The Role That Equity Underwriters Play in the Financial Markets
Investment banking is the process of raising funds for companies by connecting
those corporations with investors. There's more to it than just that, however.
Though the term 'investment bank' may sound somewhat intimidating to someone unfamiliar
with Wall Street's common lingo, the reverence is mostly unmerited. Here's
a quick but complete synopsis of what these specialized financial institutions do,
and how they operate.
What Is An Investment Bank?
Despite the name, investment banking isn't 'banking' at all - at least
not in the traditional sense. Investment banks are organizations through which
companies can raise funds by selling stakes (stock) of the company in exchange for
cash. In simpler terms, investment banks 'take companies public' by acting
as middlemen; the investment bank provides cash from investors for the company,
and in return provides new shares of that company to those investors.
The process is also called underwriting. Therefore, investment bankers are
sometimes referred to as underwriters.
That said, very few investment banks simply act as fund-raising facilitators any
longer. Services related to the stock issuance process (often called an IPO
or initial public offering) are also offered to companies raising funds through
an underwriter.
How Do Investment Banks Operate?
As with all business ventures, the purpose of providing an underwriting service
is to create a profit. With most fund-raising efforts, whether they be through
debt (bonds or notes) or equity (stock, or shares), the investment bank keeps for
themselves a nominal percentage of the funds raised in the underwriting process.
The amount of money retained as the underwriting fee can range anywhere from 3%
to 20% (or more) depending on the risk or difficulty of the fund-raising process.
As stated above, however, investment banks can generate revenues and profits in
several other ways.
The biggest ancillary revenues of investment banking are generated by offering consulting
services to a company throughout the public stock offering process. Some investment
banks, though fewer, offer bond insurance services, investment management, and proprietary
trading services.
And, some investment banks even have traditional banking divisions that accept retail
customer deposits, make loans, offer ATM services, etc. Their retail banking
and investment banking divisions are quite distinct, however.
Each of these activities is a billable or revenue-bearing service provided by in
investment bank, though none are actually considered to be under the umbrella of
'investment banking.'
The legal environment affecting these multiple business operations is always changing.
In general though, the law requires clear fiscal distinction between investment
banking funds, proprietary trading funds, loans, customer deposits, and any other
services that may co-mingle client funds with bank funds. The enforcement
and interpretation of these laws can vary, however, which generally leads to conflict-of-interest
issues.
Access to Investors is Critical
It should be noted that one of the keys to being a successful investment bank or
underwriter is being able to find enough willing investors to raise sufficient cash
to meet a company's IPO/fund-raising needs.
Most investment banks can handle small to mid-sized IPO just using their own 'books'
(a list of major clients or institutions that are apt to have a significant amount
of idle cash). For some of the biggest public offerings though, an investment
bank may need to enlist the help of other investment banks. Those recruited
underwriters will get to keep most or all of the underwriting fees associated with
the shares they are able to place (sell) using their own books of business.
Though an underwriter would prefer to place an entire IPO and keep all that income,
should the investment bank be unable to raise all the required funds, it could be
devastating to its reputation. If that were to happen, the bank may not be offered
new IPO deals in the future.
Well-Known Investment Banks
Though the investment banking business' demand can ebb and flow considerably, most
of the major underwriters have been around for quite some time. Some of the
major investment banks are Goldman Sachs, Piper Jaffray, JP Morgan Chase, and Credit
Suisse, just to name a few.