The Investment Banking Paradigm

Presented by:Nikhil Gangadhar

Concepts and definitions

Investment banking is concerned with the primary function of assisting the capital market, in its function of capital intermediation, i.e. the movement of financial resources from the investors to those who need to make use of them for generating GDP.It can be inferred that investment banks are the counterparts of banks in the capital market in discharging the critical function of pooling and allocation of funds.Investment bank, is a term used in the US to mean a bank which deals with the underwriting of new issues and advices corporations on their financial affairs.Its termed in UK as an ‘issue house’

An investment bank is also defined as, a financial intermediary that performs a variety of services including aiding in the sale of securities, facilitating mergers and other corporate re-organizations, acting as brokers to both individual and institutional clients and trading for its own account.

Merchant banking

The Dictionary of banking and finance defines a Merchant Bank as, ‘a bank which arranges loans to companies, deals in international finance, buys and sells shares and launches new companies on the stock exchange, but does not provide normal banking services to the general public’. In US Merchant Banking is the activity of making direct investments of the investment bank’s own funds, in some assets not directly related to traditional investment banking business. Thus in addition to underwriting obligations, it also takes its own exposure to securities.

When the investment bank is primarily an advisor, merchant banking involves transactions such ass buyouts and acquisitions.In India MB connotes ‘Issue Management’ of various types provided under law and activities therewith.

Evolution of investment banks in US

The earlier stage is traced to the end of WW 1, by which the commercial banks in the US were preparing for an economic recovery and consequently, to the significant demand for corporate finance.American co’s were expected to shift their dependence to stock and bond markets, where funds were available at cheaper rates and longer terms.In preparation for the boom in the capital markets in the 1920’s, commercial banks started to acquire the stock broking businesses in a bid to have a presence in such markets.The stock and bond market boom in 1920’s was an opportunity that banks could not miss. But since they could not underwrite and sell securities directly, they owned security affiliates through holding companies. They were financed by the parent banks for their underwriting and other business obligations.

The IB affiliates started making huge profits as the boom lasted. The Mc Fadden Act of 1927, allowed bank subsidiaries to underwrite stock issues as well.The stock market got over-heated with investment banks borrowing money from the parent banks in order to speculate in the bank’s stocks, mostly for short-selling. Later the price earning ratios reached absurd limits and the bubble eventually burst in October 1929 wiping out millions of dollars of bank depositors’ funds and bringing down with it banks such as the Bank of United States.

Regulation of the industryIt starts with Glass-Steagall Act or the Banking act of 1933, that restricted commercial banks from engaging in securities underwriting and taking positions or acting as agents for others in securities transactions.The exclusive domain of Investment Banking were segregated.

Other regulations include:The securities act of 1933- preparations of offer documents and registrations of new securities with the federal government.The securities exchange act of 1934- formation of Securities Exchange Commission.The Maloney act of 1938- formation of NASDAQThe investment company act of 1940- brought mutual funds within regulatory orbit.The investment advisors act of 1940-nregulated the businesses of investment advisors and wealth managers.

Global industry structure

The IB industry on a global scale is oligopolistic in nature ranging from global leaders to ‘ Pure Investment banks’ and ‘Boutique investment banks’.

The global bulge group leaders include 8 investment banks that has global presence.

League tables’- a word taken too seriously in the IB as they define their position in the industry and send a strong message to their clients about their performance and capabilities.

Pure investment banks are those which do not have commercial banking connections. Eg: Merrill Lynch, Goldman Sachs etc.

Business portfolio of Investment Banks.Investment banks handle significant fund-based businesses of their own in the capital market along with their non-fund service portfolio, which is offered to clients.There are distinct segments which are handled either on the same B/S or through subsidiaries and affiliates.The activities are segmented along 3 broad segments:1. Equity market activity2. Debt market activity3. Mergers and acquisitions activity.

US investment banking, the main sources of revenue comprises of Core investment banking- underwriting, issue management, marketing

and research. Securities portfolio Brokerage Asset management Advisory services.

Core Business Portfolio

Non-fund basedEquity PF- underwriting primary market security issues and private placements, issue management and security business( market, distribution and research)Debt PF- Fixed income underwriting and placement structures financing and securitization, junk bonds and debt finance advisory.M&A PF- corporate restructuring, M&A transaction services, Corporate finance advisory.

Fund BasedEquity PF- Underwriting bought deals, secondary market making and proprietary trading, derivatives and arbitrage.Debt PF- underwriting, secondary market making and proprietary trading.M&A PF- participation as lead/ co-investor in buyouts, LBO’s/MBO’s.

Allied Businesses

Asset management•Mutual Funds•Hedge Funds•Venture capital, private equity, buyout funds.•Stock broking and investment advisory.•Risk advisory and management.•Custodial services.

Investment Banking in India

Its existence has been traced to over 3 decades. IB was largely confined to MB services. The forerunners of Merchant banking in India were mostly foreign banks. In 1972 T he Banking commission Report asserted the need for Merchant banking Services in India. Here merchant banking was meant to provide advisory services and manage investments. By the mid eighties and early nineties, most of the merchant banking divisions of public sector banks were spun-off as separate subsidiaries. This includes SBI’s SBI capital markets Ltd in 1986 and IDBI’s IDBI capital markets in 1992.

Growth:

Merchant banking activity was regulated by SEBI in 1992 following a sever downturn due to phases of hectic activity in business. Majority of those registered under SEBI were either in Issue management or advisory services. Based on their net-worth, SEBI had 4 categories of Merchant banks. The number of registered merchant banks with SEBI at the end of march 2003 was 124 from a high of almost a thousand in nineties. In 2002-03 the number further decreased by 21.

Constraints to IB

Over dependence in the Issue management activity in the initial years led the merchant banks to perish in the primary market downturn. Later they diversified to offer a broad spectrum of capital market services. Only few industry leaders other than merchant banks could not turn themselves into full service investment banks. Indian industry has seen more or less similar developments to that of its western counterparts, though the breadth available there is still not present in India. Due to lower availability of institutional financing to fund the capital market activity, its only the bigger industry players who are in full service investment banking.The main constraint is the inadequate breadth in the secondary market, especially in the corporate debt segment.

Risk aversion, characteristics and structure of Indian Investment Banking Industry

Indian regulatory regime does not allow all investment banking functions to be performed under one legal entity as its structure over the years has evolved due to business realities and the regulatory regime. The reasons for this are:1. To prevent excessive risk exposure to business risk under one entity &2. To prescribe and monitor capital adequacy and risk mitigation

mechanisms.

Thus Indian investment banks follow a conglomerate structure by keeping their business segments in different corporate entities to meet regulatory norms.

Indian investment banking industry also has a heterogeneous structure, as bigger investment banks have several group entities in which the core and non-core business segments are distributed. Others have one or more entities depending upon the activity profile.

CORE BUSINESS PORTFOLIO

Non-Fund basedMerchant Banking services for • Management of public offers of equity and debt instruments• Rights issue• Open offers under the takeover code• Buyback offers• De-listing offers

Advisory and Transaction services in• Project financing• Syndicated loans• Structured finance and Securitization• Private equity / Venture capital• Preferential issues• Qualified institutional placements• Business Advisory• Financial restructuring• Corporate re-organizations such as mergers and de-mergers, hive-offs, asset sales and divestitures.• Acquisitions, strategic sale, buyouts and takeovers• Government disinvestments and privatization• Asset recovery agency services.

Fund Based• Underwriting• Market making• Bought out deals•Proprietary investments and trading in equities, bonds and derivatives

ALLIED BUSINESSES

Asset management services• Mutual funds, Portfolio management• Venture capital funds, Private equity fundsSecondary market services• Securities business-Broking, Sales and distribution, Equity research• Investment advisory•DerivativesSupport services• Registrars and share transfer agents• Custodial services• Other capital market services.

Inter-dependence between different verticals in investment banking

There are different verticals in investment banking and they do enjoying synergies with one another. The service or business segments form the core of investment banking, others provide invaluable support. It is important to understand and the inter-dependence and complementary existence of all these business segments. Merchant banking largely relates to management of public floatation of securities/ reverse floatation like buy backs and open offers, underwriting is an inherent part of MB for public issues. Advisory and transaction services have a close linkage with MB in public issue and reverse floatation. Venture capital enables identification of potential IPO candidates which leads to generation of fee income from MB services and good capital gain for the VC invested at the earlier rounds of financing in such companies. Stock broking and primary dealership in debt markets nurture- institutional, corporate and retail clients who can be tapped effectively for asset management,, PF management, and private equity business.

Presence in the equity derivative and foreign exchange derivative segments can help in offering solutions in treasury management to clients.

All these verticals are driven by support services such as sales and distribution and equity research and analysis, where the capability of S&D determines the success of MB vertical.

Thus IB is a business that is very sensitive to the economic and capital market scenario and therefore, the broader the platform of operations, the more is the likelihood of an IB, surviving business cycles and sudden shocks from the market.

Conflict of interest in IB

The most burning global issue in the IB industry at the beginning of the 21st century became the conflict of interest between the investment banks and their research analysis divisions.

The securities and exchange commission in the US initiated investigations into instances of investment banks issuing over-optimistic research and steering in hot IPO’s for important clients in vested interests.

In such investigations some banks were also fined.

How does the conflicts arise?

Most investment banks have in-house research divisions as a support function. The research divisions perform vital functions of tracking corporate and making recommendations to their clients in the secondary market operations or to their own dealing rooms. They also issue reviews and ratings to the new issuances hitting the market.

The conflict could arise if the analyst would promote a share, the public offering for which is being handled by the MB.

Alternatively , it could also be that the analyst is prone to insider information from the merchant banking division and there upon issue recommendations that could amount to fraudulent deceit of investors or gain for select few.

The corporate scandals of US led to precautionary amendments in India by SEBI.

SEBI amended the regulations that were in place for merchant bankers and Underwriters and for prohibition of insider trading . As a result analysts are barred from private trading in shares they analyze.

There is rule for more regulation in this area of importance for the survival of the IB industry.

Full service investment banks and financial conglomerates of the future.

The business of IB is under-going rapid changes in response to the growing sophistication in the financial markets and the need of clients.

Consolidation and globalization is the ‘Mantra’ for success and growth.

Financial conglomerates with equal presence and reach in commercial banking, IB, insurance and financial advisory are the way to go for one-step shopping for all financial needs.

Emerging areas of investment banks have been retail and institutional fund management, trust services and thrift charters etc.

The share of revenue from core investment banking has been declining steadily and is being replaced by proprietary trading, asset management and advisory services.

Investment banks are buying into asset management companies and also setting up private equity to tap the available opportunity.

The future therefore lies in ‘full service investment banking’ comprising of core investment banking, asset management, private equity, venture capital, brokerage, S&D, research and analysis, proprietary trading and investment, primary dealing in fixed income securities, structured financing and corporate advisory services.

Universal banks can add all their banking products in both corporate and retail banking segments to the long list of services offered as full service investment banks.

A step forward would be the financial conglomerates for the future that can even add on insurance and pension products to make them one-stop financial shops, large financial conglomerates such as Citygroup/ ING would be the models of growth in years to come.

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