What is Investment Banking? Explained in Simple Terms
Just what is investment banking? Have you noticed that a lot of people just throw around the term “investment banking” but none of them seem to really know what exactly it is?
Try telling people that you work in investment banking and chances are they’ll either ask you to fix their ATM machine or mistaken you for a teller.
The media likes to make it seem super complex, but in reality, investment banking is pretty simple.
Let’s use an analogy.
Think of what a real estate agent does. You know, the ones that broker a deal between people who have cash but looking to buy real estate and people who have real estate but looking to sell for cash.
Investment bankers are very much like real estate agents. Except instead of selling real estate, they’re selling investment opportunities. And they get paid A LOT doing it.
The bankers bring together parties who have capital looking for investment opportunities and parties who are looking for investors.
Broadly speaking, a company that needs money can get it in 3 ways:
1. Borrow debt
2. Sell equity (aka ownership)
3. Sell the entire company
This is the sell-side of investment banking. They’re selling an investment opportunity in exchange for cash.
But to the buy-side, each of these represent a way to invest and earn a ROI or return on investment.
Say you’re looking to buy a house for $500K and want to borrow $200K. Where do you go? You go to a bank. All the retail banks would be happy to loan you money because they’ll earn interest. Your interest expense is their interest income. By lending you money, they’re earning a return on their investment.
But where do you go if you are a large company that needs to borrow $10 billion? You can’t just walk into Chase and expect the teller to give you $10 billion.
Not many people or companies in this world can give you $10 billion in cash.
But there are plenty of investors who can loan you a small piece of that.
One investor might lend you $10 million, a second investor lend you $15 million, and so on. None of them can individually lend you $10 billion, but collectively, they might add up to $10 billion.
However, having to find and convince each investor is time consuming and you’ll need to have the relationship.
That’s where the investment bankers come in. They do this for a living and maintain relationships with all the major players on Wall Street.
They’ll meet with investors willing to lend money and see what their appetite is. If these investors like the opportunity (i.e. you’re willing to pay a high interest rate), they’ll subscribe or commit to invest in your debt. This is called debt financing.
The company gets to borrow money, the lenders earns interest, and the bankers get paid a fee.
Now let’s assume you’ve bought the house for $500K after borrowing $200K from the bank.
A few months later, you realize that you want to get on that models & bottles game.
Just one problem. You don’t have enough cash and you can’t borrow more debt.
So how can you get cash without borrowing more debt? Well, you can sell a piece of equity ownership in the house to your friends & family for cash.
That sounds good and you proceed to sell 10% of your house for $30,000 to your friend. Pro forma or “after the transaction”, you get the $30,000 cash in the bank and now you own 90% of the house while your friend owns 10%.
Simple right? Same thing for companies.
Companies that don’t want to borrow debt can sell equity ownership in the company in exchange for cash, which they can use to fund the business and grow.
But large companies are worth tens of billions and very few investor has that sort of cash laying around.
Similar to debt financing, there are plenty of investors who would want to purchase a small piece of the equity ownership.
So the investment bankers go around to meet different equity investors, who will subscribe to the investment opportunity if they like what they’re seeing. This is known as equity financing. You’re selling a piece of your equity or ownership in your company in exchange for cash.
The company gets cash, the investors gets a piece of the company, and the bankers get paid a fee.
Sell the Entire Company
A year after you purchased the house, the real estate market’s doing great and the house that you bought for $500,000 is now worth $700,000.
You’re doing pretty well for yourself.
You decide you want to sell the house so you hire a real estate agent to sell the property and in return, you pay the agent a brokerage fee.
Companies work in the same way.
The owners of a business might want to exit and sell the company for cash. So they hire an investment banker to shop the company around to find a buyer.
The investment banker finds other companies or private equity firms who might be interested in acquiring the business. If both the buyer and seller can agree on the terms, they sign an agreement and complete the purchase. In finance, this is known as mergers & acquisitions (“M&A”) or the buying and selling of companies.
When the deal is done, the seller gets the cash, the buyers acquires a company, and the banker gets paid an M&A fee. Everyone’s happy.
Who are the World’s Largest Investment Banks Today?
The 9 largest investment banks in the world today are commonly referred to as the “bulge brackets”. All of these banks are vital to the global financial markets and they are as follows:
1. Bank of America Merrill Lynch
4. Credit Suisse
5. Deutsche Bank
6. Goldman Sachs
7. J.P. Morgan
8. Morgan Stanley
The above is a high-level explanation of what investment banking is.
What you do on a day-to-day basis as an investment banking analyst though, that’s a whole different story.