What is investment banking?

Investment banking is a specialised area of finance that facilitates complex, large-scale transactions for governments, corporations, and institutions. The primary services of an investment bank include providing advisory services on mergers and acquisitions (M&A) and raising capital through initial public offering (IPO) underwriting, although they also provide risk management solutions and advice for company restructuring.

In essence, investment banks act as intermediaries who connect investors looking to deploy capital with corporations that require capital to grow or maintain their operations. They also provide strategic guidance, help negotiate favourable terms for stakeholders, and manage each deal process to completion.

The role of investment banking in corporate finance

Investment banks act as intermediaries who provide strategic financial advice, manage large, complex transactions, and negotiate terms to ensure favourable outcomes for their clients. These clients include corporations as well as institutional investors, such as hedge funds, mutual funds, private equity firms, and sovereign wealth funds (SWF).

The two core services of an investment bank are underwriting and mergers and acquisitions (M&A) advisory.

Underwriting

In investment banking, underwriting is the process of helping companies raise funds by issuing new debt or equity securities. This involves connecting corporations who require capital with institutional investors, negotiating favourable terms for existing stakeholders, and managing any potential risks (for example, an IPO during unfavorable market conditions).

M&A advisory

Mergers and acquisitions (M&A) is a broad term referring to the consolidation of two businesses. Investment banks facilitate the complex M&A process by providing strategic advisory services on behalf of the buyer or the seller. This involves managing everything from valuation and negotiation to deal structuring so that the transaction aligns with the best interests of the stakeholders involved. They also facilitate cross-border mergers and acquisitions and help clients navigate regulatory complexities in international markets.

Other investment banking services

Besides these two core services, investment banks also offer a range of additional activities across capital markets through their full-service divisions, including:

• Sales and trading: Connecting buyers and sellers of securities in secondary markets.
• Equity research: analysing securities to guide investment decisions and support the trading of stocks.
• Asset management: Managing investments for institutional investors, private banks, and individual investors according to their financial goals.

Note that the term investment banking can refer to a full-service investment bank or the investment banking division (IBD) of a commercial bank. Full-service investment banks offer a wide range of services, as outlined above, while the investment banking division of a bank will typically only provide M&A advisory and underwriting services.

How do investment banks help businesses raise capital?

Investment banks help businesses raise capital through the process of underwriting. This involves assisting companies in issuing stocks or bonds and selling these securities to investors (e.g. through an IPO). Companies can then use these raised funds to maintain or expand their operations.

There are three types of underwriting used by investment banks:

• Firm commitment: The investment bank (underwriter) agrees to purchase the entire stock or bond issue from the company and assume full financial responsibility for any unsold shares.
• Best efforts: The investment bank commits to selling as much of the issue as possible at the agreed-upon price but isn’t financially liable for any unsold shares. This can reduce risk for the underwriter but potentially limit the amount of capital raised for the company.
• All-or-none: The entire issue must be sold at the offering price, or the deal is cancelled, and the issuing company receives no funds. With this type of underwriting, the company only receives capital if it meets its target unless pre-arranged syndication or agreements are in place.

When a company needs to raise capital, it will hire an investment banker to provide underwriting services. The investment bank will then market the company to potential investors and manage the capital-raising process. Capital can be raised in the form of either debt or equity:

• Debt underwriting: This involves raising capital by issuing loans and bonds. The company receives the capital from investors upfront and, in return, agrees to pay interest periodically and repay the principal amount upon maturity. When the company raises the target amount, the investment bank collects its fees, and investors can either hold or trade their bonds in the open market.
• Equity underwriting: This involves helping companies raise money by issuing new shares that represent partial ownership in the company. This is common during IPOs, where a private company goes public. The investment bank helps the issuer set a price for the shares, sells them to investors, and collects a fee for their service. After the IPO, the company’s shares are listed on public exchanges and can be traded on the stock market. If the company needs to raise more funds, it can pursue secondary offerings.

What services do investment banks provide for mergers and acquisitions?

Investment banks provide essential services to help companies and institutions seek out, navigate, and complete mergers and acquisitions (M&A). They provide advisory services for both sides of the M&A transaction – the buy-side and the sell-side – and tap into their extensive networks to seek out opportunities and negotiate favourable terms on behalf of their clients.

Difference between mergers and acquisitions

While the terms mergers and acquisitions are sometimes used interchangeably, they have distinct definitions:

• Merger: A merger involves consolidating two companies of similar size into a single entity. One prominent example of a company merger was the 1999 merger between Exxon and Mobil, two of the world's biggest oil companies at the time. After their merger, ExxonMobil became the biggest publicly traded oil and gas company in the world.
• Acquisition: An acquisition involves a larger company purchasing a smaller one. One example of an acquisition is Facebook's purchase of Instagram in 2012, which allowed the tech company to increase its user base, revenue, and market penetration.

Buy-side vs sell-side M&A services

On the buy-side, investment banks provide advisory services for potential acquirers. This involves identifying acquisition opportunities that align with their client’s strategic goals, creating a list of potential companies, and managing the entire deal process, including negotiating the structure of the transaction.

On the sell-side, investment banks provide advisory services to sellers. This involves identifying potential buyers, marketing the business to maximise its value to sellers, and overseeing the entire sale process until the deal is finalized.

The 10-step M&A process

Investment bankers guide their clients through every stage of the M&A process, which involves ten key steps:

1. Acquisition strategy: Helping clients develop a clear strategy that states their purpose and long-term goals.
2. Acquisition criteria: Defining the main criteria for identifying suitable targets or buyers (e.g. geographical location or customer base).
3. Searching for targets: Using their networks to identify and evaluate potential targets or buyers according to the criteria.
4. Acquisition planning: Contacting suitable companies and establishing interest.
5. Valuation & evaluation: analysing key company information (e.g. financials) to assess value and suitability.
6. Negotiation: Constructing an initial offer and negotiating the terms to benefit both parties.
7. Due diligence: Deeply analysing the target company's operations, including finances, assets and liabilities, customers, etc., to uncover potential risks or opportunities.
8. Contract preparation: Drafting a final contract or purchase agreement.
9. Financing support: Exploring financing options if necessary.
10. Implementation: Managing the final stages of the transaction to ensure all terms are met, and the deal is successfully closed.

How do investment banks support corporate and institutional clients?

An investment banking business supports institutional investors and corporate clients by working as an intermediary between investors who have capital and companies who require capital.

For corporate clients, investment banks provide services that help companies go public (managing IPOs), raise additional capital, make acquisitions, grow their businesses, sell business subdivisions, and provide general corporate financial advisory services.

For institutional investors, who manage other people’s money, investment banks provide financial research and facilitate the trade of securities. They also support private equity firms by helping them acquire portfolio companies and exit these positions through an IPO or selling at a profit.

Investment banks also support government clients by helping them raise capital, trade securities, and buy or sell crown corporations.

What regulatory requirements must investment banks follow?

Investment banks operate in highly regulated markets, which are subject to strict oversight by regulatory bodies. Their activities, including corporate finance, securities services, and public finance, make compliance essential for maintaining the stability of the financial markets and protecting their clients from risks.

Below are just some regulatory requirements that have impacted the investment banking industry.

The Glass-Steagall Act

The Glass-Steagall Act was passed in 1933 after American stock markets crashed during the Great Depression. Its main provision was separating commercial banking and investment banking to prevent a conflict of interest and reduce risks for customers. Investment banks were defined as entities focused on underwriting and dealing in securities, while commercial banks only managed deposits and loans.

Under the Glass-Steagall Act, commercial banks could only use funds for lending and not for speculative purposes. This act remained in place until 1999 when it was repealed through the Financial Services Modernization Act (or Gramm-Leach-Biley Act) which, allowed commercial banks to have an investment banking division. All financial intermediaries were referred to as 'financial institutions'. 

Securities and Exchange Commission (SEC)

The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) with the purpose of overseeing activities in both primary and secondary markets. All investment banks are required to register with the SEC, which regularly reviews their operations, enforces compliance, and investigates potential violations to promote transparency and accountability.

Basel III requirements

The Basel III requirements were introduced after the 2008 financial crisis to strengthen the resilience of the banking system. These global requirements, which must be adhered to by all investment banks across borders, set out stricter capital adequacy ratios, leverage limits, and liquidity buffers to promote financial stability and reduce risk in the global financial system. 

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.