Large financial holding companies now include investment banking in their menu of services. Under the universal banking scheme, large banks in Europe and Japan have operated in commercial banking and investment banking. In the United States, after the Gramm-Leach-Bliley Act of 1999 took effect, investment banking has become an integral part of their businesses. Furthermore, these global financial holding companies all have operations in most financial centers and are competing on nearly every continent of the world. The advancement of technology has enabled these financial services giants to offer a complete menu of services on a global basis.

Several investment banks are full-service providers and are not part of a financial holding company. Goldman Sachs, Morgan Stanley, and Merrill Lynch are traditionally called the "big three." Lehman Brothers and Bear Stearns both have unique strengths—Lehman in fixed income, Bear Stearns in custodian, prime brokerage, and mortgage-backed securities. Goldman Sachs, Lehman Brothers, and Bear Stearns focus their clientele on institutions and high-net-worth individuals. Merrill Lynch and Morgan Stanley offer services to retail investors as well. Table 6.1 summarizes the business categories offered by those five Wall Street houses. These lines of business by large investment banks are discussed in detail in the next section.

Boutique investment banks do not offer a range of services and are not part of a larger financial institution that serves many competing interests. The following provides a brief description of several boutiques with different specializations, as summarized in Table 6.2.

Sandler O'Neill specializes in financial institutions. The company raises capital, provides research coverage, acts as a market maker, advises on M&As, and trades securities. Its services cover mutual-to-stock conversion (from a mutual ownership structure to a public company), loan portfolio restructuring, strategic planning, and balance sheet interest rate risk management. The investment banking team focuses on demutualization, M&A advice, fairness opinion, leveraged and management buyout, and strategic issues. The capital markets group specializes in convertible securities for financial institutions and in pooled trust preferred transactions for banks, thrifts, and insurance companies. Its research covers financial services companies.

Greenhill is a boutique house focused on M&As, financial restructuring, and merchant banking. It does not have research, trading, lending, or related activities. As such, many corporate clients regard it as an independent firm without any conflict of interests. Greenhill's M&A practice covers buy-side, sell-side, merger, special, and cross-border transactions. The merchant banking services are to identify private investment opportunities and partner with strong management teams.

Lazard has two core businesses: one specializing in financial advisory and the other in asset management. Its M&A services include general strategic advice and transaction-specific advice in M&As, divestures, privatizations, takeover defenses, strategic partnerships, and joint ventures. The financial restructuring practice specializes in advising companies in financial distress. The asset management business provides investment management and advisory services to institutions, financial intermediaries, and private clients.

Houlihan Lokey Howard & Zukin (Houlihan Lokey) provides services in M&As, financial opinion, financing, and restructuring. Its focus is middle market transactions. In M&As, Houlihan Lokey groups its bankers by industry sectors to provide in-depth knowledge of the client's industry. The group also works on transactions for distressed companies, both in and out of bankruptcy court. The firm can also arrange financing for a wide range of transactions. In fairness opinion, it performs analysis, assessments of the proposed transaction as well as alternatives, to provide clients its views on the fairness of the proposed transaction.

The main revenue-producing services are underwriting and financial advisory. Underwriting includes public offerings and private placements of equity and debt securities. Financial advisory covers M&As, fairness opinion, divestures, corporate defense activities, restructuring, and spin-offs.

Underwriting

In the equity underwriting market, initial public offerings (IPOs) are more lucrative than the secondary offerings. In a public offering, the lead manager begins by conducting due diligence research and then coordinates the preparation of the registration statement to be filed with the Securities and Exchange Commission (SEC). The registration process was streamlined in 1992 when the SEC adopted shelf registration, which permits an issuer to register multiple types of securities, both common equity and debt, that it intends to issue over the succeeding two years on a single registration statement. The advantages of the rule include flexibility in the timing of the security issuance, reduced regulatory uncertainty, and lower direct issuance costs.

There are two different types of agreements between the issuing company and the investment bank. The first type is the firm commitment, in which the investment bank agrees to purchase the entire issue and distribute it to both institutional and retail investors. The second type is known as a best efforts agreement. With this type of agreement, the investment bank agrees to sell the securities but does not guarantee the price.

Underwriting of fixed income securities covers Treasury securities and corporate debt. Investment banks, through their primary dealerships, participate in the auction of the Treasury securities. On the corporate side, investment banks underwrite corporate fixed income securities and distribute to institutional investors in a way similar to equity underwriting. One of the key differences is that a larger portion of the debt underwriting is by private placement. Private placements differ structurally from the registered public deals because they are highly negotiated in covenants and pricing, and they do not go through the SEC registration process. A private issue can save substantial amounts of legal and registration expenses against a comparable public issue.

M&A Advisory Services

M&As are one of the major areas of the investment banking business. Advice on M&As ranges from strategic recommendation to clients about which targets are worth pursuing to tactical suggestion about what price to offer and how to best structure the deal. Targets of acquisitions also seek M&A bankers for advice on how to negotiate the best price or how to defend themselves.

M&A transactions generate large sums of fee revenues for investment banks. Wall Street is obsessed with M&As, because win, lose, or draw, they produce fees: fees for advising, fees for lending money, and fees for divesting unwanted assets. Fees are usually negotiable and contingent upon the success of a deal.

After a suitable candidate has been identified, the investment bank conducts valuation of the merger candidate to determine what price to offer. The valuation techniques are used only in determining the price range reference for the target company. Each acquirer uses the technique that fits its objective. Equally important, a risk analysis such as a scenario analysis or sensitivity analysis should be performed. The valuation is not complete until the impact of the acquisition on the acquirer is also carefully examined. The techniques investment banks use to value a target include the following:

Fairness Opinion

Majority of companies involved in M&As also obtain a second opinion, in the form of a fairness opinion, to determine if the transaction is fair from a financial standpoint. Fairness opinions are established on the basis of a valuation report and require an in-depth analysis of the companies involved and the terms and conditions of the transaction. The average fee paid for a fairness opinion is small relative to the overall fees paid to investment banks on M&As. But when the investment bank providing advisory services also offers the fairness opinion, a potential conflict of interest can arise since these banks have an incentive to see the transaction completed in order to receive the success fee. Thus, it is prudent for the board's special committees to use another investment bank for fairness opinion. An independent, unbiased fairness opinion will provide value to executives and boards as an additional form of due diligence, and to shareholders as a mechanism to ensure quality transactions. A fairness opinion is also an insurance policy offering directors a first line of defense against shareholders' lawsuit. This is because a timely, independent analysis may establish for the record that the board has properly exercised their business judgment by having adequately considered the proposed transaction and the potential alternatives. Furthermore, the National Association of Securities Dealers (NASD) has intended to require its members to comply with NASD Rule 2290 to ensure proper disclosure and independence of the fairness opinion. Investment banks that provide fairness opinions are typically registered broker-dealers and NASD members.

Financial Restructuring

Financial restructuring is complex as it often involves transactions for distressed companies, both in and out of bankruptcy. Advisers in this area need to provide structure for a broad array of options for company owners, executives, creditors, and other parties. It is necessary to provide thorough and comprehensive analyses of factors in restructuring transactions and to efficiently implement creative solutions. The purpose is to ensure that the restructuring process is effectively managed to maximize value and minimize delay.

Such financial restructuring involves distressed companies in change of control, asset sales, and other M&A activities. These situations may require asset divesture quickly under extremely distressed circumstances for companies in and out of bankruptcy court. Many of those distressed sale transactions are consummated in Chapter 11. Thus, the distressed M&A adviser must be able to articulate to buyers the benefits of purchasing assets from a distressed company and allay the concerns of buyers. Often, the valuation of the company in bankruptcy requires modifications to traditional healthy company valuation and the sale must be done quickly. This is because, as time passes, the value may decline leaving liquidation as the only available alternative.

Restructuring is sometimes more strategic than transac-tional. In such a circumstance, the pressing job is to create and execute a total solution for the company to grow and to return to profitability. First, the banker thoroughly evaluates the company's finances, industry condition, and capital market environment. Second, the advisor explores and presents to company all strategic alternatives, processes, and the impact on various stakeholders. After such a comprehensive review, a value maximizing strategy is recommended and executed.

Trading and principal investments are important revenue producing operations. Trading could be for market making or for the firm's proprietary account. Principal investments are the merchant banking operation in venture capital and buyouts.

Trading

Many investment banks put up large sums of capital for proprietary trading. The first step to successful trading is to ensure survival by making risk management a top priority. Many losers are washed out while trading their way out of a hole. Many of them have difficulties taking a loss and they tend to keep on hanging on to money losing securities. The essential aspect is to understand that a 10% loss requires a gain of more than 11% just to get even, and that a 50% loss will require a gain of 100% to get back in the game. Typically, a trader would place a stop right after he got into a position. The level of stop is chosen in such a way that any loss from a single position will be limited to a small percentage of the account.

Likewise, taking profits is sometimes emotionally hard. When the market moves in the anticipated direction, a trader needs to decide whether to stay put, take profits, or add to position. A successful trader sets certain objective for each position, and once the objective is accomplished, he knows when to close out the account.

There are many markets, many instruments, and many techniques. Each market has its own unique characteristics and its own trading hours. Certain instruments continuously trade in different time zones. Fundamentals in the market where they trade and the events in other markets affect their prices. Most major currencies and the U.S. government securities trade in all major markets, and the economic fundamentals in the United States and the financial market conditions in other countries affect their prices.

There are three basic approaches to trading. The first is fundamental analysis, which bases a security price on corporate and economic fundamentals. The fundamental approach for a security involves the analysis of the economy, industry, and company. This applies to equities and fixed income securities. In commodities, fundamentalists study factors that affect market demand and supply. Currencies are affected by economic fundamentals such as production and inflation, and by political factor as well. In futures, expectations of interest rate and cash market conditions are important. Volatility and expected direction of price movements are key in determining the options valuation.

The second approach is the market efficiency hypothesis, in which securities prices are based on all available information so as to offer an expected rate of return consistent with their level of risk. There are three different degrees of informational efficiency. The least restrictive form is the weak form efficiency, which states that any information contained in the past is already included in the current price and that its future price cannot be predicted by analyzing past prices. This is because many market participants have access to past price information, and hence any free lunches would have been consumed. The second form of informational efficiency, semistrong form efficiency, states that security prices fully reflect all relevant publicly available information. Information available to the public includes past prices, trading volumes, economic reports, brokerage recommendations, advisory newsletters, and other news articles. Finally, the strong form of informational efficiency takes the information set a step further and includes all public and private information. This version implies that even insiders who have access to nonpublic material information cannot make abnormal profits. Most studies support the notion of semistrong form market efficiency, but do not support the strong form version of efficient market hypothesis. In other words, insiders can trade profitable on their knowledge of nonpublic material information. This advantage is unfair and hence insider trading is illegal.

Finally, technical analysis attempts to use information on past price and volume to predict future price movement. It also attempts to time the markets.

Principal Investments

Principal investments represent the bank's merchant banking investments. This involves the commitment of the firm's capital to equity level investments and participation. These include financing guarantees, venture capital, leveraged buyouts, and restructurings. In private equity (venture capital and leveraged buyouts), investment banks are involved, from raising capital for the funds to taking the portfolio company public or selling out to other businesses. An investment bank may simply raise money for external private equity funds such as venture capital or buyout funds. An investment bank, alternatively, can manage the fund itself. Even though many private equity investments turn sour, the successful ones are so profitable that the overall annual returns are often quite attractive. Major Wall Street houses all have private equity operations. Private equity is of interest to banks because it has several benefits including management fee, capital gains, and contributing to underwriting and merger and acquisition business.

Data on private companies are limited. Early stage companies generally experience a period of negative cash flows and negative earnings before they produce positive net income. The timing and the amount of future profits are highly uncertain. Thus, valuing private companies is subjective and difficult. Common private equity valuation approaches are comparables, net present value, option valuation, and venture capital methods. Comparables and net present value approaches have been discussed in M&A valuation. Thus, we focus on option valuation and venture capital methods.

The option valuation method assigns a value to the flexibility that the venture capitalist has on making follow-on investments. This right is similar to a call option on a company stock, which is a right, not an obligation, to acquire an asset at a certain price on or before a particular date. Options pricing theory captures this "option" to either invest or not invest in the project at a later date. This valuable option is not accounted for by the DCF approach. The Black-Scholes model was the first widely accepted method to value European options using five variables: (1) exercise price, (2) stock price, (3) time to expiration, (4) standard deviation of stock returns, and (5) time value of money. To value a firm, the five variables used are (1) the present value of expenditures required to undertake the project, (2) the present value of the expected cash flows generated by the project, (3) the length of time that the venture capitalist can defer the investment decision, (4) the riskiness of the underlying assets, and (5) the risk-free rate. The value is then obtained once those input variables have been estimated. This approach is useful because it specifically incorporates the flexibility to wait, to learn more, and then to make the investment decision. The options valuation has its drawbacks, too. Many business people are not aware of this "real option" concept. Furthermore, the real-world problems are often too complicated to be captured in the model.

The venture capital method takes into account negative cash flows and uncertain high future profits. It considers cash flow profile by valuing the target company at a time in the future when it expects to generate positive cash flows and earnings. The terminal value at that projected target date is discounted back to the present value by applying a discount rate, a target rate of return (TRR), instead of cost of capital. The TRR is the rate of return that the venture capitalist requires when making an investment in the portfolio company. The terminal value is generally obtained using price-to-earnings ratio multiplied by the projected net income in the year. The amount of proposed investment is divided by the discounted terminal value to give the required final percentage ownership that the venture capitalist wants to own. The final step is to calculate the current percentage ownership taking into consideration the dilution effects when the portfolio company goes through several rounds of financing. This is done by calculating a retention ratio that factors in the dilutive effects of future rounds of financing on the venture capitalist's ownership. For example, assume that the portfolio company will sell 30% in the second round and then another 25% in the third round before it goes public. The retention ratio is 61.5%, meaning that 1% ownership in the initial investment is diluted to only 0.615% after two rounds of financing. If the venture capitalist invests $10 million and requires a final percentage ownership of 10%, she will require the current ownership percentage of 16.26%. The 16.26% current percentage ownership is necessary for the venture capitalist to realize the target rate of return.

Investment banks operate in asset management and other securities services to better service their clients and to diversify their revenue sources. Those essential services cover financial engineering, prime brokerage, financing, and securities lending.

Asset Management

Asset management provides investment advisory services including mutual funds, separate accounts managed for clients, merchant banking funds, and other alternative assets. Investment management is an important segment of the capital markets and has become an integral part of the investment banking business. Wall Street firms have engaged in investment management because it is one of the most attractive segments of the financial services industry. It expands the menu of products and services that investment banks offer to clients. Furthermore, the income stream is less volatile than trading, underwriting, or M&A activities. The affiliated funds also provide synergy to the bank's underwriting business.

Financial Engineering

Financial engineering is the term used to describe the investment banker's creativity in innovative security design. The rapid pace of financial innovation is driven by the competition among investment bankers in response to increased price volatility, tax and regulatory changes, demand for new funding sources, arbitrage, and yield enhancement. The application of mathematical and statistical modeling, together with advances in computer technology, provides the necessary infrastructure for financial engineering.

Financial engineering helps investment banking professionals to meet the needs of borrowers and investors such as hedging, funding, arbitrage, yield enhancement, and tax purposes. It drives the explosive growth in the structured and derivatives markets. The development of the junk bond and asset-backed markets provides borrowers additional funding sources at lower costs. Structured notes add another dimension in the funding and investment spectrum. Transactions in repurchase agreements provide borrowers lower funding costs and give lenders legal title to the collateral. Through swap contracting borrowers and investors obtain a high degree of flexibility in asset-liability management at better terms. Credit derivatives have widespread applications in hedging credit risks.

Prime Brokerage and Related Services

Prime brokerage is a suite of services providing clients such as hedge funds with custody, clearance, financing, and securities lending. These services make it possible for the hedge fund and other clients to have multiple brokers while maintaining one brokerage account. In prime brokerage, the investment bank acts as the back office for the fund by providing the operational services necessary for the money manager to effectively manage his business. This enables the clients to focus on investment strategies rather than on operational issues. The services a good prime broker provides include centralized custody, clearance, securities lending, competitive financing rates, one debit balance/one credit balance, real time and periodic portfolio accounting, position and balance validation, electronic trade download, wash sale reports, and office facilities in selected markets.

Investment banks perform several essential functions in the marketplace. At the core of what they do is origination and strategic advisory. As the market evolves, the large full-service Wall Street firms are diversifying and balancing their revenue streams. Thus, most of them have expanded their menu of services and products and allocated resources to pursue higher-growth opportunities in Asia and Europe.

Deregulation and Revenue Diversification

Deregulation in the 1980s and 1990s gradually chipped away some of the barriers between investment banking and commercial banking. By 1999, the main barriers separating the three segments of the financial services industry—banks, securities firms, and insurers—were removed by the Gramm-Leach-Bliley Act of 1999.

Commercial banks are uniting with securities firms to create financial supermarkets that offer one-stop shopping for all financial services. Investment banks are undergoing a similar trend, driven both by the competition from other firms and by their corporate clients' desire to have financial advisors that can address all their needs, regardless of what types of instruments might be required. Thus, investment banks have been aggressively expanding the menu of services they provide, adding money lending, retail and institutional fund management, structured finance, and securities services. Indeed, large investment banks now derive the majority of their revenues from sources other than the traditional investment banking activities. These other sources include trading and principal transactions, commissions, asset management, and securities services.

Globalization

In addition to expanding the products and services they offer at home, large investment banks are also expanding geographically to become financial supermarkets to the world. With rapid advances in information technology and greater cooperation among financial regulators, the international capital markets are now closely linked. Larger sums of money are moving across national borders, and more countries have access to international finance. By going global, investment banks not only can serve their clients better but also can benefit from the higher growth potential of international markets. Regulatory frameworks in Japan, Europe, and developing countries are changing to accommodate and encourage private pension programs, more investments in securities, and greater participation by nonlocal firms.

Big Wall Street houses such as Goldman Sachs, Morgan Stanley, and Merrill Lynch all have a strong global presence and have established leadership positions in core products. Although they are among a select few that have the ability to execute large, complex cross-border transactions, many other Wall Street firms pursue a globalization strategy. As a result, U.S. firms have significantly increased their international securities activities. Major U.S. houses earn a significant portion of their net revenues from international operations. At the same time, foreign financial institutions are expanding their investment banking capabilities in the United States. UBS and Deutsche Bank, for example, have established an investment banking presence through acquisitions.

Internet and Information Technology

The changes in investment banking have been in part aided by the advent of the Internet and advances in information technology. As David Komansky (1999), the former chairman and CEO of Merrill Lynch, observed, together globalization and technology "have collapsed time and distance and opened a floodgate of opportunities for those who embrace them."

The Internet and e-commerce have already changed, and will continue to change, the way that securities are traded and distributed. Many firms now use the Internet for extended trading in markets around the world. Clients now have online access to research, data, and valuation models 24/7. Some have gone one step further to allocate shares of initial public offerings through online auctions. The online auction approach brought out many IPOs for small U.S. businesses. Google's IPO was undertaken via this type of auction process as well. To further enhance their distribution capabilities, major investment banks have established alliance with retail brokerage houses.

In addition to using the Internet, investment banks are developing software and information technology systems that enable them to enhance their service to clients, better manage risks, and improve overall efficiency and control. New software has made it possible for firms to tailor their research and services to each client's particular needs.

Technological advances have also provided investment banks with capabilities to design and price complex contracts and derivatives and to analyze their underlying risks. Every firm has software that enables it to monitor and analyze market and credit risks. Risk management software can not only analyze market risk at the firm, division, and trading desk levels, but can also break down the firm's risk into its underlying exposures. This permits management to evaluate the firm's exposure in the event of changes in interest rates, foreign exchange rates, equity prices, or commodity prices. Without such software, ventures into international markets and complex trading would carry much more risk than without it.

Finally, information technology has been a significant factor in improving the overall efficiency of investment banks (and many other businesses as well). Computerized and electronic trading is both more efficient and more accurate. Management now has real-time information on the firm's operations worldwide. Not only has globalization been made possible, but also better decision making and improvement in the firm's competitive edge have taken place.

Since the collapse of WorldCom and Enron (the two largest bankruptcies in North America during 2000–2005), regulators and shareholders pay close attention to transparency, accountability, and corporate governance. The objectives of the Sarbanes-Oxley Act of 2002 are to ensure corporate accountability and to restore public trust in the financial markets. Corporate responsibility will continue to be the focus. In June 2005, settlements by Citigroup and JPMorgan Chase to pay $2 billion and $2.2 billion, respectively, for their involvement in Enron scandal signify the importance of regulatory compliance. In addition, retention of talent and diversity of workforce will continue to be essential to successful operations. As firms pursue the strategy of sustained earnings growth, it is not optional but necessary to manage risks effectively.

Accountability and Corporate Governance

Public confidence in business principles and practices is the foundation of an efficient financial system. Regulations and corporate policies are evolutionary. Focus has been in the areas of corporate accountability, standards of corporate governance, and conflict of interest. Under the Sarbanes-Oxley Act of 2002, public companies are required to certify that they have established reasonable internal control systems and procedures for completeness of their financial reporting. Such accountability and transparency are expected to continue.

In corporate governance, all public companies now have independent directors and these directors meet without management at least once a year. Most financial institutions have established a sound corporate governance structure.

Another important element for investor confidence is relating to analyst conflict of interest. The Sarbanes-Oxley Act contains provisions to prevent analyst conflict of interest. Investment banks also have adopted policies to ensure compliance of analyst independence. As an example, in May 2005, Merrill Lynch withdrew from underwriting the IPO of Warner Music Group after its media analyst, Jessica Reif Cohen, told Merrill's senior bankers that they were overpricing the shares. Such analyst independence is a striking example of changes that have occurred since Wall Street's settlement of $1.4 billion with the attorney general of New York, Eliot Spitzer. After the settlement, Wall Street research analysts are asked to make separate, independent, and impartial recommendations to the underwriters about their views of the client's business prospects.

Recruitment and Retention of Talents

The most important asset at any investment bank is its people. The success of business is dependent upon the team's ability to provide the most innovative and creative solutions to clients' needs. Investment banks face competition from financial holding companies that offer similar services. These financial holding companies also compete for talent, in addition to clients. To maintain the competitive edge and meet expectations of clients, investment banks must attract, retain, and motivate employees. A performance-based compensation that rewards results is fundamental to the operations of an investment-banking firm. Thus, employee compensation and benefits is the largest item in expenses, reaching almost 50% of total net revenues at many houses. Furthermore, most firms also stress a culture of client focus, integrity, social responsibility, diversity, community service, teamwork, and entrepreneurial spirit.

Risk Management

Effective risk management is of primary importance to the success of an investment bank. The proliferation of products and increasing complexity of regulations has made effective risk management a must. All investment banks establish a comprehensive risk management process to monitor, evaluate, and manage the risks that the firm assumes in conducting its businesses. Important areas include market, credit, liquidity, operational, legal, and reputation exposures. Many believe effective management of those risk exposures will ensure regulatory compliance and maintain sustained earnings growth. More importantly, it protects the reputation and survival of the firm.

Europe and China

The global economy is becoming more and more integrated. In the process, Europe has higher growth opportunities than the Americas and China presents tremendous potentials. One of the big driving forces behind China's growth is the huge sums of money from foreign institutions invested in infrastructure. The incredible economic growth has also fostered an increase in wealth development and accumulation. The surge in consumer purchasing power creates businesses for many corporations. This in turn presents investment banks opportunities in underwriting, financing, and strategic advisory. Wealth management is another promising potential. Morgan Stanley, Goldman Sachs, and Merrill Lynch have all established a presence in China. As the equity culture develops, shareholders will demand accountability and stability of earnings. Therefore, corporate governance and risk management are important subjects.

Securities businesses by their nature are subject to volatility. The volatility comes from changes in industry competition, interest and foreign exchange rates, and global economic and political trends. Each line of business has its ups and downs, and is subject to intense competition. The menu of services is also changing. Investment banks have been forced to change to meet new challenges. In addition, most big houses have expanded overseas operations in all major capital markets and have derived a substantial portion of their revenues from non-U.S. markets. To achieve and maintain a leadership position in investment banking, a firm must have: