What is an investment bank? Investment banks (aka “ibanks”) are in some ways very mysterious creatures.
You can go on their websites, spend 3 hours reading their self-description about what they do and walk away still having no idea what exactly it is that they do.
You just know that they make a lot of money doing something.
They’re accustomed to explaining things with finance lingo to people already in the industry, which doesn’t help if you’re trying to break in.
We had that exact frustration when we were trying to break into the industry.
Here, we’ll attempt (hopefully not failing) to give an “investment bank 101” in this article and walk you through what an investment bank is and what they do.
Forgive us if there’s anything don’t didn’t explain well – leave a comment below to help us improve!
What Exactly Do Investment Banks Do
The purpose of investment banks is to bring together 1) parties who have money and looking to invest their money to earn a return and 2) parties who need money and are offering investment opportunities.
They have various divisions that provides different services to different clients but the ultimate benefit is the same. Bringing together the two sides so that the party looking for investments earns a good return and the party looking for capital gets their financing.
The analogy I like to use is comparing investment banks to real estate agencies.
Real estate agencies are basically the middlemen between people looking to sell real estate and people looking to buy real estate.
Now replace real estate with investment opportunities and that’s conceptually what investment banks do.
The party looking for capital and offering investment opportunities in exchange is referred to as the sell-side.
The party that has the capital and looking to invest is referred to as the buy-side.
Investment banks are distinct from retail banks which are the banks (i.e. Chase, Citibank) that you go to deposit checks / withdraw cash.
Instead, they facilitate investment transactions, usually in large sums of money (i.e. hundreds of millions to billions of dollars)
Why There Are Different Divisions in Investment Banks
Investment banks have different ways of connecting the two parties. That’s because they have different clients with different needs.
For one, there are different types of clients. We can segment the client base by institution type. Government agencies. Pension funds / university endowments. Large corporations. Small businesses. High net worth individuals. Basically anyone with large amounts of capital to deploy.
As you can imagine the needs of a large corporation is drastically different from the needs of a high net-worth individual.
We can also segment the client base by buy-side vs. sell-side. There are the sell-side clients looking for capital. Then there are the buy-side clients looking for investment opportunities.
Not only are the clients different, but the investment opportunities they’re looking for are also different. Some investors just want to buy stocks or bonds. Some investors may want international investment opportunities vs. domestic ones. Others may want to buy the entire company or a big chunk of it rather than just a share of the company.
Finally, the clients want different services from the banks. Some clients may just want to hand over their money to the bank and have the bank decide how to invest it. They don’t want to be bothered with it. While others may just want the banks to provide research on an opportunity and they’ll make their own investment decisions. There’re also clients in need of capital who need the banks to find them the right investors.
To meet these different needs, the investment banks need to offer different services and products. And because the banks have to offer different services, employees have to do different types of work to deliver these different services.
This wide range of client needs give rise to the various divisions in an investment bank.
Different Divisions of Investment Banks
So now you know 1) what investment banks do conceptually and 2) why they need different divisions (just different ways to meet different client needs).
Next step is to understand the different divisions in an ibank and how they function.
Conceptually, there are generally two types of divisions.
First, there are the revenue-generating divisions, commonly referred to as front office. These divisions are responsible for delivering a particular set of the firm’s products / services and generate revenue from its business activities. The jobs in these divisions are client-facing and often the most sought-after among aspiring finance professionals with entry level pay in the six-figures. As a result, recruiting for these opportunities is highly competitive. Examples: Investment Banking Division, Sales & Trading Division, Investment Management Division, Investment Research Division, etc.
Then there’re the support divisions, commonly referred to as the middle and back office. These divisions provide support services to the front office so that the front office professionals can just focus on the business activities that generate revenue. Compensation for these jobs, while lower than that of front office roles, are also generally pretty high vs. the market. Examples: Compliance, Facilities (managing the office building), Finance, Operations, Security (making sure the workplace is safe), Technology, etc.
At the top, you have executive leadership. These people are the senior management (i.e. CEO, CFO) of the bank that oversees the entire firm. They don’t belong specifically to any particular division per se, but rather works with every division to maximize the firm’s long-term shareholder value.
Now while every employee works at an investment bank, not all of them are called “investment bankers” or “bankers”.
Generally, only the professionals in the Investment Banking Division within the investment bank (and sometimes executive leadership as well) are referred to as the “investment bankers”.
Investment Banking Division
The Investment Banking Division (“IBD”) provides 1) M&A advisory and 2) financing solutions, mostly to corporate clients and private equity firms.
Let’s talk about M&A advisory first.
This is where one company with capital on hand (buy-side) is looking to invest it by acquiring another company (sell-side). The difference between M&A and buying a share on the stock market is that the acquiring party in an M&A deal is usually obtaining control of the business.
That usually requires the acquiring party to own a big chunk of the company, so you usually see the acquiring party acquiring 100% of the company or a big portion of the business.
This gives rise to a whole bunch of issues (i.e. valuation, financing, regulatory) that you don’t have to deal with when you buy stocks.
Because of this complexity, the acquirors and sellers usually need M&A advisors. The Investment Banking Division fills this role and provides advisory services to the buy-side & sell-side clients.
It’s kind of like a consulting business. But for M&A transactions.
In the case where one corporation acquires another corporation (i.e. Microsoft acquires LinkedIn), it is known as a strategic transaction. The M&A deal is usually done for a strategic business rationale.
In the case where a private equity firm or financial sponsor acquires a company, it is known as a financial transaction. The sponsor is acquiring the company with the primary objective of generating a return on investment.
IBD also offers financing solutions.
Corporations, just like people, often need more money than they have on hand.
They usually need hundreds of millions to billions of dollars. The investment banks help them raise this capital through either borrowing debt (debt financing) or selling equity (equity financing).
Sales & Trading Division
The Sales & Trading Division (“S&T”) is the division that trades publicly-listed, liquid securities like stocks, bonds, commodities and currencies.
This division serves an extremely important purpose in the financial markets called market-making.
Basically the financial markets can operate because of these banks. Let me put this in context.
If you have your own stock portfolio, have you ever wondered how there’s magically always someone that’s willing to transact with you whenever you want to buy / sell a stock? Like at that exact second that you want to transact?
That’s market-making at work. The stocks are liquid because these banks serve as the house and transact with everyone’s trades.
Through these trades, the banks profit from the bid / ask spread.
For example, a stock may show a bid and ask price of $10.00 / $10.05, which means that the bank is willing to buy it at $10.00 and sell it at $10.05. The spread of $0.05 is the profit per share. If the bank trades 10,000 shares, its profit from the spread would be $500.
Broadly speaking, there are two types of trading at the investment banks: agency trading vs. prop trading.
Agency trading is basically executing whatever trading orders that your clients want. You’re an “agent” for your client.
Prop trading is the type of trading where you’re using the banks’ own money to make whatever trades you think will be profitable. You’re making your own decisions about what you want to buy vs. sell.
Most S&T divisions have an Equities team that trades stocks, equity derivatives (i.e. stock options) as well as a Fixed Income team that trades interest rate products (i.e. treasury bills, government and corporate bonds, mortgages). Many banks have also grouped commodities and currencies trading under the Fixed Income umbrella as well.
Investment Management Division
The Investment Management Division does exactly what the name implies – it manages money & investments for its clients. Different banks may call this division different names, but they all do the same thing.
Private Wealth Management (PWM) manages investments for high-net-worth individuals, their families, and family offices, etc.
The bank will serve as these individuals’ personal financial advisor. Generally, these banks only accept clients with a liquid capital above some very large amount.
Asset Management is often more geared towards managing assets for institutions (i.e. corporations, pensions, etc.)
Representatives from the division will meet with their clients to understand their goals and needs. Based on clients’ preferences, they’ll develop customized portfolio strategies to help these clients achieve their goals (i.e. capital preservation for retirement vs. aggressive growth).
Through these divisions, clients can often access investment opportunities unavailable to the general public.
For example, Goldman has sometimes offered opportunities to invest in hot private tech companies to clients long before their IPO.
Investment Research Division
The Investment Research Division conducts research on investment opportunities, distills the findings into reports and sells these publications to clients.
Many investors don’t have the resources available to conduct their own in-depth research, so the Research division fills an important knowledge gap by providing these investors with the resources they need to make an informed investment decision.
The Research division also benefits from the bank’s institutional relationships with the corporations so they have easy access to company management. Research analysts can call up the executives and ask them questions. It’s much harder to do that as a single investor.
Many banks’ Research division will have research teams covering different types of investment securities. Usually, the division will include Macro Research, Equity Research and Credit Research.
The Macro Research team keeps track of macroeconomic developments and relevant metrics (i.e. GDP, inflation, unemployment, population, etc) in various countries.
The Equity Research team conducts research on stocks and their underlying companies. These reports will often include a recommendation to buy / sell / hold and a 12-month price target.
Similar to the Equity Research team, Credit Research also involves researching the underlying companies, but they’ll focus primarily on the debt investors as opposed to the equity investors. Credit Research is more concerned with whether the companies can repay their debt than the growth prospects of the business.
Within Equity and Credit Research, there are different teams covering different sectors. They do that because the clients want the research analysts to be subject experts on whatever they’re covering. And it’s much easier for someone to be an expert on one sector than on every single sector.
So there’d be a separate team covering software, retail, pharmaceuticals, telecom, chemicals, etc.
An example of a Morgan Stanley research report on Google can be found here.
Merchant Banking Division
A few of the investment banks (i.e. Goldman Sachs and Morgan Stanley) have a Merchant Banking Division.
The Merchant Banking Division makes investments in corporate private equity, real estate, infrastructure and credit.
This division operates in a similar manner to private equity firms.
First, they have to fundraise for a new investing vehicle or fund. So they market their investing capabilities & track record to investors (i.e. pension funds, sovereign funds, high net-worth individuals) to convince them to put money into the fund.
The fund will have a particular mandate to invest into a particular class of assets (i.e. private companies vs. real estate vs. infrastructure) and target a certain level of return. For example, they’ll have a Real Estate Fund targeting specifically real estate opportunities and a Mezzanine Fund targeting specifically mezzanine debt investments.
The investment banks usually also put some of their own money into the fund to have skin in the game.
That way, investors in the fund know that the bank is incentivized to do good work because their own money is also at stake. So the MBD funds consist of both the banks’ balance sheet cash as well as outside capital.
The proceeds raised through these funds would then be used to make investments in whatever asset class that the fund was raised for.
And if these investments generate positive returns, MBD can earn carry, allowing it to keep a portion of the investment gains. In addition to carry, MBD also earns management fees based the amount of assets that they manage. The revenue from these management fees are used to cover MBD operating expenses such as compensation and deal expenses.
So what is the product / service that MBD is offering?
The service is investment advisory and the product is investment returns.
Bulge Brackets vs. Boutiques
In today’s industry, there are the bulge bracket (“BB”) or large-scale investment banks with most, if not all, of the divisions I mentioned above and boutique investment banks much smaller in scale.
The bulge brackets are the most dominant investment banks in the world. Recall that they’re the market makers. Without them, the financial markets wouldn’t be as liquid and we would have a very hard time trading stocks.
They have trillions in assets and have their fingers practically in all of the major countries. Their activities directly affect the financial market stability and are heavily regulated by government agencies.
So who are the major bulge brackets today?
The most prominent BBs are: Bank of America Merrill Lynch, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley, UBS. There are some other large-scale BB’s as well, but these 9 banks are the most prominent.
Aside from the BBs, there are the boutique investment banks. These banks are much smaller in scale. Central to their investment banking business is the M&A advisory business.
These boutique banks don’t have 1) the market making capabilities as the bulge brackets and 2) the extensive balance sheet so they can’t lend billions of dollars.
Instead, they focus on M&A advisory, which is a lot less capital-intensive. It’s a people business (offering advice) and you don’t need trillions of dollars. You just need brainpower and some fresh college grads who type very fast.
The top / most prominent boutiques are commonly referred to as the elite boutiques (“EB”).
Examples of elite boutiques are: Allen & Co., Centerview, Evercore, Lazard, Moelis, PJT Partners, Qatalyst.
So There You Have It
That’s in a nutshell what an investment bank is and what they do.
Now what the investment banking analysts do, on the other hand, is a whole different story.
For Further Reading
What Do Investment Bankers Do? (To Come)
A Day in the Life of an Investment Banking Analyst (To Come)
About 10X EBITDA
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