Chapter 2

The Purpose of Investment Banking: What Investment Bankers Do


check Getting a high-level grasp of the role investment banks play in the capital markets

check Finding out what job investment banks play in mergers and acquisitions

check Seeing how investment banks deal with leveraged buyouts

check Coming to terms with the importance of investment research

check Getting an understanding of private business sales, trading, and initial public offerings

check Seeing why investment bankers pay so much attention to valuation of assets

Investment banking is the grease that oils the capitalistic machine. Businesses, entrepreneurs, governments, schools, and other institutions that hope to build and expand need cash to make it happen. But in the financial version of the chicken-and-the-egg dilemma, sometimes the people with the great plans don’t have the cash to get started.

And that’s exactly where investment bankers come in. Investment bankers find ways to put together investors with money, who would like a return on that money, with the people building projects.

Investment bankers play an interesting role in that they’re usually just the money people. The officials from the city or government are in charge of the project, be it building a bridge or building a power plant. But investment bankers are the critical financial players that make sure the project is adequately funded, but at the same time, generates adequate returns to make the investors happy.

This chapter isn’t designed to get into the nitty-gritty yet. The gory details of what investment bankers do comes in later chapters in this book. This chapter is more of a bird’s-eye view that shows you some of the ways investment bankers get involved in key financial transactions. You’ll read examples where investment banking plays a big role in making things happen with companies and investors. Perhaps one of the most high-profile ways investment bankers are seen in modern finance is in mergers and acquisitions (M&A), transactions where big companies decide to buy a rival or another company with advantages it would like to have. You also find out about leveraged buyouts (LBOs), which are unique transactions where buyers use large amounts of borrowed money to buy a company. Another primary driver of investment banking activity are initial public offerings (IPOs), where companies raise money by selling pieces of ownership to the public for the first time. Tying many aspects of investment banking together are the disciplines of research and valuation. Lastly, in this chapter, you get a sense of the importance of trading at many investment banking units, and appreciate the risks and potential rewards.

Putting the For-Sale Sign on Corporate America

Investment bankers are the ultimate corporate matchmakers. They’re like the friends you had when you were single, who were always trying to fix you up. When companies or investors are on the prowl to buy other companies, or put themselves up for sale, they often turn to investment bankers for a hand. We cover the M&A process in more detail in Chapter 3, but for now, know that investment bankers play several important roles in the M&A process, including the following:

  • Performing due-diligence services: Investment bankers can help the buyers and sellers determine a reasonable price for the company. The value is put on the company by comparing with other companies that trade on stock markets or based on the fundamental profitability of the company.
  • Matchmaking services: Investment bankers are only as good as their source list. When a company is looking to do a deal, investment bankers start working their personal relationships trying to find companies that may be in play or open to a bid.
  • Lining up investors: When a company is looking to raise money by selling securities, the deal hinges on being able to actually find buyers for those securities. Investment bankers are often looked to in order to find investors willing to buy the securities.

You discover the wide array of ways investment bankers help put companies on the market in the rest of this section. These deals range from everything including mergers and acquisitions to leveraged buyouts and private business sales.

Mergers and acquisitions

Typically when two people get married, there are two willing adults. From time to time, though, things may feel a little forced — a shotgun and an angry father may be involved.

The same goes when companies get together and combine. Usually, the terms of a deal are fairly straightforward. Typically, a larger company is looking to bolster a part of its business. The company could hire a team of people to build that company from scratch, pairing up researchers to design the product, finance people to price it right and control costs, marketing people to whet the consumers’ appetite, and operations people to get the product. But all that takes time and money. So instead, companies often buy already existing companies, saving themselves a lot of work.

Why companies buy other companies

Making widgets and selling them for a profit is why most companies exist. Microsoft, for instance, is in the business of making and selling computer software and hardware. So why do so many companies during the course of business wind up buying and selling businesses?

There are many reasons why companies may consider using M&A, including the following:

  • Getting big fast: Building a business takes time. There are people to hire, distribution to set up, and products to sell. Sometimes the time it takes to get up and running is too long, and the delay gives the rivals with the first-mover advantage an even bigger lead.

    Example A great example of a merger done for speed was Microsoft’s 2016 purchase of LinkedIn, a professional social media site. Microsoft bought the company for $29 billion. By buying LinkedIn, Microsoft was instantly a player in the online media business with an already established brand name.

  • Filling out a product line: Some companies may have been hugely successful in a narrow product line. But to find growth, which investors are always clamoring for, companies may need to fill in some gaps.

    Example An old but classic example of using M&A to fill in a product-line hole came in 2001. Leading jelly maker J.M. Smucker bought the Jif peanut butter brand (along with Crisco oil) from Procter & Gamble for $813 million in stock. The deal solved a problem for J.M. Smucker — now the company could sell all the ingredients for a tasty peanut-butter-and-jelly sandwich. Talk about synergy. But at the same time, Procter & Gamble also wanted to reduce its holdings in the food business.

  • Geographic expansion: Business is going global, and companies need to have a worldwide presence or risk getting beaten by rivals. M&A deals are a quick way to spread into other countries.

    Example The biggest proposed M&A deal of 2019 (see Table 2-1) was a great example of a company looking to M&A deals for a product expansion push. Pharmaceuticals firm, Bristol-Myers Squibb, made a nearly $100 billion offer for U.S. biotech company Celgene. Bristol-Myers looks to the deal as a way to get a beachhead in the fast-growing cancer-treatment area.

TABLE 2-1 Biggest U.S. Merger Offers of 2019



Transaction Value ($ billions)



Bristol-Myers Squibb


Health Care


United Technologies






Health Care

SunTrust Banks







Communication Services

Source: S&P Global Markets Intelligence

The advantages of building versus buying

Some large companies may decide it’s better to just buy another company to get in the new market quickly. Large companies that buy for this reason are called strategic buyers. Investment banks are often brought in during these typical M&A deals to advise on whether it makes sense or help come up with the money to make it happen.

Sometimes the target — the company being eyed — doesn’t want to be bought. And that’s when deals often turn hostile, where the investors or management of the strategic buyer are hoping to make the deal happen, but the target is resisting. Again, investment banks are often pivotal in hostile M&A deals because the buying of a company that doesn’t want to be bought often requires more brinkmanship and cash.

Pitfalls of ill-conceived mergers

One of the reasons companies engaged in merger activities call in so many investment banks and advisors is that they don’t want to blow it. Mergers are often big bets that cost a great deal of money, either consuming cash or requiring the company to borrow or sell debt. Companies, and their shareholders, don’t want companies to blow it on deals that don’t work out. You can read more about botched M&A deals in Chapter 4.

Leveraged buyouts

Leveraged buyouts are another area where investment bankers can really put their skills to use. LBOs are a form of corporate buyout, but the high-octane version. In an LBO, the acquiring company typically buys the company with a large amount of debt. The acquired company then pays off the debt over time using the cash flow generated by the business.

You can find more details about LBOs in Chapter 5. For now, just know that leveraged buyouts are typically done by specialized firms, called financial sponsors. One of the most common forms of financial sponsors are private-equity firms. These investment firms typically have a host of limited partners, or investors, who provide money to the private-equity firm. The private-equity firm uses the cash from the limited partners, plus a heap of debt, to buy companies, fix them up, and then sell them for a tidy profit. Sometimes, the management of a company, including the CEO, may look to use a leverage buyout to buy the company from investors. These management lead deals are called management buyouts.

Some of the biggest private-equity firms include Bain Capital, Blackstone, Carlyle Group, a unit of Goldman Sachs, Kohlberg Kravis Roberts, and TPG Group. These firms often work alongside investment banks to not only raise money by selling debt, but also conduct the transaction. Investment banks typically get involved in leveraged buyouts later, when the private-equity firms want to exit.

How leverage changes the nature of a deal and a firm

Private-equity firms are looking to own the companies for a relatively short period of time. Debt is a way to drive higher profitability from the company that was bought. By boosting profit, the buyer, the private-equity firm, can sell the acquired company for a big profit later. Here are some ways private-equity firms sell companies:

  • IPOs: One way for private-equity firms to get out of a buyout deal is by selling the company to the public. This is done by carving the company up into shares that are sold to public investors. During raging bull markets, IPOs become a popular way for private-equity firms to exit deals because they can get top dollar.
  • Sales to strategic buyers: If a private-equity firm wants to sell its position in a company, and the stock market is depressed, it may court big companies that may be interested in the deal.
  • Recapitalizations: If a private-equity firm can’t find a buyer for a business, or if the timing isn’t right, it may consider restructuring the makeup of the company’s financing. The company, for instance, may take on an additional investor as a way to reduce the amount of debt.

Why leverage is used

Private-equity firms and investment banking operations have a tight relationship because they’re very mutually beneficial. Private-equity firms are constantly looking to buy and sell firms, which is exactly in the wheelhouse of investment bankers. Meanwhile, because private-equity firms rely on financial events like IPOs to exit positions, investment banks can make money on these deals when they’re opened and closed.

The pros and cons to debt in deal making

Debt can be like dynamite for investment bankers and private-equity firms. When companies borrow, they can invest in new capacity or equipment using other people’s money. The investment can push up profit without asking shareholders to put more money into the business. That’s the upside of debt.

But debt comes with a big downside. The company must pay an interest rate to borrow the money. That interest rate is a cost that must be less than the returns being obtained from the assets bought with the debt. Also, if the interest gets too onerous and the company can’t keep up with the payments, the company may be forced into bankruptcy protection.

Private business sales

Much of what investment banks do is out in the open and public. When a giant company like Microsoft buys LinkedIn, there’s no secret about it. For one thing, LinkedIn was a publicly traded company, meaning the shares are held by the public and free to trade on a public marketplace, called a stock exchange.

But sometimes investment banks work behind the scenes to help sell off or allow private companies to conduct sales. These deals take a bit more massaging because there are no publicly traded securities from which to glean a value of the company. When dealing with publicly traded companies, there’s really no secret in terms of what price tag investors are putting on the firm. The value of a public company is its market value, which is the per-share stock price multiplied by the number of shares outstanding.

But with private companies, there is no objective and dispassionate way to measure the value of the company. The value is, plainly stated, a meeting of minds between what potential buyers are willing to pay and how much the seller is willing to accept.

Appreciating the rationale of private sales

It’s a classic American story. A young entrepreneur invents a technology in a garage or dorm room and knows he or she is onto something big. Some entrepreneurs, like Bill Gates of Microsoft, may stick with the idea and build and expand and create a giant publicly traded company.

Other entrepreneurs, though, know that building a company takes time and a string of not just one-hit products, but several, to fend off competition. Additionally, building a company requires the ability to tap many business skills, ranging from marketing to finance, not just research and development.

For that reason, it’s not uncommon for young fledging companies with a hot technology to simply sell themselves to bigger companies that already have an organization in place to put the technology to use right away. In deals like this, investment bankers are called in to put a price tag on the company and technology being bought.

Example Some of these private company sales can be significant bets. In May 2013, for instance, Internet firm Yahoo! bought a young website called Tumblr for $1 billion. Tumblr, a blogging platform used to share photos and other digital musings, was a private company founded by David Karp, who was a 19-year-old high-school dropout when the company started. Interestingly, Verizon bought Yahoo!, and shortly after, sold Tumblr. Just to show you how companies’ values can change, Tumblr reportedly sold for less than $3 million.

Seeing where private transactions are the best choice

During the Internet boom of the late 1990s, going public was the ultimate goal of many companies. The dream of creating a company, selling the shares to the public and becoming instantly fabulously wealthy was the reason many Internet companies existed.

But some companies actually want to do just the opposite. There are major, short-term pressures associated with being a publicly traded company. The biggest obligation is that public companies must provide the investors a complete rundown of their financial performance during the quarter, disclosures you can read about in Chapter 7. This required disclosure is fine when the company is doing well — kind of like plastering a grade-school paper with an “A” on it on the refrigerator door.

Remember When a company is suffering, though, and needs to make major changes in a painful restructuring, the quarterly reporting can be an exercise in humility. And this is one reason why some companies look to going-private transactions, where investment banks assist in allowing private investors to buy back all of a company’s shares.

One classic example is computer maker Dell. The company had been struggling with slower sales of personal computers. It wanted to go private to give it the time to restructure its business. Dell’s management team offered to take the company private for nearly $25 billion in a bid in early 2013. Going private would allow the company to make the necessary long-term investments (which short-term investors may not like) to make it more competitive in a world where mobile gadgets have become a big threat to traditional desktop computers and laptops. It worked. Dell returned to the public market as Dell Technologies in 2018 as a much stronger company.

Understanding the unique traits of private deals

IPOs may get all the attention. Splashy sales of stock to the public, such as ride-sharing company Uber Technologies in May 2019, grab headlines and investors sometimes line up to buy shares.

But sometimes companies raise money in more subtle and private ways. One example of a way investment banking pairs up companies and investors, away from the prying eyes of the public, is with a private placement. In a private placement, a company can sell stock directly to investors even if there’s no public offering or shares listed on an exchange (a regulated marketplace for securities to be bought or sold). Companies may use private placements because they offer a few advantages:

  • Lighter regulation: IPOs are heavily monitored by regulators. Every risk the company faces must be disclosed along with audited financials, meaning the books have to be studied by an accounting firm. But because private placements are not offered to the public, the securities don’t have to be registered with the Securities and Exchange Commission (SEC). This means the company and investment banks don’t have to jump through all the hoops to get the sale done.
  • Limited to sophisticated investors: Private placements can’t be offered to the general public. Instead, they must be extended only to accredited investors (typically, professional investors like mutual funds or high-net-worth individuals). These investors are the ones who are supposed to know how to research risky investments, or have the wherewithal and understanding to take losses.
  • Lower costs: Because a private placement doesn’t require as much regulatory oversight, the costs of putting out the offering tend to be lower. Fewer lawyers are needed because there are fewer documents to create. And there’s less cost associated with investment banking, because private sales tend to be smaller and don’t require the lining up of a massive group of investors to get the deal done.

Warning Private placements may seem like a dream come true for companies. After all, who wouldn’t like having fewer regulators breathing down his neck? But private placements come with their drawbacks, too. Because these offerings aren’t made to as many investors, companies tend to get lower price tags on their stock than they would if they sold shares to the public. Academic studies show that companies that sell stock in private placements tend to be valued about 30 percent lower than public companies. There’s also a limit to the number of private shareholders a company can have (500) before it must register with the SEC. After a company accumulates more than 500 private investors, which includes employees who get shares of the company, it must file with the SEC. Triggering this rule was a big reason Google (now called Alphabet) conducted an IPO when it did, in 2004.

Initial public offerings

The IPO still remains one of the pinnacles of what a company can achieve in its early life. When a company sells stock to the general public for the first time, it’s a sign that the company has a compelling enough story that it can attract outside investors to buy a piece of the company.

IPOs are a financial transaction that requires the heavy involvement of investment banks. You’ll read more details about these important deals in Chapter 4.

In this section, you find out the basics of IPOs. In a traditional IPO, the investment banking operation gets involved very early. The investment bankers are critical partners in allowing a company to go public.

The lifecycle of a company: When going public makes sense

When a company is young, financing can get pretty dicey. It’s not unheard of for very early investors to pay for equipment and salaries of employees with any money they can get their hands on. Charging up credit cards, hitting up family members for loans, and tapping retirement savings are all ways that an entrepreneur with the burning passion to start a company gets the process started. Starting a company takes a tremendous amount of money.

If the company proves to be successful, the options for raising money, or financing, grows. Prior to going public with an IPO, a growing company may consider a few options to raise money, including the following:

  • Venture capitalists: Venture capitalists are investors who pool money from other investors looking for very high potential returns, and are willing to suffer huge losses in the process. Venture capitalists take the money they gather, usually from large institutions like insurance companies or pension funds, and bet money by buying stakes of young companies that have great prospects. Although many of these bets don’t pan out, if the venture capitalists hit it big with a few of their bets, the returns can be enormous. You don’t need to invest in many Googles (which ultimately sold stock to the public in an immense payday for venture capitalists) to make the gambles worthwhile.

    Remember Although venture capitalists can be a critical place for young companies to raise money, it comes at a steep price if the company pans out. The venture capitalists end up owning a big slice of the company, which reduces the ultimate payout for the entrepreneur.

  • Bank loans: Commercial banks are in the business of lending to companies that need capital. Periodically, a bank may extend a line of credit to a small business, especially if the business is stable. Banks, though, tend to be skittish and won’t lend if there’s even a scent of risk with the company. Internet companies, which have little in the form of assets, for instance may be turned away for bank loans because there isn’t anything to be used as collateral.
  • Crowdfunding: The idea of crowdfunding is very new but likely to become more important. Currently, an entrepreneur with an idea can use websites like Kickstarter ( to explain to the public what her idea is and how much money she needs to make it happen. Consumers interested in making the product come to life are able to pledge a dollar amount on the crowdfunding site. As soon as enough money is raised, the company can use the cash to build the product.

    Remember Crowdfunding is currently only a way for consumers to donate money to new businesses, not invest in them. Typically, these crowdfunding donors are given a token of appreciation for their contributions, usually early dibs on the product after it’s released. Currently, though, companies aren’t allowed to sell stock using crowdfunding. That’s changing though. The 2012 Jobs Act contains a provision that opens the future to the idea of stock-based crowdfunding where companies can sell stock to the public. The SEC is tasked with the job of allowing companies to raise money with crowdfunding, while protecting investors.

    For much more information on crowdfunding, check out Crowdfund Investing For Dummies, by Sherwood Neiss, Jason W. Best, and Zak Cassady-Dorion (Wiley).

There may be options for companies not ready for an IPO to raise money. But at some point, the companies with the best prospects outgrow the venture capitalists, don’t want to pay the onerous terms of bank loans, or need more capital than can be raised casually. When these things happen, it’s time for the company to go public. Going public is a relatively long and costly process that requires preparing statements for regulators and investors, getting the company’s story out, and actually selling the shares.

Tip IPOs tend to be lagging indicators, meaning investors are more willing to take a wager on a newly public company when the broader stock market is doing well. IPOs tend to ebb and flow quite a bit, as Table 2-2 shows.

TABLE 2-2 Number of U.S. IPOs, 2014–2018


Number of U.S. IPOs

Proceeds Raised



$46.9 billion



$35.5 billion



$18.8 billion



$30 billion



$85.3 billion

Source: Renaissance Capital (

The role of the investment banker in IPOs

Investment bankers are involved in the very onset of a company going public, and they’re the keys to making the deal happen. When investment bankers assume the role of selling securities, especially in an IPO, they’re often called the underwriters.

A typical IPO usually follows these steps:

  1. The company produces information about its stock sale.

    The company must give investors an extremely detailed outline of its opportunities, financial results, and risks. This filing is called the prospectus. Investment bankers assist in making sure the company includes all the material information investors need to know about the offering. You’ll learn more about what’s in the prospectus in Chapter 4.

  2. The company takes its story to the streets.

    If companies are going to ask investors to pony up millions of dollars for the company, they’re going to have to convince them to buy. That’s the role of the roadshow. Roadshows are events and meetings investment bankers arrange between companies selling stock and prospective investors.

  3. The investment bankers gather up the investors in the book-building process.

    The traditional IPO is a process shrouded in a bit of secrecy. During the roadshows, investment bankers get an idea of how likely it is for specific investors to buy stock, how many shares, and at what price. The investment bankers record this indicated interest, or general idea of how much buyers want to invest, to gauge how many shares are likely to be bought when the IPO is sold. This process of tallying up how much interest there is in the stock is called book building. The book-building process is critical because it tells the investment banks selling the deal at what price the shares should be sold.

  4. Underwriters price the deal.

    Underwriters typically work late into the night before the stock starts to trade, assembling all the orders of investors. The underwriters look at all the orders for the stock and at what prices investors are interested. The underwriters then find the highest possible price at which all the shares would sell. The IPO is priced, or the initial price charged to these initial investors is set.

  5. Underwriters support the IPO.

    The initial price of the new stock is set by the investment bankers the night before, and all the shares are sold to the initial investors. The initial investors in IPOs are typically the friends and business partners of the underwriting firms. For instance, large institutions that use the investment bank’s other services are often given access to IPOs, as are wealthy individuals that may be clients of the investment banks.

    After the deal is priced, these initial investors are free to sell on the open market, in what’s called aftermarket trading. And it’s during the first day of regular trading when regular investors, customers of brokerages like TD Ameritrade and Charles Schwab of the world, are able to buy the stock.

What matters in an IPO

Underwriters stay involved in the process during this tenuous first day of trading. Investment banks want to do whatever they can to make sure the shares of the newly public company don’t break (close below the initial price). A broken deal is often looked at negatively by investors; plus, a broken deal makes it look like the investment bank didn’t set the initial price correctly.

Investment bankers try to balance the needs and wants of the buyers and sellers. If the price of the IPO zooms upward, the investors who sold their shares may feel like they were shortchanged and missed out on gains. However, if the price drops after the stock starts trading, the buyers may feel cheated and avoid that investment banking firm’s deal in the future. There’s also a risk that if an investment bank prices shares too high, it might need to step in and buy the shares to stop them from falling too much. On the first day of trading of Internet stock Facebook in May 2012, for instance, underwriters had to step up and buy to hold the stock from closing below the $38-per-share offering price.

Lastly, several months after the IPO has been trading, the investment bank’s research unit will initiate coverage on the new stock. A research analyst at the bank will write a report describing the company and the stocks, advising the investment bank’s clients on whether to invest in the new stock. This investment research capability of investment banks is covered in the next section as well as in Chapter 3 in greater detail.

Helping Investors Decide Whether to Buy or Sell

Investment banks make most of their money helping companies and governments raise money by selling securities. But most important, the investment bankers act as middlemen between buyers and sellers. Investment bankers not only help the sellers prepare securities to be sold, but also interact with potential investors. One of the great values offered by investment bankers to their customers selling securities is their ability to find buyers.

The importance of research

Even if there were thousands of companies lined up to sell securities, that wouldn’t necessarily translate into big profits for investment banks. The fees, generated by underwriting securities, only materialize if there are ample buyers to soak up the stock being offered. And that’s the role of the research unit of investment banks. By tasking research analysts with closely following developments in industries or by individual companies, the investment bank can assist investors on deciding whether to buy into securities. Chapter 3 describes this process in more detail, but here you can find out why research is so important.

Sell-side and buy-side analysts

Most large investment banks have entire research divisions that employ armies of research analysts. These research analysts pick apart the prospects of a company and tell investors whether to buy the stock. These analysts are called sell-side analysts because it’s their job to highlight stocks they say are worthy of investment, but they don’t actually invest in the stocks themselves. Sell-side analysts typically are creating research to be used by investors actually doing the buying, called buy-side analysts. These research reports are also often provided to individual investors who are clients of the firm for free, or sometimes made available through discount brokerage firms or for purchase.

Buy-side analysts are the ones who will be actually plunking down cash if they decide to purchase a security. These analysts consider the demands of the investors who have given them money to invest, be it mutual fund investors or pensioners with money in the pension plan. Buy-side analysts typically work for large mutual funds, which have pooled money from smaller investors to build a diversified portfolio. Buy-side analysts rely primarily on their own in-house research, which is not typically available to individual investors. Buy-side analysts, though, also use sell-side research to bolster their own insights about potential investments.

How an analyst’s research can make money for investors

Investment bankers, looking to sell shares of a security they’re pitching for a client raising money, will often seek out buy-side analysts to stoke demand. The buy-side analysts are the ones who decide whether the risk of a particular investment is worthwhile given the potential returns. There are massive potential conflicts of interest here, because there’s the danger that the buy-side analysts at an investment bank may issue positive reports on IPOs sold by that investment bank. For that reason, sell-side analysts at investment banks that did an IPO must wait 40 days before issuing a research report on that company.

What do the analysts do?

Sell-side analysts are billed as industry experts who follow companies closely and provide insights. These professionals typically build financial models that tell them how much a stock is worth and what investors should be willing to pay. These financial models aren’t made with plastic parts and model glue; instead, they’re made from spreadsheets and quantitative analysis.

What recommendations are and why they are important

Typically, sell-side analysts provide a recommendation on a stock, on whether investors should buy, sell, or hold the shares. Most sell-side analysts also put a price target on the shares, putting their best guess on what the shares may be worth a year from now. Some sell-side analysts also do channel checks from time to time. In channel checks, the analysts find out how much demand for products there is by examining orders from end-users and customers.

How the sell side interacts with the buy side

Sell-side analysts are also often given the role of providing buy-side analysts access to the management teams of a company. Most large investment banks put on conferences or presentations that allow potential investors to hear CEOs of companies talk about the prospects of their firms.

How sell-side analysts make money for the investment bank

Research continues to be one area in which making money can be somewhat problematic. With the money-raising functions of investment baking, the ways investment banks generate fees is pretty straightforward. A company pays the investment bank a charge for handling an IPO, for instance.

Getting paid for research is a bit more elusive, though. There are some instances where buy-side investors pay an investment bank to access the research from its sell-side research team. But more often than not, research is paid for in less direct methods.

One of the most common ways that investment banking operations are paid for research is through trading commissions. Sell-side analysts try to pitch investment ideas to buy-side analysts. Instead of paying for the research reports, the buy-side analysts may instead place trades for the investment through the investment bank’s trading desk. By trading through the investment bank’s trading desk, the buy-side analyst’s firm pays a trading commission, which acts as payment for the research services.

Digging Into the Role of the Trading Desk

Traders sitting in their living rooms in their pajamas may be the image conjured by the term active trader. But it turns out, a vast majority of the millions of orders to buy and sell stocks and bonds each day don’t come from the keyboards of ambitious day traders, but the massive trading operations of the world’s largest investment banking operations.

Most major investment banks maintain trading desks. These trading desks are responsible for buying and selling securities. The trading operations of investment banks are typically involved in buying and selling everything from stock to bonds, futures contracts (contracts that allow buyers to take delivery of an asset at a certain time in the future at a preset price), commodities (claims on real assets ranging from energy to agricultural products), and foreign exchange contracts.

Remember The trading desk of an investment bank often sits at the epicenter of its operations. On one hand, the investment bank is tasked with selling securities to help raise money for clients; on the other hand, it’s in charge of helping to find buyers. The buyers and sellers often intersect at the trading operations.

Why investment banks are into trading

Investment banks’ trading operations are designed to serve several purposes. At the source, the trading operations are made to handle the demands of customers of the firm who need to purchase or unload large amounts of stock or other investments.

The trading desks of investment banks can assist customers, including pension plans and mutual funds, to build large positions in a financial asset or unload it.

Many investment banks get involved in trading to generate money from a variety of sources, including the following:

  • Trading financing: Many investment banking operations lend lines of credit to other financial institutions, usually on a short-term basis. These loans can be used by the investment bank’s clients who want to place trades.
  • Trade facilitation: Companies that use big investment banks usually aren’t buying or selling 100 shares of a stock. Hundreds of thousands of shares may be bought or sold by these mega players. There are so many moving parts that having an investment bank can help in the transactions, including offering insurance services where a client can be protected if there’s an unforeseen drop in portfolio values. Investment banking operations often serve the role of market maker (a position where they buy and sell securities). As a market maker, investment banks stand ready to buy or sell lots of stock just to make sure there’s adequate trading in a security.
  • Creating securities to be traded: Investment banks are routinely cooking up new securities, typically those that have value based on other investment like stocks, for investors to trade. These invented securities are called derivatives, because they derive their value based on another asset.

How investment banks turn pennies into billions

Next time you log onto your online brokerage account to buy a stock, don’t think there’s a human on the other end selling to you. More likely than not, you’re buying the stock from a computer that trades in and out of stocks millions of times a day.

Wall Street has been taken over by an army of computers that buy and sell stocks as easily as you may shoot down aliens in a video game. Some sources estimate that 70 percent or more of the trading on the major stock market exchanges is being done by computer programs. These programs, often referred to as algorithmic trading, program trading, or automated trading, are a big area of interest for many investment banking operations.

Computerized trading can be used for a number of reasons, including the following:

  • Serving needs of clients: Sometimes computers are employed to serve the customers of investment banks, helping them sell large positions of stock. Selling for big customers takes a bit of finesse — if all the stock is dumped at one time, the stock price can be pushed lower and cause the seller to reduce his or her own proceeds. Investment bankers have systems in place to help them sell more gradually to avoid these problems.
  • Part of market-making responsibilities: Computerized trading may also be part of investment banks’ role as market makers. Investment banks certainly trade to try to make a profit, looking for chances to buy and sell stocks for a gain. But in some cases investment banks can also serve a secondary role. When making a market, investment banks aren’t necessarily trading to make a profit (although they probably don’t complain when they do). They’re the buyer of last resort, standing on the market looking to buy and sell when there are people looking to sell and buy. They’re providing liquidity.

The type of analysis used in trading operations

Many large investors that work with investment banks aren’t very transparent about the trading they’re doing — and that’s no mistake. One of the greatest downsides of trading is that when other investors get wind of the strategy and start to copy it, the strategy doesn’t work anymore.

Imagine that an investment bank’s client figured out that stocks tend to soar on the first trading day of January. Talk about an easy way to make money. The client would simply buy stocks on December 31 and sell them on January 1, or whatever the first day of trading is. But if the secret got out, other traders would buy stocks on December 31, too, which would spoil it for everyone. Why? The stock prices would be pushed up on December 31, essentially eliminating the January 1 pop.

Due to the value of keeping trading secrets quiet, you don’t often hear what investment bankers’ clients have been doing until the strategy blows up on them. But investors can see that typically trading strategies fall into several categories, including

  • Cross-market arbitrage: Arbitrage is a fancy word used to describe a situation when assets are temporarily mispriced relative to each other. These cross-market arbitrage strategies can get pretty complicated, because computers are programmed to find unexplained relative differences in price between stocks, bonds, exchange rates, and currency prices. The computers can locate mispriced assets and theoretically make risk-free trades.
  • Event arbitrage: Some trading operations try to anticipate and place bets ahead of major market-moving events. Events that may move stocks include a company being included in the popular Standard & Poor’s 500 stock market index, which is usually a boon for the stock. Another example may be a company being ripe to be bought or a small biotech firm getting approval to market a new blockbuster drug.
  • High-frequency technical trading: Another area of trading that some investment firms are turning to is a type of high-frequency trading where they take advantage of different trading speeds. It’s becoming increasingly common for large trading operations to develop light-speed networks that will let them place that buy or sell order just a millisecond or less before competitors, giving them an edge.

Remember High-frequency technical trading is attracting attention from regulators. There’s a concern that some investment bankers are taking advantage of the trading systems to get an unfair advantage.

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