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HomeLeadership&StrategyLeadershipWhatDoInvestmentBanksDo?

WhatDoInvestmentBanksDo?

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Corporatestrategistandinvestmentbanker,RobertLawrenceKuhn,
examinesthedifferentfacetsofinvestmentbankingfrompublic
offerings,debtandequitysecuritiestoM&Aandstructuredfinance.
KuhnscrashcourseininvestmentbankingwilltellaCEOalmostallhe
orsheneedstoknow.
Postedby:robertlawrencekuhn June21,2011

Investmentbanksfacilitateflowsoffundsandallocationsofcapital.Theyarefinancialintermediaries,the
criticallinkbetweenusersandprovidersofcapital.Theybringtogetherthosewhoneedmoneytoinvest
(e.g.,corporationsthatbuildfactoriesandbuyequipment)withthosewhohavemoneytoinvest(e.g.,
institutionsthatmanagemoneyforpensionplans),andtheymakethemarketsthatallocatecapitaland
regulatepriceinthesefinancialtransactions(i.e.,whogetshowmanydollars,withwhattermsandatwhat
cost).
Investmentbankingisadynamicindustrycharacterizedbyfluxandtransformation.Financialinstruments
havegrownmorecomplexasfinancialintermediarieshavebecomemorecompetitive.Blizzardsof
innovativeinstrumentshavesweptfinancialmarkets.Boundariesamongdiversefinancialinstitutionshave
blurred.Barriersbetweeninternationalfinancialmarketshaveeroded.Andamplifyingthecomplexityand
thecompetition,financialmarkets,firms,productsandtechniquesaremergingandmelding.
Itisinthisvolatileenvironmentthatinvestmentbanksofallsizesandstrategiesstrugglewithchange.
Investmentbanking,longsimplysynonymouswiththedomesticunderwritingandmarketmakingof
corporateequityanddebtsecurities,hasexpandeddramaticallyinpastdecades:newfunctions(e.g.,the
prominenceofmergersandacquisitions,M&A),newproducts(e.g.,riskmanagementmechanismssuchas
swaps),newtechniques(e.g.,securitizationofilliquidreceivables),newinternationalexchanges(e.g.,
importanceofHongKonginadditiontoNewYork,LondonandTokyo),newfinancialmarkets(e.g.,China),
andnewmuscle(e.g.,privateequity,hedgefundsandmerchantbanking).

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Whatservicescaninvestmentbankersprovide,andhowcanseniorexecutivesuseinvestmentbankstotheir
firmsadvantage?

December19,2014

Strategies of Investment Banks

December19,2014

Investmentbanksenableissuerstoraisecapital(i.e.,enterprisesthatsellorissuesecuritiesforcash)and
investorstoplacecapital(i.e.,individualsorinstitutionsthatbuyorinvestinthosesecurities)inthemost
reasonablyefficientmannerforboth:thelowestoverallcostofcapitalforissuersandthehighestratioof
returntoriskforinvestors.Designingfinancialinstrumentsthatevermorecloselymatchtheseopposite
desiresofissuersandinvestorsisthehallmarkoftheindustry.
Whetherdebtorequity,allcapitalhasacostandissuerswanttoraisecapitalatthelowestpossibleoverall
(allin)cost.Thecostofdebtisitsinterestrate,repaymentschedule,covenants,andthelike.Thecostof
equityisthedilutionofcurrentstockholdersrelativetothemoneyraised.Thecostofcapitalisdirectly
relatedtotheoverallvalueofthefirmasdeterminedbythemarketcapitalizationandtotheapparentriskof
thefirmasdeterminedbybothcompetitivebusiness(productmarket)andfinancialstructure(leverage,
debt/equity).Investors,naturally,wanttoachievethehighestoverallreturncommensuratewithagiven
levelofrisk.Byarrangingmonetarytransactions,exchangesandrelationshipsamongeconomicentities,
investmentbanksmakethecapitalmarketsmoreefficient.Matchingthehighlyspecificprofilesofmyriad
issuersandinvestorsisthespecialcapabilitythatinvestmentbanksoffer.

Scope of Investment Banks

Followingarefourteenactivitiesofinvestmentbanks.Theycanbeallocatedintocategoriessuchas
CorporateFinance,CapitalMarkets,WealthManagement/PrivateClient,AlternativeInvestments,
andthelike.

Public Offerings of Debt and Equity Securities

Therearefourgeneraltypesofpublicofferings:1)Initialpublicofferings(IPOs)ofsecuritiesissuedby
companiesthathaveneverbeforeissuedanypublicsecurities(normallycommonstockisthefirstsecurity
tobeissuedinanIPO)2)Initialpublicofferingsofnewsecuritiesthatcompaniesthatarealreadypublic
havenotbeforeissued(e.g.,anewclassofconvertibledebtsecurity)3)Furtherpublicofferingsof
securitiesthatarealreadypubliclytraded(e.g.,theissuanceofadditionalcommonstockwhenitspriceis
sufficientlyhighsothatcostofcapitalissufficientlylow)4)Publicofferingsbycompanyshareholdersof
securitiesthatarealreadypubliclytraded(e.g.,whenanoriginallargeshareholder,sayaprivateequity
fund,wantstocashoutitsposition).
Inthepastwecouldcleanlydifferentiatedebtandequitysecuritiesandputthemintoseparatecategories.

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Inthepastwecouldcleanlydifferentiatedebtandequitysecuritiesandputthemintoseparatecategories.
Investmentgradecorporatebondsweredistinctfromhighyield(junk)bonds.Todaytheolddistinctions
arefuzzy.Debtandequityaremorepointsonacontinuumthanboxesonachart.Juniorsubordinatedzero
couponconvertibledebenturescanbethoughtmoreequitythandebtanddutchauctionpreferredstockcan
bethoughtmoredebtthanequity.Geography,aswell,isnolongeraconstraint:Companiescanreach
anywhereintheworldtolowertheircostofcapital.

Private Placements of Debt and Equity Securities

Privateplacementisthesellingofsecuritiestoinvestorswithouttheregulatoryrequirementsofpublic
offerings.Theregulationsdefiningprivateplacementsarecomplexandthesecuritiesandinvestment
vehiclesofferedarenumerous.Rangingfromcorporateequitiestorealestateinterests,privatelyplaced
securitiescarryahigherreturnthansimilarlystructuredsecuritiesthatcantradeinthepublicmarkets.The
lossofliquidityenhancesriskandthereforerequiresaproportionallyhigherreturn.

Mergers and Acquisitions (M&A)

Thisisthefrontpagestuffthehugeacquisitions,takeoverbattles,hostileattacksandfiercedefenses.But
itsnotallwar.ThevastmajorityofM&Asarefriendly.Investmentbankersseektooptimizepriceand
terms,sothatthebestpricemaynotbethehighestpriceforclientsellers(allcashorconfidencein
closingmaybemoreimportant)northelowestpriceforclientbuyers(certaintyofgettingthedealdone
maybemorevital).Investmentbanksfind,facilitate,price,andfinancemergersandacquisitions.Also
includedinM&Aareleveragebuyoutsbyprivateequity,therestructuringandrecapitalizationofcompanies,
andthereorganizationoftroubledcompanies.

Financial Advisory / Sponsor Group Finance

Financialadvisoryserviceshavegrowndramaticallyasinvestmentbanksworkwiththelargenumberof
privatefundshedgefundsandprivateequitythathavemushroomedinrecentyearsandcontrol
hundredsofbillionsofdollars.Servicesinclude(i)raisingofcapitalforgeneralfunds,(ii)M&Aacquisitions,
(iii)financingacquisitions,(iv)IPOsofportfoliocompaniesownedbythefunds(whenappropriate)and(v)
M&Aofthesecompanies(whenIPOsarenotappropriate).Investmentbanksliketoinvolvethemselveswith
hedgefundsandprivateequitysincetheyaretransactionoriented,generatehugefeesandareinperpetual
dealmode
.

Fairness Opinions
FairnessopinionssupportM&A,leveragedbuyoutsandrestructuringsforpubliccompanies.Providingan
independent,defensible,expertstatementonvaluesandthefairnessofthosevaluesisanessentialpart
ofanysuchpublictransaction.Investmentbankscommandwhatmayseemtobeexorbitantlyhighfeesfor
givingfairnessopinions,consideringthenumberofhoursworked(andtheamountofpaperproduced).The
reasonisthesignificantliabilitytheinvestmentbankassumes,whichcanberealizedbothinthecourtsvia
shareholdersuitsandinindustryreputation.Infact,majorinvestmentbanksdonotliketoprovidefairness
opinionstherisksaretoohighforthefeesbutgenerallydosoonlytoserveimportantclients.

Structured Finance / Securitization

Thecreationofsyntheticfinancingmechanismsandstructuresmakespossibleallocationsofcapitalwith
betterriskreturnfeaturesforbothissuersandinvestors.Thisisgenerallyachievedbyinstrumentsthat(i)
poolassets,(ii)allocateliabilitiesintodifferenttrenches(withdifferentriskreturnprofiles),and(iii)are
containedwithinanindependentlegalentity.
Securitizationistheprocessbywhichformerlyilliquidassets,mostlysmallconsumerreceivablesofallkinds
(e.g.,homemortgages,automotiveloans,creditcardreceivables),canbeliquefiedbytheirbeingrolled
upintolarge,publiclytradablesecuritieswithimprovedriskreturnforbothissuersandinvestors.(Such
innovationsexemplifyinvestmentbankingscontributiontofinancialmarkets.)
Securitizedobligationsaresophisticatedindesignandoftenrequirestatisticalanalysisandsensitivitytesting
ofkeycriteria(e.g.,defaultrates,prepaymentprofiles,interestratesensitivity,taxchanges,etc.).For
example,achangefromforecastedratesofprepayment(e.g.,duetointerestratedeclinesandthe
resultingrefinancingofolder,higherratemortgages)canresultinshockingdifferencesinreturnsfrom
initialexpectations.(Principalitselfcansuffersignificantly.)
Otherkindsofstructurefinanceincludeprojectfinance,whichisusedtofundlargescaleenterprisessuch
aspowerplantsandinfrastructure.

Risk Management
Hedgingpositionsininterestrates,foreigncurrencyexchangesandcommoditypositionsthroughswaps,
optionsandfuturesareanessentialbuildingblockoffinancialmarkets.Swapsarethemechanismbywhich
twoormorepartiesexchangetheirdebtobligationsinordertocontrolmorepreciselyeachpartysdesired
risk/returnprofile.Swapsworkbecausedifferententitieshavedifferentcomparativeadvantageswhen
pricingdifferentcategoriesofdebtindifferentfinancialmarkets.Partiesofdissimilarcreditratingsor
financingneedscanexchangetheirobligations(e.g.,fromshortertermtolongertermandviceversa)in
ordertooptimizetheirfinancialstrategyandstructure.Riskmanagementgroupscombineexpertisein
diversehedginginstrumentstodevelopacompletehedgingstrategyforenterprises.

Merchant Banking
Merchantbankingisthecommitmentofaninvestmentbanksowncapitaltoequitylevelinvestmentsand
participations,seekingveryhighreturns.Suchcommitmentofcapitalismadefortwogeneralpurposes:1)
tofacilitateaclienttransaction(i.e.,abridgeloanuntilpermanentfinancingisobtained)or2)topurchase
securitiesinanoperatingcompanyforthefirmsownaccount(i.e.,whether100%ownershipbythe
investmentbank,inpartnershipwithaclient,orasthemanagerofanLBO[BP1]fund).Bridgeloansare
highlyprofitable,combiningcommitmentfees,placementfees,highinterestrates,andequitykickers.

Public Trading of Debt and Equity Securities

Mostlargeinvestmentbanksmaintainstrongtradingcapabilities,whichisasignificantthoughvolatileprofit
centerprofitsaremadebothfromcommissionsgeneratedbytradingforclientsandfromcapital
appreciationgeneratedbytradingforthefirmsownaccount.Investmentbanksactasbrokers,dealers,
and/ormarketmakers(whichcandifferfordifferentsecurities).Inadditiontotraditionalstocksandbonds,
moneymarketinstrumentsandcommodities(e.g.,gold,silver,coffee,crudeoil,variousmetals,various

moneymarketinstrumentsandcommodities(e.g.,gold,silver,coffee,crudeoil,variousmetals,various
foods),investmentbankscreatesyntheticsecurities(e.g.,stripedTreasuries,interestonlyandprincipal
onlyinstruments),whichbyappealingtodifferentinvestors,enhancetheriskreturnforall.
Brokersarecommissionedagentswhorepresenteitherbuyersorsellersandworkmuchasdorealestate
agentstheycarrynosecuritiesininventoryandthereforeassumenoriskinpricevariationorinterest
charge.Dealerssetbidandaskpricesforeachsecuritytheyofferfortradebymaintaininganinventoryof
securities,dealersassumeapricerisksincethemarketmaygoupordownduringthetimetheyholdthe
securities.MarketMakersestablish(andsupport)theentiremarketforasecurityoneithersideofa
transaction.Brokersanddealersareregulatedbythevariousexchangesofwhichtheyaremembersand
theNationalAssociationofSecuritiesDealers(NASD),whichistheselfregulatingorganizationtowhich
theyallbelong.

Investment Research and Security Analysis

Fordecades,theresearchcapabilitiesofaninvestmentbankssecurityanalystswereoftenthefirmsmost
prestigiousandvisiblestrength.(Morerecently,M&A,IPOs,LBOs,andprivateequity/hedgefundshave
usurpedthelimelight.)Indeed,manyinvestmentbanksusedthereputationderivedfromtheirinvestment
analysisexpertisetodevelopunderwritingandmoneymanagementbusinesses.Typicalsubdivisionsare
GlobalEquitiesandFixedIncome.Today,aftervariousscandalsandprosecutions,investmentbanksmust
enforcestrictcompartmentalizationbetweentheircorporatefinanceandinvestmentresearchdepartments
(thesocalledChineseWall).

Wealth Management
Theaccumulationofvastwealthbyinstitutionalinvestors(i.e.,pensionandinsurancefunds),andbyrich
andsuperrichindividuals,hasmademoneymanagementavitalbusiness.(Forindividuals,thedepartments
arecalledprivatebankingorprivateclient.)Investmentbankscompetewithoneanother,andwith
largecommercialbanksandspecializedmoneymanagementfirmsinaccumulatingassetsunder
management.Hundredsofbillionsofdollarsareatstake.

Alternative Investments
Theinvestmentsinfinancialproductsotherthanexchangetradedstocksandbondshavebecomeahuge
business,suchasprivateequity,realestate,arbitrage,international,andthelike.Thedevelopmentoffunds
undermanagement,includingprivateequityandhedgefunds,hasincreaseddramatically,andinvestment
banksbothdeveloptheirproprietaryproductsandsellothers.

Public / Government Finance

Theraisingofmoneyforgovernments(sovereigns)atalllevels:nationalgovernments,state
governments,countyandmunicipalgovernments.Alsoincludedisworkingwithnationalgovernmentsinthe
privatizationofgovernmentassets.

International Investment Banking

Globalizationisthebywordofinvestmentbanking.Financinghasbecomeamultimarketsearchforthe
lowestcostofcapitalforissuers,anda24houradayquestforthehighestreturnforinvestors.Growthis
highestinemergingmarkets,theopportunitiesforinvestment,underwritingandM&Aareextensive,andall
majorinvestmentbankshavesignificantpresenceinmanycountries.
Bothissuersandinvestorsseektheoptimumlevelofriskforagivenlevelofreturn.Suchoptimizations
covertheuncertaintiesandvolatilitiesofinterestrates,currencyexchangerates,creditavailability(for
usersofcapital),creditinstability(forprovidersofcapital)andequityinvestments.Optimumriskforagiven
return,orconverselyoptimumreturnforagivenlevelofrisk,isachievedbyusingtechniquesoffinance
theorysuchashedginganddiversification.Theinternationalexpansionofonesinvestmenthorizonsallows
moreefficientoptimizationproceduresforbothissuersandinvestorsi.e.,investmentportfolioscanbe
diversifiedmorewidely,therebyexpandingtheirrisk/returnfrontierandachievinghigherefficiency.

Underwriting Public Offerings

Thepublicofferingofdebtandequitysecuritiesisthefoundationofinvestmentbanking.Althoughtheterm
underwritingseemstoimplyanabsoluteguaranteethatthemanaginginvestmentbankanditssyndicate
members(i.e.,theunderwriters)willbelegallyboundtopurchasethesecuritiesfromtheissuingcompany,
therealworldismorecomplicated.Regardinganinitialpublicoffering,therearereallyonlytwoapproaches
thataninvestmentbankcantake:firmcommitmentorbestefforts.

Firm Commitment
Afirmcommitmentmeansthatthemanaginginvestmentbankanditssyndicatewillagreetobuythe
entireissueatanegotiatedprice.Theunderwriterswillthenresellthesesharestoitsclients,makingasits
profitsthepreviouslynegotiatedspread,whichisthedifferencebetweenthegrossproceedspaidbythe
publicandthenetproceedsgiventotheissuer.Thismeansthattheunderwritersbeartheentireriskof
persharepricingandtheamountoftotalproceedsraised.(Itshouldbestressedthatafirmcommitment
isoftennotasfirmasitsounds.Afirmcommitmentonlybecomesabsolutelyfirmontheofferingday
itself(orthenightbefore)justbeforetheissuegoeseffective,whichisthemomentwhentheSECgives
itsfinalapproval.Untilthenthefirmcommitmentisnotfirm,nomatterwhopromiseswhattowhom.
(Eventhentheunderwritingagreementisnotperfectlyfirmithasvariousouts,formarketdisturbances,
actsofGod,andthelike.)Furthermore,allthemarketingoftheissuehasalreadybeendonetheroad
showshavebeenconductedandtheunderwritingsyndicatemembersknowwhichoftheirclientsare
committedtobuyhowmanyshares.Theyknowiftheissueisoversoldorundersoldandcanmakefinal
adjustmentstopriceaccordingly.Thebottomlineisthatwheninvestmentbanksgivefirmcommitments
theyhavelittleuncertainty.

Best Efforts
Abesteffortsrelationshipiswheretheinvestmentbankusesitsexpertiseasstructurerindesigningthe
issueandasmarketerinsellingtheissue.Thismeansthattheunderwritersbearnoriskinthedeal,leaving
totheissuingcompanyalltheuncertaintyofpersharepricingandtheamountoftotalproceedstobe
raised.

The Underwriting Process

The Underwriting Process

Theunderwritingprocessisaformalprocessinvolvingmanysimultaneousfunctions,procedures,
requirementsandactivities.Followingaresomeofthecriticalsteps:companyinterestandunderwriter
selection,preliminaryanalysisofissuestructureandsecuritiespricing,duediligencereviewsby
underwritersandtheircounsels,legalandaccountinganalysisanddocumentpreparation,preliminary
compilationoftheregistrationstatement,submissionofregistrationstatementtotheSecurityandExchange
Commission(SEC),circulationofpreliminaryprospectustoprospectiveinvestors,informationmeetings
(roadshows)inmajorcitiesfordescribingthecompanyanditssecurities,receiveandrespondtoSEC
comments,finalpricingnegotiationsandsigningtheunderwritingagreement,finalregistrationstatement
filedwiththeSEC,SECapprovaldeclaringtheissueeffective,pressreleasesandtombstoneadvertisement,
closingandsettlement.
Investmentbanksareatthecenterofbusinessandfinance,andallseniorexecutives,irrespectiveoftheir
directresponsibilities,needtounderstandwhattheydoandhowtheydoit.

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ABOUT ROBERT LAWRENCE KUHN

Dr.RobertLawrenceKuhnisaninternationalcorporatestrategist,investmentbankerandexpert
onChina.Since1989,hehasworkedwithChinasseniorleadersandadvisedtheChinese
governmentonmattersofeconomicpolicy,industrialpolicy,mergersandacquisitions,science
andtechnology,mediaandculture,SinoU.S.relations,andavarietyofinternationalbusiness
matters.Dr.Kuhnadvisesleadingmultinationalcompanies,CEOsandCSuiteexecutives,
regardingformulatingandimplementingChinastrategiesinavarietyofsectors,includingscienceand
technology,energyandresources,industrial,mediaandentertainment,healthcare/medical/pharmaceuticals,
consumerproducts,andfinancialservices.HeworkswithmajorChinesecompaniesonstructuringtheircapital
marketsfinancingandM&Aactivities.

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