The Role of Investment Banks in Financing

Underwriter

Investment bank underwriters help securities issuers lessen their risk in exchange for a premium.

Learning Objectives

Explain the role of underwriters

Key Takeaways

Key Points

  • Security issuers want to mitigate the risk of having an unsuccessful issue.
  • Underwriters will buy the securities from the issuer and then sell it on the market. The underwriter aims to buy the securities below market price, and then sell them for a profit.
  • Underwriters deal with both companies and government. The issuer could issue stocks, bonds, or any other type of security.

Key Terms

  • security: proof of ownership of stocks, bonds, or other investment instruments.W
  • issuer: The firm or government selling the security.

Underwriting refers to the process that a large financial service provider ( bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products ( equity capital, insurance, mortgage, or credit). Underwriters exist in a number of different industries, and are primarily responsible for evaluating the risk of potential clients.

In investment banking, underwriters are best known for the role that they play in initial public offerings ( IPOs ). IPOs are when a company decides to sell equity on the stock market for the first time. They sell their own stock on the market and in the process, raise money through selling equity. However, investment banks are involved in the underwriting of all types of securities, not just stock.

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NYSE: Firms may issue an IPO on an exchange such as the New York Stock Exchange (NYSE). They sell their stock in exchange for cash.

The company needs to set a price for its stock; they want to set it high enough to raise as much money as possible but low enough that they will be able to sell their stock. Thus, there is a risk to the company in the offering of securities. For all types of securities, whether offered by companies or the government, there is a risk that the issuer may not be able to have a successful securities offering.

That is where the job of the security underwriter comes in. The underwriter offers to take on some of the risk of the offering in exchange for a premium. In essence, the underwriter buys the securities from the issuer and then turns around to sell the securities on the market. This means that the issuer gets cash up front. The issuer knows that it is probably not getting the full market value of the securities, but that’s okay because it no longer has the risk of having to find enough buyers to purchase the securities at a desirable price. The underwriting investment bank likes the deal because if it can sell the securities on the market at a higher price than it purchased them, it can make a profit.

There are sometimes multiple investment banks involved in the underwriting of a security. The details of the process may vary from deal to deal, but the fundamental job of the underwriter(s) is to take some of the issuer’s risk in exchange for a premium.

Market Maker

Market makers provide liquidity to securities markets by submitting both bids and asks on a security.

Learning Objectives

Explain the role of market makers

Key Takeaways

Key Points

  • Without sufficient liquidity, markets would become more inefficient because there may not be a buyer/seller to transact with, even at what should be the market price.
  • Market-designated market makers provide liquidity by submitting both bids and asks on certain securities. This helps ensure transactions can occur at the market price.
  • By submitting bids below ask prices, the market maker can make money.
  • The difference between the highest bid and the lowest ask price is called the bid-ask spread.

Key Terms

  • bid-ask spread: the difference between the prices quoted for an immediate sale and an immediate purchase
  • bid: The submitted price at which the trader is willing to buy.
  • ask: The submitted price at which the trader is willing to sell.
  • bid price: the amount offered by a buyer
  • liquidity: Availability of cash over short term: ability to service short-term debt.

The price of a stock is determined through a simple process of matching buyers and sellers. All those who want to sell the stock say the price at which they’re willing to sell a certain number of shares (the ask price). All those who want to buy say the maximum price they’re willing to pay for a certain number of shares (the bid). The difference between the highest bid and the lowest ask price is called the bid-ask spread. If the one person’s bid equals another’s ask price, they have found a price at which they’re both willing to do business, and the transaction occurs. The mutually agreeable price is then inputted as the stock price.

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New York Spot Prices: The highest price someone is willing to pay (bid) for gold is $742.30 and the lowest someone is willing to accept (ask) is $743.30. There is a bid-ask spread of $1.10.

In major stock exchanges (such as the New York Stock Exchange) there are enough people who want to buy or sell at any given time that it’s generally easy to find someone to transact with if you’re making a bid/ask near the last price. This is called liquidity.

But what happens if there is no liquidity? Since there aren’t very many people looking to trade the stock, the highest bid may be significantly lower than the lowest ask price, so no transactions occur. A lack of liquidity is really bad for investors. If they don’t think they can buy/sell the stock when they need to, they will choose to just not deal with it.

That’s where a special type of trader comes in. They are the market makers. Market makers are a company or individual that quotes both an ask price and a bid. This helps to provide liquidity to the market, making the market more efficient. For this reason, many exchanges (such as the New York Stock Exchange and American Stock Exchange) have designated market makers for certain securities.

The financial reason why market makers do this is because the ask price that they submit will always be slightly higher than their bid. It is the bid-ask spread that provides the money-making opportunity. A bid-ask spread of even a cent can mean a huge profit when trading thousands of shares.

The Role of an Advisor

The advisory group of an investment bank is primarily concerned with facilitating the mergers and acquisitions of businesses.

Learning Objectives

Define how investment banks act as advisors

Key Takeaways

Key Points

  • Mergers and acquisitions ( M&A ) require an investment bank to bring the buyer and seller together and to help negotiate the deal.
  • The advisor is hired by the client company to find a buyer/seller. The advisor pitches the deal to potential buyers/sellers using a pitch book, which contains all relevant financial information.
  • The advisor also helps facilitate the deal which is incredible context because it must account for everything from financial projections to assets to brand names.

Key Terms

  • M&A: Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.

Advisory Role

Investment banks also play the role of advisor to companies. They are not consultants, but are more like facilitators. The advisory group in an investment bank is often termed M&A.

M&A stands for “mergers and acquisitions”, which refers to the the buying, selling, dividing and combining of different firms. For example, if a company wants to sell of an unprofitable division, they will hire an investment bank to find a company that would want to buy it. Investment banks play a large role in facilitating M&A deals. The advisory group is charged with the task of helping buyers find sellers and vice versa, and then facilitating the deal.

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Pricewaterhouse Cooper: Pricewaterhouse Cooper got it’s name after the 1998 merger of Price Waterhouse and Coopers & Lybrand.

Once the advisory group is hired by a company looking to sell itself to another, it will put together something called a pitch book. The pitch book contains all the relevant financial information about the company looking to get acquired. The investment bank then takes the pitch book to companies that it thinks might be interested in acquiring their client.

If the pitch is successful, the bank arranges the deal for the client. In order for the acquisition to take place, the two boards and leadership must be agree on the terms. This is often a very complex process because of the intricacies of the financial, functional, and organizational structures of both companies. There must be a plan for transferring everything from technology to debt to employees to titles, and the transaction must occur at a favorable price. If the negotiations are successful, the investment bank’s client will be acquired.

Agency

In its agency role, an investment bank is tasked with matching companies with investors.

Learning Objectives

Define the different sources of capital financing

Key Takeaways

Key Points

  • Many small and private companies cannot access traditional financial markets for capital, so they need to either take on debt or find other sources of financing. Investment banks help them find those other sources of capital.
  • Common sources of financing are equity financing, mezzanine financing, and specialist financing (e.g., government loans).
  • The investment banks match their clients to investors and then charge a fee for the service.

Key Terms

  • private: A company that is not publicly traded.

Investment banks are not confined solely to working with and making money on large, publicly traded companies. They also can be hired by private firms. A private firm might hire an investment bank for help with a merger or acquisition or for issuing an IPO (initial public offering of shares). A private firm might also hire an investment bank as a placement agent.

Suppose a firm does not want to be acquired and cannot (or does not want to get) good loans from banks. They still need to raise capital, but can’t access public markets, such as the stock market; they have to find different ways to raise capital. They hire a placement agent to act as an intermediary between them and investors. This allows them not only to connect with investors, but also allows them to focus on management, instead of finding investors.

Capital financing for private companies can come from a number of sources. Three of the main capital sources are:

  1. Equity financing: Private firms can sell some or all of their equity to investors. This is akin to selling off a portion of the ownership of the company. It may seem undesirable to sell a portion of the company’s ownership, but many firms (especially start-ups and growth companies) need to do so for immediate capital to fund future growth.
  2. Mezzanine capital: A subordinated debt or preferred equity instrument that represents a claim on a company’s assets, which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock.
  3. Specialist financing: This could include things such as government loans or special grants that the company qualifies for.

Placement agents are most often compensated through fee arrangements based on the amount of money raised and supported by the fund or company they are representing.