Investment Banking 101: Everything You Need to Know

What is Investment Banking?

Investment banking is an area under the financial services industry that involves helping individuals, corporations, and governments raise capital and complete complex financial transactions. Companies rely on investment banking to support the development and growth of their business.

There are a variety of methods for investment bankers to help clients raise money, such as through underwriting, initial public offerings (IPOs), mergers and acquisitions, leveraging, bond issuance, and much more. Don't worry if you're unfamiliar with these terms as they will be explained in the next section.

Investment banking can be divided into debt financing, which involves raising capital through the issuance of debt instruments like bonds or loans, and equity financing, which involves raising capital by selling shares of the company. There are also other areas in this industry including mergers and acquisitions (M&A) which is the strategic buying, selling, or combining of companies to stimulate growth, efficiency, or market presence.

Key Investment Banking Terms

Before diving deeper, let's go over some key terms that are essential to understanding investment banking:

Asset - An item with economic value that can be owned or controlled by an individual, business, or government (e.g. cash, stocks, bonds, real estate, mutual funds, personal property, etc)
- Stocks - Shares of ownership in a company
- Bonds - Debt securities issued by governments or corporations
- Real Estate - Property including lands and buildings
- Mutual Funds - Investment funds that pool money from many investors to buy a diversified portfolio of assets
- Personal Property - Valuable items like jewelry and vehicles
Securities - Tradable financial assets that represent ownership or a claim on future payments (e.g. stocks, bonds, etc)
Portfolio - A collection of financial investments including stocks, bonds, and other assets held by an individual or organization to achieve specific financial goals
Shares - The individual units of stocks issued by a corporation that represent ownership
Capital - The money or assets used by individuals or businesses to invest in projects, buy goods, or fund operations, helping them generate more wealth
Debt Financing - Raising capital through borrowing, often through issuing bonds
- Leveraging - An investment strategy that uses borrowed money (debt) to increase the potential return on an investment
Equity Financing - Raising capital by selling shares of stock in the company
- Initial Public Offering (IPO) - A company sells its shares to the public for the first time to raise capital
Commodities - Interchangeable goods or raw materials that are traded on markets and used to produce other products or services (e.g. oil, gold, wheat, natural gas, etc)
Equity - Refers to the amount of money that would be returned if all a business's assets were sold and its debt paid off. In simpler terms, it is the portion of a company that shareholders own
Fraud - A type of deception that occurs with the purpose of gaining something, usually money
Mergers - A process that sees two separate organizations unite into one new company in order to improve both businesses (e.g. Exxon and Mobil)
Acquisitions - Involve one company buying another company to expand its operations or market share (e.g. Facebook purchasing Instagram in 2012)
- Leveraged Buyout (LBO) - The acquisition of a company using a significant amount of borrowed money (combination of equity and debt)
Valuation - Determining the worth of a company or asset, often as part of a merger or acquisition process
Trading - An activity that involves the transfer (either the purchase or sale) of securities
Underwriting - The process of raising capital for a company by issuing and selling securities
Regulators - Government or independent agencies that oversee and manage financial markets to ensure fairness and good practice

Types of Investment Banks

There are four main types of investment banks that specialize in different areas of the financial industry:

Bulge Bracket Banks
- Major international banks with a significant global presence
- Largest and most prestigious
- Tend to deal with organizations that are global brands and some of the richest in the world
- Offer a wide range of services including mergers and acquisitions (M&A) advisory, underwriting, and trading
- E.g. Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, etc
Boutique Banks
- Focused on specialized areas
- Typically smaller than bulge bracket banks and offer more personalized services
- International and nationwide presence
- E.g. Lazard, Evercore, Moelis & Company, etc
Middle-Market Banks
- Cater to mid-sized companies
- Provide a full range of services including M&A advisory, capital raising, and financial restructuring
- E.g. William Blair, Lincoln International, Jefferies, etc
Regional Banks
- Smallest investment banks in terms of employee numbers, firm size, and typical deal size
- Provide investment banking services on a regional or local scale
- Only offer a select amount of the typical investment bank services
- Typically specialize in their own niche area of the market
- Cater to the needs of local businesses
- E.g. Piper Sandler, Stifel Financial Corp, Raymond James, etc

Investment Banking Services

Mergers and Acquisitions (M&A) Advisory

A term used to signify the unification of businesses and their assets through financial transactions. These are transactions that see the ownership of an organization change, either to be joined with another owner in mergers or obtained by someone else in acquisitions.

A merger is hence the combination of two businesses of near enough the same size during which an entirely new company forms. Some famous examples of mergers include AOL and Time Warner in 2000, Exxon and Mobil in 1999, Disney and Pixar in 2006, and Amazon and Whole Foods in 2017. Typically, mergers are conducted to gain a bigger share of the market, reduce competition, and to increase reach to new consumers.

Mergers can be categorized into several types based on the relationship between the companies involved:

Horizontal Merger - A merger between two companies that operate in the same industry and are often direct competitors (e.g. Exxon and Mobil in 1999)
Vertical Merger - A merger between companies that operate at different stages of the same supply chain (e.g. AT&T, a telecommunications company, acquired Time Warner, a content provider, in 2018)
Conglomerate Merger - A merger that occurs between companies that are completely unrelated, meaning they operate in entirely different industries or markets (e.g. Berkshire Hathaway and Precision Castparts in 2016)
Market-Extension Merger - A merger that occurs between companies within different markets or geographical regions, but that sell similar products or services (e.g. Sanofi and Genzyme in 2011)
Product-Extension Merger - A merger between two companies that operate in related industries and produce related products (e.g. PepsiCo and Frito-Lay in 1965)

An acquisition is when one company buys more than 50% of another company, meaning they can start making decisions without consulting the other owner. These transactions can be either friendly or hostile, with the latter also known as a non-friendly acquisition when the company being bought does not give consent to the process. Typically, acquisitions occur for companies to enter an international market, reduce costs, or gain a larger portion of the market.

There are four main types of acquisitions categorized based on the strategy, purpose, or relationship between the acquiring and target companies:

Horizontal Acquisition - When a company acquires another company that operates in the same sector/industry and is often a direct competitor (e.g. Facebook acquiring Instagram in 2012)
Vertical Acquisition - When a company acquires another company that operates at a different stage of the same supply chain (e.g. acquisition of a farm that distributes meat products on behalf of a butcher that sells meat products)
Congeneric Acquisition - Occurs between two companies that are in related industries but do not directly compete with each other (e.g. Citigroup’s acquisition of Travelers Insurance in 1998)
Conglomerate Acquisition - A company buys another company in an entirely different industry, which occurs for the purpose of diversification (e.g. Berkshire Hathaway’s purchase of Duracell in 2014)

Underwriting

A process where an investment bank helps a company issue new securities by buying them and selling them to investors, or by finding buyers for them. In other words, the investment bank acts as the intermediary between the company issuing securities such as stocks or bonds and the investors willing to buy them.

The two main types of underwriting include:

Firm Commitment - The investment bank buys the entire issue of securities from the company and guarantees to sell them to investors, also taking on the risk if the securities cannot be sold at the expected price
Best Efforts - The investment bank agrees to sell as many securities as possible but does not guarantee that the entire issue will be sold, meaning the company bears the risk of any unsold securities

When a company allows people to invest in it, it's also taking on a risk. If too many shares are issued, for example, the company might 'flood' the market meaning that there won't be enough demand for the shares and therefore the price will decline. The demand for shares might also be low if they are initially overpriced. Ultimately, a company's stock price is very much tied to its reputation and that is where the role of investment bankers come in to ensure proper pricing and mitigate risks associated with issuing new shares. They help set a fair price for the shares, gauge investor interest, and create a positive market environment to support the company's valuation.

The most common point at which these underwriting services are needed is when a company first makes its stock available, also known as the Initial Public Offering (IPO). An IPO underwriter helps prepare a business for the IPO, considering how much money needs to be raised, what kind of securities should be made available, the price of stocks, and checking they meet requirements. A common practice is for IPO underwriters to underprice the stock, which increases the demand and results in 'oversubscription', where the number of shares requested by investors exceeds the number of shares available for sale. This typically creates a situation where the stock price rises sharply on the first day of trading, benefiting early investors and generating strong market interest. Strong market perception can also positively impact the stock price, where a company's reputation and the investment bank’s role are crucial in determining the success of the securities issued.

Investment banks charge fees for their underwriting services, including advisory fees, underwriting fees, and other related charges. These fees compensate the bank for its risk and efforts. Lastly, after the securities are issued, the investment bank may provide additional services, such as market making to ensure liquidity, and investor relations support to help maintain a positive market perception.

Sales and Trading

A division of an investment bank that helps clients buy and sell securities and other financial instruments.

Salespeople work within an investment bank to sell ideas and opportunities to potential or current clients, who are usually large institutional investors like hedge funds. Investment opportunities selling could be shares in a new stock, government or corporate bonds, and commodities. Selling occurs either in the primary market where firms sell new stocks and bonds to the public for the first time (IPOs), or in the secondary market also known as the stock market where investors buy and sell securities that have already been issued. In order for salespeople to maximize their ability to sell opportunities to clients, they will keep on top of market trends and industry research and build relationships with large institutional buyers who can be relied on to buy substantial amounts of shares regularly.

While the sales part involves selling the investment products to clients and understanding their needs, the trader actually makes the trade after it has already been sold. This entails buying or selling the stock, bond, or asset and ensuring that it happens at a reasonable price. Similar to salespeople, traders also have to keep up to date with the markets and clients, collecting information, analyzing how the market is moving, and making informed decisions to sell at the moment when the shares are at highest value or buying when they are the lowest in value. Trading can further be divided into active trading and passive trading:

Active Trading - Buying and selling investments based on their short-term performance, attempting to beat average market returns
- Relies on short-term price movements to make a profit
- Influenced by supply and demand
Passive Trading - Involves holding on to an investment for a long period of time and believing it will grow as a result of long-term market growth
- Generally less expensive than active trading

Ultimately, sales involve pitching investments towards clients about securities while trading involves the actual buying and selling of financial instruments.

Financial Advisory

Financial advice involves providing information and personalized recommendations that help individuals or corporations make informed financial decisions and allow them to achieve their personal financial goals. This could be advice about which savings account to choose, how to invest in stocks, how to get out of debt or how to sell a business.

Financial advisors are those who operate under this umbrella, working closely with individual or corporate clients to construct financial plans, budgets, tax strategies, goals and more. Overall, a financial advisor is tasked with creating a tailored plan to help their client achieve their goals.

The three main categories of advice are general advice and information which doesn't take personal circumstances or specific goals into account, focused advice which covers a specific topic that takes personal circumstances, needs, and goals into consideration, and lastly comprehensive advice which looks at all areas of a person's finances on an ongoing basis.

The two types of financial advisers include independent financial advisers (IFAs) who give advice about products and services available from the entire market, and restricted advisors who can only provide advice on a limited selection of products from a set number of companies rather than the whole market.

Lastly, services are offered depending on the customer, whether it's an individual or a business. Financial advice for individuals is usually offered for divorce, retirement, a new business venture, and personal investments, while financial advice for businesses is generally offered for taxation, increasing business assets, and mergers and acquisitions.

Asset Management

This involves managing a client's investments, including stocks, bonds, real estate, and other assets, with the goal of growing and preserving wealth. Asset managers create and execute investment strategies tailored to clients' financial goals and risk tolerance.

Pathways and Career Opportunities

Exploring the pathways and career opportunities within investment banking reveals a diverse range of roles and specializations, each offering unique challenges and rewards for those interested in the financial industry. Some common roles include:

Investment Analysts - Monitor financial news and keep up to date with the changing market conditions, and use this to advise individuals in other roles such as traders and fund managers
Operations Analysts - Typically focus on administrative processes and ensure they're carried out for all trades and that money is secured from the buyer
Client Advisor - Provide specialized services for wealthy individuals, mostly portfolio management. You may also network with clients and communicate the progress of their investments
Risk Manager - Analyze and manage the large variety of risk in the bank as a whole
Fund Manager - Make investment decisions on behalf of the bank's or firm's clients to increase the value of the client's portfolio, and have overall control over traders within the organization
Traders - Execute all the transactions made by the bank (bonds, currencies, options and futures)
Sales - Build strong relationships with clients to bridge the gap between traders and clients, and to negotiate rates with clients on behalf of the traders

Investment Banking and Economics

Investment banking is a key part of the modern economy, connecting people who need capital with those who have it. It can impact the economy in several ways, including:

Capital Formation - Investment banks can help alleviate capital shortages by encouraging saving and investing
Gross Domestic Product (GDP) - Investment banks can provide direct and indirect investments in a country's economic development, which can increase GDP
Job Creation - Investment banks can play a key role in job creation
Infrastructure Development - Investment banks can finance projects by conducting feasibility studies

The Bottom Line

Ultimately, investment banking is a sector within the financial services industry that assists individuals, corporations, and governments in raising capital and executing complex financial transactions. Companies turn to investment banking for support in their development and growth initiatives, and several investment banking services are offered from Mergers and Acquisitions (M&A) to underwriting.