The Major Functions of Investment Banks In An Economy
Right off the bat, we’ll move to the definition of investment banking. Investment banking is one of the specific divisions of banking operations that help individual organizations or government agencies raise their capital and provide financial consultancy services to them. Another definition of investment banking is investment banking, which is a specific division of banking that purely helps individual corporations or governments to raise their capital. So, what are the functions of investment banks? There are different functions of investment banks, so the main function is trading the securities generally. This is particular investment banking.
The Functions of Investment Banks: Function Overview
If I want to buy a share of a particular company named ABC, then the company ABC is an issuer. And I want to buy shares of ABC company, which means I am an investor. So, if that particular ABC company is new, they are not listed on the share market or the stock exchange. Then, this particular investment banking helps this new company list on the stock exchange. The main function of trading is to exchange money and security. Security may represent secure shares, bonds, or commodities, so it will help exchange the money. In this particular security, in which the issuer is providing security and the investor is providing money, investment banking helps with mergers and acquisitions. But What do mergers and acquisitions mean? Two companies have equal-level values. For example, ABC is one company, and XYZ is another company. Both companies have equal value in the market, so this investment banking can suggest they merge and gain profit. As individuals, if they are getting less profit if both companies get merged, then there are some chances of getting more profit. This investment banking may suggest that they merge, for example, so most of the time, this kind of merging happens in the same sector. For example, if two companies are working in the textile sector, then these two textile companies can merge.
Suppose I have established one particular company named ABC and want to raise capital. In that case, I don’t know how to go public or issue my shares, and at that particular time, this investment banking helps new companies for a public listing. Next, the following are some examples of the largest investment banks: Bank of America, Barclays, Capital City Group investment banking, JPMorgan Goldman Sachs, Morgan Stanley, UBS, and many more. You can easily google it, and you can find out the many investment banks.
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The Functions of Investment Banks: IPO Creation
First in the list of functions of investment banks is IPO Creation.
IPO means an initial public offering. It is the first time a company has issued a share to the public. This is when any private company decides to go to a public. A company may be new; for example, I have established ABC, and I want to issue my shares to the public. So this is a very young company in the market. Some old companies decided to list on the stock exchange; hence, they go to the public.
Recently, the LIC has launched their IPO. LIC is an old organization, but it now wants to list its shares to the public. So, this is nothing but the initial public offering.IPO provides a company with the opportunity to obtain capital by offering shares through a primary market. Remember that the primary market, which means the very first time you are launching your shares to the public, is known as a primary market.
And when that particular IPO gets launched, then the IPO list. After the IPO listing, when the investors get the share, they can sell or buy the shares in the secondary market. The main point is companies hire investment banks to market for IPO listing. For example, my company is newly named ABC, and I need to figure out how I issue shares to the public. Then, I have to take the help of investment banks to decide the price and at what time and date I have to launch my particular IPOs.
Many investment banks are there. They will analyze the same and give you advice on the price of your company. They will help you to decide the price of particular shares, and also they will help you to decide the launch date and time. The investors are going to buy several shares. For example, if one buys ten shares, at that time, investors will buy that particular amount of shares that your company issues. So, the company offering a share is known as an issuer. Remember that an IPO is an initial public offering when a first-time company issues a share.
The main need for an IPO is when a particular company wants to raise capital or for they want to expand its business. For example, my company is named ABC, and now I am working in the textile industry, but I want to move into the steel industry as well. Now, I need some particular capital, and then I will launch my IPO. I want to list my company on the stock exchange and make and want to make shares available to the public.
Another need of companies is to allow owners to early investors to sell their shares initially and make money. The next main point is greater public awareness, meaning I am going to market for marketing my particular company through an IPO. so most of the customers can be attracted to my particular company.
I need to create a prospect, so here in prospect are the financial records, plans of my companies, and risks related to the market. And the expected share price, which I decided with the help of investment banking. So once a prospect is prepared with the help of some agencies, then I require the SEBI’s approval. SEBI is nothing but a securities and exchange board of India.
Depending on the prospect, they will approve or reject my IPO. If they approve, they will give me a particular date and time to launch my particular IPO; if they reject, they will suggest some changes in prospects. After SEBI’s approval, there is a stock exchange approval. So, there are stock exchanges like the Bombay Stock Exchange or the National Stock Exchange.
If I want to list my IPO on the Bombay Stock Exchange, I require approval from them. So this listing process means on which stock exchange I want to list my particular IPO, I need to get their approval. Once I get approval from the stock exchange, I must subscribe to my share. What if I launch my IPO, and you are the investor? Then, as an investor, you wish to apply for the share. Then, what you are going to do by using your demat account you are going to fill out a particular application to buy shares.
You will invest particular money once you fill out that particular application form and submit it. The listing will be using your Demat account. You have invested a particular amount. Then, depending on that, you will get the shares on the particular specified date and specified time. So next is how this particular IPO was issued to investors. What happens most of the time is when a company gets an oversubscription, which means so many people are interested in buying the shares of a particular company.
At that time, what happens if the number of shares is less and the demand is more at that time based on a lottery scheme? Some investors get the shares, but some may still need to get the shares. So, whatever the amount they have deposited, they will get a refund. But if any company has a subscription, all the investors, or all the investors who wish to buy the share, will get the share on a particular specified date and time.
The Functions of Investment Banks: Underwriting Process
This is one of the main functions of investment banks. There’s negotiation structuring and valuation associated with a deal. This could be on the advisory side as an investment bank or a transaction advisor or in-house in corporate development. Similarly, on the capital raising side, this includes IPOs or follow-on offerings, but jobs exist on the sell side with the investment banks providing advisory services.
On the corporate side, corporate development groups are very involved in these processes and finally, the accounting firms provide support services for these types of transactions. There are three main components of advisory services: the first is the planning phase, the second is assessing the timing and demand for the issue, and the third is the issue structure.
The demand side is time to think about the market conditions like now. What is the investor appetite or risk level in the market? right now, an investor experience, and finally, when we get into structuring, will it be domestic or international? It’s time to start thinking about actually selling the deal.
There are three types of underwriting commitments or offerings. The first is a firm commitment, the second is the best effort, and the third is all or none in a firm commitment.
The underwriter buys the entire issue and is responsible for anyone’s shares. So, in summary, there are three main stages of the underwriting or capital raising process and three types of underwriting commitments. Finally, all-or-none, a best-effort or marketed deal is the most common. let’s talk about the mechanics of the capital raising or underwriting process.
The book-building process starts with a prospectus price range where there’s a range of prices that investment bankers expect investors to be interested in. There, the price can be narrowed to an institutional investor commitment, at a more firm price. This is how the book of demand is built, so orders come in at certain prices from institutional investors. and the bankers then have this list of orders or book of demand, as they call it, that they build. and to justify the pricing.
Finally, a price is set to ensure clearing based on the book of orders. so the investment bankers can look at all the orders that have come in from institutional investors and decide what the clearing price will be. So the issue is fully closed.
The orders are allocated. Some investors might not get all of the orders that they wanted. if the book is called oversubscribed, then some may get less than they asked for the roadshow process. so the roadshow isn’t often talked about as part of capital raising, and this is when management goes on the road with the investment bankers and goes to meet the institutional investors. That is going to be buying this investment.
There are a few areas that are critical to a successful Roadshow: The first is understanding management structure. and governance investors are adamant about management structure. And governments must be conducive to creating good returns.
Additionally, the investors will want to know the key risks of the business, although not positive. it is important to highlight the risks and be upfront about them. the next is strategy, both tactical and long-term: what are the strategic initiatives of this business? and how it is going to create sustainable value over the long run.
Your use of proceeds, and finally, they’ll need to be a thorough analysis of the industry or sector, looking at trends in the industry, not just for this company. That’s raising money for the industry, so price stability is essential, a buoyant aftermarket.
If there is going to be volatility, it should hopefully be to the upside with a strong market. And certainly not to the downside. A deep investor base will help achieve this, having many investors in an issue instead of just one or two highly concentrated investors.
This will help stabilize and make a deep aftermarket. and finally, access to the market will always be critical in pricing the issue. There are a couple of trade-offs. There’s tension in the choices. The first is having strong aftermarket price performance on one side. but on the other side, not under-pricing is too much, so that money is left on the table.
So you want to price it just low enough that there’s good after-market performance but not so low that the issuer feels they’ve left money on the table. Let’s talk about the cost associated with the flotation. One is reducing the risk of an equity overhang, and the other is ensuring a point aftermarket, but there’s an action from the bank to underprice the issue.
That is because they want to get the deal done, and they want to reduce the chance of being caught with an equity overhang, which is another way of saying unsold equity at the end of the deal. so reducing the risk of an equity overhang helps ensure a buoyant aftermarket.
But it doesn’t necessarily get the best returns for the current owners, which is to say, the highest price of the issue. so there is a lot of complexity around pricing. an issue of getting the issue to sell but not pricing it too low and having the right balance.
So if we review the IPO pricing process, we start by determining the full value of a business. a combination of discounted cash flow analysis, comparable company analysis, precedent transactions, etc., does this. By these methods, from there, you deduct an IPO discount, so we come in a little bit lower than the intrinsic value or full value of the business to price.
The offering, after deducting the IPO discount, we arrive at the pricing range of a minimum and maximum price that we believe institutional investors will fill this issue. typically, ten to fifteen percent is a normal range for the indicated minimum and maximum prices.
Finally, the issue will be priced typically within the range. but it may be priced outside the range of a heavily oversubscribed offering. it may be repriced below the range if demand is lower than expected. It is ultimately up to the institutional investors to determine the price of the offering.
The Functions of Investment Banks – FPO
Again one of the primary functions of investment banks is FPO. What if the company wants to raise capital even after the IPO? What can they do well? They will do a follow-on public offering (FPO), so what is it? Why do companies do this? How do they do this? A company would first have an IPO and then the FPO. That’s why it gets its name followed.
There are two ways a company can have an FPO: they can offer the shares to the general public. One thing to note here is that companies cannot just go and sell the shares in the stock market and claim that they have given the shares to the general public. It must be offered in the primary IPO, and FPO both happen on the primary market while the stock exchange makes the secondary market.
Examples of some FPOs: In 2019, a Chinese company, huya, completed an FPO of 343 million dollars. There are mainly two types of FPO based on what kind of shares the company offers. If the company offers new shares in the FPO, it brings more shares into the market, which leads to the dilution of its stake. And their earnings per share get reduced.
This type of FPO is known as dilutive FPO. For example, a company already has 100 million dollar shares in the market and then offers 20 million dollars more shares in the FPO. Now, the total number of shares in the market is 120 million dollars.
The second type of FPO is non-dilutive FPO. In this type of FPO, the company does not bring new shares into the market but offers existing shares. The promoters or private investors may have previously held these shares. After such an FPO, since there is no dilution, that would remain the same reasons for FPO. You might now have a question about why a company has an FPO after they have already had an IPO. Well, a company would do that for a couple of reasons.
Number one is to clear debt: companies often take debt to carry out their business activities, which requires regular payments irrespective of the company’s profits. So, the company can decide to have an FPO and use the capital raised in the FPO to clear its debt. At times, the interest rates of the debts may be high for the company.
Therefore, they would prefer to give away their shares to the public rather than take on more debt. Number two is to reduce control of debtors. Sometimes, this may limit the scope of expansion of the company. They would seek to reduce this control that the debtors have on them.
Hence, they would have an FPO pay off their debts and retain control over the company. Number three is to raise more capital. The business plans, at times, the capital raised in the IPO may need to be more for them, so they need an FPO to raise more capital.
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FAQs- The Functions of Investment Banks
1. Are investment banking courses worth it?
Investment banking courses are completely worth your money if you know what you are doing in these courses and how you are going to use the courses in the future. It would help if you had a proper plan before the execution of the training.
2. Does investment banking require math?
Yes, you need sound mathematical knowledge of statistical concepts while making financial modelling for several companies. It is a must-have skill.
3. Does investment banking pay well?
Yes, you are paid well in investment banking by the clients. You will get lots of bonuses as compensation for your salary every month.
Concluding Thoughts on Functions of Investment Banks
You can understand from this blog that an investment bank has very complex functions regarding a business. Not all investment bank has a few functions which I wish to cover in a future article. Share your valuable view on the function as well. I have tried to give it a detailed outlook in this article.