Introduction to Investment Banking
Aimed at those interested in a summarised and broad overview of investment banking, this article briefly introduces what investment banking is, its divisions and functions, its relevant processes, as well as real-life examples of the involvement of investment banks.
What is investment banking?
Despite similarities in their names, investment banks and investment banking are not the same. Investment banks offer a wide range of financial services, including divisions such as sales & trading, asset management, and equity research. On the other hand, investment banking is a subdivision of an investment bank, and has two primary roles in advisory and underwriting.
An investment bank (or more specifically the investment banking division) acts as the intermediary between corporations and institutional clients, connecting corporations (who require capital to expand and grow their business) and institutions (who seek to invest in these firms, in return for debt or equity). Investment banks facilitate these transactions by connecting these two stakeholders, offering their expertise, and leveraging their connections to best serve both corporations and institutional clients (hence referred to as the “sell-side”).
Figure 1: Key players in the capital markets (minus public accounting firms) Source: CFI
Investment Banking Divisions Breakdown:
Investment Banking Divisions (IBD) at the bank can be broken down into product groups vs industry groups. Product groups focus on executing certain deal types and tend to do so across industries. Common examples include:
Mergers and Acquisitions (M&A)
Equity Capital Markets (ECM)
Debt Capital Markets (DCM)
Leveraged Finance (LevFin)
On the other hand, industry groups work on many different deal types but will specialise in a certain industry. Common examples include:
Technology, Media & Telecom (TMT)
Financial Institutions Group (FIG)
Product groups focus on specific transactional models, such as merger and LBO models, On the other hand, industry groups in contrast need to have strong knowledge of the industry group they are in, what different companies are doing, as well as their operating models.
For M&A, ECM, and DCM, both groups may have to work with each other depending on the specific transaction, the structure of the investment banking division they are in, as well as the general availability of product and industry groups.
So in the case of the merger of two pharmaceutical companies, the initial pitch is done by the healthcare group bankers. After which, the M&A process is split between both the M&A and healthcare bankers, depending on the factors mentioned above, but generally speaking, the M&A bankers are more likely to build the models required for the merger.
The 3 most popular product groups at investment banks involve Mergers and Acquisitions (advisory), and Equity and Debt Capital Markets (underwriting). Restructuring and Leveraged Finance involve smaller and more specialised groups of investment banking divisions. However, it is important to note that not all banks are structured this way. Goldman Sachs for example, does not have product groups, but instead handles everything through their industry groups. Boutiques and middle-market banks also tend to have stronger restructuring practices, as bulge-bracket banks may face potential conflicts of interest if hired as restructuring advisors due to them having corporate banking or lending practices.
Mergers and Acquisitions (M&A)
Often incorrectly interchanged, mergers involve the amalgamation of two similar-sized companies into one consolidated entity. On the other hand, acquisitions involve the purchase of a smaller company by a larger business, integrating its business with the acquirer’s own.
Firms undergo M&A for a variety of reasons, but in the case of similar-sized firms and strategic acquirers (buyers who are interested in how the acquired firm aligns with their long-term plan), it is primarily for the purpose of acquiring synergies. Core to the idea of synergies is that the combined entity is worth more than the sum of its parts. If the combined entity is able to generate better returns than if they were separate firms, then firms may pursue M&A depending on the predicted synergies that can be acquired.
Investment banks advise these companies on these transactions, dealing with both sides of the sale. Companies pursuing an acquisition, as well as those being acquired will hire their own investment banks to advise on key discussion points. Several tasks of banks include sourcing potential buyers or sellers, building valuation models, and creating pitch books for clients.
The split in terms of sourcing buyers vs sellers can be split into “buy-side” and “sell-side” investment bankers.
Not to be confused with the broader “buy-side or sell-side”, Sell-side bankers serve the seller. Sell-side bankers find potential buyers for the company, build valuation models, create initial marketing materials, and handle bids from buyers.
Buy-side bankers deal with the buyer, advising the client on potential acquisition targets, conducting thorough due diligence, presenting to the buyer, and building valuation models to figure out the offer price should both firms agree to the transaction.
The process of underwriting involves raising capital for clients, ranging from governments, companies, or institutions to investors. This happens through equity or debt, and banks facilitate these transactions through various channels such as Initial Public Offerings (IPO), debt offerings, and private placements.
Investment banks formally separate the divisions that handle the sale of stocks and debts, respectively called Equity Capital Markets (ECM) and Debt Capital Markets (DCM).
The ECM division handles the raising of capital by advising companies on the most appropriate type of equity offering. Most notably, they advise and help companies through IPOs. This occurs when a previously private company sells new or existing securities to the public for the first time. Investment banks are brought in to handle this process, either as the book runner (lead investment bank of the IPO) or as co-underwriters.
On the other hand, the DCM division raises capital for companies by issuing debt securities, in the form of bonds, treasuries, or money market instruments. There are several reasons why companies choose to raise capital through debt, such as not diluting the ownership of existing shareholders, and not wanting to go through the lengthy IPO process. DCM tends to be a high volume, low-margin business, and teams in DCMs will pitch to a variety of clients on possible debt issuances, guiding them on the best way to structure their capital raising and generally work in a more fast-paced environment than ECM.
What’s the M&A process in investment banking?
The process for buy-side and sell-side deals can vary significantly depending on the nature of the deal, i.e whether it is a targeted or broad deal.
In sell-side M&A, deals can occur when an unsolicited buyer approaches the seller or when a company independently arrives at that idea itself. Regardless, the process for investment banks to structure the sale can be broken into 4 ways.
Beginning from the largest, broad auctions occur when a seller does not have any specific bidders in mind. The investment bank in charge, after conducting its own due diligence, will then begin the process of reaching out to as many potential bidders (more than 50).
The primary objective of a broad auction is to maximise the purchase price of the company. Soliciting offers from as many potential buyers maximises the likelihood of receiving a high offer.
Similar to the broad auction, the investment bank reaches out to fewer potential bidders (around 10-50), as their potential pool is perhaps lower due to their larger equity value. However, it still follows a similar philosophy as broad auctions: maximising the purchase price by reaching more potential buyers.
Instead of reaching out to many firms, the investment bank will only contact a few firms (2-5) as potential buyers. These usually occur for companies that are much bigger in size. They seek to maintain the confidentiality of the sale (if the pool of potential buyers is larger, less confidentiality of the sale can be maintained despite NDAs), and also only have a few logical choices for sellers.
On the other end, the final structure of an M&A sale would be through an exclusive negotiation. The buyer solely negotiates with the seller, with no other competition. This process provides the least disruption to the seller, but faces difficulties such as limited leverage in negotiation due to having only one buyer.
The different methodologies for structuring the sale can be summarised below:
Full Moon = High. Empty Moon= Low
Figure 2: Different methodologies of structuring a sale
In the case of broad or limited auctions, the sell-side investment bank produces more marketing materials and has to go through more process work such as setting multiple bid deadlines, going through several rounds of meetings, and responding to numerous information requests and many more before reaching the final purchase agreement with the winner. Targeted auctions generally require less process work, instead focusing more on building plenty of merger models for different buyers under different deal terms.
In buy-side M&A, deals can also be split into broad versus targeted. Targeted deals are similar to the sell-side, but instead of coming up with the marketing material and pitching to potential buyers, the investment bank will be tasked to review the deck and perform their own analyses on the potential acquisition target, to determine the best purchase price for your client.
Broad buy-side deals follow a lengthier process, involving extensive time researching and filtering potential acquisition targets for your client, many valuations, and presenting your client with company profiles. This process repeats until either the client finds a potential target they find attractive and begins deal discussions, in which it becomes a targeted deal. Otherwise, the deal may never close.
Broad buy-side deals in investment banking tend to more closely represent the work in private equity firms and therefore may be a good chance to learn more if your intentions are to move there after.
Differences in both processes can be summarised below:
Figure 3: Differences in the process of Buy-side and Sell-side M&A. Source: DealRoom
What’s an IPO? IPO and Debt Issuance Process
Initial Public Offerings (IPOs) are used by private companies to raise large amounts of capital and become publicly traded companies. While no longer as popular, due to alternative channels of going public such as de-SPACs and reverse mergers, as well as the extended time and costs of IPOs, they still remain as possible avenues to go public.
Described below is the brief guide to an IPO process execution:
Investment banks are invited to pitch to the company why they should be chosen to be the underwriter for the IPO. Considering the banks’ IPO record, and reputation with institutional investors, a lead book-runner and several co-underwriters will be chosen.
Initial meetings will be conducted with everyone involved in the IPO (lawyers, auditors, investment banks, etc). This is to ensure that everyone knows what needs to be done, e.g. required registration forms, legal and tax documents. Investment banks will be responsible for “customer calls”, analysing the company’s items like revenue stability and key risks.
An important part would be the S-1 Filing (for the US) or Registration Statement which presents the company’s statements, investors that are selling shares in the offering, risks, etc. This document is then reviewed by the SEC (or any equivalent government organisation in other countries).
Pre-selling the offering
During the revisions of the S-1 Filing, companies will hold pre-IPO meetings with bankers and sales teams to plan the “selling” of the offering to investors.
The underwriter will create a preliminary prospectus consisting of details of the issuing company minus the effective date and offer price, which will be used to market the company to institutional investors.
Management will travel all over the country or world to meet with investors and market the company for 1-2 weeks.
Banks will then accept orders from institutional investors, and perform a delicate balancing act of pricing. If the price is too high, and falls once the company begins trading, reflects badly. If the price is too low, and rises significantly after trading, means the company could have sold shares closer to the higher price.
IPO Pricing Meeting
The company sets the final IPO price based on the orders received.
If a deal is over-subscribed, the company will price the company at the high end of the range and will do the opposite for under-subscribed deals
Sometimes management will deliberately price the company at a lower price (leaving some money on the table) so the stock can trade up on the first day of trading, which is always a positive indicator of the market.
Allocation of shares
The syndicate team will allocate shares to investors, based on both who will be long-term holders of the stock as well as the future money-making value of each investor.
The stock begins trading on the open market, and the general public can begin buying and selling shares.
Often, for existing investors and employees, a lockup period often exists before they can sell their shares. This explains why sharp price declines occur several months post-IPO, as individuals try to cash out.
Investment banks usually earn a commission from the gross offering (the value of additional shares issued), ranging from 3% for very large deals, to a traditional 7% for normal deals. The reason for this difference is that a larger company does not usually require the bank’s marketing and investor relationships. They generally are already well-known, compared to smaller companies which may require that additional help from the banks.
In the case of debt issuance, the process is similar except for a couple of differences. There are fewer banks involved, the process is much faster compared to IPOs. Also, there is no need for the SEC or any equivalent organisation’s approval because the debt isn’t sold to the general public, but to sophisticated institutional investors and funds.
Case studies in M&A and IPOs
EIG’s $12.4 billion acquisition of Aramco Oil Pipelines
On 18th June 2021, EIG Global Energy Partners-led consortium acquired a 49% stake in Aramco Oil Pipelines, in an infrastructure deal worth $12.4 billion. A leading institutional and infrastructure investor, EIG’s was advised by HSBC Bank on the transaction. It drew significant attention across the world from institutional investors such as Mubadala Investment Company, an Abu Dhabi Sovereign Investor, Silk Road Fund, Hassana, and Samsung Asset Management.
This deal represents a long-term investment by EIG, acquiring the holding company from Saudi Aramco (the world’s largest oil producer). As part of this transaction, both parties entered into a 25-year lease and leaseback agreement, which allowed the usage of Saudi Aramco’s crude oil pipeline network to be leased to Aramco Oil Pipelines.
Following the completion of this infrastructure investment deal, in 2022, EIG and Saudi Aramco’s agreed to a partnership in building critical infrastructure in the energy complex, and to drive new investment towards low-emissions energy solutions.
AIA Group’s IPO
First established in Shanghai in 1919, AIA’s successful listing on the Hong Kong Stock Exchange (HKEX) on 22 October 2010 remains the 6th largest IPO in history, and the largest-ever insurance IPO to date. It raised a staggering $20.51 billion, after AIA exercised the Over-Allotment Option, raising 15% more than planned.
At the time, AIA was part of American International Group, which suffered significant losses and was bailed out by the US Government during the 2008 financial crisis. After talks with British Prudential (an insurance firm) collapsed, a record number of book-runners including Citigroup, Goldman Sachs, and Credit Suisse were hired for the IPO. For banks involved in the IPO, a total of $355 million in fees were collected.
To date, AIA group remains the largest independent publicly listed pan-Asian life insurance group and the largest IPO on the HKEX.