This blog post contains my notes for a course on basics in understanding Investment Banking(IB). In the course they discussed the history of IB, the four main areas of investment banking, company valuations and modeling, and leverage buyouts(LBO). My notes are from a course called The Complete Investment Banking Course on Udemy. It is really great and there is a lot of information that has since been updated check it out (not affiliate link or affiliated in anyway).


Table of Contents

  1. History of Investment Banking Services
  2. Four Main Areas of Investment Banking
  3. Capital Markets - Equity Capital Markets
  4. Capital Markets - Debt Capital Markets
  5. Advisory Services - Mergers & Acquisitions
  6. Advisory Services - Restructuring
  7. Trading & Brokerage
  8. Asset Management


History of Investment Banking Services

Importance of History, Name and Tradition

  • History, Name, and Tradition play an important role for Investment banks because over the years they have built up their connections, partnerships and experience allowing them to attract top clients and investors.


Early Origins of Investment Banking

  • IB emerged in the early 19th century when economic expansion was occurring and commercial banks could not serve loan growth for railroads, mining, and heavy industry.
  • Security underwriting - when banks buy stocks and bonds from companies and resells them to public.
  • Investment Bankers - bridge that connects businesses in need of financing to investors willing to lend that capital.
    • governments used investment bankers to sell bonds to public.
    • bankers contact potential investors in order to make sure they could sell the debt.
  • Debt 2 Issues
    • what if government defaults?
    • what if government tries to renegotiate its debt?
  • IB as Middleman
    • IB told states that defaulted they could not borrow anymore
    • states then restructured debt to be able to pay
    • reputation was born


Commercial Vs Investment Banking

  • Commercial Banking
    • Takes deposits & lends out to borrowers
    • Makes money via spread
      • Interest Income - Interest Expenses = Spread
  • Universal Banks
    • combine commercial and investment banking services
    • can sell several products to the client (one stop shop)
    • advisors for all situations
    • understand the business (competitive advantage)
  • Dangers of Universal
    • they have too much information on borrower/investor
    • tempted to sell risky positions
    • Glass Steagall Act 1933 prevented this
      • repealed in 1999
      • led to mega mergers


Conflicts of Interest

  • Products of IB
    • Trading
    • Underwriting Debt & Equity
    • Asset Management
    • Advisory
  • Conflicts in Trading
    • Proprietary - buying shares with banks money (more important)
    • Brokerage - buying shares with clients’ money
    • Research Department
      • Chinese Wall - underwritters cannot share info with research.


Four Main Areas of Investment Banking

Capital Markets

  • Capital Markets
    • Issue Equity(ECM) or Debt(DCM)
  • Going Public
    • Founders - want to sell at right price and raise capital
    • Investors - investment in management and growth potential
    • Companies administrative expenses will increase due to regulations and document filings
  • What Company Needs for IPO?
    • size
    • profitability
    • administration
    • growth
    • strong management
  • IB’s Role
    • provide guidance
    • IPO preparations
    • deal with investors
    • stabilize stock price
  • Seasoned Equity Offerings (SEO)
    • sell additional shares (dilution)
    • shares already priced on market
    • company is compliant with requirements
    • IB just needs to find buyers for the securities
  • Debt Capital Markets (DCM)
    • issue bonds
    • investors buy loan and expect interest payments
  • IB’s Role
    • advise loan terms
    • prepare presentations
    • find investors
    • price the loan
      • easy because credit of company is rated by independent agency
  • Loan Syndication
    • loans granted by a pool of banks
    • syndicate (banks) -> loan -> company


Advisory Services

  • Advisory Services
    • Mergers and Acquisitions (M&A)
      • acquisition - company buys assets or shares of another company
      • merger - buying company absorbs target company and ceases to exist
      • two parties - buyer and target
      • buyer offers cash, shares, or cash + shares
    • What use an IB?
      • bankers have deep industry knowledge
      • M&A specific know-how (bidders & targets)
    • Two Sides
      • Buy-side is the acquiring company
        • fee only if client buys target
        • strategic advice
        • provide valuation
        • estimate synergies
      • Sell-side is the target company
        • fee is guaranteed
        • finds bidders
        • prepare target with questions
        • provide valuation
        • coordinate sales
    • Restructuring
      • services when debt cannot be paid and endangered of going bankrupt
      • private workout - get bought, sell assets, or restructure debt
      • bankruptcy procedure


Trading and Brokerage

  • Trading and Brokerage
    • Two Ways
      • prop trading - bank’s own money
        • buy low sell high and profit
        • research department provides insights
      • brokerage - buying on behalf of clients
      • usually account for 35-50% revenues for IB
    • Market Makers
      • buy shares of lightly traded securities
      • sell to provide liquidity and make money on spread
    • Traded Securites
      • stocks
      • bonds
      • derivatives (options, futures, forwards, swaps)


Asset Management

  • Asset Management
    • Managing clients’ investments to make money
    • Gargeted towards wealthy individuals
    • Multiple asset classes
      • stocks, bonds, commodities, real estate, private equity
    • Geographical expertise
    • Tailored portfolio towards client’s risk portfolio
    • Goal is to maximize returns with minimal risk
    • Department
      • Research provides analysis of the portfolio
      • Portfolio Manager allocates the capital
      • Sales Representative brings in clients


Capital Markets - Equity Capital Markets

Why Go Public?

  • Why Companies Go Public?
    • Finance growth
    • Use stock to acquire other companies
    • Reputation and visibility into company
    • Signal strong market position
    • Use stock as management compensation
    • Exit opportunities for founders and venture capitalists


Who Are The Investors In IPO?

  • Who are the Investors in IPO?
    • Three Types
      • Retail Investors
        • private individuals who want to diversify their holdings
        • buy for extra income
      • Institutional Investors
        • mutual, pension, insurance company
        • professional investors with resources for analysis
        • Blackrock & Fidelity
      • Hedge Funds
        • investment vehicles with sole purpose of making bets to generate quick returns
        • short time period
  • What do Investors look for in a IPO Company?
    • Success stories
    • Market leadership
    • Strong management
    • Solid financials
    • Visibility and disclosures
    • Liquidity
  • Investors also want a discount to valuation
    • institutions and retail tend to hold stock for the long term


Share Price

  • IPO process lasts 4-6 months
  • Price is usually given at a discount to keep investors satisfied
  • Methods of Share Price Calculation
    • DCF Model
      • discounts all future cash flows for a set time period to the present
    • Multiples
      • finds similar companies that are similar size, industry, geography, and market strategy
      • analyst use this technique
  • Economic environment must be good ex: tech IPOs were hot during dot com boom.
  • Growth perspectives
  • Roadshow feedback
    • IB gather what investors are willing to pay during their attempt to sell shares to potential investors
      • Book building is IMPORTANT as it will give you true pricing vs a model


IPO Time Table

  • Two Phases
    • Pre-launch
      • 1) company hires advisors to help with analysis, tax, regulation
      • 2) define key issues or problems on compliance
      • 3) valuation of company
      • 4) prepare prospectus about 2 months prior to going public
    • Execution
      • 5) roadshow to get potential investor and feedback
      • 6) marketing and price range of stock
      • 7) allocate the shares to retail, institutions, hedge funds


IPO Syndicate

  • Every IPO involves multiple banks called syndicate banks
  • Syndicate banks are each able to allocate shares to their clientele
  • Syndicate Roles
    • Global Coordinator - oversees entire process
    • Bookrunners - market, prepare analyst presentations, and roadshow (1-3 banks)
    • Lead Manager - client contacts and selling efforts
  • IPO Fees
    • Fees are typically 1.5% - 7% (3% avg) - bigger company lower fees
    • Lead Managers - 60%
    • Bookrunners - 20%
    • Global Coordinator - 20%


Seasoned Equity Offerings (SEO)

  • SEO is a seasoned equity offering where a public company already listed raises equity by selling additional shares
  • Much easier since company already has regulation needed in place
  • Fees are lower since stock is already priced by the market
  • Private placement is equity offered to institutional investors only


Capital Markets - Debt Capital Markets

Bonds

  • Bonds
    • similar to bank loans
    • investors lend money to business/government and eventually recoupe capital plus interest
    • Four Types
      • Fixed Rate Bonds
        • predetermined rate of return
        • fixed interest rate
        • Maturity of 5, 10, 20 years
      • Floating Rate Bonds
        • linked to a reference rate
        • interest varies as interest rate fluctuates
      • Equity Related Bonds
        • debt securities paying an interest rate
        • can be converted into equity
      • Asset Backed Securities
        • bonds offered by a project vehicle
        • bank loans, credit card debt, mortgage loans and other similar assets


Why Issue Bonds?

  • Bonds are much cheaper than bank loans due to a lower interest rate (as long as company’s financials are decent)
  • Less covenants or rules/restrictions by the borrower; for example, maintaining key levels of financial ratios
  • Benefits larger corporations due to fixed costs associated with bonds; you need scale
  • Banks are very risk averse when loaning large amounts of money vs bonds where investors will take risk for higher reward
  • Bond holders are in the hundreds and dealing with them is a difficult and complex task


Bond Offerings

  • Similar to equity offering
  • Pricing is easier because credit rating agencies rate the company’s ability to repay loan
    • Standard and Poor’s Rating Services
    • Moody’s
    • Fitch Ratings
  • Process
    • 25-35 days
    • 1) Hire an advisor
    • 2) Assemble syndicate
    • 3) Hire credit rating agency (2 or more better)
    • 4) IB contact investors and give them provisional conditions such as interest rates and maturity
    • 5) Bookbuilding
    • 6) Underwrite and sell to investors
    • 7) Stabilization service to hold up price of bond


Securitization

  • Group of loans are collected and group together in a special purpose vehicle (SPV) to be sold to investors
  • Reason for this is that banks must maintain a certain capital adequacy ratio (equity/loans > cap adequacy ratio)
  • Capital Adequacy Ratio = Bank’s Capital / Risk-Weighted Assets
    • to raise ratio you could raise capital (costly) or decrease risk-weighted assets
    • solution was securitization where banks sell the loans and transfer risk to investors
  • Banks act as originators where they can lend money to borrowers, package up the loans and sell to investors generating fees
  • Securitization allows investors to gain diversification; for example, pension funds can’t loan to consumers but can buy securitized loan full of mortgages


Loan Syndication

  • Large loans pooled from several banks
  • Why group loans from multiple banks?
    • reduce loan size
    • access to large corporate clients
    • commission to the lead bank
  • Great diversification on a global scale


Advisory Services - Mergers & Acquisitions

Why Acquire Another Company?

  • Why Companies Acquire Other Companies?
    • Growth and Synergies
    • Usually companies are in same industry
    • Some efficient synergies is accounting, sales, IT, finance, basically SGA
    • Extend product/service offering to their customer base
    • Extend product/services by integration
    • Acquiring top talent in management
  • Defensive M&A is acquiring a company so that competitor doesn’t buy them


Deal Lifecycle

  • Company’s Lifecycle
    • Development
      • early days in startup stage
      • rarely acquire company
      • often get acquired if idea is innovative or team is talented
    • Growth
      • ramp up in revenues
      • even more attractive for acquirers
      • defensive M&A of smaller firms
    • Maturity
      • revenue slows down or flattens
      • cash rich company
      • mergers and LBOs instead of getting acquired
    • Decline
      • revenue starts to decline
      • takeovers or restructuring


M&A Types

  • Private Transaction (1-2 bidders)
    • easy to organize
    • no sense of urgency for the buyer since they don’t feel threatened by company
    • often avoided by sell-side
  • Auction (many bidders)
    • many interested bidders with goal of 3-5 offers
    • competition causes increase in price
  • Listed Firm (public company)
    • complicated due to regulatory requirements
    • friendly or hostile takeover (tender offer)
    • easier valuation since public (usually offers premium to shares)


Valuation of Targets

  • Buyer
    • find fair value for target
  • Seller
  • decide if it is right price to sell
  • Both need to understand and idea about the value of underlying business
    • acquiring company will end up taking on liabilities
    • Enterprise Value = Equity + Net Debt
      • influenced by capital structure
    • Equity = Total value of a firm’s shares
      • not influenced by capital structure
  • Use DCF, Multiples, LBO Analysis, Market Price (if public)
    • bankers use couple methods
    • DCF is most popular method and use discount future cash flows to present
    • Multiples compare similar company in same/similar industry, size, market positioning, number of employees, geography, growth perspectives
    • LBO is based on how much leverage is sustainable by the target
    • Market Price is just share price times number of outstanding shares = equity


Payment

  • Cash
    • preferred by targets so they can monetize immediately
    • buyers must be prepared (Microsoft, Facebook, Apple, Google)
    • must consider cost of issuing new debt
  • Stock
    • buyers interested in stock to avoid borrowing
    • must consider cost of issuing new stock
    • allows targets to retain possible future upside
  • Combination
    • usually both happens or a choice is given
  • Deal breakers usually when buyer/seller have a difference of >5% for the price
  • Earn-out mechanism could be applied for differences <5%
    • goals are set that if met additional payouts will be made
    • ex: if margin of 20% is met in 2 years after closing then $50M will be awarded
    • seller keeps upside but it can also be difficult to measure


Corporate Vs Financial Buyers

  • Corporate Buyers
    • firms operating in same industry as target
    • unlock synergies, long-term, integration of the management of two companies
  • Financial Buyers
    • main concern is cash flows and capital gains, 3-5 years, follow the company through board of representatives
    • Venture Capital Funds - startups
    • Private Equity - growth companies
    • Leveraged Buyout Funds - mature companies


Advisory Services - Restructuring

Restructuring Services

  • The firm has insufficient cash for operations due to:
    • Obsolete products
    • Industry decline
    • Bad investments
    • Lack of innovation
    • Opperation inefficiency
    • Bad management
    • Bad M&A deals
    • Excessive leverage
  • Restructuring is a viable option when recoverable portion of debt is higher vs liquidation
  • Benefits of restructuring
    • Higher recovery ratio
    • Employees keep their jobs
  • Restructuring unsuccessful
    • Higher losses due to late liquidation


Restructuring Types

  • Think firm’s balance sheet
    • easy way to strengthen is to increase capital, but most investors are unwilling to lend
    • Asset Side
      • sale of non-core assets
      • reduce costs such as advertising & R&D
      • less capital expenditures
      • sale of controlled firms
    • Liability Side
      • agreement between creditors to alter conditions of the liabilities, as they cannot pay entire debt
        • suspend interest
        • debt write-off
        • debt-equity swap
        • convertible bonds
  • Negotiation with creditors is the hardest part as time could take up to a year
  • Restructuring Plan must be approved by creditors
    • Creditors Assess Three Parameters
      • Probability of default
      • Loss given default liquidation
      • Successful restructuring


Trading & Brokerage

Investment Bank Trading & Brokerage

  • Trading is important source of revenue
  • Trading
    • Brokerage
      • trade on behalf of clients & profit from bid/ask spread
      • asset managers and other clients buying in for long-term or short-term (hedge funds)
    • Proprietary
      • buy and sell stocks to profit from capital gains
      • short-term quick profit
    • Intermediary Service
    • Buy & Hold Securities
    • Short Selling
      • borrowing a stock to sell now and buy back in future at a lower price


Types of Securities

  • Financial Instruments
    • Equity
      • shares of stock publicly traded on exchanges
      • blue chip stocks have market cap > $5 billion & are well recognized established companies
        • mutual and pension funds
      • other stocks have market cap < $5 billion which are still in young/growing but higher risk
        • insurance and retail investors
    • Fixed Income
      • Government Bonds
        • less risky
        • credit rating agencies track the credibility of government & their macroeconomic data
      • Corporate Bonds
        • growing importance
        • use services of credit rating agencies when issuing
      • Derivatives Contracts
        • swaps, futures, forwards, and options
        • could be linked to commodity price or events
        • used for hedging positions aka buying an insurance policy
        • hedge funds use for speculative gambling


Asset Management

Investment Bank as Asset Managers

  • Investor has high net worth and investible income
    • person, insurance company, pension funds, or other institutional investors
  • Why Investment Bankers?
    • specialized knowledge
    • they are professionals with investment knowledge about the markets
    • technical expertise
    • trading know-how
    • global macro knowledge

Risk-Return on Assets

  • Types of Asset Vehicles
    • Open & Closed-end Funds (Low Risk - Low Return)
    • Real Estate Funds (Moderate Risk - Moderate Returns)
    • Private Equity Funds (High Risk - High Return)
    • Hedge Funds & Alternative Investments (Very High Risk - Very High Return)
  • Asset Managers combine asset classes depending on the client’s goals and risk tolerance