(Updated: February 10, 2000)
A. Two General Functions for Investment Bankers
1. raising funds for clients including corporations, federal
government agencies, state and local governments and
foreign entities (Chinese Governments and state-own
enterprises) -- Corporate Finance, Underwriting, M&A
2. assisting clients (investors) in the sale or purchase of
securities -- Retail Brokerage
B. Definition of Investment Banking
1. Investment banks, merchant banks, and restricted licensed
Traditional difference between investment bank and merchant
• Merchant banks actually risk their own capital; they take
stakes. (Proprietary trading)
• Investment banks arrange thing and earn fees.
In Hong Kong, “restricted licensed banks” is used for either
“investment banks” or “merchant banks”.
F232_Topic03 1 John Wei
2. Investment bankers vs. commercial banks
Reselling stocks stocks & bonds
Individual Investment Banks Firms
• Most commercial banks perform at least some investment
bank functions, but investment banks do not do "typical"
commercial bank things.
• In particular, merchant banks do not rely on small
• Disadvantage for investment bankers --just a few big
depositors, including banks overseas, means that funds can
be lost quickly. Example, Drexel (Michael Milken),
Peregrine (Andre Lee).
• In Hong Kong, deposits of MBs count about 20% of total
assets. Flows of funds still mostly come from individuals
• MBs largely provide advice to firms.
• Traditionally, firms got short-term financing from
commercial banks and long-term financing from MBs.
3. Definition of investment bankers
• Investment banking covers all capital market activities,
from underwriting and corporate finance, to mergers and
acquisitions (M&A), to fund management and venture
Included are (1) merchant banking, when investment bankers
work and invest for their own account and (2) the nonretail
trading of blocks of securities for financial institutions.
F232_Topic03 2 John Wei
Excluded are the selling of securities to retail customers
(brokerage or security firms), consumer real estate brokerage,
mortgage banking, insurance products, and the like.
II. NATURE OF THE BUSINESS
A. Nature of the Business
• Investment bankers are highly leveraged.
• In addition to needing long-term sources of capital,
investment bankers borrow on short-term basis to finance
their inventory of securities (repurchase agreement).
B. Capital Structure of Investment Bankers
Capital Structure of the Ten Largest Investment Banking Firms Ranked
by Total Consolidated Capital (in millions, as of end of 1993)
Total Consolidated Equity Long-Term
Firm Capital Capital Debt
Merrill Lynch $18,954.8 $5,485.9 $13,468.9
Salmon Inc. 17,023.0 5,331.0 11,692.0
Goldman, Sachs & Co. 15,249.0 5,008.0 10,241.0
Lehman Brothers 11,951.0 2,052.0 9,899.0
Morgan Stanley 8,208.8 3,906.2 4,302.6
Bear Stearns & Co. 4,665.3 2,040.4 2,624.9
CS First Boston 4,649.0 1,324.0 3,325.0
Paine Webber 3,131.0 1,195.0 1,936.0
Smith Barney Shearson 2,742.0 2,055.0 687.0
Prudential Securities 1,842.0 1,379.0 463.0
Source : “Ranking America’s Biggest Brokers,” Institutional Investor (April 1994), p. 156.
This copyrighted material is reprinted with permission from Institutional Investor,
488 Madison Avenue, New York, NY 10022.
F232_Topic03 3 John Wei
C. Revenue is Generated from:
• fee income
• principal activities
III. ACTIVITIES OF INVESTMENT BANKERS
A. Underwriting (Public offering of securities)
• Helping firms raise funds thru stocks or bond issues.
• It is a traditional activity -- "sponsoring"
1. Origination: advising the issuer on the terms (what type
and how much) and timing of the offering
In the U.S., firms sell new stock every 15-20 years and debt
every 2-3 years on average. For equity, it is more often in Hong
Investment bankers are in market all the time -- including
creating new securities (innovations).
2. “Underwriting”: a kind of insurance
IBs buy securities from issuers and re-sell them to customers.
If demand is lower than expected, IBs take loss.
In practice, what IBs provide may be pre-selling rather than
insurance. This is similar to “bridge financing.” (Peregrine
provided bridge loans to Indonesia taxi company Steady Safe)
F232_Topic03 4 John Wei
Example of underwriting risk: IBM - October 1979
On October 3 (Wednesday), IBM agreed with Salmon Brothers
and Merrill Lynch to have largest public offering in corporate
history -- US$500 million in 7-year notes and US$500 million
in 25-year bonds.
Two lead underwriters, Salmon and Merrill Lynch wanted to
handle the top blue-chip firm's underwriting. Morgan Stanley
had refused to be co-manager with Salmon or anyone.
Notes priced at 7 basis points above T-notes,
Bonds priced at 12 basis points above T-bonds.
Deal closed at 12:40p.m.
That afternoon, Treasury rates went up 5 basis points.
The next day (October 4), Treasury auctioned 4-year notes, at
rate 17 basis points over IBM's notes.
Underwriting syndicate is committed to selling bonds at the
On Friday (October 5), there was a rumor that Paul Volcker was
about to resign; over weekend, Fed took major measures to
tighten credit [trying to curb inflation], interest rates leapt
By Wednesday (October 10), Salmon Brothers had to disband
syndicate [letting members sell at whatever price they could
The loss -- the syndicate member would not say, but probably
F232_Topic03 5 John Wei
3. Sales and distribution:
IBs have built up regular network to sell securities.
Often, a syndicate is often organized by the lead or co-lead
underwriters (or co-managers) to share the capital risk.
4. Making a market afterwards:
IBs may act as a dealer later, giving the issue extra liquidity.
Investors are more willing to buy the issue if they know there
will be a market later.
Types of underwriting:
a. firm commitment: When the IB agrees to buy the
securities from the issuer at a set price.
b. best efforts: the underwriter agrees only to use its expertise
to sell securities == it does not buy the entire issue from
c. standby: underwriting arrangement calls for the
underwriter to buy the unsubscribed shares. The issuer
pays a standby fee to the IB. (uncommon in the U.S.)
The fee earned from underwriting is called:
Gross spread (or underwriter discount)
= the reoffering price - the price paid
= f(risk, size, type)
F232_Topic03 6 John Wei
Typical Gross Spreads by Offering Size
Common Stock Offering* Initial Public Offering
Size (in Millions) Gross Spread Size (in Millions) Gross Spread
$10 6.0-8.0% $5 8.0-10.0%
15 5.0-7.5 10 7.5-9.0
20 5.0-7.0 15 7.0-8.0
30 3.5-5.0 20 6.5-7.0
50 2.0-5.0 30 5.5-7.0
100 2.0-4.5 50 5.0-7.0
150 2.0-4.0 200 2.0-4.0
Size (in Millions) Gross Spread
* For industrial companies, not utilities.
** Typical offering of A-rated corporate debt with 10 years to maturity.
Source : Adapted from Figures 1,2, and 3 of G. Clyde Buck, “Spreads and Fees in Investment
Banking,” Chapter 5 in Robert Lawrence Kuhn (Ed.), The Library of Investment
Banking, Volume II (Homewood, IL: Dow Jones-Irwin, 1990).
Variations in the underwriting process:
a. "bought deal" for the underwriting of bonds
without a syndicate.
First used in Eurobond market in 1981: Credit Suisse First
Boston purchased from General Motors Acceptance
Corporation a US$100 million.
b. auction process -- competitive bidding
c. rights offering
The firm can issue new common stock directly to existing
shareholders via a preemptive rights offering.
F232_Topic03 7 John Wei
The underwriting of securities is not limited to offerings in the
domestic market. Example: China Telecom.
Investment bankers have assisted in offering the securities of
government-owned companies to private investors, a process
referred to as privatization.
B. Trading of Securities
The trading arm of an investment bank provides important input
for the pricing of a security, the selling of the issue, and the
subsequent liquidity for the issue.
IBs must take a principal position in a transaction.
Revenue from trading is generated via
• bid-ask spread, and
• appreciation of the price of the securities held in inventory.
To protect against a loss, investment banks engage hedging strategies.
1. riskless arbitrage:
A security trades at different prices in the different markets: sell
high buy low.
Payoff in Payoff in
Security Price State #1 State #2
A $70 $50 $100
B 60 30 120
C 80 38 112
F232_Topic03 8 John Wei
Is there any riskless arbitrage opportunity?
Yes: Long 4 shares of A and 6 shares of B, and short 10 shares
of C. ==> Guaranteed profit = $160.
The key point for a riskless arbitrage transaction is that the trade
is not exposed to any adverse movement in the market price of
securities in the transaction.
Speculation (betting on one direction) is different from riskless
Example: Baring’s trader Nick Leeson
2. risk arbitrage:
• exchange offers for securities of corporations coming out
of a bankruptcy proceeding.
• a merger or acquisition is announced.
Example 1: Company A is being reorganized.
One of its bonds is selling for $500. The trader believes that
after reorganization, its bond can exchange for 20 shares with an
estimates value of $600.
Risk arbitrage profit = $600 - $500 = $100 per bond.
(1) exchange will not take place on the term the trader
(2) the value of the 20 shares is less than $500.
Example 2: Nam Pei Hong was a takeover target in 1994 at a price of
HK$ 1.00 when its share price was selling at HK$ 0.50.
After announcement, its share price jumped to HK$ 0.90.
F232_Topic03 9 John Wei
HK$ 0.10 difference represents the risk the deal will not go
The offer was rejected by the majority shareholder and the price
Example 3: UAL Corp.
In 1989, there was a $300 bid by pilots and management. ==>
bid up the price to $296 ==> financing was denied ==> price
In January 1990, the union bid for $201. ==> financing for the
takeover could not obtained ==> share price plunge.
Estimated loss for arbitrageurs = US$ 1 billion
Example 4: Privatization of Kwong Sang Hong by Peregrine in 1997
Offered price valued at about HK$4.00,
Price subsequently increased from around $ 3.20 to about $4.00
The deal fell: Price dropped back to about $3.50
Example 5: Takeover by exchange of securities rather than cash.
Three risks involved:
• takeover failed
• a time delay
• bidder's share price may decline
• bet on rising price
• bet on falling price
• bet on price movements on either up or down
• bet on a stable (directionless) market
4. Execution of trades for clients
• retail or institutions
• block trades and program (or basket) trades
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5. Research and trading
• give advice/research to clients: analyst reports
• conflict of interest (IPOs and afterward recommendation)
• “buy”, “hold”, very few “sell”
C. Private Placement of Securities
Private placement: investment banks assist the placement of
securities with a limited number of institutional or wealthy individual
Fee for private placement:
Size (in million) Fee
$ 5 - 10 1.5 - 4.0%
10 - 15 1.0 - 3.0%
25 - 50 0.7 - 2.0%
over 50 0.5 - 1.5%
Rule 144A: eliminate the two year holding period for privately placed
securities; allow institutions to trade among themselves.
D. Mergers and Acquisitions
Investment bankers role in M&A:
(1) find M&A candidates
reasons for M&A:
• vertical merger
• horizontal merger
• use for excess cash/way to expand
• find undervalued business (bad management?)
• access to another market
Samsung buys AST Research, Chinese state
F232_Topic03 11 John Wei
enterprises buy shell companies in HK
(2) advise acquiring firms or target firms with respect to price
and nonprice terms of an exchange or help target firms
fend off an unfriendly takeover attempt
(3) Assist acquiring firms in obtaining financing.
Mergers in the US come in waves"
• wave in the early 1960s but few IBs involved
• wave in the 1980s - many takeovers were initiated by IBs
E. Merchant Banking
Merchant banking refers to a transaction in which an investment
banking firm commits its own funds by either taking an equity interest
or creditor position in companies.
An example is bridge financing wherein an investment banking
firm loans funds to a client to consummate a takeover. Bridge
financing is not only important for its potential source of interest
income, but also to attract clients who are considering an LBO.
Example: Risk of bridge financing
First Boston Corporation's bridge loan of US$450 million to
Ohio Mattress Co. to finance an LBO.
After the LBO was completed, Ohio Mattress could not get
permanent financing. First Boston was stuck with the bridge
Another example is project financing: Funding provides by a
syndicate of merchant banks. Claim is only to the revenue from the
project itself, not to the rest of revenues and assets of firms taking on
project. Such as new airport project, MTR project.
F232_Topic03 12 John Wei
HK MBs often lend directly to firms or hold their stocks. (See
Peregrine Investment). They are the major source of financing
F. Securitization of Assets
Securitization of assets refers to the issuance of securities that
have a pool of assets as collateral.
Example: Citibank and Cheung Kong Holding's Mortgage-backed
Asset-backed securities: automobile loans and
credit card receivables.
Revenue from securitization:
• the underwriting of an issue
• price difference
G. Trading and Creation of Risk Control Instruments
Examples of contracts that can be used to control risk for both
investors and issuers include futures, options, interest rate swaps, and
customized interest rate agreements.
Commissions are generated from the exchange-traded
instruments that customers buy and sell through investment banking
There are risk control instruments which an investment banking
firm creates for its clients and in which it acts as a counterpart to the
==> These are called over-the-counter or dealer created
==> Today, any type of contract will be created for a client if
the investment banking firm can hedge the associated risk
(i.e., lay off the risk).
F232_Topic03 13 John Wei
Risk control instruments are also used by investment banking
firms to protect their own position in transactions.
H. Money Management
Investment banking firms have created subsidiaries that manage
funds for either individual investors or institutional investors such as
Unit trust, mutual funds.
Examples of Investment Revenue
Sources of Revenue in 1993 for Merrill Lynch
Revenue Percent of
Source (in thousands) total revenue
Commissions $2,894,228 17.5%
Interest and Dividends 7,099,155 42.8
Principal Transactions 2,920,439 17.6
Investment Banking 1,831,253 11.0
Asset Management and
Professional Service Fees 1,577,778 9.4
Other 285,324 1.7
Total revenues $16,588,177 100.0%
Source 1993 Annual Report.
I. Ranking Measures
Global and Domestic (U.S.) Rankings of Underwriting Firms
Full Credit to Lead Manager
Manager $Amount % Issues $Amount Rank
Merrill Lynch 137,761.7 12.6 862 192,826.2 1
CS First Boston/Credit Suisse 96,945.6 8.9 648 113,418.7 5
Lehman Brothers 89,432.4 8.2 653 129,726.1 4
Goldman, Sachs 86,458.1 7.9 512 151,344.4 2
Morgan Stanley 74,785.4 6.8 557 89,482.0 7
Salmon Brothers 65,447.5 6.0 542 104,180.0 6
Paine Webber 61,743.7 5.6 344 131,993.4 3
J.P. Morgan 41,242.9 3.8 271 36,795.6 10
Bear, Stearns 34,934.0 3.2 209 56,904.2 8
Nomura Securities 23,666.6 2.2 151 37,012.3 9
Donaldson, Lufkin & Jenrette 23,611.4 2.2 227 36,678.6 11
UBS 21,970.4 2.0 163 19,836.9 14
Swiss Bank 17,066.5 1.6 113 12,956.4 21
Prudential Securities 16,476.9 1.5 141 28,135.0 12
Citicorp 15,398.4 1.4 234 17,943.2 15
Top 15 Total 806,941.6 73.8 5,627 1,159,269.0 --
F232_Topic03 14 John Wei
Industry Totals 1,093,627.8 100.0 9,009 1,500,877.6 --
F232_Topic03 15 John Wei
A. IPOs in General
• MB gives issuers an idea of price range
• Issuer and underwriter put together a prospectus, describing
firms current condition and future plans; it includes results of an
• Underwriter does "road shows" and tries to "fill the book" -- i.e.,
presell the issue with orders or indications of interest.
• Final price is set.
MBs did not follow this procedure for many B shares and H
shares. ==> may miss the market.
B. Why do Firms Use MBs?
• expertise: advise firms on what types, how much, what price,
• MBs know the current market and have customer base
• certification: "due diligence", reputation
• market-making service after issue
• economies of scale in distribution
• price support?
C. IPOs in Hong Kong
1. Issuer and merchant bank write prospects and set price.
2. Shares offered to public:
• must pay full amount in advance
• “fairness” rule: all investors who place same size order
have same probability getting shares (but can favor
small or large investors)
F232_Topic03 16 John Wei
Example: Shanghai Hai Xing Shipping (New name: China Shipping
Development Co. Ltd.)
(1) Shares ordered (Last time for lodging application
12:00 noon on Friday, November 4, 1994
(2) Checks cashed in the afternoon of Friday.
(3) Shares allocated ["balloting"]: Tuesday, November 8.
(4) Refund checks to be posted on or before: Wednesday,
(5) Certificates to be post on or before: Wednesday,
(6) Trading begins: Friday, November 11.
Key differences: No pre-selling; MBs has no discretion in
Multimarket IPO is allowed: Shanghai Petrochemical, CEPA,
Over-allocations are allowed since Chengdu Telecom offering
D. Problems in HK's IPOs
Major problem: High oversubscription levels
During the hot market: Average = 50 times
Denway - Feb, 1993 - 658 times oversubscription
wanted to raise $402.6 mn; it had $240 bn (5 time bank
7 days of interest at 3% worth $138 mn
November 1992: China Travel: 412 times ==> $162 bn tied up
Guangzho Inv.: 230 times ==> $143 bn tied up
Kunming Machine (November 1993):627 times ==> $81.7 bn
Beijing Enterprises (May 1997): 1,276 times => 200 billion
F232_Topic03 17 John Wei
(1) 10% margin - can borrow only up to 90% of the total
(Actually must put up deposit = 10% as security)
(2) No investor can order more than 100% of total or
10% of shares to be outstanding [this often = 40% of total, since
they have often been selling 25% of total]
Is it profitable using borrowed money to subscribe IPOs in Hong
Kong? (See Wei, V.1, pp.161-167)
Subscription price = $10; 10% own money plus 90% borrowed
money; Number of days that interest is charged = 6; interest rate =
6.5% versus 10%. Page 167 shows the break-even cost under
different over-subscription rates.
In Hong Kong, two methods are currently used: (1) pure public
offerings, and (2) book-building plus public offerings (some rules
applied to protect retail investors)
E. IPOs in Taiwan
• process slower
• price follows a formula set by SEC
• investors did not put up cash
• lottery (One ID can only subscript one specified lot)
• investors can back out if price drops
• two methods are used; (1) discriminatory auctions plus open
offers and (2) open offers.
F. IPOs in Singapore
• Issuer cannot cash check
• process very fast
• combination of auction/fixed price (fixed price first)
F232_Topic03 18 John Wei
V. CURRENT INDUSTRY STRUCTURE
Depending on the activity area, there are several potential
measures of the relative ranking of an investment banking firm.
For underwriting activity:
1. Market share can be measured by the number of deals done in a
year or the total dollar volume of all deals done in a year.
2. It can be refined further by the level of participation (i. e., lead
manager, comanager or just part of the underwriting syndicate).
Classification of Firms
ο bulge-bracket firms
First Boston; Goldman Sachs; Merrill Lynch; Morgan Stanley;
Salmon Brothers; and Lehman Brothers.
ο major bracket firms
Bear Sterns; Smith Barney; Kidder Peabody; Paine Webber;
Donaldson, Lukfin & Jenrette; Dean Witter; and Prudential-
Bache Capital Funding.
ο submajor bracket firms
ο regional firms
ο specialized firms
ο research firms
ο merchant banks
M&As and fund-raising: Blackstonbe Group and Wasserstein,
Perella & Co.
F232_Topic03 19 John Wei
VI. COMPETITION AND CHALLENGES FOR
INVESTMENT BANKING FIRMS
Investment banking firms are facing increased competition
which has forced them to reconsider their long-term business
Investment banking firms are facing competition from:
(1) commercial banks with the virtual elimination of Glass-
(2) new trading technology that is allowing institutional
investors to execute trades without employing investment
banking firms as intermediaries
(3) direct purchase by institutional investors of publicly
registered securities from issuers
(4) some of the more sophisticated corporations themselves
who are establishing in-house groups to perform some of
the activities traditionally done by investment banking
B. Reassessing the Business
Investment banks are now reassessing the nature of the various
businesses that they are in.
F232_Topic03 20 John Wei
VII. INVESTMENT BANKS IN HONG KONG
A. Hong Kong Major Merchant Banks
1992 Results of Hong Kong’s Major Merchant Banks
Major merchant banks are defined as merchant banks with total net worth of not less than US$25
million or profit of not less than US$10 million.
Name 1992 1991 Total Total Return Return On
Profit/(Loss) Profit/(Loss) Net Assets On Assets Equity
1. Jardine Fleming Group Ltd 591.30 654.20 1,730.90 15,828.80 %3.74 %39.72
2. Wardley Holdings Ltd 542.20 473.60 2,157.40 48,790.50 1.11 25.58
3. Peregrine 492.50 274.20 3,268.10 5,190.40 9.49 16.25
4. Sun Hung Kai & Co Ltd 310.00 206.60 1,581.00 5,017.70 6.18 21.91
5. Schroders Asia Ltd 92.80 88.30 301.10 5,573.90 1.67 37.24
6. Canadian Eastern Finance Ltd 86.80 116.90 418.00 1,911.50 4.54 21.49
7. Nomura International (31/3/93) 81.70 185.80 3,149.80 10,606.80 0.77 2.65
8. China Development Finance Co 65.80 33.90 320.00 2,042.10 3.22 25.88
9. Chase Manhattan Asia Ltd 39.60 76.40 470.70 3,967.60 1.00 9.17
10. BA Asia Ltd 21.40 30.50 552.10 2,671.80 0.80 4.03
11. Citicorp International ltd 17.30 11.40 250.8 534.10 3.24 7.06
12. Lehman Brothers Finance Ltd 6.90 14.70 245.90 1,769.40 0.39 3.22
13. BT Asia Ltd (5.00) (21.90) 206.80 218.10 -- --
B. Top 20 International Investors in Asia-Pacific Equities
94 93 Score
1 1 Jardine Fleming Investment Management 36
2 3 Baring International Asset Management 28
3 6 Fidelity Investment Management 26
4 2 GT Management Asia 21
5 11 Schroder Asset Management 15
6 - Capital Research 12
7 18 Thornton Management 9
8 - Tiger Management Corporation 7
9 - Indosuez Asset Management 6
10 11 Global Asset Management 6
= - AMP (Australia) 6
12 - Nomura Investment Management Co 5
= - John Govett & Co 5
= - Warburg Asset Management 5
15 - JP Morgan Investment 5
16 - AIA (Singapore) 4
= 16 Bankers Trust (Australia) 4
= - Morgan Grenfell Asset Management 4
= - Perpetual Asset Management 4
= - Templeton Investment Management 4
F232_Topic03 21 John Wei