.Investment Banking for first two sections.pdf

Investment Banking
July 22, 2022
Tapas Mitra

Introduction
7/22/22 Investment Banking/TM 2

Concept
• The main function of a financial system is the collection of savings and their
distribution for industrial investment, thereby stimulating the capital formation
and to that extent, accelerating the process of economic growth.
• The relevance of the main function to the saving-investment process is derived
from what is called the transfer process.
• There is a need for institutional arrangement to facilitate the transfer of
resources – capital intermediation.
• Investment Banking Institution with the help of other market intermediaries,
plays this role of bringing the users of funds to the market (investors).
• While the primary role will be this, there are other allied roles played by the
investment bank along the way. Allied services include asset management,
securities business, proprietary trading, forex and commodity derivatives trading,
risk advisory, settlement and custodial services, wealth management, etc.

Evolution
• American Investment Banks
• Can be traced to the end of World War I
• Funds availability in stock and bond markets inspired companies to the potential of draw on these long-term
and low-cost money
• Banks began to acquire stock broking businesses for participating in such markets
• The legal and political environment also improved towards corporations and contracts
• Laws were passed by different states to restrict auctioning of stock and rendered void contracts to sell stocks
short.
• The New York Stock Exchange and Board was formed
• The adverse effects of Panic of 1837 were turned around in the mid 1840s owing to the initiatives of European
financiers such as Baring Brothers, the Rothschilds, and the Dutch House of Hope and Co. The restoration
campaign was orchestrated by Barings, and it began to bear fruit as many of the defaulting states
recommenced interest payments on their debt.
• By the 1861 outbreak of Civil War, investment banking had emerged as a significant financial activity.
• The Glass-Steagall Act of 1933 separated commercial banking from investment banking for domestic
transactions in the USA. Commercial banks were allowed to carry out underwriting and dealing in securities
outside of the USA.
• Some US investment banks:
• Goldman Sachs, Morgan Stanley Dean Witter, Merrill Lynch & Co., J.P. Morgan Chase, Salomon Smith Barney (Citigroup), and
others.

Evolution – contd.
• European Investment Banks
• In continental Europe (excluding UK), the concept of “Universal Banking” had
been the undercurrent since the late nineteenth century
• UK, the largest investment banking market in the region had its own structure
evolved from history. The oldest merchant bank being “Barings Brothers”
• In 1980s the US investment banks with their integrated global business model
entered UK and Europe and later into Japan
• Cross border M&A transactions happened between European Banks and their
American counterparts to create bigger investment banks.
• Some non-US investment banks:
• Barclays, HSBC, Credit Suisse (erstwhile CSFB), Deutsche Bank, UBS AG, BNP Paribus, and
others.

Evolution – contd.
• Indian Investment Banks
• Traced to the mid 1960s - largely driven by debt services in the form of term financing from
FIs and working capital financing by commercial banks;
• Capital services was restricted to only stock broking activity;
• Front runners were foreign banks such as – Grindlays bank (later merged with SCB) followed
by Citibank in 1970
• In 1972 the Banking Commission Report asserted the need for merchant banking services in
India by public sector banks. They also recommended a structure for merchant banks as
distinct from commercial banks and FIs
• RBI set up its merchant banking division in 1972; BOI, CBI, BOB, SB, PNB and CB set up their
merchant banking divisions.
• ICICI set up its merchant banking division in 1973 followed by IFCI and IDBI in 1992.
• In early 1990s, most merchant banking divisions were spun off as separate subsidiaries; SBI
Caps emerged in 1986 and thereafter others.
• Some of the investment banks:
• Indian origin – SBI Caps, ICICI Securities, Axis Capital, Kotak Mahindra Capital, Edelweiss Financial
Services, JM Financial, Motilal Oswal, and others;
• Foreign origin – J.P. Morgan, Goldman Sachs, Morgan Stanley, Citi, BofA Securities, Credit Suisse,
Barclays, UBS, BNP Paribas, HSBC.

Regulatory framework
The Laws
• The Securities and Exchange Board of India Act,
1992
• Securities Contract Regulation Act, 1956
• The Depositories Act, 1996
• The Companies Act, 2013
• Foreign Exchange Management Act, 1999
• Income Tax Act, 1961
• Benami Transactions (Prohibition) Act, 1988
• Prevention of Money Laundering Act, 2002
The Regulators
• The Securities and Exchange Board of
India (SEBI)
• The Ministry of Corporate Affairs (MCA)
• The Department of Economic Affairs,
Ministry of Finance (DEA, MoF)
• The Reserve Bank of India (RBI)
• Stock Exchanges
• The Insurance Regulatory and
Development Authority of India (IRDA)
• Pension Fund Regulatory and
Development Authority, Ministry of
Finance (PFRDA)

Merchant banking vs Investment Banking
• Definition of merchant banking as per SEBI Regulations –
“any person who is engaged in the business of issue management either by making
arrangements regarding selling, buying or subscribing to securities or acting as
manager, consultant, advisor or rendering corporate advisory service in relation to such
issue management”
• Definition of merchant banking as per US practices –
“a bank which arranges loans to companies, deals in international finance, buys and
sells shares and launches new companies on the stock exchange, but does not provide
normal banking services to general public”
“Merchant Banking is the activity of making direct investments of the investments
bank’s own funds in some asset not directly related to the investment bank’s traditional
business”
• Definition of merchant banking as per UK practices –
“a British term for a bank that specializes not in lending out of its own funds but in
providing various financial services such as accepting bills arising out of trade,
underwriting new issues, and providing advice on acquisitions, mergers, foreign
exchange, portfolio management, etc.”

Functions Investment Banking Merchant Banking
Primary Advisory and support in
arrangement of funds in the form
of equity and debt
Advisory and support in
arrangement of funds in the form
of equity and debt
Use of own funds Does not use own funds for
investment in assets
May use own funds for investment
in some assets (US)
Capital intermediation Plays a vital role Plays a vital role
Underwriting Includes Includes
Normal banking services to
general public
Does not provide Does not provide
Allied businesses Includes fee-based capital market
activities
Restricts to regulated services in
India

Role of an Investment Bank
• Equity & debt advisory
• Taking public offers of equity & debt to the market – domestic &
international
• Underwriting
• Private equity placements & advisory
• Structured products
• M&A advisory
• Mezzanine financing
• Allied businesses – mutual funds, hedge funds, etc., securities business,
trading, derivatives, risk advisory, wealth management, & others

The Revenue Mix
• Commission from agency transactions ( when the IB is acting as an
intermediary) as a %age of the transaction value.
• Trading income is the realized and unrealised gains and losses when bank
“makes a market” (takes the other side of customer trades).
• Underwriting revenues are the gross profits (or losses) from underwriting
the security issues.
• Interest can be margin interest (when customers borrow against the value
of their securities to finance purchases) or interest from investment
accounts.
• Asset management fees include fees from sale of mutual funds and from
management of portfolios.
• Other securities-related revenues include advisory fees from M&A, but also
dividends and interest from investment accounts.

Prerequisites – with respect to clients
• What do the financial statements reflect?
• A reasonable sense of the business of an undertaking – short-term
and long-term reflection
• Where does the value come from?
• How do the cash flows reflect – strong or weak?
• How is the management – quality of people, decisions, processes, etc.
• Working capital management
• Management of finances

Investment Banking and Allied
Activity

Book Building Process
• It is a process that allows large stock offerings to be marketed.
• Merrill Lynch did work with the lawyers to convince the French government of
its merits of the book building procedure. The work paid off, and all
privatisations in France began to follow along.
• Three different mechanisms for completing an IPO: auctions, fixed-
price offerings, and book building.
• In auction, shares are offered for sale, on a predetermined schedule, to
several competing potential buyers;
• Fixed-price offerings render certain number of shares to retail investors at a
preset price which is generally identical to the price offered to institutional
investors; and
• Book building is the process whereby the bank marketing the IPO gets to
know the price investors intend to offer and the volume of the security they
are interested in.

Book Building Process – contd.
• Book-building process reduces the underwriters’ risks in a bought
deal.
• A pre-marketing phase, a “road-show” during which underwriters
gather indications of interest from would-be investors – in respect of
volume and price.
• The final price and allocation of IPO shares will depend on the
responses received during the premarketing phase.
• In this offer the underwriter has some influence on the offering price
and on the allocation.
• Investors have a built-in incentive to provide an accurate report.

Book Building Process – contd.
• Investment banks the world over have always been in favour of book-
building method for placement of the bought deal.
• The key differences between book-building and auction are:
Items IPO through auction IPO through Book Building
1. Responsibility for unsold
shares
Investment Bank is not
responsible
Investment Bank commits to
underwrite the IPO
2. Control over information Little or no control Substantial control
3. IPO proceeds No influence on investors Can influence the investors to
maximise proceeds
4. IPO price No or little influence on investors Can induce investors to more
carefully evaluate the issue
resulting in a more accurate
aftermarket price.
5. Number of bidders Not certain The underwriter can recruit
investors leading to lesser
undersubscription

Underwriting
• It is a core function of an investment bank
• An underwriter guarantees the issue proceeds
• It is called a “bought deal” or a “firm commitment” transaction, where the
issuer sells its securities outright to the underwriter, who the resells the
securities to dealers and/or general public
• In some cases, investment banks agree only to do their best so sell shares
to the public; this is called a “best-efforts underwriting” or “standby
agreement”
• Definitions as per SEBI (Underwriters) Regulations 1993:
• Underwriting – “an agreement with or without conditions to subscribe to the
securities of a body corporate when the existing shareholders of such body corporate
or the public do not subscribe to the securities offered to them”
• Underwriter – “a person who engages in the business of underwriting of an issue of
securities of a body corporate”

M & A Advisory
• Alliances, joint ventures, strategic acquisitions and mergers are the turf of the
M&A Division of an Investment Bank (IB)
• The investment bank plays a role of a matchmaker
• Typically needs to focus on the following questions
• What is the client’s M&A strategy?
• How does each specific target enhance our client’s strategic objectives?
• What does our client need from potential partner?
• What does the target need from our partner?
• Where are the synergies?
• What are the risks?
• If the deal is convincing to make sense, the IB will have to consider how to
approach the potential client.
• What is the best contact point?
• What is the relevant angle (access, knowledge) for the target?
• Is there a special know-how (trusted advisor on negotiating and/or on structuring) involved?
• How should the bidder approach the target, as a friend or a foe?

Asset Management Services
• Managing pools of savings is known as asset management
• It is a business imperative for growth and sustenance of core investment banking
business
• Private banking and private wealth management cater to the complex needs of
high net-worth clients, their families, and select institutions
• Mutual funds are offered to other clients
• Asset management garners a management fee and often a performance fee
• Broad range of investments strategies are offered – alternative investments,
equity, money markets, and fixed income.
• Fund management helped the IBs to wield strong financial clout in the capital
market
• All major Indian investment banks have their presence in asset management –
SBI, HDFC Bank, ICICI, Kotak Mahindra, Axis Group have their mutual funds.

Estimating the borrowing capacity of a project
• The borrowing capacity of a project is defined as the amount of debt
the project can fully service during the loan repayment period.
• Bank lenders to a project typically estimate the borrowing capacity of
a project in two ways:
1. They employ a discounted cash flow methodology; and
2. They test the ability of the project entity to meet its debt service payment
obligations year by year.
20
7/22/22 Investment Banking/TM

Borrowing capacity, assuming full drawdown
immediately prior to project completion
• The borrowing capacity model determines, for a given set of project and
loan parameters, the maximum amount of debt the project’s cash flow
stream will support.
• The amount the banks will lend equals a fraction of the present value (PV)
of the available cash flow stream. Stated equivalently, the present value of
the available cash flows must not be less than some specified multiple of
the maximum loan amount.
• Let PV = α D0 , where PV denotes the present value of the cash flow stream
that is available to service the debt; α is the target cash flow coverage ratio
and D0 is the maximum loan amount. Then the maximum loan amount is
D0 = PV/α Eq 1
Often sponsors desire a rough estimate of a project’s borrowing capacity before a
detailed set of projections is available.
21

Borrowing Capacity – contd.
• Assume the following given parameters for XYZ Ltd.:
Revenues for Y1 = INR 150 m;
Expenses for Y1 = INR 45 m;
Project cost = INR 100 m;
Depreciation = 10% every year;
Growth of revenues = 5% YoY;
Growth of expenses = 5% YoY
Tax rate = 40%;
Changes in working capital: Y1 = INR 15m; thereafter it will grow till Y5;
Normal capital expenditure: Y4 onwards INR 0.5 m every year;
Interest rate = 10% per annum;
α = 1.50x
Tenure of loan = 12 years
D0 = PV/α
22

Workings for arriving at Borrowing Capacity of XYZ Ltd
Years 1 2 3 4 5 6 7 8 9 10 11 12
Revenues in INR Millions year 1 150
Expenses in INR Mullions year 1 45
Growth in revenues 5.00%
Growth in expenses 5.00%
Changes in working capital in INR Millions 15.00 0.75 0.79 0.83 0.87 - - - - - - -
Normal capital expenditure in INR Millions 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
Tax rate 40.00%
Cash Flow Coverage targetted 1.50
Interest rate expected per annum 10.00%
Depreciation rate 10.00%
Project cost in INR Millions 100.00
Fixed Assets Gross Block
Opening balance 100.00 100.00 100.00 100.00 100.50 101.00 101.50 102.00 102.50 103.00 3.50 4.00
Additions - - - 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
Sale or disposal - - - - - - - - - 100.00 - -
Closing balance 100.00 100.00 100.00 100.50 101.00 101.50 102.00 102.50 103.00 3.50 4.00 4.50
Depreciation workings
On opening balance 10.00 10.00 10.00 10.00 10.05 10.10 10.15 10.20 10.25 10.30 0.35 0.40
On additions - - - 0.03 0.03 0.03 0.03 0.03 0.03 0.03 0.03 0.03
Total Depreciation 10.00 10.00 10.00 10.03 10.08 10.13 10.18 10.23 10.28 10.33 0.38 0.43
Build-up of Free Cash Flows in INR Millions
Revenues 150.00 157.50 165.38 173.64 182.33 191.44 201.01 211.07 221.62 232.70 244.33 256.55
Expenses 45.00 47.25 49.61 52.09 54.70 57.43 60.30 63.32 66.49 69.81 73.30 76.97
EBITDA 105.00 110.25 115.76 121.55 127.63 134.01 140.71 147.75 155.13 162.89 171.03 179.59
Depreciation 10.00 10.00 10.00 10.03 10.08 10.13 10.18 10.23 10.28 10.33 0.38 0.43
EBIT 95.00 100.25 105.76 111.53 117.55 123.88 130.54 137.52 144.86 152.56 170.66 179.16
Taxes 38.00 40.10 42.31 44.61 47.02 49.55 52.21 55.01 57.94 61.03 68.26 71.66
NOPAT 57.00 60.15 63.46 66.92 70.53 74.33 78.32 82.51 86.91 91.54 102.40 107.50
Add: Depreciation 10.00 10.00 10.00 10.03 10.08 10.13 10.18 10.23 10.28 10.33 0.38 0.43
Cash profits 67.00 70.15 73.46 76.94 80.61 84.46 88.50 92.74 97.19 101.86 102.77 107.92
Less: changes in working capital 15.00 0.75 0.79 0.83 0.87 - - - - - - -
normal capital expenditure - - - 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
Free Cash Flows 52.00 69.40 72.67 75.61 79.24 83.96 88.00 92.24 96.69 101.36 102.27 107.42
Discounting factors at interest rate 0.90909 0.82645 0.75131 0.68301 0.62092 0.56447 0.51316 0.46651 0.42410 0.38554 0.35049 0.31863
Discounted cash flows 47.27 57.36 54.60 51.65 49.20 47.39 45.16 43.03 41.01 39.08 35.85 34.23
Present value of free cash flows 545.81
Cash Flow Coverage (DSCR) required 1.50
Maximum borrowing in INR Millions 363.87

.Investment Banking for first two sections.pdf

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