Understanding Investment Banking
Investment banking is a specialised division within the finance and banking industry that engages in advisory-based financial transactions for its clients, the clientele includes individuals, government and corporations. Investment bank helps in capital creation for its clients. The primary function of these banks is to act as a mediator and facilitate financial transactions between two or more parties. The investment banks leverage its vast network to connect borrowers seeking funds with investors having surplus capital to invest in profitable avenues.
Investment banks help the economy on a macro level by channelling funds between borrowers and investors. Investment banks also help to facilitate Mergers and Acquisitions deal; it requires conductions rigorous research on the companies that can be a good fit for its client’s M&A strategy. Investment banks also help with underwriting new debt and equity securities for various corporations.
Let’s understand the functioning of an investment bank using a familiar example. You must’ve heard of Initial Public Offering (IPOs), during the IPO process the company issues shares and invites the public to be a part of the organisation by buying its shares at a predetermined price. A lot is going on behind the scenes, like valuation of the company, market analysis, competitor’s analysis, etc.
All these complex tasks are carried out by Investment banks to help companies go public and accumulate the required capital for its growth and profitability. Investment banks also determine the share prices so that the chances of oversubscription and under subscription can be avoided. Let’s dig deeper into some of the key advantages of Investment banks and how they help the economy.
Key Advantages of Investment Banks
The key advantages of Investment banks can be highlighted in its functioning.
- Initial Public Offering (IPOs): Initial Public Offering process is an overwhelming financial transaction process and requires expertise in various aspects. Investment banks serve their clients going public by acting as intermediaries between corporations and investors. Investment banks provide underwriting services for companies opting for equity funding by issuing company stocks to the public. The underwriting process is not as simple as it sounds. The underwriting process involves investment banks purchasing the shares of the company at an agreed-upon price which it then resells to the public using a stock exchange.
This requires the investment bank’s commitment to purchase a specified number of shares, it could purchase all or part of the total shares being issues. There are three types of underwriting commitments; it includes firm commitment, best efforts, all or none. In the firm commitment, the investment banks have to purchase all the shares being issued at a predetermined price.
The best effort commitment is suggestive of the name, here investment banks commit their best to sell as many shares as possible and there is no legal obligation for them to buy all the shares being issued. All or none case requires selling all the shares being issued to the public, any under the subscription will lead to a null deal.
- Mergers and Acquisitions (M&A): Mergers and acquisitions is a strategy used by corporations to come together and boost collective profit by eliminating competition. Corporations leverage their synergy in operations to boost profitability and growth prospects. The merger involves two companies usually competitors coming together whereas acquisition involves one company buying a majority stake in another company or acquiring it.
This whole process entails complex research work to understand the competitors in the market and what they bring to the table for a profitable M&A deal. The M&A deals also require investment banks to value to targeted companies that could be a profitable prospect, this valuation requires conducting rigorous due diligence to understand the financials of the prospective company.
Also Read: Beginner Guide to Investment Banking