You probably heard about investment bank, but you may have no idea how it works. Investment bank bridges the gap between large enterprises and investors. It works as an advisor to businesses and government by teaching them to meet their financial challenges and helping them secure financing – whether it will be from stock offerings, bond issues, or derivative products.
For a company to manage to raise capital, one of the key moves is to issue stocks and bonds. However, doing this requires great expertise that involves financial instruments that will maximize revenues and navigate regulatory requirements. From here, an investment bank will enter the scene.
Investment Bank as an Advisor
Mostly, a company or government leans on an investment bank to decide how to raise capital. These entities get guidance from these banks. Whether a big firm or a small business, they need an investment bank to do the work.
The bank will recommend the best way to raise funds, depending on the current nature of investing. The move may come with selling an ownership stake in the company through a stock offer or borrowing from the public through a bond issue. The investment firm, on the other hand, can help determine the price of the instruments by using financial models.
In the stock offering, the financial analysts will study an array of different factors, like the earning potential and management team’s strength. From here, they can estimate how much the worth of the company’s share is. If the client offers bond, the bank will take a look at the current interest rates for the same rated businesses to figure out the cost that it will have to compensate borrowers.
Investment banks also advise a merger or acquisition events. If a business wants to buy a competitor, the bank can tell its management team how much the company’s worth and how to create a deal that will be in favor of the buyer.
Underwrite the Securities
One or more investment banks will underwrite securities if a company decides to raise funds using the equity of debt offering. This move means that an institution will buy a certain number of shares or bond at a fixed price and resell it through an exchange.
For example, a company wants to have $1 million in an initial public offering. Based on different factors that include its expected earnings in the coming years, an investment bank will determine if the investors will be willing to pay $11 each for 100,000 shares of the company’s stock. As an underwriter, the investment bank will buy all the shares at $10 per share. If it manages to sell it as $11, it will earn $100,000 profit with its $1 spread.
However, it will all depend on its arrangement with the seller. The investment bank will experience a deficit if the public’s appetite is weaker. It may also have to lower its price to $9 per share to liquidate its holdings, resulting in a $100,000 lost.
This only means that pricing securities can also come tricky. Investment banks have to outbid other companies that want to handle the transaction on behalf of the seller. If its spread is not big enough, it may not be able to earn a significant profit from the sale.
In reality, underwriting securities’ task is often handled by more than one bank. If the offer is more extensive, the managing underwriter will create a syndicate of other banks that will sell a portion of the shares. This move will help them to market its stocks and bonds to a more significant part of the public and lower their risk. However, the manager will still take part of the profit, even if another syndicate member manages to sell the security.
Investment banks also have a dual role in stock offerings. It is its job to do the documentation that must be sent to the Securities and Exchange Commission (SEC) before the company can sell shares. The work involves compiling financial statements, company management information, and ownership. It also has to create a statement about the firm’s plans on the proceeds.
Other Investment Bank Activities
Aside from giving companies some advice and helping them raise money, investment banks have a lot of other activities to do. Most known banks have diverse services to offer. Some of those are:
Research – Larger investment banks have bigger teams that work to gather information about companies and provide their recommendations on whether they need to buy or sell their stock. They may use the data they collected internally, but they can also make a profit from it by selling it to hedge funds and mutual fund managers.
Trading and Sales
Most major investment banks have a trading department where they can perform stock and bond transactions on behalf of their clients. Some banks also previously held propriety trading, whereas they gambled their own money on securities. However, a new regulation called Volcker Rule has stopped this kind of method.
Investment banks like J.P. Morgan and Goldman Sachs manage big portfolios for pension funds, foundations, and insurance companies through their asset management section. Their expert analysts help choose the right combination of stocks, debt instruments, real estate trusts, and another investment medium to achieve their clients’ goals.
Some of the investment banks that complete investment banking functions for Fortune 500 businesses also accommodate retail investors. With the help of a financial advisor ream, they assist people and families to save for retirement and other long-term financial needs.
Nowadays, companies often pool financial assets, from mortgages to credit card receivables, and sell them all to investors as fixed-income products. The investment bank will come to the picture to recommend opportunities to securitize income streams, fix the assets, and market them to already-established investors.
The word investment bank seems to be an inaccurate name for its work. Generally, it does a lot of things other than just raising capital for companies.
Investment banks play an essential role in helping companies and government entities to make a proper financial decision to raise their needed capital. There are also other things that these banks can do to help these institutions reach their business goals.
Photo Sources: Albawaba, Basch Corp, 5 Star Essay