Investment Banking For Dummies
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Investment banking has a big impact on the world you live in, whether you have investments or not, and understanding what investment bankers do is important. Part of investment banking has to do with mergers and acquisitions, like why companies buy other companies and what’s in it for them. Even people who aren’t big on investing sometimes get the urge to be part of an initial public offering, more commonly known as an IPO. If visions of yachts and Bentleys are dancing in your head, we’ll disabuse you of those dreams, while letting you know what it really means to get in on an IPO.

illustration of investment banking © g0d4ather/

What investment bankers do

To most people, investment banking is a big mystery — they know it’s important, but they aren’t really sure why. On the other hand, there’s no mystery about what traditional banking is. Just about anyone with a savings account has, at some point, walked into a bank and looked around. But investment banking is an entirely different matter.

It’s easy to write off investment banking as something a bunch of people in suits can worry about, but that’s a mistake. Increasingly, more Americans are being handed the keys to managing their financial futures. It’s up to consumers to find ways not just to save their money but to invest in assets that will grow in the future. And more times than not, this process requires interfacing with investment bankers and their products.

Given how important investment banking is to how Americans save and invest, it’s critical to understand what investment bankers do and the role they play. Traditional banks are easy to understand. They take in deposits from consumers and businesses, and then lend out the money to companies or consumers. But the duties of investment banks are quite different. Instead of taking deposits, investment banks sell securities. The proceeds from selling these securities, in some cases, then go to finance usually massive projects that might be too risky for traditional banks. Projects investment banks take on often fall into one of several categories, including the following:

  • Financing large projects: Massive projects, such as building giant bridges or power plants, usually require enormous amounts of cash up front. These projects may ultimately make money, but they require loads of cash to be built. The need for upfront cash is so great, it may outstrip the lending capacity of traditional banks, or it may be too risky for traditional banks. That’s where investment banks can come in. Investment banks gather cash by selling securities to investors with excess money looking for a chance at a good return.

  • Selling companies: It takes money to make money, an adage well known by most entrepreneurs. Many successful companies start off being bankrolled by the owners’ credit cards or savings, but at some point, that’s not enough. Entrepreneurs may turn to banks for loans, but those deals can be hard to get or carry high costs. The answer for many companies looking to expand is an initial public offering (IPO). In an IPO, the company sells itself to the public. The investment bankers are critical to this service, lining up investors and finding companies eager to sell securities to the public.

  • Conduct mergers and acquisitions: There’s usually a point in time when companies start looking over their shoulders for opportunities. A promising startup with interesting technology may fit nicely with another company’s products. Instead of pouring the money into developing a similar technology, which can be costly and risky, a company may ask its investment bankers to help it buy the company outright.

  • Offering asset management and brokerage services: Investment banks are in the money business. One of the things they do is collect money from clients — and help those clients put the money to work in a way to generate returns. Helping clients manage their money, either by selecting individual stocks or by putting them into a mutual fund, is part of investment bankers’ services.

Why do companies buy other companies?

Whenever you buy stock in a company, more likely than not, you’re buying a sliver of that company. But for some investors, a small sliver isn’t enough.

Companies are constantly scanning the corporate landscape for other firms that may be for sale, or may own assets that are worth buying. Buying companies can be a risky proposition. After all, the only way to buy a healthy company is to offer a price higher than the current market price, called a premium. By paying up for the company, the buying company had better make the right moves to get the deal to work. Investment banks help companies on the prowl find buyout targets, make the deal, and sometimes even finance it.

But despite the huge possible risks of buying companies, it’s still attractive for a variety of reasons, including the following:

  • Access to a new geography: Success in business is increasingly a matter of tapping global demand. It’s not enough to just have a hit product selling like hotcakes in the United States, because companies quickly grow by selling to consumers around the world. Getting up to speed with international sales, though, takes time, money, and know-how into the vagaries of different markets. Sometimes buying a company that’s already set up in a foreign country can speed up time to market.

  • Access to an interesting technology: Small companies, often financed by investors willing to go for a home run, can often afford to take big chances in research. And when these small companies make major discoveries or create products that reinvent categories, larger companies may look at them enviously. Meanwhile, to turn a small company into one big enough to distribute products worldwide takes money and time the company may lack. These factors combine into why it’s often best for an established company to buy a smaller one. The established company can quickly incorporate the technology into its products and get it out into the hands of consumers.

  • Vertical integration: Companies relying on important raw materials can often find themselves beholden to the suppliers of those materials. If the raw materials are important enough to the success of a company, it may be in the company’s best interest to buy the supplier and lock up the access to the goods.

How to get in on an IPO

Wildly successful initial public offerings leave investors talking and fantasizing for years. Investors who got into Microsoft or Google at the IPO prices have made a bundle.

Given how desired shares of hot IPOs are, it’s not surprising that investment bankers hold them very closely. Investment bankers’ role in the IPO process remains one of their most high-profile functions. The investment bankers are in charge of helping the company promote itself to prospective investors and determine how much to sell the shares for.

But in many ways, the idea of an IPO is a bit of a misnomer, because they’re not entirely public. Investment bankers typically follow a process that can make it difficult for regular investors to get a piece of an IPO.

Shares of an IPO are typically first sold at the initial offering price to the large clients of investment banks. These clients, usually mutual funds, hedge funds, or pension funds, are then free to sell the shares on the open market on an exchange such as the New York Stock Exchange or NASDAQ. This usually happens the day after the IPOs are sold to the lucky initial investors at the offering price. Most investors, then, must often wait until the IPO starts to trade on a stock exchange, often paying a higher price as the public bids on those coveted shares.

But don’t get too discouraged. Armed with your knowledge of how investment banking works, you can find a way to get into the IPO process. Here are some tips:

  • Work with your online brokerage. Most of the major online brokerage firms have cut deals with select investment bankers to get shares of IPOs. For instance, online brokerage Fidelity has a deal with Deutsche Bank and Kohlberg Kravis Roberts (KKR) to get shares of select upcoming IPOs at the offering price. If you’re interested in a particular IPO, check with your online brokerage to see if it offers shares.

  • Build a relationship with an investment banking firm. If an IPO is in particularly high demand, you can be sure the investment banks doing the deal will be judicious with who gets shares. And in these cases, the vast majority of shares will go to the client’s own customers. If you think that buying IPOs is going to be a frequent occurrence with you, you might consider creating a brokerage firm account with one of the investment banks that’s doing the types of IPOs you’re interested in. Keep in mind, though, that the brokerage units of investment banking firms tend to charge much higher commissions and fees than discount brokerage firms, so you’re not getting something for nothing.

  • Buy a mutual fund. Instead of lamenting the fact that IPOs usually go only to mutual funds, profit from that knowledge! You can find out which mutual funds typically get shares of IPOs or invest in them using the research tools at Morningstar. If you own a mutual fund that gets shares of hot IPOs, you win!

  • Wait. Sometimes the best advice in finance is to do nothing. Remember: IPOs are risky investments that can, and often do, decline in value. Instead of rushing to buy in at the offer price, you may want to cool your heels and wait. Waiting worked great for investors in social-networking stock Facebook, which went public in mid-2012. Shares of the company crashed about 40 percent from its offering price just months after its IPO, meaning investors who waited got the shares for 40 percent less than the initial investors!

Most important, carefully consider whether you should be buying shares of an IPO at all. IPOs are untested securities often of companies with no track records. Even professional investors have difficultly buying IPOs correctly and making money. Just because you can buy an IPO, doesn’t mean you should.

About This Article

This article is from the book:

About the book authors:

Matt Krantz is a nationally known financial journalist who specializes in investing topics. He's personal finance and management editor at Investor's Business Daily. He's also worked in the financial industry and covered markets and investing for USA TODAY. His writing on financial topics has also appeared in Money magazine, Kiplinger's, and Men's Health. Krantz is the author of Fundamental Analysis For Dummies and co-author of Investment Banking For Dummies.

Matt Krantz is the personal finance and management editor at Investor's Business Daily. Matt's recent books include Online Investing For Dummies and Fundamental Analysis For Dummies.

Robert R. Johnson, PhD, CFA, CAIA, is a Professor of Finance at Creighton University, where he teaches in the Master of Security Analysis and Portfolio Management Program.

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