How are investment banks organized
Investment bank explained simply!
Investment banks were often featured in the media during and after the financial crisis. The reputation of investment banks in Europe is very bad. So today we're going to look at what the real job of an investment bank is. We will also see whether the investment banks are useful for our economic system or just parasites.
Investment banks - The explanation
The investment banking business differs largely in that it is capital markets oriented.
Any private individual can become a customer at retail banks, but this is not the case with investment banks. The customers of these banks are large companies, financial institutions, pension funds or even entire states and municipalities. Some investment banks are increasingly active in the area of SME business, i.e. business with small and medium-sized companies.
First of all, we will look at the structure of an investment bank, which can vary from bank to bank. Basically, there is a public side, the public side, and the private side, the private side. Between these sides there is the Chinese Wall, which means that both parties to the bank are not allowed to communicate with each other.
The public side
In this area of the bank, bankers actively interact with the various financial markets. For example, the public side sells blocks of shares to mutual funds or institutional investors, which is the sell side.
However, proprietary trading is also carried out with the bank's equity, so-called prop trading. Institutional investors such as fund managers are also advised on this page. If this fund manager wants to get into the automotive industry and invest there, he can get advice from the bank. The bank will then, in its opinion, name and suggest the best automotive stocks.
In order to be able to make statements about which company could have a price increase, there is a research department in investment banks.
This department consists of analysts who carefully examine and analyze individual sectors.
The fund manager would now be matched with an analyst from the bank, in the automotive sector in a particular country, and the fund manager would get the information from the analyst. This page is called the Public Side because all the information this department works with is publicly available.
The analysts cannot obtain any information from the management that is not yet publicly known. This means that, theoretically, no illegal insider trading can be carried out on this site.
The private side
On the private side of an investment bank, highly confidential information is traded, such as future mergers of a company.
These include the already mentioned mergers of two companies, an IPO of a new company or the issue of new bonds. Each of this information is strictly confidential until the company makes it available to the public.
Since these events will have a major impact on the course of the customer company, the information must also be handled carefully by the banks. To ensure this, the private side is closely monitored by the compliance department.
This creates a large difference in information between the public and the private side.
This is why the Chinese Wall is so important, because otherwise an analyst could sit down with an employee from the private side. There, for example, he learns something about a takeover that the public does not yet know about. The analyst then speculates how the stock market price will develop and counts on it.
That would then be classic insider trading and therefore prohibited.
Business areas of both sides
As already mentioned, sales and trading are carried out on the public side, so there is an active participation in the market and blocks of shares are sold to a wide variety of institutions.
On the private side, the most popular activity is probably M&A. This is the abbreviation for Mergers & Acquisitions, which means something like merger and takeover.
The bank plays an advisory role for the companies. When advising, the investment bank takes either a buy side or a sell side position. If a company wants to sell part of the company or a founder wants to sell his entire company and seek advice from the investment bank, then the whole thing is a so-called sell-side mandate.
The bank is on the buy side when a company that is advised by the bank wants to buy another company. When Bayer bought Monsanto, the investment bank advising Bayer had a buy-side mandate because Bayer wanted to buy Monsanto.
When two companies merge, the bank is there to provide advice until the deal, i.e. the completed transaction. In large mergers such as Bayer and Monsanto, the two companies employ several investment banks. In the case of Bayer, those were Credit Suisse, Rothschild Bank, and Bank of America Merill Lynch.
Monsanto's sell side mandate was given to Morgan Stanley and Ducera Partners.
The areas of the private side
The M&A process and the bankers behind it
An experienced M&A banker is always available to advise his customers, i.e. the CEO and CFO.
He comes up with ideas about when it would make sense to sell part of the company or buy another company. He then presents these ideas to the companies in a pitch.
It is also possible that a company already knows that it wants to sell a part or take over a competitor.
If there is no buyer, the M&A banker has to find one who has the financial strength and interest. M&A bankers also need to value companies. There must be a price at the end of a deal.
This price is negotiated with the other company's M&A banker. Bankers, auditors and lawyers are on hand to help.
The negotiation process is also carried out by the M&A bankers.
The ECM area and its tasks
The next department is the ECM area, which stands for Equity Capital Market. Here the bank advises the management of a company on all activities that have anything to do with the shares.
The most popular activity is certainly the IPO, which is accompanied by the investment bank. Before Snapchat went public in 2017, Snapchat was advised by investment banks Morgan Stanley and Goldman Sachs.
The task of the two banks was to prepare the IPO from A to Z and then to carry it out.
Just like in the M&A department, an assessment of the company is also carried out here. This then shows how high the price will be and at what price most investors would buy.
Roadshows are also organized in which the bankers and the company's management visit various investors and present the company. The goal is to get investors to buy large blocks of shares in advance. The bank also has a coordinating role between lawyers, regulatory institutions and the investors.
The DCM department
The DCM department, which is called Debt Capital Market, is similar to the ECM area.
The difference, however, is that this is not, as with the ECM, about equity, i.e. the shares, but about debt. This borrowed capital can be bonds, for example.
If a company wants to imitate bonds and bring them to market, it is advised by the DCM department of the bank. The DCM team then does everything for issuing the bond.
Bayer was also advised by a DCM team when they wanted to issue a bond to fund the deal with Monsanto.
These were the areas most of the major investment banks offered.
There are of course other services such as the restructuring of companies that are currently in a difficult phase and on the verge of bankruptcy.
How do the investment banks make their money?
Investment banks make their money on the public side
When an employee from the sales department sells shares to a mutual fund, he either collects a commission or gives a spread on the price. This means that he sells the shares to the fund a little more expensive than he actually buys them.
On the private side, the money is earned through advisory commissions. The banks are paid on success and receive 0.5% to 1.5% of the deal volume. The business is therefore lucrative but also very volatile, since investment banks are the first to be hit in times of crisis.
Because a company then thinks twice about whether it wants to go public or buy a competitor.
Which investment banks are there?
In the US, the banks are J.P. Morgan, Morgan Stanley, Goldman Sachs and the Citi Bank are the most famous. In Europe there are Credit Suisse, HSBC, UBS, Barclays and Deutsche Bank.
Specialized consulting boutiques
Banks like Lazard, Rothschild and Jefferies specialize in the private side business and do not finance deals, but are consultants for large corporations.
The bottom line
Now you know a little better about the investment banking business. The job of the investment banker may seem very attractive due to the high bonuses, but it is still a backbreaking job where beginners can also have an 80-100 hour week. Nonetheless, investment banks help many companies in all areas of the financial world.
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