What Is Investment Banking? What Investment Bankers Do

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Investment banking is the part of the financial industry that helps corporations, governments and other institutions raise capital and carry out large, complex transactions. An investment bank underwrites new stocks and bonds, advises on mergers, acquisitions and restructurings, and trades securities for institutional and private clients. Its customers are issuers and investors, not households opening checking accounts. Most of its income comes from fees and trading rather than from lending deposits.

How Investment Banking Works

An investment bank sits between parties who need capital and parties who supply it. It also sits between buyers and sellers of whole companies. Its work falls into a few core functions.

Capital raising (underwriting). When a company, government or agency wants to raise money by selling securities, the bank structures the offering, helps set the price, prepares the regulatory documents and sells the securities to investors. Equity capital markets (ECM) teams handle stock offerings such as IPOs and follow-on offerings. Debt capital markets (DCM) teams handle bond issues for corporations and public entities.

Mergers and acquisitions (M&A) advisory. Bankers advise companies on buying, selling or combining businesses. On the sell side, they value the company, find and approach buyers, run the sale process and negotiate terms. On the buy side, they help a client identify targets, decide what to pay and structure the deal as cash, stock, debt or a mix. Valuation work often relies on methods such as discounted cash flow (DCF) analysis and comparisons based on enterprise value.

Restructuring. When a company is under financial stress, investment bankers advise on reorganizing its debt, selling assets or recapitalizing the business.

Sales and trading. Many investment banks buy and sell securities for institutional and private investors. They act as broker (executing trades for clients) and as dealer or market maker (trading from their own inventory). This desk also helps distribute the new securities the bank underwrites.

Research. Analysts at many banks publish research on companies, industries and markets for the bank’s investor clients.

Large investment banking operations are often units or affiliates of bigger financial groups, such as Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Deutsche Bank. Smaller “boutique” firms focus on advisory work, often in a single sector or deal type, without large lending or trading operations.

Interpreting investment banking

The common thread is risk and information. A company might do an IPO once and a major acquisition a few times in its life. A bank works on such deals constantly and knows how investors are pricing similar securities, which buyers are active and what regulators require. Clients pay for that knowledge, for the bank’s ability to place securities and, in some deals, for its willingness to take on pricing risk.

Regulation: Past and Present

Before the 1929 stock market crash, U.S. banks could take retail deposits and also underwrite and invest in securities. Some took large speculative positions that put depositors’ money at risk. When the market crashed and depositors rushed to withdraw funds, banks that could not pay them back failed.

Congress responded with the Banking Act of 1933, known as the Glass-Steagall Act. It separated commercial banking (taking deposits and making loans) from investment banking (underwriting and dealing in securities). For decades, firms generally had to choose one side.

Critics considered the separation too restrictive. The Gramm-Leach-Bliley Act of 1999 repealed the provisions that kept the two businesses apart. Since then, most major U.S. banks have run commercial and investment banking under one corporate group. Investment banking activity remains regulated. Securities offerings must comply with SEC rules, and exchanges set their own listing requirements for companies that want to go public.

The Investment Bank’s Role in an IPO

An initial public offering is the first sale of a private company’s shares to the public, after which the shares trade on an exchange. The company must meet SEC requirements and the listing standards of the exchange it chooses.

Companies hire investment banks as underwriters. The underwriters take part in every stage of the offering:

1. Due diligence on the company’s business, finances and risks
2. Preparing and filing the registration documents
3. Marketing the offering to investors
4. Setting the offer price and allocating shares
5. Issuing and distributing the shares

Underwriting can be arranged in different ways. In a firm-commitment underwriting, the bank buys the shares from the company at an agreed price and resells them to investors. The company receives its money even if investor demand turns out weak. The bank aims to profit from the difference between what it pays and what it sells for. In a best-efforts arrangement, the bank agrees only to try to sell the securities and does not guarantee the amount raised.

Large offerings are usually split among several banks in an underwriting syndicate, led by one or more lead underwriters. Each bank earns a smaller share of the profit, but each also carries less of the risk if the deal goes badly.

Example of Investment Banking: A Firm-Commitment IPO

Hypothetical example. Figures are for illustration only and ignore fees, expenses and legal costs.

Harbor Tools Inc., a private manufacturer, wants to go public. A single investment bank agrees to buy 2,000,000 shares at $18 per share, a price its analysts set after reviewing the company and comparable businesses. The bank pays Harbor Tools $36,000,000 and plans to resell the shares at $20.

Scenario A: demand is reasonable. The bank sells 1,200,000 shares at $20. To clear the remaining 800,000 shares, it cuts the price to $17.

• 1,200,000 × $20 = $24,000,000
• 800,000 × $17 = $13,600,000
• Total proceeds: $37,600,000
• Bank’s gain: $37,600,000 − $36,000,000 = $1,600,000

Scenario B: demand is weak. The bank sells only 500,000 shares at $20 and has to sell the other 1,500,000 at $17.

• 500,000 × $20 = $10,000,000
• 1,500,000 × $17 = $25,500,000
• Total proceeds: $35,500,000
• Bank’s result: $35,500,000 − $36,000,000 = −$500,000

In both scenarios, Harbor Tools receives the same $36,000,000. The bank carried the pricing risk, and in Scenario B it overvalued the shares. Competition makes this risk sharper. Banks bidding for a mandate may offer the issuer a higher purchase price, which leaves less room for error. If three banks had formed a syndicate and split the shares equally, each would have faced one third of the Scenario B loss, about $166,667, and earned one third of any gain.

What Investment Bankers Do

Investment bankers are the people who carry out this work. Part of the value they provide is spotting risks before the client commits, which can save the client time and money.

Day to day, that work includes:

• Building financial models and valuations, often using measures such as the weighted average cost of capital (WACC)
• Preparing pitch materials, offering documents and presentations for clients and investors
• Running due diligence and coordinating lawyers, accountants and regulators
• Contacting potential buyers, sellers or investors and negotiating terms
• Advising on timing based on current market conditions

Junior bankers do much of the modeling and document work. Senior bankers manage client relationships, bring in new mandates and lead negotiations. In a merger, even one described as a “merger of equals,” each side commonly hires its own advisers so that someone is looking after its shareholders’ interests.

Why Investment Banking Matters

Investment banks are one of the main channels through which savings reach companies and governments. An underwritten offering reaches pension funds, insurers and mutual funds far more efficiently than approaching investors one by one. Advisory work helps businesses change hands, combine or reorganize, and trading desks support liquidity in the securities the banks help create.

Limitations and Risks

• Pricing risk. As the example shows, a firm-commitment underwriter can lose money if it misjudges demand.
• Conflicts of interest. A bank may advise a company, underwrite its securities, publish research on it and trade its stock at the same time. These roles do not always point in the same direction. Firms use internal separation between departments to manage this.
• Cost. Advisory and underwriting fees add to the cost of raising capital or completing a deal.
• Market dependence. Deal activity rises and falls with market conditions. In weak markets, IPOs and acquisitions can be postponed or canceled.

Investment Banking vs. Related Terms

Commercial banking. Commercial banks take deposits and make loans to individuals and businesses. Investment banks underwrite securities and advise on transactions. Since 1999, U.S. banks may run both under one group, but the activities remain different.

Investment management. Asset managers invest money on behalf of clients. Investment banks mainly help clients issue securities and complete deals. The name is misleading: investment bankers are not primarily investors.

Venture capital and private equity. VC and PE firms invest their own funds in companies, including startups. An investment bank may advise a startup on raising money or on a sale, but providing that capital is not its core role.

Corporate finance. Corporate finance covers how any company manages its capital, investment decisions and funding. Investment banking is the outside advisory and capital-markets service that companies use for the largest of those decisions.

The Bottom Line

Investment banking matters most to companies, governments and institutions planning large transactions such as an IPO, a bond issue or an acquisition. These clients pay fees for the bank's market knowledge, its reach to investors and, in firm-commitment deals, its willingness to absorb pricing risk. Those fees add to the cost of the deal, and conflicts of interest can arise when one bank advises, underwrites, researches and trades the same company.