Investment bank divisions
Mergers and acquisitions (M&A)
INTRODUCTION
An investment bank is a financial institution that provides services to governments and corporations. Unlike commercial and retail banks, it does not transact with individuals or take deposits. It assists its clients in raising funds through underwriting or issuance of securities (debt obligations, equities, stocks or derivative instruments). It can offer assistance to companies in the process of mergers and acquisitions and further services in trading fixed income instruments, equity securities, foreign exchange, commodity and derivatives. Most investment banks are comprised of multiple divisions, including:
- Mergers and acquisitions
- Capital markets
- Securitisation
- Sales and trading.
MERGERS AND ACQUISITIONS (M&A)
The mergers and acquisitions division devises and executes innovative, customised solutions in domestic and international transactions including, but not limited to: acquisitions, divestitures, mergers, corporate restructurings and recapitalisations.
The terminology explained
Acquisition is a term used to describe a takeover of another company or institution. In the UK, this only applies to public companies; whilst in the USA both public and private companies can either be takeover targets or initiators. Takeover can be friendly, where the board of directors of the target company agrees to the acquisition and recommends it to the shareholders; or hostile, when the initiator uses various strategies to bypass the target company’s management, unwilling to agree on the proposed terms. In either case, the acquisition involves the purchase of target company shares, requiring substantial funding. The required capital can be raised through bond issuance, or more commonly though a bank loan. Acquisitions financed through debt are known as leveraged buyouts. The role of the investment bank M&A department is the assistance in raising and structuring acquisition finance, management of the acquisition process (structuring of debt and repayment schedule) and advice on alternative financing strategies.
Divesture (or divestment) is a term opposite from investment or consolidation. It refers to the reduction in company size, typically through a sale of subsidiary or a part of the business. The motivation can be either financial (raising funds, creating increased company value through the break-up into component parts etc.) or strategic (achieving greater stability by eliminating a risky or loss-making part of the business or by reducing the diversity of services by concentrating on the core business). Whatever the reasons behind the divesture, investment banks act as advisors and agents in structuring, finance management and investment of acquired funds.
Merger is the term often used as a synonym for acquisition, even though it has a somewhat different meaning. Whilst acquisition (friendly or hostile) implies that the target company is acquired by the initiator, and thus legally ceases to exist, merger is typically seen as a partnership of equals choosing to become a single company for a mutual benefit. Mergers involve complex valuation of both businesses (their assets, historical and projected earnings etc.), thus investment banks offer valuable service in raising finance, debt structuring, business valuation and a wide range of ancillary issues associated with the merger process.
Corporate restructuring is the process of redesigning the company structure. The motivation is either strategic or financial. Strategic restructuring is typically initiated when the company outgrows its original size, such that its operational structure can no longer be effectively maintained. Restructuring provides the opportunity for greater profitability, a move in a new direction or simply more efficient management. Financial restructuring is typically driven by financial difficulties within the company, the sector, or the economy as a whole. It is done through reduction in personnel, product lines, merger of departments or other cost-cutting measures. Investment banks provide financial and strategic advice before, during and after the restructuring process, helping the corporation achieve its goals more efficiently and successfully.
Recapitalisation is the process of restructuring company’s debt-to-equity ratio, motivated by the need for stabilising its capital structure and improving liquidity. It can also be implemented in order to minimise taxes or as a defence strategy against a hostile takeover. In essence, recapitalisation is the exchange of one type of financing for another, such as replacing bonds with company shares or vice versa. Investment banks act as advisors and agents in providing bond issuance, share valuation and other financial aspects of recapitalisation.
The role of the M&A division
The first stage in any M&A project is securing the actual client. There is fierce competition within the investment banking industry, offering the clients a choice of who to transact with. Hence, for any potential new project, the M&A team typically produces a ‘pitch book’ containing a list of all services the client can expect the bank to provide. The client will ultimately choose the bank with the best reputation, providing the highest level of service at the most competitive prices (in terms of fees and debt structuring).
Once the client is secured, the services that the M&A department provides are typically carried out in two main stages: proposal pitching, marketing and origination; and deal execution.
The first stage in any project is proposal pitching, client marketing and deal origination. Here the M&A team meets the client, suggests strategies, and performs industry overviews and competitor analysis in order to identify the issues affecting the company. Regardless of the type of deal involved, the bank acts on behalf of the client who is either on a buy or a sell side.
Mergers and acquisitions clearly involve two parties – the originator and the target. The banks can be approached by either, in two different scenarios: either the client has already identified the counterparty for the transaction, or the bank is expected to find a suitable counterparty.
If the client is on the sell side, i.e. wishes to merge or sell off its assets to another company, the role of the M&A team is finding a suitable company to acquire the client. Firstly, the initial research and analysis of the client company’s assets is performed, resulting in objective valuation and, ultimately, the suggested price. All the relevant information is collated in a proposal (pitch) document that will be sent to a potential (or targeted) counterparty. Even if the counterparty is already known, typically several other potential contenders may be identified in order to make the sale more competitive. A similar approach is taken when the bank is entrusted with finding the suitable counterparty, but it is extended to a broader range of companies. This is followed by marketing the client, making the proposal attractive to the potential suitors. The client matching process can be very lengthy and require time and effort in producing documentation, analysis and answering queries. Once both parties are willing to transact, the deal origination can proceed. This involves drafting the initial documentation, performing more detailed analysis on both parties and proposing strategies for the deal execution.
A similar procedure is followed when the client is on the buy side of a merger or acquisition process. If the client is simply buying (acquiring) another company, the bank is either entrusted with finding a suitable target – according to specified criteria – or, if the target is already identified by the client, the role of the M&A team at this stage is ensuring that the target company is willing to participate in the deal. The pitching process is followed by the marketing, and finally the deal origination.
In the merger process – which typically assumes voluntary participation of two entities in a future partnership of equals – the client matching process also involves research and analysis of client company’s assets, resulting in valuation. This is crucial in securing a suitable partner, as it will impact the financial aspects of the deal as well as the structure of the future joint company. Again, the pitching and marketing process are followed by the preliminary proposals, i.e. deal origination.
Other transactions (divestures, restructurings and recapitalisations), even though they are primarily concerned with only the client company, often involve selling parts of the existing business or acquisitions of new ventures. Hence the procedures described above would still be incorporated.
The second stage of a typical M&A project is the execution of the transaction itself. Essentially this is a major project in which the M&A division works closely with the legal and finance departments in order to negotiate the specifics of the deal. This includes, but is not limited to: structuring the new entity that results from the transaction, management of financial transactions on behalf of the client and providing the debt finance – if required. Debt structuring is often the key aspect of the transaction and typically involves other investment bank divisions.
In order to achieve the best possible outcome for the client, the M&A team works with a wide range of colleagues in different areas throughout the entire process.
CAPITAL MARKETS (CM)
The capital markets division offers services to clients wishing to raise capital through: initial public offerings (IPOs), debt structuring or leveraged buyouts. They originate, structure and execute public and private placement of a variety of securities: equities, investment-grade and non-investment-grade debt and related products. They offer market solutions that enable clients to mitigate strategic, operational, credit and market risks.
The terminology explained
Initial public offering (IPO), also known as ‘flotation’, refers to the issuance of company stock or shares for the first time. It is typically used by new companies as means for raising capital; however, it is not uncommon for old and successful privately owned companies, looking for additional funds or opportunity for public trading, to ‘go public’. As the successful IPO depends on many factors, including timing of issuance, share price or type of shares (preferred vs. common), the assistance of an underwriter is of great value. Most investment banks provide underwriting services, meaning – in this context – that they provide detailed asset valuation in order to advise on the appropriate share price under the IPO. They also assist the ‘floated’ company in share issuance and provide a full range of related banking services.
Debt structuring is the process of customising debt to suit the borrower’s needs. Its main purpose is lowering the debt burden, either by reducing the repayment amount or deferring the repayment. Structured debt can have many components, spanning across different financial instruments and/or markets. Hence it is the job of investment banks to provide advice and debt management services to their customers. The capital markets division is responsible for meeting client’s bespoke requirements either through the existing product range or through innovative structures, often involving exotic and hybrid products.
Leveraged buyout occurs in acquisitions/takeovers (described earlier) funded mainly through borrowing (leverage). The capital markets division provides debt structuring services within the leveraging process.
The role of the capital markets division
In most investment banks the capital markets division is further sub-divided into three main departments: equity capital markets, fixed income capital markets, and leveraged and acquisition finance. Their key roles and responsibilities are very different, with some areas that not only overlap within the division but also transcend into another part of the business.
The key responsibility of the equity capital markets department is raising finance on behalf of the client in the equity market, through IPOs or issuance of new shares of existing public company. The department is involved in each stage of the process, from deal origination to final execution of transactions. The key aspect of the origination is valuation of the company’s assets and, using complex financial models, calculation of an accurate share price. The execution involves managing the equity issue process and all financial services related to, and resulting from, this transaction.
The fixed income capital markets department provides clients with strategies for raising capital in the fixed income market (typically through bond issuance). It provides the company valuation, thus suggesting the best financing options and terms the company can achieve. It further offers valuable updates on market news and trends and how these affect the client’s access to the debt capital markets. Other responsibilities include weekly market updates, working with trading and syndication departments on interest rate forecasts, product management and assisting in deal execution.
The leveraged and acquisition finance department works closely with the M&A division in the final stages of deal execution, when debt financing is required. It provides clients with financing alternatives in the context of debt and/or loan financing, leveraged buyouts and acquisition financing. As a part of the service, it builds complex financial models – working closely with M&A specialists – to develop projections, valuation and merger analysis in relation to valuation of capital structure alternatives.
SECURITISATION
Securitisation is a process of aggregation of debt instruments in a pool and their reissuance in the form of a new security to be traded separately. Thus, the securitisation division provides services in structuring, underwriting and trading collateralised securities: asset-backed, residential mortgage-backed, commercial-backed and collateralised debt obligation securities.
The terminology explained
Asset-backed security is a security whose value and financial proceeds are derived from and are backed by a pool of underlying assets (mortgage payments, credit card loans, student loans etc.). These assets are typically illiquid and cannot be traded separately. Through securitisation, they are grouped and structured into products suitable for sale to general investors, diversifying the risk in the process. The securitisation division is responsible for aggregation of underlying assets, their structuring into new products and their successful issuance in the market.
Mortgage-backed security is a type of asset-backed security, where the underlying assets are residential mortgages. Due to the large number of home loans, the market in mortgage-backed securities is expanding. The job of the securitisation division is to create bespoke and innovative structures that can be successfully sold to investors.
Commercial-backed security, akin to the above, is an asset-backed security collateralised by a pool of commercial mortgage repayments. It is perceived to carry less risk to the investor, as commercial mortgages are often subject to lockout clauses that provide some protection against default. The role of the investment bank is very much the same as for other types of asset-backed securities.
Collateralised debt obligation (CDO) is a type of asset-backed security that derives value and income from a pool of fixed income underlying assets (bank loans, corporate bonds, insurance payments etc.). They are often split into seniority tranches, whereby the most senior class takes priority in coupon and principal repayment over others, thus carrying least default risk. The securitisation division is responsible for structuring CDOs, assessing tranche repayment schedules, associated default risks and evaluation of required risk premiums that investors would be willing to accept on lower-grade tranches.
The role of the securitisation division
The key role of the previously capitalised (securitisation) division is in structuring, underwriting and trading collateralised securities.
Structuring involves segmentation of cashflows and risks underpinning the collateralised transaction. Since the size of original investments (mortgages, bank loans, insurance payment etc.) involved in securitisation is either too large or too small, often involving complex risk components, they are structured into a form that is more desirable to the investors. This initially involves careful analysis of underlying cashflows, market and credit risks, followed by the creation of tranches and prepayment schedules. Each tranche thus carries a different level of risk and associated investment potential to an investor. The securitisation division works on behalf of the client, aiming to ensure the best possible outcome, whilst providing an investment-grade product that would be attractive to investors.
Underwriting involves assessment of the underlying securities’ creditworthiness, repayment ability and collateral valuation. Since collateralised securities are essentially packages of a large number of smaller underlying assets, this assessment is a very complex process. The securitisation department has to establish the likelihood of default on each asset class; and in the event of default, how much of the original value can be recovered. This involves complex mathematical models that predict – based on historical data, credit ratings, market trends and a host of other variables – the most likely payment schedule. Furthermore, in order for the repackaged securities to be transformed into an investment-grade product, the investment bank ‘underwrites’ the risks associated with the underlying securities, making them more attractive to investors.
Trading of collateralised instruments falls under the remit of the sales and trading division (described next). However, pricing and trading strategies are the responsibility of the securitisation department, as it has the necessary expertise in this product class. It is further entrusted with monitoring credit rating changes, regular evaluation of default probabilities, monitoring prepayment schedules etc.
SALES AND TRADING
Sales and trading on behalf of the bank and its clients is the primary function of a large investment bank. With an increasing number of OTC derivatives products, it is the fastest growing division. In market making, traders enter into transactions to maximise profits. Banks also undertake risk through proprietary trading. Typically the sales and trading division is split according to the product classes that are the subject of this book: money markets, capital markets, interest rate derivatives, credit derivatives, commodity derivatives etc.
The sales and trading division actively pursues clients and executes their orders. This can be done by offering an existing range of products or through tailor-made structures specifically created to meet a client’s needs. More details on sales and trading are provided in the following chapter.