The Role of Investment Banking in Enterprise Mergers and Acquisitions

The Role of Investment Banking in Enterprise Mergers and Acquisitions

Overview

Investment banking is a specific division of banking that is related to the creation of capital for other companies and governments. It is the job of investment banks to underwrite new debt and equity securities for every type of corporation, aid in the sale of securities as well as helping to facilitate mergers and acquisitions, reorganizations and broker trades for both institutions and private investors. Investment banks also offer guidance to issuers with regard to the issue and placement of stock. Broadly speaking, investment banks play a huge role in large and complicated financial transactions. This includes advice as to the worth of a single company and how best to structure a deal if an investment banker’s client is considering an acquisition, merger or sale. It may also include the issuing of securities as a way of raising money for the client groups and creating documentation for the Securities and Exchange Commission necessary for a single company to go public.

Investment banking is quite different from other kinds of banking services. For instance, based on the specific work performed by banks, the financial industry is bifurcated into two major segments namely investment bank and commercial bank. Commercial banks are set up with the sole purpose of concluding commercial transactions, such as legally taking deposits and lending money to customers who may be either individuals or corporates. On the other hand, investment banks are set up to offer services to investors. For investments banks, operations are different and they do act as an intermediary between buyers and sellers of bond and stock and by so doing, they help clients in the process of raising capital. As investment banks earn underwriting commission, commercial banks earn interest on the loans that they provide to customers[1]. The thin line of difference that exists between investment banking and commercial banking is presented in the table below for clarity.

Basis for Comparison Investment bank Commercial bank
Meaning Financial institution offering services like underwriting of securities, brokerage services and so on Provides services like lending money, accepting deposits, payment on standing order and many more.
Offers Customer specific service Standardized service
Customer Base Few hundreds Millions
Associated with Performance of financial market Nations economic growth and demand
Banker to Individuals, governments and corporations All citizens
Income Fees, commissions or profit on trading activities Fees and interest income

The types of clients and activities of an investment bank compared to those of a retail bank highlight the main difference between the two institutions. The focus of retail banks is directed towards the taking of deposits and making loans to individual customers as well as offering other ancillary services such as payment services and safe deposit boxes. A common term for these services is consumer or personal banking in addition to retail banking. Retail banks reach their customers in the local market through branch or automated teller that consists of individuals, families and small businesses. Depository activities may include savings accounts, checking accounts and certificates of deposit. Lending also focuses on credit such as credit cards, home mortgages, vehicle loans and other financing for large clientele. Retail banks make money through charging fees (for checking accounts) and interest incomes from loans. The key performance drivers for retail banks are typically deposit growth, geographic coverage and technology used to grow the customer base.

Unlike investment banks, a mutual savings bank is a financial institution that is chartered by a regional or central government without capital stock and is owned by its members who subscribe to a common fund and from this fund, claims and loans are paid. Profits after deductions are also shared among members. The purpose of these institutions is to offer a safe place for individual members to save and to invest their savings in loans mortgages, stocks, bonds, and other securities and any profits or losses encountered are shared among the members.

The role of a central bank/reserve bank/ monetary authority differs greatly from that of an investment bank, in that as an institution, the central bank manages a state’s currency, money supply, and interest rates. Central banks also oversee the commercial banking systems in the respective countries. Unlike an investment bank, a central bank enjoys the monopoly of increasing monetary base in the state and also prints the national currency that serves as the state’s legal tender[2]. During times of financial crisis, central banks act as a “lender of last resort” to the banking sector; a role that an investment bank cannot perform.

It is easy to confuse an investment bank with a brokerage firm. However, there is a slight difference between the two. A brokerage firm has clients who want to buy and sell things such as securities, art, real estate or other things. When the client, or the client’s advisor decides to buy some stock, the broker can make some arrangements with the stock exchange to actually buy it after which he or she gets a commission for his or her work. On the other hand, clients come to an investment bank with the aim of raising money. the investment bank assists such clients in issuing stocks or bonds, etc. the bank may prepare marketing material, help to structure the transaction, securitize variables etc. but it is also good to note that there are some companies that do both.

Example of Investment banking

Suppose that Stv’s Paints Co., a chain of supplying paints and other hardware wants to go public. Steve, the owner gets in touch with Jamleck, an investment banker working for a larger investment banking firm. Steve and Jamleck strike a deal where Jamleck (on behalf of his firm) agrees to buy 100,000 shares of Steve’s Paints for the company’s IPO at the price of $24 per share, a price that was arrived at after careful consideration by the investment bank’s analysts. The investment bank goes ahead to pay $2.4 million for the 100,000 shares and after filling the paper work, the bank begins selling the stock for @26 per share. However, the investment bank is unable to sell more than 20% of the shares at this price and it is forced to reduce the price to $23 per share in an attempt to clear the remaining shares. For the IPO deal with Stv’s paints, then, the investment bank has made $2.36 million. In other words, Jamleck’s firm has lost $40,000 on the deal since it overvalued Stv’s paints.

It is natural for investment banks to compete with one another for securing IPO projects, and by so doing, they may be forced to increase the price they could be willing to pay in a bid to secure a deal with a company that yearns to go public. When the competition is fierce, the result is usually a substantial blow to the bank’s bottom line. In most cases, there may be more than one investment bank underwriting securities in the same way. This means risk reduction and each bank has less to gain.

Here is a list of the top 6 full-service investment banks on the global scale

  1. Goldman Sachs
  2. JP Morgan Chase
  3. Barclays
  4. Bank of America Merrill Lynch
  5. Morgan Stanley
  6. Deutsche Bank

What roles do investment banks play in M & A transactions?

The increasing competitive pressure that is being placed on businesses and the trends towards globalization, companies are engaging themselves more and more in M&A activities. Now more than ever before, companies have been looking towards the expansion and streamlining of businesses through the use of advice from investment banks on potential targets and buyers. This will normally include a full valuation and recommended tactics. The role of investment banks in mergers and acquisition falls into either seller representation or buyer representation.

Valuation

One of the significant roles of investment banking in mergers and acquisition is to establish fair value for the companies that are involved in transactions. Investment banks are excellent at calculating the worth of a business and they are also able to predict how such worth can be altered. Financial models are usually constructed by these banks in a bid to capture important fixed and variable financial components that may influence the overall value of a company. These models are solely dependent upon proposed transactions that can be extremely complex and special variables are also added for special areas depending on the different financial factors that are considered in different sectors, countries and markets with the aim of predicting or measuring the value of a company[3].

Due to their expertise in business valuation, investment banks can provide the service of arbitrage opportunities for their clients. For example, if a bank performs a valuation on a potential target company that suggests that its market value is less than what the business is actually worth, it can facilitate a merger and acquisition of this target company for its client that holds its substantial profit opportunity.

Buyers versus sellers

Investment banks are not fully reliant on buyers and sellers that approach them. They also source deals by studying the markets themselves and approaching companies with specified strategic ideas. There is a greater likelihood of completing a transaction for an investment bank that represents a potential seller compared to an investment bank that represents a potential acquirer. This seller representation, that is also known as sell-side work is a kind of advisory assignment that is generated by a company when it approaches an investment bank and checks whether it is possible to find a buyer of either the entire company or part of its assets. Generally, the work that is involved in finding a buyer includes the sale of memorandum for financial buyers. In advising sellers, the work of an investment bank is to complete when another party purchases the business up for sale. However, the representation for a buyer is not always as straight forward. The advisory work in itself is simple enough. The investment bank also contacts the firm that a client wishes to purchase and attempts to structure acceptable offers for every party and finalize on making the deal a reality. It is however, good to note that these proposals do not work out. Only few firms are willing to readily sell their business. Due to the fact that investment banks primarily collect fees based on the number of completed transactions, they are often forced to defend their proposals.

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