What Is Investment Banking?

Here, we’ll look at what investment banking is and what investment banks do. Often there is confusion between “investment banks” and “investment banking divisions.” The term “investment bank” typically refers to a full-service investment bank and the term “investment banking” normally refers to the profession of offering M&A advisory services or underwriting. The distinction is between the products and services offered and how the bank itself is organized and structured. For more on this, we recommend our guide: Types of Banks.

This infographic briefly explains what underwriting and M&A advisory services are:

These are the two main functions of investment banking, and we’ll look at them in more detail below.

What Is Underwriting?

One of the most important functions of an investment bank is their role in raising capital. Generally, investment banks tend to work with larger corporations, organizations, and governments.

The term “underwriting” refers to the process of raising capital for clients in the form of debt and equity securities.

When businesses (or other organizations) want to expand, but don’t have the ability to pay for that growth out of cash flow, they look to raise outside capital. They can choose to do so with either debt or equity.

Often, larger businesses choose to raise large amounts of capital by issuing securities to the public. Here, we’ll look at how investment banks help to facilitate that process. In order to understand this process, we need to understand the difference between the primary market and the secondary market.

When a business issues new securities for the first time, it does so through an initial public offering (IPO). Through this IPO the business will issue either bonds (debt) or shares of stock (equity) to the public.

The first time that a business issues any shares or bonds to the public is called an initial public offering. Sometimes bond IPO’s are just called new issues. Any additional time that a business issues new shares or bonds to the public, for the first time is called a follow-on offering.

Both of these types of transactions happen in the primary market. Here, investment banks facilitate the issuance and sale of these securities (stocks or bonds) to public markets.

In exchange for money the corporations issue these debt or equity securities to mostly institutional investors. Both IPO’s and follow-on offerings help the business raise capital. The business makes money when investors purchase these shares. Fundamentally, when businesses issue debt securities (bonds) they are effectively borrowing money. When they issue stock, they are selling ownership stake in the company.

For clarity purposes we’ll also talk about the secondary market. The secondary market is where institutional investors and portfolio managers go to trade (purchase or sell) existing securities. It’s important to note that the corporation that originally issued these stocks or bonds in the primary market doesn’t profit from their trading on the secondary market. In the secondary market money is made and lost between the investors trading these securities on the open market. To learn more about the primary market vs secondary market, we recommend our guide: Primary vs Secondary Market.

For clarity regarding the underwriting process, the distinction between the primary and secondary market has to do with whether or not the bank is helping the company raise money. Investment banks provide advisory services for both the primary and secondary markets, but the primary market is where businesses raise capital through the issuance of debt and equity securities.  

To learn more about underwriting, we recommend our guide: Investment Banking Underwriting Services.

Investment Banking M&A Advisory Services:

In addition to underwriting, investment banks act as intermediaries between buyers and sellers of businesses in M&A (mergers and acquisitions) transactions. They advise both sides on the mergers and acquisitions process from start to finish.

How does this work?

When potential sellers decide it’s time to sell their business, they often go through intermediaries such as investment banks to help facilitate the sale. In M&A transactions, it’s essential that the seller can draw in multiple offers for their business so that they can drive the price up through those competitive offers.

Generally, businesses have three categories of intermediaries they can go through to help them sell their business successfully. The first category is business brokers which specialize in the purchase and sale of small businesses. Next, M&A advisory firms often act as intermediaries for the sale of businesses in the lower-middle market, and Investment banks generally focus on large businesses, although they also service clients in the middle market.

The important thing to understand is that these business sizes serve as guidelines, not official cut-off points.

Why are they useful?

Because each of these three categories of intermediaries focuses on building and maintaining relationships with buyers that make acquisitions focusing on businesses in those size ranges.

Investment banks are best positioned to act as intermediaries for upper middle-market and large businesses because they have working relationships with many potential buyers that can afford to make offers on businesses of that size.

Investment banks work as intermediaries that can serve both buyers (buy-side) and sellers (sell-side). Here, we’ll look at the services that they provide to buyers and the services they provide to sellers.

For these services investment banks normally charge an upfront retainer fee and a success fee.

The retainer fee is guaranteed and is paid to retain the services of the investment bank. These retainer fees typically range from $50,000 to $250,000. These fees are designed to cover some of the basic costs of the service. This retainer fee is paid by both buy-side (acquiring companies) and sell-side (sellers) clients.

In addition to retainer fees, investment banks also charge both buy-side and sell-side clients success fees. These fees work slightly differently for buy-side and sell-side clients, due to the nature of the relationship the investment bank has in the M&A process. For buy-side clients the success fee is paid when the deal is closed. From the investment banks standpoint, there is some uncertainty regarding this fee because buy-side clients normally focus all of their efforts on a single target (business for sale). If the deal falls apart, the investment bank isn’t paid this fee.

For sell-side clients, success fees are also paid at deal closing. However, when investment banks act as intermediaries for sell-side clients, the success fee is pretty much guaranteed because the bank (as the intermediary) will make it a point to get several acquiring businesses to make offers for the target company.

Success fees for deals between $1 and $5 million range from 8 to 12 percent. Fees for deals between $5 and $25 million range from 4 to 7 percent. Investment banking success fees for deals between $30 and $100 million range from 2 to 4 percent.

Understand that these fees are based on the size of the deal, not the revenue ranges of the business acquired. Some businesses are acquired for less than earnings, and some are acquired for many times their earnings. Additionally, understand that while investment banks are the best option for M&A intermediary services for large businesses, boutique investment banks will focus on smaller transactions, or on transactions in specific industries.

To learn more about the M&A process, we recommend our guides: Intro To Mergers & Acquisitions and The M&A Process Explained.

Full-Service Investment Banking:

Normally, the term “investment banking” refers to the division in a bank that deals primarily with M&A advisory and underwriting services. However, the banks that offer investment banking services can be structured differently. For more information on how these banks can be structured, we recommend our guide: Types of Banks.

In addition to M&A advisory services and underwriting, full-service investment banks also offer sales and trading, research, and restructuring services.

First, we’ll look at sales and trading. The term “trading” refers to the execution of orders in the capital markets. Traders work with asset managers to buy and sell the securities for their funds.

Investment banks offer asset management services as well as trading services. Asset management is the service of investing the funds of other people. To quickly clarify, normally asset management is a buy-side service, but investment banks do have asset management groups and offer sales and trading services to facilitate buy-side funds, within the limitations they are given.

Second, we’ll look at research. Investment banks provide research reports on publicly traded companies. This is called equity research. Generally, the goal of these reports is to provide an analysis and purchasing recommendation regarding a company’s shares. Investment banking equity research has five main aspects—industry research, management overview, historical & forecasted financials, valuation (both for the company and its stock price), and finally the recommendation (ie. buy, hold, or sell).

Third, well look at restructuring. Restructuring is a term used to describe when a company makes significant changes to its financial structure. Often, restructuring happens when businesses are unable to meet their liabilities to their creditors. When this happens, companies rely on investment banks to help them restructure, and renegotiate their liabilities with creditors. Normally, restructuring is broken down into two types. Debt restructuring and organizational restructuring. Most of the time investment banks work with companies on debt restructuring. Often creditors are amenable to this because it often means they will get something as opposed to nothing out of a default. If the investment bank cannot help the corporation and the creditors reach an agreement, it will have to file for bankruptcy. In the case of organizational restructurings, the investment bank acts like a consultant to help the company change operations and turn its prospects around. Investment banks can make recommendations to change management, sell off assets, or on strategic changes.

Investment Banking Market Segments:

Investment banks are often categorized by the market segments they focus on serving.

First, we have bulge bracket investment banks. These investment banks focus on doing very large deals for multi-national corporations.

Second, we have the middle-market investment banks. These investment banks focus on serving mid-sized companies.

Finally, we have boutique investment banks. These investment banks specialize and focus on specific niches and as a result may have services geared to specific types of smaller businesses as well as the middle-market.

Investment Banking Industry Coverage:

For all of the products and services we discussed, investment banks will have specialty groups that will cover a specific sector or geographic area.

These groups are normally categorized as follows: consumer related, financial institutions, financial sponsors, healthcare, technology, media & telecom, real estate, “gaming, leisure & lodging”, and technology.

Having these industry-focused teams, aims to ensure that the investment bank is providing the right services to its clients at the right level of expertise.

Larger investment banks will have all of these industry coverage groups covered, while boutique investment banks may only focus on one or a few of these groups.

Investment Banking Vs Commercial Banking Services:

Since both commercial banks and investment banks offer advisory services to businesses, and they are both often in regard to raising capital, we’ll clarify the difference in these advisory services.

Investment banks directly offer advisory services for M&A transactions, the structuring of capital markets products, and the assistance in raising capital through debt and equity offerings.

Commercial banks focus on maintaining banking relationships with their clients as well as offering some advisory services as well. However, these advisory services are different than the advisory services that investment banks offer.

When commercial banks offer advisory services on raising capital, they are often advising their clients on which commercial banking products and services are the best fit for their use case. So, if a business were looking to raise capital through debt, then commercial banks would be advising on loan products such as term loans, rather than raising capital through issuing publicly traded debt securities (bonds), as an investment bank would.

The main difference here is that investment banks serve as advisors regarding publicly traded securities (stocks and bonds), and commercial banks will be advising businesses on non-securitized loan products and services, like traditional term loans, revolver debt, or working capital management services.

To learn more about commercial banking products and services, we recommend our guide: Intro To Commercial Banking.

Recommended Resources:

• Types of Banks
• Investment Banking Underwriting Services
• Intro To Mergers & Acquisitions
• Intro To Commercial Banking
• Primary Vs Secondary Market

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