Investment banking: definition, how it works

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  • Investment banking is a specific type of bank that helps businesses, governments, and institutions raise funds and execute financial transactions.
  • Unlike retail banks, which may focus on transactions for individual consumers, investment banks help with transactions such as mergers and acquisitions and the issuance of securities.
  • Investment bankers conduct research, manage projects, and provide strategic advice, and their salaries can be among the highest in the world.

Unlike retail banks, which may work with individual consumers on offerings such as deposits and loans, investment banks are a special type of financial institution that helps businesses, governments, and institutions raise funds. capital.

What is Investment Banking?

“If you want to borrow money to buy a house, when you go to the bank, they connect people who have savings in the bank [with] borrowers,” says Emil N. Siriwardane, Finnegan Family Associate Professor of Business Administration at Harvard Business School. As he notes, investment banking essentially performs this function for companies.

Investment banks have been around for a while. The first investment bankers are said to have started as merchants dealing in commodities like spices and cotton. These merchants could then facilitate the production and transportation of products.

A few centuries later, in the 19th to be exact, the term “investment banking” became more popular. Global business JPMorgan Chase & Co. even traces its roots to 1799 New York, pointing to what it calls “heritage businesses.” And early investment banks raised capital through actions such as selling railroad stocks and arranging corporate buyouts.

What do investment banks do?

To raise capital, investment banks act as advisers and intermediaries between companies, other entities and investors. These banks may specialize in areas such as mergers and acquisitions, underwriting, private equity, and venture capital.

Bankers can even focus on specific sectors, like health care and technology, as well as sectors based on their size, notes David Erickson, senior fellow and lecturer in the Department of Finance at the Wharton School and co-director of the Stevens Center for Innovation in Finance.

As far as classification is concerned, so-called “boutique banks”, including regional boutique banks, can be smaller and more independent. They can also focus on specific areas of investment banking, Erickson notes. Meanwhile, “bulging banks” include large global companies with easily recognizable names. Think Goldman Sachs, JPMorgan Chase & Co, Morgan Stanley, and more.

Also be aware: An investment bank is not the same as an investment banking division. Full-service investment banks can provide a wide range of offerings including underwriting, mergers and acquisitions, sales and trading, and equity research. During this time, a investment banking division of a bank provides underwriting and M&A advisory services.

The role of investment bankers

Investment banks can employ a variety of people, and there is a hierarchy. Employees can include investment banking analysts, investment banking associates, vice presidents, directors or senior vice presidents, and general managers.

These staff members work on a variety of projects and transactions and may work long hours. But these professionals are also highly paid for their skills, with annual rates in the possible six figures for junior staff and in the millions for senior staff. And the work can be rewarding both personally and professionally, notes Erikson.

Investment bankers can also work on different types of projects. “Banks help businesses that need money get it,” Siriwardane says, noting that within this structure there are different ways banks raise money.

“A typical investment banker works with a group of companies,” adds Erickson. Next, they will determine business needs and consider potential funding sources.

These finance professionals can provide many different services:

Equity financing. This process of raising capital can include private equity, which is private funding, such as capital from a high net worth investor or company. Venture capital investments, which can be popular for start-ups, are another way to obtain equity financing, as shareholders finance companies in exchange for an equity stake. Investment banks can act as intermediaries to connect companies to private investors or venture capital, or to oversee the process of offering shares to the public in an initial public offering or IPO. If you’ve ever bought stocks or been interested in the stock market, you might remember how companies like Facebook and Google raised billions of dollars in capital through IPOs. With this type of financing, companies can share their profits with investors and consult them on decisions.

Subscription. For this function, investment banks can work between investors and companies that want to raise money or go public. This process involves researching and assessing risk, then the investment bank assesses, underwrites and sells the new securities. Investment banks can profit from the difference between the price paid for the securities and the price at which the securities are then sold. Underwriting can also involve a bank taking a financial risk in the project, for a slice of the pie. For example, when investment banks offer underwriting, Siriwardane explains, they may, in some cases, arrange for the debt to be collected by investors, but retain some of the debt themselves to “skin in-game”, usually for a very specific amount. kind of debt.

Debt financing. For this process, investment banks will help companies to borrow money, like a loan. Then the companies agree to pay the money back over time, with interest. This process is different from equity financing because the lender does not own the business they are financing and therefore usually has no say in business decisions. When the debt is repaid, the business relationship can end. That said, this process may create some restrictions while the company pays off the debt.

Sales and trading. This job consists of acting as an intermediary between buyers and sellers of securities on the secondary market. For this function, banks can work with mutual funds, hedge funds, etc., confirms the Corporate Finance Institute, noting that these trading groups “act as agents for clients and can also trade the capital of the company”.

Leveraged buyouts. In this type of transaction, a business can be acquired using mostly borrowed money, says Siriwardane. This way, the buyer – like a private equity firm – can invest money and borrow the balance to fund the acquisition. Sidwardane likens this business to when a consumer purchases a home using a down payment and a loan. This model can be layered, creates debt and also carries its own risks.

Mergers and Acquisitions (M&A). In this well-known area of ​​projects, investment bankers can advise buyers and sellers of businesses and manage the merger and acquisition process from start to finish. In a merger, two companies combine into a new legal entity. And in an acquisition, one company buys — or otherwise acquires — another.

“[The M&A process] can quickly become complex,” says Siriwardane. As part of this process, an investment bank “will help you determine the price to pay for a company,” he adds, noting that the bank must research and understand what drives a company’s profits, how to estimate costs and general industries, and more.

There can be different ways to structure these transactions, and the financing can be in cash, stock, or even when one company assumes the debt of another. Depending on the transaction, this process can take months or even years.

When it comes to the work of investment bankers, the stakes are high. As Erickson notes, these bankers need to do their due diligence and help their clients understand the risks involved with financial transactions. And bankers need to understand and manage the risks their banks are taking.

Also, relationships matter. “You have to have a very, I would say, consultative approach…Make sure you’re a good listener to understand what the company is trying to achieve,” adds Erickson. “And think about different potential solutions that can help them achieve these things,” he says, while doing the work to present the pros and cons.

The bottom line

Investment banking is a type of banking that focuses on raising or creating capital for businesses, governments, and other entities. Investment bankers are responsible for analyzing trends, assessing risk, providing strategic advice and managing projects.

If you are interested in working in this field, it is important to understand the responsibilities of these banks and the work required to achieve business goals. And if you want to raise capital for your own business or entity, it is important to understand how an investment bank can advise you and help you manage your project.

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