What Is Investment Banking?

Investment banking is a type of banking that organizes large, complex financial transactions such as mergers or initial public offering (IPO) underwriting. These banks may raise money for companies in a variety of ways, including underwriting the issuance of new securities for a corporation, municipality, or other institution. They may manage a corporation's IPO. Investment banks also provide advice in mergers, acquisitions, and reorganizations.

In essence, investment bankers are experts who have their fingers on the pulse of the current investment climate. They help their clients navigate the complex world of high finance.

Understanding Investment Banking

Investment banks underwrite new debt and equity securities for all types of corporations, aid in the sale of securities, and help facilitate mergers and acquisitions, reorganizations, and broker trades for institutions and private investors. Investment banks also provide guidance to issuers regarding the offering and placement of stock.

Many large investment banking systems are affiliated with or subsidiaries of larger banking institutions, and many have become household names, the largest being Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill Lynch, and Deutsche Bank.

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker's client is considering an acquisition, merger, or sale. Investment banks' activities also may include issuing securities as a means of raising money for the client groups and creating the documentation for the U.S. Securities and Exchange Commission (SEC) necessary for a company to go public.


Initial Public Offering (IPO) Underwriting

Essentially, investment banks serve as middlemen between a company and investors when the company wants to issue stock or bonds. The investment bank assists with pricing financial instruments to maximize revenue and with navigating regulatory requirements.

Often, when a company holds its IPO, an investment bank will buy all or much of that company's shares directly from the company. Subsequently, as a proxy for the company launching the IPO, the investment bank will sell the shares on the market. This makes things much easier for the company itself, as it effectively contracts out the IPO to the investment bank.

Moreover, the investment bank stands to make a profit, as it will generally price its shares at a markup from what it initially paid for them. In doing so, it also takes on a substantial amount of risk. Although experienced analysts use their expertise to accurately price the stock as best they can, the investment bank can lose money on the deal if it turns out that it has overvalued the stock, as in this case, it will often have to sell the stock for less than it initially paid for it.

Example of Investment Banking

Suppose that Pete's Paints Co., a chain supplying paints and other hardware, wants to go public. Pete, the owner, gets in touch with José, an investment banker working for a larger investment banking firm. Pete and José strike a deal wherein José (on behalf of his firm) agrees to buy 100,000 shares of Pete's Paints for the company's IPO at the price of $24 per share, a price at which the investment bank's analysts arrived after careful consideration.

The investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate paperwork, begins selling the stock for $26 per share. However, the investment bank is unable to sell more than 20% of the shares at this price and is forced to reduce the price to $23 per share to sell the remaining shares.

For the IPO deal with Pete's Paints, then, the investment bank has made $2.36 million [(20,000 × $26) + (80,000 × $23) = $520,000 + $1,840,000 = $2,360,000]. In other words, José's firm has lost $40,000 on the deal because it overvalued Pete's Paints.

Investment banks often will compete with one another to secure IPO projects, which can force them to increase the price they are willing to pay to secure the deal with the company that is going public. If competition is particularly fierce, this can lead to a substantial blow to the investment bank's bottom line.

Most often, however, there will be more than one investment bank underwriting securities in this way, rather than just one. While this means that each investment bank has less to gain, it also means that each one will have reduced risk.

What Do Investment Banks Do?

Broadly speaking, investment banks assist in large, complicated financial transactions. They may provide advice on how much a company is worth and how best to structure a deal if the investment banker's client is considering an acquisition, merger, or sale. Essentially, their services include underwriting new debt and equity securities for all types of corporations, providing aid in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors. They also may issue securities as a means of raising money for the client groups and create the necessary U.S. Securities and Exchange Commission (SEC) documentation for a company to go public.

What Is the Role of Investment Bankers?

Investment banks employ people who help corporations, governments, and other groups plan and manage large projects, saving their clients time and money by identifying risks associated with the project before the client moves forward. In theory, investment bankers should be experts who have their finger on the pulse of the current investing climate. Businesses and institutions turn to investment banks for advice on how best to plan their development. Investment bankers, using their expertise, tailor their recommendations to the present state of economic affairs.

What Is an Initial Public Offering (IPO)?

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors. Companies must meet requirements set by exchanges and the SEC to hold an IPO. Companies hire investment banks to underwrite their IPOs. The underwriters are involved in every aspect of the IPO due diligence, document preparation, filing, marketing, and issuance.

The Bottom Line

The names of investment banks like Goldman Sachs and Morgan Stanley come up frequently in discussions about the financial market, highlighting the importance of these
institutions in the financial world. In general, investment banks assist clients with large and complex financial transactions. This includes underwriting new debt and equity securities, aiding in the sale of securities, and helping to facilitate mergers and acquisitions, reorganizations, and broker trades. Investment banks may help other organizations raise capital by underwriting initial public offerings (IPOs) and creating the documentation required for a company to go public.