Friday, 3 February 2012

Investment Banking Analysis

What is Investment Bank:

An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities. 

Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G8 countries, have historically not maintained such a separation. 

There are two main lines of business in investment banking. Trading securities for cash or for other securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) is the "sell side", while dealing with pension funds, mutual funds, hedge funds, and the investing public (who consume the products and services of the sell-side in order to maximize their return on investment) constitutes the "buy side". Many firms have buy and sell side components. 

An investment bank can also be split into private and public functions with a Chinese wall which separates the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas such as stock analysis deal with public information. An advisor who provides investment banking services in the United States must be a licensed broker-dealer and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulation.

Top Investment Banks:
>>  J.P. Morgan  ,
>>Bank of America Merrill Lynch ,

>>  Goldman Sachs,
>>  Morgan Stanley
>> Credit Suisse
>> Deutsche Bank 
>> Citi Bank
>> Barclays Capital 
>> UBS
>> BNP Paribas

Investment Banking Analysis:
Investment Banking falls under two broad headings:
  • the provision of financial advice
  • capital raising.
Principal clients are companies, particularly publicly listed companies, and governments. For companies, these services are primarily directed towards raising shareholder value (that is, ensuring that the share price fully reflects the value of the business); and the actions prescribed are corporate actions (taking over another company, selling a division, returning cash to shareholders by paying them a special dividend, etc). For governments, these services are usually directed at executing government policy, for example by selling off, or privatizing, government-held businesses or industries. 
Provision of financial advice:
As noted above, investment banking advice relates to corporate actions rather than product or organizational matters, such as product improvement, market analysis or management of organization. Nonetheless, an investment banker needs to have an understanding of all these things because they, too, will have an impact on shareholder value.

Mergers and Acquisitions (or "M&A"):
The majority of financial advice relates to M&A. The client company seeks to expand by acquiring another business. There are many possible commercial reasons for this, such as:
  • increasing the range of products
  • increasing the business' geographical footprint
  • complementing existing products
  • integrating vertically (i.e. acquire suppliers, further up the chain, or customers, further down the chain)
  • protecting a position (for example by preventing a competitor from acquiring the business in question).
In practice therefore, Investment Banking divisions tend to be divided into industry sector teams, who can then familiarize themselves with the principal players, economics and dynamics of the sector.
There are also many possible financial reasons for making an acquisition, such as:
  • Raising profitability, and therefore the share price
  • Increasing in size
  • followed and more widely invested in; again, likely to have a positive effect on the share price
  • Financing growth
  • Improving quality of profits - the market likes predictable profit streams, and will value these more highly
  • Shifting the business towards sectors more favourably viewed by the market.
The Investment Bankers' roles in these transactions involve:
  • Using their knowledge of the industry sector, to help with the identification of potential targets which meet commercial criteria such as those referred to above
  • using their knowledge of the investment market, to advise on valuation, form of consideration (should the sellers be paid in cash - which is likely to involve the buyer borrowing the money - or in the buyer's shares - so that the seller ends up with a stake in the buyer, or a blend of the two?), timing, tactics and structure
  • Coordinating the work of the other advisers involved in the transaction - lawyers, who prepare the documentation for the acquisition and help with the "due diligence" to be performed on the business being acquired; accountants, who advise on the financial reporting aspects of the transaction, and tax consequences; brokers, who advise on shareholder aspects (how are the buyer's shareholders likely to view the acquisition?) and how the market as a whole is likely to receive the transaction; and public relations consultants, who ensure that the transaction has a favourable press.
General financial advice:
Investment Banking also involves providing general financial advice on a range of issues, such as funding structure (perhaps the company is too indebted, and should issue shares to raise more money; or does it have too much cash on its balance sheet, just sitting there not earning interest, so that it should consider paying a large dividend to its shareholders or buying back some of its own shares?).
Capital raising:
If a company is to grow, it has to invest and, often, that capital comes from external sources. This can be in the form of either "equity", when the company issues more shares to investors, who buy them for cash; or debt, either from banks or - more usually nowadays - directly from investors. Investors may be either institutional (pension funds and the like) or “retail” (individuals).
Investment Banks advise on the raising of capital - in what form, how much, from whom, timing - and may also charge a fee for arranging the financing or for "underwriting" (guaranteeing to take up any securities that are unsold in the market, so that the issuer knows for sure how much cash it is going to raise and can plan accordingly).

Ways of Raising Capital:
There are several ways of raising equity capital: These are discussed below:
Rights Offerings:
Most company regulations or charters allow shareholders to have a pre-emptive right in additional stock issues. Thus, anytime the company wants to raise additional equity capital, it must make a formal offer to existing shareholders before it can seek the interest of potential outside investors. Where it sells additional stock issues to existing shareholders, it is called a rights offering. This offer may be renounceable or non-renounceable. A renounceable rights offering gives the shareholder the option to exercise his right to purchase the new shares at the issue price. A non-renounceable rights offering obligates the shareholder to exercise his rights at the issue price.

Public Offerings:
Where the corporate charter or regulations are silent on pre-emptive rights of existing shareholders, it may decide to sell new shares or stock through a rights offering or a public offering.

Private Placements:
This method of selling securities is generally used by companies who are interested in reducing their floatation costs and are interested in a specific group of investors. Under private placements, new stocks are sold to one or a few investors, generally institutional investors who invest in large blocks of shares.

Employees Purchase Plans and Employee Share/Stock Ownership Plan:
In most organizations, the regulations or charter allows employees to purchase the shares of the company usually at predetermined prices based on the financial performance of the entity. This usually affects managerial staff in order to reduce the prevalence of the principal-agency problem.

The Initial Public Offering and the Regulatory Framework 
At this stage we will focus on the Initial Public Offering (IPO) process, the regulatory framework within which the activity is organized and the role of the investment banker.

The IPO Process:
Many writers in corporate finance have given different descriptions of the initial public offering process. A combination of the approaches used will yield the best description of this process. Brigham et al (1999), divides the process into two distinct stages: Stage-one decisions are internal to the company while stage-two involves the company and an investment bank or investment banks. Some writers (Weston and Copeland, 1989; Brealey and Myers, 1994; Grinblatt and Titman, 2002) give a summary of the process by focusing on decisions concerning pre-registration statements to the trading of the securities on stock exchanges. This study describes the process under sections Phase-I and Phase-II IPO decisions.

Phase-I IPO Decisions:
At Phase-I, IPO decisions usually start with the company making decisions in the following areas:

1.      Amount to be raised: The decision variable here is the amount of new capital needed by the firm.

2.      Type of Securities to use: This stage of the process will consider the best security to use; the firm would have to choose from basic forms such as shares, bonds or other innovative types, which may include various combinations of securities usually called exotic securities. The choice of security and the method of selling will normally fall within the regulatory framework of the securities industry.

3.      Competitive bids versus a Negotiated deal: Should the company offer a block of securities for sale to the highest bidder? Or should it negotiate a deal with an investment banker? Competitive bids normally are used by large well-known firms whiles negotiated deals are used by small firms not known to the investment banking community.

4.      Selection of an Investment Banker: the firm must decide on the investment banker to use in raising the needed capital. This stage is very important to the firm, as it tends to have other implications on the success of the IPO process. The intensity of the problem faced by the issuing firm may stem from the fact that there is no model to rely on in selecting an investment banker to make the IPO successful (Manaster and Carter, 1990). Reputable investment banks target more established firms whiles other investment banks are good at speculative issues or new firms going public.

Phase-II IPO Decisions:
At Phase-II, decisions include the input of the firm’s selected investment banker. Components of Phase-II decisions generally include the following:

1.      Re-evaluating the initial decisions: at this stage, the firm and its investment banker will have to re-evaluate regarding issues such as size of the issue and type of securities to use etc. These decision processes are organised under pre-underwriting conferences as espoused by Weston and Copeland (1989). The main aim of the re-evaluation processes is to fine-tune the internal decisions of the company under Phase-I. This is to ensure the success of the issue.

2.      Filing of Registration: The investment banker, after taking an inventory of all the relevant information, it has to file an application with the Securities and Exchange Commission (SEC) and the stock exchange if it wants the shares to be publicly traded. In Ghana, the securities industry laws (SIL) however allow applications to be filed with the GSE before it is filed with the SEC. Without the examination and approval by these regulatory bodies, public sale of the security can never begin.

3.      Pricing of the Security: Another important decision at this phase is the pricing of the security. This depends on a plethora of issues, usually resolved through the research or experience of the investment banker. The important issues considered here include, the risk profile of the issuer, the capacity of the market to accommodate the issue, the reputation of the investment banker etc. The pricing of the issue has been identified as one of the sources of controversy between the issuer and the investment banker (Weston and Copeland, 1989; Brigham et al, 1999; Grinblatt and Titman, 2002).

4.      Forming the Underwriting Syndicate: In underwriting of security issues, the managing/selected investment banker may or may not be in the position to underwrite the whole issue. Where it is unable to underwrite the issue, it may have to form an underwriting syndicate.  This will ensure the diversification of underwriting risk to the managing investment banker and permits economy of selling effort and expense and encourages nationwide distribution.

5.      Forming of the Selling Group: The selling group is formed to facilitate the distribution of the issue for a commission. The managing investment bank through the selling group agreement, which usually covers the description of the issue, concession, handling of purchased securities and duration of the selling group, is able to control the selling group.

6.      Offering and Sale: The last important step in this process is the formal sale of the securities after the approval by the regulatory authorities. This is usually preceded by a series of publicity campaigns. The date on which the selling of the issue will begin is made public before or during the publicity campaign in order to avoid unfavourable events or circumstances.

The process in Ghana is very much the same as what pertains in other economies. Differences may be found in the regulatory framework within which it is organised. Important requirement in Ghana for a company going public is the appointment of an investment banker to guide it through the process. 
The Role of the Investment Banker in the IPO Process:
It is clear from the above discussion that, the activities or roles of the investment banker in the IPO process cannot be discounted. The success of the IPO will to a large extent depend on the capabilities of the investment banker selected (Ellis, 1989). However, in the absence of a model to guide issuers of securities in selecting investment banks, how does a company come up with the right investment banker to manage its IPO? Despite the numerous efforts made by academics to investigate into issues concerning the market for IPOs, not much has been done on the capabilities of investment banks. However by examining critically the roles and responsibilities of investment banks in the IPO process, we can glean some qualities or capabilities an investment banker must possess in order to survive in its market. Weston and Copeland (1989) identified three main functions or roles investment banks play in the IPO process and these include: Underwriting, Distribution and, Advice and Counsel.

Underwriting: This is the insurance function of bearing the risk of adverse price fluctuations during the period in which a new issue of securities is being distributed. There are two fundamental ways of doing this, and they are the firm commitment and best efforts underwriting agreements. The firm commitment agreement obligates the investment banker to assume all the risks inherent in the issue. On the other hand, the best efforts agreement absolves the investment banker from any risks in the issue. Under this underwriting agreement, the investment banker undertakes to help sell at least a minimum amount of the issue with any unsold amounts returned to the issuing firm. Where the investment banker is not able to sell the minimum quantity agreed upon, the whole issue is cancelled and reissued when the market is ready to accommodate the issue.

Distribution: Another related function to the one described above is the ability of the issuing firm to reach as many investors as possible with its security. According to Weston and Copeland (1989), investment banks play a very crucial role here, because of their expertise in doing this relative to the issuing firm assuming this responsibility when issuing securities.

Advice and Counsel: This involves the investment banker making valuable inputs into decisions concerning its client ability to succeed in the capital market with an IPO. Its ability to make valuable inputs in this direction may largely depend on its experience in origination and selling of securities.

In addition, Ellis (1989), identified two categories of factors critical to evaluating and choosing an investment bank. In his assessment, the most important factors include.

1.      Understand our company
2.      Earn credibility with our senior management
3.      Make useful recommendations to our company

 The least important are:
1.      Expertise in Eurobond market
2.      Expertise in equity underwriting

Ellis (1989), again identified six (6) reasons why investment banks gain importance with their corporate clients. These are:

1.      Credibility with the client corporation’s senior management-earned over several years.
2.      Understanding the client company’s needs for service and its financial goals and policies.
3.      Making useful recommendations to the company over a period of time.
4.      Innovating with new financing techniques.
5.      Having special expertise in a specific service.
6.      Recommending a specific transaction.

Credibility with Senior Management:
His postulation on the role of an investment banker goes beyond the IPO process to include other activities or capabilities of the investment banker, which tends to impact on choice of an investment banker by senior management who are interested in strategic issues of the organisations they are responsible for. Thus if an investment banker’s capabilities fit well with financial strategies of the organisation, it is made an integral part of implementing the financial strategy.

Understand Client Company:
Another reason he finds important to corporate executives is the investment banker’s knowledge of their companies and their operations. More conservative corporate executives rated this as a critical success factor in dealing with investment banks, especially when the investment banking industry in US has over the years survived, by maintaining a relationship with their clients.  In his study, 3 of the 4 different industries he studied ranked this variable as the most important of all in dealing with an investment banker.

Making Useful Recommendations
A more IPO related factor is the ability of the investment banker to make valuable recommendations to the issuing firm over time. This is because it reinforces the reliability and consistency of the investment bank’s capabilities to its corporate clients. In this light an investment banker that is able to consistently make valuable inputs into the financial decisions of a client strengthens the relationship between itself and its client.

Expertise in Equity Underwriting:
Another important IPO related capability is the ability of the investment banker to underwrite securities.  In the absence of any model to determine the overall capabilities of an investment banker, this has been one of the criteria for ranking the performance of investment banks.

Having Expertise in a Specific Service:
The competitive wave sweeping the US investment banking industry has caused most investment banks to concentrate on their capabilities where they can gain a competitive advantage. The era where one investment banker was at the centre of a corporate entity’s financial strategy is over. Corporate entities are ‘shopping’ for specific capital market capabilities of investment banks. This has eventually changed the structure of the investment banking industry where size used to be a competitive factor.

Supplementing Capabilities:
Other capabilities such as Euro market capabilities, recommending specific transactions and innovating with new financing techniques are all additives to the more generic functions described above. These capabilities, though not really taken to be very important then are now making very important inputs into the choice of firms by corporate clients. Grinblatt and Titman (2002), point out that investment banks have been motivated in various ways to develop capabilities in these areas to expand their client-base beyond their domestic financial markets.

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