The investment banking paradigm

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The investment banking paradigm

  1. 1. The Investment BankingParadigm Presented by: Nikhil Gangadhar
  2. 2. Concepts and definitionsInvestment banking is concerned with the primary function of assistingthe capital market, in its function of capital intermediation, i.e. themovement of financial resources from the investors to those who need tomake use of them for generating GDP.It can be inferred that investment banks are the counterparts of banks inthe capital market in discharging the critical function of pooling andallocation of funds.Investment bank, is a term used in the US to mean a bank which dealswith the underwriting of new issues and advices corporations on theirfinancial affairs.Its termed in UK as an ‘issue house’
  3. 3. An investment bank is also defined as, a financial intermediary thatperforms a variety of services including aiding in the sale of securities,facilitating mergers and other corporate re-organizations, acting asbrokers to both individual and institutional clients and trading for itsown account.
  4. 4. Merchant bankingThe Dictionary of banking and finance defines a Merchant Bank as,‘a bank which arranges loans to companies, deals in internationalfinance, buys and sells shares and launches new companies on thestock exchange, but does not provide normal banking services to thegeneral public’.In US Merchant Banking is the activity of making direct investmentsof the investment bank’s own funds, in some assets not directlyrelated to traditional investment banking business. Thus in addition tounderwriting obligations, it also takes its own exposure to securities.When the investment bank is primarily an advisor, merchant bankinginvolves transactions such ass buyouts and acquisitions.In India MB connotes ‘Issue Management’ of various types providedunder law and activities therewith.
  5. 5. Evolution of investment banks in USThe earlier stage is traced to the end of WW 1, by which the commercialbanks in the US were preparing for an economic recovery andconsequently, to the significant demand for corporate finance.American co’s were expected to shift their dependence to stock and bondmarkets, where funds were available at cheaper rates and longer terms.In preparation for the boom in the capital markets in the 1920’s,commercial banks started to acquire the stock broking businesses in a bidto have a presence in such markets.The stock and bond market boom in 1920’s was an opportunity thatbanks could not miss. But since they could not underwrite and sellsecurities directly, they owned security affiliates through holdingcompanies. They were financed by the parent banks for theirunderwriting and other business obligations.
  6. 6. The IB affiliates started making huge profits as the boom lasted. The McFadden Act of 1927, allowed bank subsidiaries to underwrite stockissues as well.The stock market got over-heated with investment banks borrowingmoney from the parent banks in order to speculate in the bank’s stocks,mostly for short-selling.Later the price earning ratios reached absurd limits and the bubbleeventually burst in October 1929 wiping out millions of dollars of bankdepositors’ funds and bringing down with it banks such as the Bank ofUnited States.
  7. 7. Regulation of the industryIt starts with Glass-Steagall Act or the Banking act of 1933, thatrestricted commercial banks from engaging in securities underwritingand taking positions or acting as agents for others in securitiestransactions.The exclusive domain of Investment Banking were segregated.Other regulations include:The securities act of 1933- preparations of offer documents andregistrations of new securities with the federal government.The securities exchange act of 1934- formation of Securities ExchangeCommission.The Maloney act of 1938- formation of NASDAQThe investment company act of 1940- brought mutual funds withinregulatory orbit.The investment advisors act of 1940-nregulated the businesses ofinvestment advisors and wealth managers.
  8. 8. Global industry structureThe IB industry on a global scale is oligopolistic in nature rangingfrom global leaders to ‘ Pure Investment banks’ and ‘Boutiqueinvestment banks’.The global bulge group leaders include 8 investment banks that hasglobal presence.League tables’- a word taken too seriously in the IB as they definetheir position in the industry and send a strong message to their clientsabout their performance and capabilities.Pure investment banks are those which do not have commercialbanking connections. Eg: Merrill Lynch, Goldman Sachs etc.
  9. 9. Business portfolio of Investment Banks.Investment banks handle significant fund-based businesses of their own inthe capital market along with their non-fund service portfolio, which isoffered to clients.There are distinct segments which are handled either on the same B/S orthrough subsidiaries and affiliates.The activities are segmented along 3 broad segments:1. Equity market activity2. Debt market activity3. Mergers and acquisitions activity.US investment banking, the main sources of revenue comprises of Core investment banking- underwriting, issue management, marketing and research. Securities portfolio Brokerage Asset management Advisory services.
  10. 10. Core Business Portfolio Non-fund basedEquity PF- underwriting primary marketsecurity issues and private placements, Fund Basedissue management and security business( Equity PF- Underwriting bought deals,market, distribution and research) secondary market making and proprietaryDebt PF- Fixed income underwriting and trading, derivatives and arbitrage.placement structures financing and Debt PF- underwriting, secondary marketsecuritization, junk bonds and debt making and proprietary trading.finance advisory. M&A PF- participation as lead/ co-M&A PF- corporate restructuring, M&A investor in buyouts, LBO’s/MBO’s.transaction services, Corporate financeadvisory. Allied Businesses Asset management •Mutual Funds •Hedge Funds •Venture capital, private equity, buyout funds. •Stock broking and investment advisory. •Risk advisory and management. •Custodial services.
  11. 11. Investment Banking in India Its existence has been traced to over 3 decades. IB was largely confined to MB services. The forerunners of Merchant banking in India were mostly foreignbanks. In 1972 T he Banking commission Report asserted the need forMerchant banking Services in India. Here merchant banking was meant to provide advisory services andmanage investments. By the mid eighties and early nineties, most of the merchantbanking divisions of public sector banks were spun-off as separatesubsidiaries. This includes SBI’s SBI capital markets Ltd in 1986 andIDBI’s IDBI capital markets in 1992.
  12. 12. Growth: Merchant banking activity was regulated by SEBI in 1992 followinga sever downturn due to phases of hectic activity in business. Majority of those registered under SEBI were either in Issuemanagement or advisory services. Based on their net-worth, SEBI had 4 categories of Merchantbanks. The number of registered merchant banks with SEBI at the end ofmarch 2003 was 124 from a high of almost a thousand in nineties. In 2002-03 the number further decreased by 21.
  13. 13. Constraints to IB Over dependence in the Issue management activity in the initialyears led the merchant banks to perish in the primary marketdownturn. Later they diversified to offer a broad spectrum of capitalmarket services. Only few industry leaders other than merchant banks could notturn themselves into full service investment banks. Indian industry has seen more or less similar developments to thatof its western counterparts, though the breadth available there is stillnot present in India. Due to lower availability of institutional financing to fund thecapital market activity, its only the bigger industry players who are infull service investment banking.The main constraint is the inadequate breadth in the secondarymarket, especially in the corporate debt segment.
  14. 14. Risk aversion, characteristics and structure of Indian Investment BankingIndustryIndian regulatory regime does not allow all investment banking functions tobe performed under one legal entity as its structure over the years hasevolved due to business realities and the regulatory regime. The reasons forthis are:1. To prevent excessive risk exposure to business risk under one entity &2. To prescribe and monitor capital adequacy and risk mitigation mechanisms.Thus Indian investment banks follow a conglomerate structure by keeping their business segments in different corporate entities to meet regulatory norms.Indian investment banking industry also has a heterogeneous structure, as bigger investment banks have several group entities in which the core and non-core business segments are distributed. Others have one or more entities depending upon the activity profile.
  15. 15. CORE BUSINESS PORTFOLIO Non-Fund based Fund BasedMerchant Banking services for • Underwriting• Management of public offers of equity and debt • Market makinginstruments • Bought out deals• Rights issue •Proprietary investments and trading in equities, bonds• Open offers under the takeover code and derivatives• Buyback offers• De-listing offers ALLIED BUSINESSESAdvisory and Transaction services in• Project financing• Syndicated loans Asset management services• Structured finance and Securitization • Mutual funds, Portfolio management• Private equity / Venture capital • Venture capital funds, Private equity funds• Preferential issues Secondary market services• Qualified institutional placements • Securities business• Business Advisory -Broking, Sales and distribution, Equity research• Financial restructuring • Investment advisory• Corporate re-organizations such as mergers and de- •Derivativesmergers, hive-offs, asset sales and divestitures. Support services• Acquisitions, strategic sale, buyouts and takeovers • Registrars and share transfer agents• Government disinvestments and privatization • Custodial services• Asset recovery agency services. • Other capital market services.
  16. 16. Inter-dependence between different verticals in investment bankingThere are different verticals in investment banking and they do enjoying synergieswith one another. The service or business segments form the core of investmentbanking, others provide invaluable support. It is important to understand and theinter-dependence and complementary existence of all these business segments.Merchant banking largely relates to management of public floatation ofsecurities/ reverse floatation like buy backs and open offers, underwriting is aninherent part of MB for public issues. Advisory and transaction services have a close linkage with MB in public issueand reverse floatation. Venture capital enables identification of potential IPO candidates which leadsto generation of fee income from MB services and good capital gain for the VCinvested at the earlier rounds of financing in such companies. Stock broking and primary dealership in debt markets nurture- institutional,corporate and retail clients who can be tapped effectively for asset management,,PF management, and private equity business.
  17. 17.  Presence in the equity derivative and foreign exchange derivative segmentscan help in offering solutions in treasury management to clients.All these verticals are driven by support services such as sales and distributionand equity research and analysis, where the capability of S&D determines thesuccess of MB vertical.Thus IB is a business that is very sensitive to the economic and capital marketscenario and therefore, the broader the platform of operations, the more is thelikelihood of an IB, surviving business cycles and sudden shocks from themarket.
  18. 18. Conflict of interest in IBThe most burning global issue in the IB industry at the beginning of the 21stcentury became the conflict of interest between the investment banks and theirresearch analysis divisions.The securities and exchange commission in the US initiated investigations intoinstances of investment banks issuing over-optimistic research and steering in hotIPO’s for important clients in vested interests.In such investigations some banks were also fined.
  19. 19. How does the conflicts arise? Most investment banks have in-house research divisions as a supportfunction. The research divisions perform vital functions of trackingcorporate and making recommendations to their clients in the secondarymarket operations or to their own dealing rooms. They also issue reviewsand ratings to the new issuances hitting the market.The conflict could arise if the analyst would promote a share, the publicoffering for which is being handled by the MB.Alternatively , it could also be that the analyst is prone to insiderinformation from the merchant banking division and there upon issuerecommendations that could amount to fraudulent deceit of investors orgain for select few.
  20. 20. The corporate scandals of US led to precautionary amendments in India bySEBI.SEBI amended the regulations that were in place for merchant bankers andUnderwriters and for prohibition of insider trading . As a result analysts arebarred from private trading in shares they analyze.There is rule for more regulation in this area of importance for the survival ofthe IB industry.
  21. 21. Full service investment banks and financial conglomerates of the future.The business of IB is under-going rapid changes in response to the growingsophistication in the financial markets and the need of clients.Consolidation and globalization is the ‘Mantra’ for success and growth.Financial conglomerates with equal presence and reach in commercialbanking, IB, insurance and financial advisory are the way to go for one-stepshopping for all financial needs.Emerging areas of investment banks have been retail and institutional fundmanagement, trust services and thrift charters etc.The share of revenue from core investment banking has been decliningsteadily and is being replaced by proprietary trading, asset management andadvisory services.
  22. 22. Investment banks are buying into asset management companies and alsosetting up private equity to tap the available opportunity.The future therefore lies in ‘full service investment banking’ comprisingof core investment banking, asset management, private equity, venturecapital, brokerage, S&D, research and analysis, proprietary trading andinvestment, primary dealing in fixed income securities, structuredfinancing and corporate advisory services.Universal banks can add all their banking products in both corporate andretail banking segments to the long list of services offered as full serviceinvestment banks.A step forward would be the financial conglomerates for the future thatcan even add on insurance and pension products to make them one-stopfinancial shops, large financial conglomerates such as Citygroup/ INGwould be the models of growth in years to come.

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