Investment banks are middlemen between those with money and those with ideas who need funding.
Interested in an investment banking career but unsure what the sector actually does? We’ve put together an introduction to this often misunderstood area of work.
How do investment banks differ from retail and commercial banks?
Retail banks accept deposits of money and lend it out to borrowers; commercial banks do the same but their depositors are businesses rather than individuals. Investment banks don’t take deposits. Instead, one of their main activities is raising money by selling ‘securities’ (such as shares or bonds) to investors, including high net-worth individuals and organisations such as pension funds.
The proceeds from these sales help companies, government entities or entrepreneurs to finance big projects that require a lot of upfront cash, such as research and development or an expansion into a new region or market. Investment banks’ clients tend to be larger or more sophisticated organisations with more complex funding needs, compared to clients of commercial banks.
In short, investment banks are middlemen between those with money and those with ideas who need funding. They give money a productive purpose by channelling it into projects.
What do investment bankers do?
Investment banks provide a range of services, which varies from one organisation to another. Helping clients raise money by finding investors is one of an investment bank’s main activities, but they also have a separate function of giving impartial financial advice to organisations – both of these will be explained in more detail below.
Other services typically offered by investment banks include:
- research to assist investors in deciding which securities to buy
- developing new types of securities
- brokerage – helping clients to trade with each other
- private equity – investing the bank’s own money in projects rather than finding investors
Some investment banks are part of a large retail or commercial bank (Barclays is one example) and some provide separate services such as asset management alongside their investment banking divisions.
The middleman between investors and organisations
When a bank’s client needs some extra cash, one way the bank might help is by making a loan or bond to be repaid with interest – this is called debt financing. It works in the same way as a retail bank offering you a mortgage to buy a house. The bank takes into account how much financing the client needs and for what purpose, as well as their credit history and current market conditions. This information helps the bank to work out how much investors would be willing to invest. Investors benefit by receiving interest payments from the loan or bond, and the receiving organisation benefits from a lump sum that it can pay back gradually afterwards.
Investment banks also provide equity financing, which is when they find investors to invest directly in the company by becoming shareholders. Shareholders are part-owners of the organisation and receive a proportion of the profits, while the company receives a financial contribution that it doesn’t need to pay back.
In order to advise its clients, an investment bank needs to have a good sense of whether a company would be attractive to investors and whether the terms of a loan, bond or equity offering would appeal to them. Banks make money by charging a fee for their services.
Investment banks also give advice to organisations, charging fees for these services. One issue they advise on is mergers and acquisitions (M&As). M&A activities include when:
- a company is looking to acquire or merge with another one (for example, it might not have a strong presence in a certain geographical area and decide it would be best to acquire an existing company in that country to expand quickly as well as gaining funds and complementary knowledge)
- a company is looking to divest itself of a subsidiary organisation
- an owner is looking to sell their business
An investment bank would help the organisation decide how to approach the other company, how to structure the transaction, what would be a fair price to pay and how to finance the acquisition.
Initial public offerings (IPOs) are another example of investment banks’ financial advisory role. Essentially, an IPO allows a business to be listed on a stock exchange, giving private individuals and organisations the ability to buy and sell shares easily (online, for example). To buy shares in a privately held company that has not done an IPO, investors need to contact it directly to agree on the price. Being listed on public markets enables a company to grow more quickly. Investment bankers help a company to get itself listed, which would include everything from internal preparations to marketing materials for research analysts and investors to analyse.
How does investment banking affect society?
Most ordinary people are unlikely to have had any direct contact with an investment bank – unlike other financial areas of work such as retail banking or insurance. However, investment banks indirectly affect most aspects of our lives because they advise and work on behalf of many different entities in society.
Their clients include companies, government entities, funds (including pensions), entrepreneurs and families that run a business – all of which have a big impact on our lives. Investment banking clients provide us with goods and services such as clothes, internet and transport, and may also employ us or people we know. Banks also work closely with investors including pension funds, whose performance will affect the value of our pensions. So the role of investment banks in society is to provide good advice and services to organisations that affect everyone’s lives, enabling them to grow and thrive.
With thanks to Antonia Riera, a vice president at Goldman Sachs, for her help with this article.