadth of services that they offer:
- Bulge Bracket: These are the top tier banks (e.g. Goldman Sachs, Morgan Stanley, etc.). Essentially, these are the biggest investment banks and enjoy the most access to capital, and are usually the intermediaries in the biggest transactions.
- Boutique: Boutique investment banks tend to focus on mid-tier companies and SMEs. They usually focus on one area (e.g. M&A, selling securities, etc.) and don’t have the same reach or access to capital as their bulge bracket counterparts.
- Industry/Regional focus: These investment banks - essentially boutique investment banks - tend to focus on an industry or region gaining a specialization and focused network of contacts in an effort to gain an edge on their industry agnostic competitors.
World’s largest investment banks
Based on Market Capitalization at April 30, 2021:
Who are the clients of investment banks?
The simple answer to this question is ‘anybody with a large finance-related project’. Broadly speaking, these can be divided into three categories:
- Governments: Increasingly, this group includes sovereign wealth funds. Investment banks help governments to raise funds for infrastructure projects (for example, in public private partnerships), provide advice on sovereign debt, and help with privatization initiatives.
- Corporations: Investment banks help corporations with all of the tasks outlined above in this article, with most of the work focused on mergers and acquisitions, raising capital, and bringing companies to IPO. Research services are also commonly provided by investment banks before any of these activities are carried out.
- Institutions: Institutions, such as pension and savings funds hire investment banks for research services, general investment advice, and sometimes to take over the asset management tasks entirely.
What are typical investment banking fees?
The services provided by investment bankers don’t come cheap.
As one might expect of individuals that are highly skilled in structuring complex financial deals, investment bankers are adept at ensuring they get paid well for what they offer.
The most common methods of generating fees are as follows:
- Commissions: Invariably, when an investment bank plays any form of intermediary role in a transaction, it charges a commission on that transaction based on the total amount. This commission also applies to when an investment bank buys equity on behalf of its clients. Typical commission fees are around 2-3% of total deal size.
- Advisory fees: Even if a company doesn’t close a transaction, it will have to pay advisory fees (sometimes referred to as ‘retainer fees’). The biggest companies may be able to obtain these services for free as investment banks compete among each other for the commissions that will ultimately be generated when a deal closes. Typical fees are usually over $100K per month.
- Underwriting fees: A huge source of fees for large investment banks are the underwriting fees that they receive for their role in bringing companies to IPO. Recent years have seen companies try to bypass these fees through direct listings and SPACs, suggesting the golden age of these enormous fees for investment banks may have passed. Typical underwriting fees are around 4-7% of the gross IPO proceeds.
- Asset management fees: Having constructed teams with outstanding ability in financial matters, it follows that governments, companies, and institutions would turn to investment banks for advice on how to manage their capital. For instance, if a company sells a business unit with an investment bank and finds itself flush with cash as a result, what should it do with that cash? It may turn to the investment bank that just helped to sell the business unit. There are a range of fees that add up here, ranging from entry and exit fees to ongoing management fees. Typically, these amount to around 3-4%.
- Trading Income: Investment banks make money on buying and selling equities and bonds on the public markets, allowing them to tap into yet another lucrative income stream. Here, the fee is usually less than 1%, but the size and regularity of the trades means that it’s a highly lucrative source of income for investment bankers.
The value that DealRoom brings to investment banking
DealRoom works with dozens of investment banks in their ongoing M&A, IPO, and capital rising processes.
Most of these are boutique banks or investment banks with an industry/regional focus, but we have worked with bulge bracket investment banks on occasion.
Talk to us today about how DealRoom’s project management and virtual data room services add value to your investment banking process.