The Role of the Investment Banker
The investment banker acts in a capital markets advisory capacity to corporations and governments, rather than dealing directly with individual investors. Investment bankers help their clients raise money in the capital markets, provide various financial advisory services, and assist with mergers and acquisition activity.
Thus, when the capital markets are doing well, investment bankers tend to do well since they can generate more revenues from all the activities that they undertake. (See also, Financial Careers: Investment Banking Jobs)
Arranging Finance
If a large company wants to build a factory and is looking to issue bond financing to finance its expansion, it may seek the help of an investment banker. Similarly, if a government wants to finance the building of an airport, highway or other large municipal project, it may work with an investment banker to issue bonds to raise capital.
In such a case, the investment banker would plan the bond issuance, price the bond issuance so that there is enough demand for the bonds, work with the issuer to manage the U.S. Securities and Exchange Commission (SEC) documentation required to issue the bonds and help sell the bonds.
The investment banker also plays a role when it comes to arranging equity financing.
Suppose a company decides it needs more money to grow and decides to raise the funds by going in for an initial public offering, or IPO.
An investment banker would put together a prospectus explaining the terms of the offering and the risks it carries, manage the issuance process with the SEC, and help price the offering.
The shares should be priced just right. If they are priced too high, the public may not be interested in buying them. If they are priced too low, the investment banker may be leaving some money on the table that he or she could have generated for the client.
Underwriting Deals
In the course of arranging capital markets financing for its clients, investment bankers also typically undertake the underwriting of the deals.
This means that they manage the risk inherent in the process by buying the securities from the issuers and selling them to the public or institutional buyers.
Investment bankers buy the securities at one price and then add on a markup in the sale price and thereby generate a profit that compensates for the risk they take on.
This spread is the underwriting spread. Typically, a lead investment banker works with a group of investment bankers, called a syndicate, to underwrite an issue so that the risk is spread out among them.
Sometimes, the underwriter merely acts as a go-between in marketing the deals and puts in a best effort to market the securities but does not take on the underwriting risk.
In this case, the investment bankers have the option to sell securities and get paid, on a commission basis, for the actual amount of securities they sell.
Private Placements
Instead of taking on the cost of a public offering, sometimes investment bankers help their clients raise capital through private placements.
For instance, they could place an offering of bonds with an institutional investor such as an insurance company or a retirement fund.
This is usually a faster way to raise money since there is no need to register this sort of offering with the SEC.
The government considers institutional investors to be more sophisticated than individual investors, so there are fewer regulations for private placements.
Or they can raise the capital through shares from Accredited investors as well with a memorandum and disclosures, raise capital through non-accredited investors
Mergers and Acquisitions
Another area where investment bankers play a role is when a company is looking to buy another company.
An investment banker offers advice on how the company should go about the acquisition, including the pricing of the offer.
This involves valuing the targeted company and coming up with a price that represents its value.
On the other side of the deal, companies putting themselves up for sale also need investment bankers to evaluate asking price and offers.
Sometimes, mergers and acquisitions can involve lengthy battles.
Conflict of Interest
Even as investment bankers help grease the wheels of capital markets, they have attracted criticism.
For one, the legitimacy of Wall Street’s equities research has come into question since investment bankers have been said to pressure analysts to favorably rate securities to please their clients to generate investment banking business.
The SEC has put in legislation to address such conflicts of interest between a firm’s investment banking business and its securities research activities.
Another conflict of interest can occur when investment bankers, who have access to confidential information from clients related to their business and prospects, can pass information to their firm’s traders.
Traders can use this insider information to an unfair advantage when dealing with investors who don’t have the same information.
The Bottom Line
In a capitalist economy, investment bankers play a role in helping their clients raise capital to finance various activities and grow their businesses.
They are financial advisory intermediaries who help price capital and allocate it to various uses.
While this activity helps smooth the wheels of capitalism, the role of investment bankers has come under scrutiny because there is some criticism that they are paid too much in relation to the services they provide.