A (Rather Politically Incorrect) Guide to Investment Banking

By John / Stephanie

Many people have been asking the same question of “What’s exactly Investment Banking”. And I have been giving my answer in layman terms but in a conventional, “text-booky” manner.

People nodded, but I could see this is not what they are looking for. I did not answer their real question: what do you guys do to justify your outrageous pay and bonuses?

So here is my attempt to answer the question in a different way.

The “Alternative” Guide to Investment Banking

Essentially, Investment bankers are “middlemen”. Their main job — their way to make money — is to broker a deal between those who need money and those who have idle money to invest, and they get a small percentage from the consideration as reward.

Who need the money?

The corporations and governments that need the capital to expand, buy something, make their balance sheet look good, or get rid of some stupid debt they got themselves into a while back.

Who has the money?

You and me, and the general public at large. Retail investors put money into funds (e.g. pension funds, mutual funds) and these funds are institutional investors who make the investment decision on behalf of us. That’s it. As simple as that.

It sounds easy enough. Why do the middlemen get paid so much?

When the consideration is in the 9+ figures, a couple of percentage means a couple of millions of dollars.

More importantly, it does take a lot of coordination, effort and skills to pull off a deal, such as good market timing, correct reading of sentiment of the investment community, a good institutional sales team to help market and distribute the large amount of stocks/bonds. Most corporations don’t mind pinching away 0.5-2% as an incentive for the middleman to complete the deal.

I still don’t get it.

Think of i-bankers as super real estate agents who can pull off a billion-dollar sale to a group of investors. It’s quite a challenging job isn’t it?

Questions

1. How about M&A and other cool jobs that i-bankers do?

When you think about it, M&A and other advisory work should fall into the realm of management consultants, not i-banks. Well, providing advisory work is originally the Middleman’s way to generate deal-making ideas, because in many cases a successful merger or acquisition will result in capital raising.

Having said that, M&A has grown big in i-banks because it proves to be a lucrative and risk-free business (see below) in and of itself.

Other advisory work e.g. business restructuring, credit rating remains a free service in exchange for potential financing product and future businesses.

2. It sounds like investment banks are simply agents and they don’t need to contribute any capital to do the work. Why and how did banks collapse in this “risk-free” business?

Excellent question! In its simplest terms, no capital is indeed required in the i-bank business model.

However in reality, in a stock/debt offering an i-bank “underwrites” the entire offering before it is marketed and distributed to the investors.

This means that if there is not enough investors to take the new stocks, the i-bank will buy them from the market such that the stock price is somewhat stabilized at a reasonable price.

This implies that the i-bank needs a certain capital base to be able to underwrite in the first place and to support the stock price in case it falls. Underwriting of plain-vanilla stocks and bonds alone will not pull down an established investment bank.

The problem started when i-banks underwrite fancy stuff such as sub-prime loans and other illiquid structured products. Also, most investment banks nowadays have gone way beyond their role as an agent — they became a (major) investor themselves.

Classic example is proprietary trading in which i-banks use their own money to trade, often making big bets on trends. Definitely a high-risk-high-reward model.

3. How do Sales & Trading and Research fit into this picture?

A full-serviced Investment bank has 3 major divisions: Corporate Finance, Sales and Trading and Research. Just think of them as 3 brothers in the same middleman business.

Their respective roles are:

A) Corporate Finance (also known as Investment Banking division): the middleman responsible for maintaining the relationship with those who need money (corporations) and for brewing up capital raising ideas.

B) Sales and Trading: the middleman responsible for marketing the corporation’s stocks/bonds to the institutional clients (those who have money).

C) Research: the middleman who keeps the institutional clients happy by recommending good companies’ stocks and bonds for their investment.

You can learn more get the job description of these respective divisions here.

4. If Investment Banking is a middleman business, does it mean i-bankers are salesmen? I thought you guys are financial modeling guru.

Yes and no. Junior bankers are technical guys and senior bankers are sales guru.

People outside the industry may not realize the major change of skill set required as Associates are promoted to VP. You can learn more about their respective roles in the link immediately below.