Although many entrepreneurs seeking capital approach angel investors, friends or family, or venture capitalists for the money, an alternate source of lending always exists with an investment banker. Investment banking is an alternative lending source where a borrower seeks significant capital for a venture.
By definition, “An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client’s agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities.”
This definition has two main points:
An investment banker:
1. Helps raise capital by helping issue securities, and
2. Helps companies merge together, purchase another company through an acquisition, and develops all types of financial instruments for both domestic and international options.
Two simple examples:
In May 2012, Facebook (FB) offered an IPO to the buying public, and “went public” in the vernacular definition. The IPO, although reportedly oversold, did not increase in value beyond the first few minutes of trading. In fact, the trading volume was so high that NASDAQ computers were swamped, and the stock began what was to be a downward spiral. Since the offering did not go well in the market, Morgan Stanley’s Michael Grimes drew enormous criticism for the FB offering’s lack of success.
Why did this occur? Morgan Stanley had performed the mandatory due diligence on the company and heavily advised what the opening stock share value should be, when FB stock was tendered. Facebook Finance Chief David Ebersman purportedly relied on Morgan Stanley’s expertise, and followed its recommendation.
Since the offering did not go as planned, the investment banker looked somewhat incompetent – which is very unusual for a firm started over a century ago by J. P. Morgan.
Do not misunderstand. The FB owners got wealthy— just not as initially wealthy as they thought they would get. Morgan Stanley, on this occasion, did not accurately predict the market. As a matter of fact, the market makers on the first day of trading were buying and selling to keep the value at the offering price at the end of trading on the first day.
In 1901 J.P. Morgan acted as an investment banker, and with attorney Elbert Gary, founded the U.S. Steel Corporation with the assistance of Charles Schwab, who was Andrew Carnegie’s protégé– and right hand man.
The corporation merged Andrew Carnegie’s Carnegie Steel Company, (Elbert) Gary’s Federal Steel Company, and William Henry “Judge” Moore’s National Steel Company and created what was considered a monopoly (known in 1901 as a trust).
The merger was capitalized at $1.4 billion ($39.11 billion in 2011 dollars) and created the first billion dollar corporation in the United States. Charles Schwab was placed as the president of US Steel until 1930 and at one point US Steel was the largest steel producer in the world.
Investment Banks Are Unlike Commercial or Retail Banks
Two quick points:
1. Investment banks do not take deposits.
2. Advisers who provide Investment banking services must be licensed by
• The Securities & Exchange Commission (SEC), and
• Financial Industry Regulatory Authority (FINRA).
Investment banks usually:
• Trade securities for cash or other securities,
• Underwrite securities
• Promote securities (as in the FB example, above) including assisting in the sale of securities
• Assist pension funds, hedge funds, mutual funds, in the purchase of securities.
Investment banks advise on both the sale (private) and buying (public) side of securities.
• The private side has insider information which cannot be revealed to buyers.
• The public side provides stock analysis and provides non-insider information to the public.
Any conflict of interest between the buying and selling public is removed by a “Chinese Wall” which does not allow information sharing between both sides of the business, and especially with specifically private information, which is never to be shared with the public.
The Organizational Structure
Investment banking is divided into three principal categories of service:
1. Front office activities, which include investment banking, sales and trading, and equity research.
2. Middle office activities, which include risk management, treasury management, internal controls, and corporate strategy.
3. Back office activities, which include data-checking trades that have been conducted, ensuring that they are not erroneous, and executing the required transfers.