investment banking vivek (1)
TRANSCRIPT
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A Project on
INVESTMENTBANKING
Submitted to Prof. sangam
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INDEX Page no
INTRODUCTION 4
WHONEEDS ANINVESTMENT BANK? 5
WHATDOESITDO? (TOEARN) 6
COMMERCIAL BANKINGVS.INVESTMENT BANKING 8
THE BUY-SIDEV/STHESELL-SIDE 12
HEDGE FUNDS: An over view 12
ORGANIZATIONAL STRUCTUREOF ANINVESTMENT BANK 13
POSSIBLECONFLICTSOF INTEREST 17
Bibliography 18
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INTRODUCTION
An investment bank is a financial institution that raises capital, trades in
securities and manages corporate mergers and acquisitions. Investment banks profit
from companies and governments by raising money through issuing and selling
securities in the capital markets (both equity, bond) and insuring bonds, as well as
providing advice on transactions such as mergers and acquisitions. A majority of
investmentbanks offer strategic advisory services for mergers, acquisitions, divestiture
or other financial services for clients, such as the trading of derivatives,fixed income,
foreign exchange, commodity, and equity securities.
Trading securities for cash or securities (facilitating transactions,market-making),
or the promotion ofsecurities (underwriting, research, etc.) was referred to as the "sell
side".
Dealing with the pension funds, mutual funds, hedge funds, and the investing
public who consumed the products and services ofthe sell-side in order tomaximize
their return on investment constitutes the "buy side".Many firms have both buy and
sell side components.
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DEFINITION:-
An individual or institution, which acts as an underwriter or agent for
corporations and municipalities issuing securities. Most also maintain broker/dealer
operations, maintain markets for previously issued securities, and offer advisory
services toinvestors.Investmentbanks also have a large role in facilitating mergers and
acquisitions, private equity placements and corporate restructuring.Unlike traditional
banks,investmentbanks do not accept deposits from and provide loans toindividuals.
Also called investmentbanker.
To continue fromthe above words ofJohn F.Marshall and M.E.Eills, investment
banking is whatinvestmentbanks do.This definition can be explained in the contextof
how investment banks have evolved in their functionality and how history and
regulatory intervention have shaped such an evolution.Much ofinvestmentbanking in
its present form, thus owes its origins to the financial markets in USA, due o which,
American investment banks have banks have been leaders in the American and Euro
markets as well.Therefore,the term investmentbanking can arguably be said tobe of
American origin.Their counterparts in UK were termed as merchants banks since they
had confined themselves to capital market inter-mediation until the US investments
banks entered the UK and European markets and extended the scope of such
businesses.
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WHO NEEDS AN INVESTMENT BANK?
Any firm contemplating a significant transaction can benefit from the advice of
an investmentbank. Although large corporations often have sophisticated finance and
corporate development departments provide objectivity, a valuable contact network,
allows for efficient use of client personnel, and is vitally interested in seeing the
transaction close.
Most smalltomedium sized companies do not have a large in-house staff, and in
a financial transaction may be at a disadvantage versus larger competitors. A quality
investment banking firm can provide the services required to initiate and execute a
major transaction, thereby empowering small to medium sized companies with
financial and transaction experience without the addition of permanentoverhead, an
investment bank provides objectivity, a valuable contact network, allows for efficient
use ofclient personnel, and is vitally interested in seeing the transaction close.
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WHAT DOES IT DO? (TO EARN)
CORPORATE FINANCE
The bread and butter of a traditional investment bank, corporate finance generally
performs two differentfunctions:
1) Mergers and acquisitions advisory and2) Underwriting.
On the mergers and acquisitions (M&A) advising side of corporate finance, bankers
assistin negotiating and structuring a merger between two companies.If,for example,
a company wants tobuy another firm, then an investmentbank will help finalize the
purchase price, structure the deal, and generally ensure a smooth transaction. The
underwriting function within corporate finance involves shepherding the process of
raising capitalfor a company.In the investmentbanking world, capital can be raised by
selling either stocks or bonds toinvestors.
SALES
Sales is another core componentofany investmentbank.Salespeople take the formof:
1) the classic retailbroker2) The institutional salesperson,or 3)the private client service representative.
Brokers develop relationships with individualinvestors and sell stocks and stock advice
tothe average Joe.Institutional salespeople develop business relationships with large
institutional investors. Institutional investors are those who manage large groups of
assets, for example pension funds or mutual funds. Private Client Service (PCS)
representatives lie somewhere between retail brokers and institutional salespeople,
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providing brokerage and money management services for extremely wealthy
individuals. Salespeople make money through commissions on trades made through
their firms.
TRADING
Traders also provide a vital role for the investmentbank.Traders facilitate the buying
and selling ofstock,bonds,or other securities such as currencies, either by carrying an
inventory of securities for sale or by executing a given trade for a client.Traders deal
with transactions large and small and provide liquidity (the ability to buy and sell
securities)for the market. (This is often called making a market.)Traders make money
by purchasing securities and selling them at a slightly higher price. This price
differentialis called the "bid-ask spread."
RESEARCH
Research analysts follow stocks and bonds and make recommendations on whether to
buy, sell, or hold those securities. Stock analysts (known as equity analysts) typically
focus on one industry and will cover up to 20 companies' stocks at any given time.
Some research analysts work on the fixed income side and will cover a particular
segment, such as high yield bonds or U.S. Treasury bonds. Salespeople within the I-
bank utilize research published by analysts to convince their clients to buy or sell
securities through their firm.Corporate finance bankers rely on research analysts tobe
experts in the industry in which they are working. Reputable research analysts can
generate substantial corporate finance business as well as substantialtrading activity,
and thus are an integral partofany investmentbank.
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SYNDICATE
The hub of the investment banking wheel, syndicate provides a vital link between
salespeople and corporate finance.Syndicate exists tofacilitate the placing ofsecurities
in a public offering, a knock-down drag-out affair between and among buyers of
offerings and the investmentbanks managing the process.In a corporate or municipal
debt deal, syndicate also determines the allocation ofbonds.The breakdown ofthese
fundamental areas differs slightly fromfirmtofirm.
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COMMERCIAL BANKING VS. INVESTMENT BANKING
While regulation has changed the businesses in which commercial and
investmentbanks may now participate,the core aspects ofthese differentbusinesses
remain intact. In other words, the difference between how a typical investmentbank
and a typical commercialoperate bank is simple: A commercialbank takes deposits for
checking and savings accounts from consumers while an investment bank does not.
We'llbegin examining whatthis means by taking a look at what commercialbanks do.
COMMERCIAL BANKS
A commercial bank may legally take deposits for current and savings accounts
from consumers.The typical commercialbanking process is fairly straightforward.You
deposit money into your bank, and the bank loans that money to consumers and
companies in need of capital (cash). You borrow to buy a house, finance a car, or
finance an addition to your home. Companies borrow to finance the growth of their
company or meet immediate cash needs. Companies that borrow from commercial
banks can range in size from the dry cleaner on the corner to a multinational
conglomerate.
PRIVATECONTRACTS
Importantly, loans from commercial banks are structured as private legally
binding contracts between two parties - the bank and you (or the bank and a
company). Banks work with their clients to individually determine the terms of the
loans, including the time to maturity and the interest rate charged. Your individual
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credit history (or credit risk profile) determines the amount you can borrow and how
much interest you are charged. Perhaps you need to borrow Rs. 1,00,00,000 over 15
years tofinance the purchase of your home,or maybe you need Rs. 1,50,00,000 over
five years tofinance the purchase of a car.Maybe for the first loan, you and the bank
will agree that you pay an interest rate of 7.5 percent; perhaps for the car loan, the
interest rate willbe 11 percent.The same process applies toloans to companies as well
-the rates are determined through a negotiation between the bank and the company.
Let's take a minute tounderstand how a bank makes its money.On most loans,
commercialbanks earn interest anywhere from 5 to 14 percent. Ask yourselfhow much
your bank pays you on your deposits - the money that it uses to make loans. You
probably earn a paltry 1 percenton a current account, if anything, and maybe 2 to 3
percent on a savings account. Commercial banks thus make gobs of money, taking
advantage ofthe large spread between their costoffunds (1 percent,for example) and
their return on funds loaned (ranging from 5 to 14 percent).
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INVESTMENT BANKS
An investmentbank operates differently. An investmentbank does not have an
inventory of cash deposits to lend as a commercial bank does. In essence, an
investmentbank acts as an intermediary, and matches sellers ofstocks and bonds with
buyers ofstocks and bonds.
Note, however, that companies use investment banks toward the same end as
they use commercialbanks.Ifa company needs capital,itmay get a loan from a bank,
or it may ask an investment bank to sell equity or debt (stocks or bonds). Because
commercial banks already have funds available from their depositors and an
investmentbank does not, an I-bank must spend considerable time finding investors in
order toobtain capitalfor its client.
PUBLIC SECURITIES
Investment banks typically sell public securities (as opposed private loan
agreements). Technically, securities such as Microsoft stock or Ford AAA bonds,
represent government-approved stocks or bonds that are traded either on a public
exchange or through an approved dealer.The dealer is the investmentbank.
Private Debtvs. Bonds - An Example
Let's look at an example to illustrate the difference between private debt and
bonds. Suppose Acme Company needs capital, and estimates its need to be Rs. 200
million. Acme could obtain a commercial bank loan from Bank of New York for the
entire Rs. 200 million, and pay intereston that loan just like you would pay on a Rs.
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2,000 loan from Bank of New York. Alternately, it could sell bonds publicly using an
investment bank such as Morgan Stanley. The Rs. 200 million bond issue raised by
Morgan would be broken intomany bonds and then sold tothe public. (For example,
the issue could be broken into 200,000 bonds, each worth Rs. 1,000.) Once sold, the
company receives its Rs. 200 million and investors receive bonds worth a totalof the
same amount.
Over time,the investors in the bond offering receive the interest, and ultimately
the principal (the originalRs. 1,000) atthe end ofthe life ofthe loan, when Acme Corp
buys back the bonds (retires the bonds).Thus, we see thatin a bond offering, while the
money is stillloaned to Acme,itis actually loaned by numerous investors, rather than a
bank.
Because the investment bank involved in the offering does notown the bonds
but merely placed them with investors at the outset, it earns no interest - the
bondholders earn this interestin the formofregular coupon payments.The investment
bank makes money by charging the client (in this case, Acme) a small percentage ofthe
transaction upon its completion. Investment banks call this upfront fee the
"underwriting discount." In contrast, a commercialbank making a loan actually receives
the interest and simultaneously owns the debt.
Later, we will cover the steps involved in underwriting a public bond deal.
Legally, bonds must first be approved by the Securities and Exchange Commission
(SEC). (The SEC is a government entity that regulates the sale of all public securities.)
The investment bankers guide the company through the SEC approval process, and
then marketthe offering utilizing a written prospectus,its sales force and a road-show
tofind investors
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THE QUESTIONOF EQUITY (UNDERWRITING)
Investment banks underwrite stock offerings just as they do bond offerings. In
the stock offering process, companies sell a portion of the equity (or ownership) of
itselftothe investing public.The very firsttime a company chooses to sell equity,this
offering of equity is transacted through a process called an initial public offering of
stock (commonly known as an IPO). Through the IPO process, stock in a company is
created and sold tothe public. After the deal, stock sold are traded on a stock exchange
such as the NSEor the BSE.The equity underwriting process is another major way in
which investment banking differs from commercial banking. Commercialbanks (even
before Glass-Steagall repeal) were able to legally underwrite debt, and some of the
largest commercialbanks have developed substantial expertise in underwriting public
bond deals.So, notonly dothese banks make loans utilizing their deposits, they also
underwrite bonds through a corporate finance department. When it comes to
underwriting bond offerings, commercialbanks have long competed for this business
directly with investmentbanks. However,only the biggesttier ofcommercialbanks are
able to do so, mostly because the size of most public bond issues is large and
competition for such deals is quite fierce.
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THE BUY-SIDE V/S THE SELL-SIDE
The traditional investment banking world is considered the sell-side of the securities
industry.Investmentbanks create stocks and bonds, and sellthese toinvestors.Sellis
the key word, as I-banks continually selltheir firms' capabilities to generate corporate
finance business, and salespeople sell securities to generate commission revenue.
Who are the buyers of public stocks and bonds? They are individual investors
(you and me) and institutionalinvestors,firms like Fidelity and Vanguard.The universe
ofinstitutionalinvestors is appropriately called the buy-side ofthe securities industry.
Mutualfund companies represent a portion ofthe buy-side business.These are
mutualfund money managers.Insurance companies like ICICI Prudential, Birla Sunlife,
LIC also manage large blocks of assets and are another segmentof the buy-side. Yet
another class ofbuy-side firms manage pension fund assets -frequently, a company's
pension assets will be given to a specialty buy-side firm that can better manage the
funds and hopefully generate higher returns than the company itselfcould have.There
is substantial overlap among these money managers some manage both mutual
funds for individuals as well as pension fund assets oflarge corporations.
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HEDGE FUNDS: WHAT EXACTLY ARE THEY?
Hedge funds are one component of the buy side. Since the mid-1990s, hedge
funds popularity has grown tremendously. Hedge funds pool together money from
large investors (usually wealthy individuals) with the goal of making outsized gains.
Historically, hedge funds bought individual stocks, and shorted (or borrowed against)
the S&P 500 or another market index, as a hedge against the stock. (The funds bet
against the S&P in order to reduce their risk.) As long as the individual stocks
outperformed the S&P,the fund made money.
Nowadays, hedge funds have evolved into a myriad ofhigh-risk money managers
who essentially borrow money toinvestin a multitude ofstocks,bonds and derivative
instruments (these funds with borrowed money are said tobe leveraged).Essentially, a
hedge fund uses its equity base to borrow substantially more capital, and therefore
multiply its returns through this risky leveraging. Buying derivatives is a common way to
automatically leverage a portfolio.
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ORGANIZATIONAL STRUCTURE OF AN INVESTMENT BANK
Main activitiesand units
On behalfofthe bank and its clients,the primary function ofthe bank is buying
and selling products. Banks undertake risk through proprietary trading, done by a
special setoftraders who do notinterface with clients and through "principal risk", risk
undertaken by a trader after he buys or sells a productto a client and does not hedge
his total exposure. Banks seek tomaximize profitability for a given amountof risk on
their balance sheet. An investmentbank is split into the so-called frontoffice,middle
office, and back office.
Front office
Investmentbanking is the traditional aspectofthe investmentbanks which also
involves helping customers raise funds in the capital markets and advise on mergers
and acquisitions.These jobs pay well, so are often extremely competitive and difficult
toland.On a similar note,they are extremely stressful.Investmentbankers frequently
work 80 to 100 hours a week,often working well pastmidnight and during weekends.
Investment banking may involve subscribing investors to a security issuance,
coordinating with bidders, or negotiating with a merger target. Other terms for the
investment banking division include mergers and acquisitions (M&A) and corporate
finance. The investment banking division (IBD) is generally divided into industry
coverage and product coverage groups. Industry coverage groups focus on a specific
industry such as healthcare,industrials,or technology, and maintain relationships with
corporations within the industry to bring in business for a bank. Product coverage
groups focus on financial products, such as mergers and acquisitions, leveraged
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finance, equity, and high-grade debt and generally work and collaborate with industry
groups in the more intricate and specialized needs ofa client.
Investment management is the professional management of various securities
(shares, bonds, etc.) and other assets (e.g. real estate), to meet specified investmentgoals for the benefit of the investors. Investors may be institutions (insurance
companies, pension funds, corporations etc.) or private investors (both directly via
investment contracts and more commonly via collective investment schemes eg.
mutualfunds).The investmentmanagement division ofan investmentbank is generally
divided into separate groups,often known as Private Wealth Management and Private
Client Services. AssetManagementmarket making, traders will buy and sell financial
products with the goalofmaking an incremental amountofmoney on each trade.Sales
is the term for the investment banks sales force, whose primary job is to call on
institutional and high-net-worth investors to suggest trading ideas (on caveat emptor
basis) and take orders. Sales desks then communicate their clients' orders to the
appropriate trading desks that can price and execute trades,or structure new products
thatfit a specific need.
Structuring has been a relatively recent division as derivatives have come into
play, with highly technical and numerate employees working on creating complex
structured products which typically offer much greater margins and returns than
underlying cash securities. The necessity for numerical ability has created jobs for
physics and math Ph.D.s who act as quantitative analysts.
Merchantbanking is a private equity activity ofinvestmentbanks.[2] Current examples
include Goldman Sachs Capital Partners and JPMorgan's One Equity Partners.
(Originally, "merchantbank" was the British English termfor an investmentbank.)
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Research is the division which reviews companies and writes reports abouttheir
prospects,often with "buy" or "sell" ratings. While the research division generates no
revenue,its resources are used to assisttraders in trading,the sales force in suggesting
ideas to customers, and investment bankers by covering their clients. There is a
potential conflict of interest between the investment bank and its analysis in that
published analysis can affect the profits of the bank. Therefore in recent years the
relationship between investment banking and research has become highly regulated
requiring a Chinese wallbetween public and private functions.
Strategy is the division which advises external as well as internal clients on the
strategies that can be adopted in various markets.Ranging from derivatives to specific
industries, strategists place companies and industries in a quantitative framework with
full consideration ofthe macroeconomic scene.This strategy often affects the way the
firm will operate in the market, the direction it would like to take in terms of its
proprietary and flow positions, the suggestions salespersons give to clients, as well as
the way structurers create new products.
Middle office
Risk management involves analyzing the market and credit risk thattraders are
taking ontothe balance sheetin conducting their daily trades, and setting limits on the
amountof capitalthatthey are able totrade in order to prevent 'bad' trades having a
detrimental effect to a desk overall. Another key Middle Office role is to ensure that
the above mentioned economic risks are captured accurately (as per agreement of
commercial terms with the counterparty), correctly (as per standardized booking
models in the most appropriate systems) and on time (typically within 30 minutes of
trade execution).In recent years the risk of errors has become known as "operational
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risk" and the assurance Middle Offices provide now includes measures to address this
risk. When this assurance is not in place, market and credit risk analysis can be
unreliable and open to deliberate manipulation.
Finance areas are responsible for an investmentbank's capitalmanagement andrisk monitoring. By tracking and analyzing the capital flows of the firm, the Finance
division is the principal adviser to senior management on essential areas such as
controlling the firm's global risk exposure and the profitability and structure of the
firm's various businesses. In the United States and United Kingdom, a Financial
Controller is a senior position,often reporting tothe ChiefFinancialOfficer.
Compliance areas are responsible for an investment bank's daily operations'
compliance with government regulations and internal regulations. Often also
considered a back-office division.
Back office
Operations involves data-checking trades that have been conducted, ensuring
thatthey are not erroneous, and transacting the required transfers. While some[who?]
believe that operations provides the greatest job security and the bleakest career
prospects of any division within an investment bank, many banks have outsourced
operations.It is, however, a critical partofthe bank.Due to increased competition in
finance related careers, college degrees are now mandatory atmostTier 1 investment
banks.[citation needed] A finance degree has proved significant in understanding the
depth ofthe deals and transactions thatoccur across allthe divisions ofthe bank.
Technology refers to the information technology department. Every major
investment bank has considerable amounts of in-house software, created by the
technology team, who are also responsible for technical support. Technology has
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changed considerably in the last few years as more sales and trading desks are using
electronic trading. Some trades are initiated by complex algorithms for hedging
purposes.
Chinese wall
An investment bank can also be split into private and public functions with a
Chinese wall which separates the twoto preventinformation from crossing.The private
areas of the bank deal with private insider information that may not be publicly
disclosed, while the public areas such as stock analysis deal with public information.
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POSSIBLE CONFLICTS OF INTEREST
Potential conflicts of interest may arise between different parts of a bank,
creating the potential for financial movements that could be market manipulation.Authorities that regulate investmentbanking (the FSA in the United Kingdom and the
SEC in the United States) require that banks impose a Chinese wall which prohibits
communication between investment banking on one side and equity research and
trading on the other.
Some of the conflicts of interest that can be found in investment banking are listed
here:
Historically, equity research firms were founded and owned by investment
banks.One common practice is for equity analysts toinitiate coverage on a company in
order to develop relationships that lead to highly profitable investment banking
business.In the 1990s,many equity researchers allegedly traded positive stock ratings
directly for investmentbanking business.On the flip side ofthe coin: companies would
threaten to divert investmentbanking business to competitors unless their stock was
rated favorably. Politicians acted to pass laws to criminalize such acts. Increased
pressure from regulators and a series oflawsuits, settlements, and prosecutions curbed
this business to a large extent following the 2001 stock market tumble.[citation
needed]
Many investmentbanks alsoown retailbrokerages. Also during the 1990s, some
retailbrokerages sold consumers securities which did notmeettheir stated risk profile.
This behavior may have led to investment banking business or even sales of surplus
shares during a public offering to keep public perception ofthe stock favorable.
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Since investmentbanks engage heavily in trading for their own account,there is
always the temptation or possibility that they might engage in some form of front
running. Front running is the illegal practice of a stock broker executing orders on a
security for their own account before filling orders previously submitted by their
customers,thereby benefiting from any changes in prices induced by those orders.
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