Major roles played by Investment Banks

By admin
Feb 9th, 2012
Major roles played by Investment Banks
We have already discussed the role of an investment bank as an underwriter while understandingthe issue process of an IPO.

Here we will try to understand what are the other roles that an investment bank playsapart from underwriting. We will also take up underwriting and will try to build on it.

Main lines of business where an Investment bank isinvolved are:

  • Underwriting
  • Mergers and Acquisitions
  • Merchant Banking
Let’s have a look at them one by one.

Underwriting Although we have already discussed about the underwriter, there is no harm in repeating some of it and adding some crucial new information.

Raising funds for a corporation by issuing securities is whatis underwriting. In case of issuing equity of a private firm, the process is known as IPO.  There are two types of commitments from the investment bank to the issuer for the sale of stock. We have already discussed about commitments in detail.
  1. Firm commitment: The bank guarantees the sale ofall the stocks to the investors.
  2. Best Efforts: The bank gives its best shot tosell as many shares out of the total offering.
Now we introduce a concept of an ‘Underwriting Syndicate’. The underwriter investment bank instead of managing the entire process of the IPO creates an underwriting group. This is done primarily for two reasons:
  •  To spread the risk involved while issuing an IPO
  • To capitalize on the sells capability of other syndicate members in selling the shares to the investors. Different banks can have better sells capabilities in their geographies.
Here the bank runs the risk of being unable to sell the entire equity as planned. In case of firm agreement the bank might be needed to purchase the left over equity at an agreed upon price which might be considerably higher than the market price. 

The lower market price is understandable as there were not many buyers of the stock and there was less demand in the market.

Structure of the Syndicate: Here’s a short story.

The syndicate consists of the lead investment bank, alongwith some other banks, to distribute the risk involved in issuing an IPO. Thisgroup can also participate in selling of the stocks. The lead investment banktakes the maximum risk in this case. This group is the underwriting group. There is another group of banks whichdo not share any risk, but only helps the first group in selling the stocks.This group is the selling group. Insome syndicates there is no selling group. In such syndicates the entireresponsibility of the selling of shares lies with the underwriting groupitself.

The fee amount is cut from the total proceeds from the issuebefore the net capital raised is paid to the issuer. Now what happens with the fee that is collected through the issue?

Obviously the fee is distributed within the members ofthe syndicate. And more obvious is the fact that the member who took thelargest share of the risk gets the largest share of the fee collected throughthe issue. So it is clear that the lead investment bank, which the client orthe issuer has chosen to be the underwriter, gets the largest share and theother underwriters get a smaller share. And then the members of the sellinggroup who are paid according to the actual sales made by them.

Mergers andAcquisitions: The term is loosely used whenever there is a buying orselling of a business, either fully or partially. The investment bank advises aclient for such activities where a client wants to buy/sell business from/to anothercompany.

From the above information it is quite clear that theinvestment bank can be approached from both the sides, i.e. either the buyer orthe seller of the business.

This divides the line of business into two:
  • Buy side: When an interested buyerapproaches the investment bank, the bank does the client’s and the marketanalysis and provides the client with many prospective candidates. Out of thesecandidates many might get rejected by the client and only few would beconsidered. Out of this filtered list, many candidates would not be receptiveto the offer made and some others might ask for a better price than beingoffered by the client. Hence, it is difficult for a buy deal to actualize.
  • Sell Side: When a would be seller approachesthe investment bank, the deal is a bit easier to actualize as the sellernormally has some pressing reasons for the sale and might succumb to the conditionsand offer of the would be buyer.
Let’s just quickly see what the stages in a buy side dealare.

The bank is approachedby the client, the buyer, and the bank after understanding the objectives of the client search for the potential candidate. The bank does allthe analysis work and then advice and assists the client on the offer and finally assists in closing the deal. Here a lot moredetails can be added but for the sake of simplicity we keep it short.

MerchantBanking: A merchant bank invests its own funds in business.  These investments are generally long term investments. A merchant bank provides capital in the form of shares but loan. It provides advisories on a range of corporate matters to its clients or the firm that it has funded.

So here we come to an end of our post on Investment Banking. We can take the discussion forward in the comments section below. Do write in your thoughts or your queries.

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