Investment Banking 101
Investment banks provide a menu of financial services to their clients. They help companies raise capital by selling ownership stakes in them (known as equity) and also aid in mergers and acquisitions.
Previously, investment banks traded their own money and made money by doing so (known as proprietary trading). However, most of this type of trading has been banned since mid-2015 thanks to the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker.
IPOs
IPOs are the first public offering of a company’s stock, and they can be lucrative for investment banks. They also offer a chance to make big money for everyday investors, though the process can be complex.
Investing in IPOs is risky, and the returns can be volatile. This is why many financial advisors recommend that people invest only a small amount of their portfolio in IPO stocks, which are typically traded on exchanges like the Nasdaq and the New York Stock Exchange.
The IPO process is typically coordinated between the company and an investment bank, which helps the firm raise capital in the form of shares. The bank will help the company decide how much to sell and how much to issue, and it will assist in the pricing of the IPO.
After the IPO, the investment bank will buy the shares it raised and sell them on the market, which makes it easy for the company to raise additional funds. This helps to lower the cost of the IPO and keep the initial offering price low.
Since the internet bubble, there has been a lot of attention on IPO pricing and allocation. This has led to numerous media stories and law suits aimed at investment banks, issuers and investors.
Investment banks that lead an IPO typically build a book of institutional orders and determine the initial listing price. They then stabilize the offering, usually after the first day of trading.
In the first day of trading, there is a ‘pop’ or gain in the IPO share price that typically accounts for about 16-19% of the total value raised in an IPO, according to Deal Logic. This can be seen as a reward to institutional investors who take a risk on the new issue before it lists, but it also reflects money left on the table by the issuer.
This pop is a positive for companies that list in the future, as it encourages long-term investors to stay invested in the company. It is also helpful for banks as it allows them to track how investors trade their IPO shares, which can be used to balance liquidity and long-term allocations in the future.
LBOs
Leveraged Buyouts (LBOs) are a type of acquisition where companies use debt to fund their purchase of another company. A private equity firm acquiring a company in an LBO is usually looking for high returns on its investment and uses debt to increase the potential return to investors, as well as reduce risk of the acquisition.
The capital structure of an LBO is typically comprised of a mix of debt and equity, with the debt being used first. The private equity firm (or financial sponsor) will build a model to determine how much debt they can strap on the business without blowing through credit metrics and debt covenants that lenders require. The financial sponsor will also calculate the internal rate of return for the debt investors, as well as for equity investors.
In a typical LBO, the equity investors will own 20%-30% of the acquiring company. The debt investors will own the other 50%-90%, which is called the debt/equity ratio. The debt/equity ratio is higher when a company has good cash flow, and lower in an unfavorable economy.
One of the biggest money-lending games on Wall Street is bridge loans, which are temporary financing for takeovers and leveraged buyouts. These loans are made to cover the short-term gap between when the deal is completed and when the bonds are issued to cover the long-term debt.
This has been the most lucrative area of business for merchant banks in America. They have been able to charge high interest rates for these loans, and make hefty profits in the process.
But as the economy continues to recover, merchant banking firms are finding that they are losing out on a lot of business to newer, less-expensive sources of financing. Some analysts and Wharton alumni say this trend is likely to continue, as the big players in the investment banking industry scramble for the best ways to boost their profits.
In order to do this, some merchant banks are developing a new kind of securities that blend elements of both debt and equity, such as preferred shares. These securities pay more than bonds but don’t have a claim on the assets of the company they are sold to, and can be suspended by the company if it wants to.
M&A
Mergers and acquisitions (M&A) are a type of corporate transaction that involves the purchase of assets or control from another party. A company may choose to make an acquisition to increase growth or reduce costs. It is a common practice in many industries.
M&A is a powerful tool that can help companies grow rapidly, without the need to perform a lot of work. Moreover, mergers and acquisitions can also provide financial advantages. In this way, a company can increase its revenues and cut down on its costs at the same time.
Investment banks act as intermediaries between those entities that demand capital and those that supply it. They are responsible for facilitating mergers, acquisitions, restructurings and other major corporate actions.
They provide strategic advice to clients on how they can best acquire other companies or sell existing ones. They also analyze trends in M&A and identify appropriate targets/acquirers. They then begin the M&A process and reach out to prospective buyers/sellers.
As investment banking professionals, they are responsible for analyzing business opportunities and creating pitches, models and valuations. They also participate in M&A transaction calls on the buy-side and the sell-side and negotiate terms of a deal.
The M&A industry is a lucrative one, especially for investment bankers. They often earn a high salary, and they get to travel the world as they complete deals.
In addition, they can also get bonus compensation based on the results of their work. The bonuses vary depending on the bank and the position, but they are typically paid quarterly.
Some of the best-known and most prestigious banks have M&A departments. Some of the top names include Goldman Sachs, Morgan Stanley and Credit Suisse Group.
While the M&A market has been declining over the years, it is expected to see robust momentum going forward due to resumption of normal business activities, excess cash levels, appetite for improving scale and market share and a solid economic recovery. Consequently, M&A transactions have witnessed strong growth and will continue to be a significant part of investment banks’ financial performance in the near future.
Valuation
Valuations are the foundation of many investment banking transactions, whether they’re IPOs, LBOs, M&A or other corporate transactions. They’re essential for evaluating companies to determine a fair price, facilitating transactions and generating money for their partners.
While valuations are a key part of all transactions, they vary according to the type of deal. For example, an investment bank assisting a seller on a sell-side M&A transaction will likely conduct a valuation of the company using LTM* EBITDA multiples (enterprise value / earnings before interest, taxes, depreciation and amortization), while an investment bank advising a buyer on an IPO may use EV / revenue or NTM** multiples.
In addition to the financial aspects of valuations, it’s important to consider other factors that can impact the valuation. For example, it’s important to understand the industry the company is operating in and its current trends.
If the company is in a niche that is undergoing significant change, it’s also important to understand what changes could be coming down the road. For example, if there are significant environmental impacts or regulatory issues that may impact the company, it’s a good idea to understand how these affect the business.
The investment bank will work closely with the client on this aspect of the transaction. They’ll make recommendations on how to position the company for sale, draft marketing materials, conduct investor outreach and perform a valuation of the company.
Depending on the client, the investment bank may also be responsible for determining a fair price and facilitating the transaction. They can do this by conducting a thorough due diligence and analyzing the company’s financial statements and other related information.
It is also necessary to consider the risk of the company, including its current level of profitability and liquidity. For example, if the company has a lot of debt, it might be prudent to look at how the debt has been used.
The valuation process is a vital part of all investment banking transactions and can be used to identify opportunities for investors. It’s a great way to evaluate a company’s prospects and assess its financial health, which is particularly useful for deciding whether or not to take it public. It can be especially helpful for smaller and mid-size companies that are seeking capital to grow, as it can help them obtain a more palatable price for the stock they’re selling.
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