10 Ways Investment Banking Touches Main Street - dummies

10 Ways Investment Banking Touches Main Street

By Matt Krantz, Robert R. Johnson

If you’re like most people, you may believe that investment banking is something for well-dressed finance types in New York City to think about. But consumers are often surprised to hear how closely many aspects of their lives interact with investment banking.

Bridges you drive across every day on the way to work, schools your kids attend, and even the water you drink may be financed, at least in part, by operations by investment banks. Understanding the role of investment banking in your life makes it easier to see why it’s important to understand the industry, even if you have no interest in Wall Street.

Here are a few ways that investment banking intersects with Main Street investors.

Financing public facilities

Cities, schools and other government agencies are responsible for maintaining massive infrastructures of buildings, bridges, and utilities. Because these facilities are designed to last a long time, coming up with the money to finance such projects can be onerous for a city. And finding lenders with the ability to lend enough money to finance such a large-scale effort can be difficult.

That’s where investment bankers come in. By selling securities to the public, an investment bank is able to raise money from a broad group of investors. When the cost of a large project is spread across many investors, the risk is spread out as well. In addition, investors are able to decide how much money they want to commit to a particular project, which allows them to control the risk they’re taking.

There are countless examples of situations in which investment banking generated capital that would have been difficult to come by otherwise. One example occurred in 2012 with the construction of a new medical facility in the Philadelphia area. The facility was built by Einstein Healthcare Network. But to pay for the 146-bed facility, Einstein Healthcare Network sold $300 million in bonds issued in 2010 by an investment bank. It’s impossible to know how well the facility will perform financially, but the risk of the investment is at least spread over many investors, not concentrated with a single bank or group of banks. And the patients can enjoy the facilities now, instead of waiting for the hospital group to amass enough cash to pay for construction out of pocket.

Providing profit to public companies

You may think you have nothing to do with investment banks, but that couldn’t be further from the truth. Even if your only investments are stuffed in your 401(k) retirement plan, the success of investment banks has a role in your financial success.

Financial companies, including investment banks, are among the biggest contributors to the overall profit of U.S. public companies. Financial companies are also major payers of dividends, making them an important source of wealth generation for anyone with money in the stock market.

During 2013, for instance, financial companies accounted for the biggest slice, 20.3 percent, of the total profit generated by companies in the Standard & Poor’s 500, according to S&P Capital IQ. The contribution of financial companies to the overall profit of corporate America was equal to the 20.3 percent slice of profit generated by companies in the materials sector of the economy, which includes makers of steel and aluminum.

That’s not to mention the indirect influences of the investment banking industry on the economy. When investment banks are strong and looking to plow money into deals, that sparks growth and expansion that often leads to new jobs and opportunities.

Helping companies grow and expand

If companies could only grow when they had the cash in the bank, it would be a pretty slow-going economy. Even if a young employee at a factory had a great idea for a new product, the company wouldn’t be able to move on it until it was generating ample profit from existing product lines.

Enter investment banking. Investment bankers play the critical role of gathering idle cash from investors short on business ideas, and getting that cash into the hands of entrepreneurs with big ideas but no money. The combination can dramatically shorten the time it takes for new ideas to hit the market.

Perhaps the most dramatic example of investment bankers turbocharging growth and the economy is with initial public offerings (IPOs). Consider Chipotle Mexican Grill, one of the biggest new restaurant concepts in some time. The company was founded in 1993 by entrepreneur Steve Ells, who had the idea that Americans were ready for a gourmet burrito. The company started slowly, as Ells took loans from family to get going. But unless your parents are billionaires, there’s a limit to family loans. Chipotle even landed an investment from fast-food giant, McDonald’s, allowing it to get to about 500 locations by 2005. But the real growth occurred when the company sold shares to the public for the first time in early 2006. That’s when Chipotle raised roughly $150 million from selling shares in its IPO. Loaded with the capital raised by the public, Chipotle then had the resources to expand fast. And expand it did. Through 2013, the company has more than 1,400 locations in the United States, Canada, and Europe. Had the company needed to rely on its own cash flow generation to expand, it would’ve taken decades to get this big and create this many jobs.

Providing liquidity to the market

Investment bankers are really in the money flow business. Their job is to find projects that are worthwhile and potentially profitable, but that can’t seem to get the money needed to get started.

Due to investment banks’ relationship with investors, they have access to pools of capital looking for a home. By pooling investment capital, investment banks are able to bring together the capital needed to get deals done.

Investment banks also serve a role in the public markets. By buying and selling stakes in companies and bonds, investment banks create an actively trading market that anyone can buy or sell into. A vibrant and actively trading marketplace benefits anyone who needs to buy or sell.

Take the example of eBay, an online marketplace you might be more familiar with. The more people who are on eBay buying and selling goods, the easier it is to buy and sell goods yourself. Investment bankers play the same role in capital markets, making sure there’s ample trading activity to allow all investors to buy or sell if they choose to.

Offering higher returns to investors

Anyone who has ever put money into a savings account understands the sting of low interest rates. Banks are infamous for taking in consumers’ deposits and paying next to nothing in the form of interest rates.

But thanks to investment banks, investors have more options. Investment bankers create new types of securities, many of which pay much higher rates of interest than what’s available at the bank.

Additionally, because investment bankers are working with all sorts of projects and companies, they create new financial opportunities for consumers to pick and choose from.

Investment bankers sometimes get a bad name for creating high-risk investments that blow up from time to time, and that’s certainly lamentable. But investment banks, too, are responsible for selling conservative investments that generate decent returns for investors looking for better returns than they might get from their local bank branch.

Unlocking hidden value

Parents often shake their heads when they see their kids falling short of their potential. And capitalists have a similar feeling of dismay when companies or other assets don’t reap their maximum potential.

One of the great losses in our capitalist system happens when a unit of a company finds itself buried and neglected inside a larger firm. It’s a fairly frequent occurrence, because a small but creative group of people inside a big company might stumble upon a breakthrough technology or product. The value of this innovation may be locked inside a company, unable to reach its full potential.

Investment bankers can play a pivotal role in allowing these trapped assets to break out and realize their full potential. Investment bankers are often tapped to advise companies on whether they can divest units in the form of spinoffs or other reorganizations that will make the sum of the parts worth more than a whole. A spinoff is a financial maneuver when a company breaks off a part of its business into a new, separate company.

If you’ve ever booked plane tickets on online travel site Expedia, you’ve experienced the power of breaking away a promising unit from a large company focused on other things. Expedia was created by software giant Microsoft in the 1990s. The online travel business may have been buried inside the company, which focused its efforts on operating systems, web tools, and other technology systems. But by spinning off Expedia, Microsoft created a stand-alone business valued at more than $6 billion that trades on the NASDAQ exchange.

Saving valuable assets from oblivion

The annals of business history are littered with devastating stories of missteps and failures. But one of the ultimate cases of a business wipeout is when a company files for bankruptcy protection. Bankruptcy protection is a process designed to preserve parts of the business that are valuable but trapped inside a faulty business model.

Investment banks often play an important role in the bankruptcy protection process. The goal of bankruptcy protection is to isolate the parts of the failed business that are worthwhile and get them into the hands of other investors or companies that can keep them alive.

Investment banks can serve the important role of lining up financing for companies or investors who want to buy parts of a company in bankruptcy protection. Armed with fresh capital and better management, parts of a doomed company, or the whole thing, can be saved. Consider General Motors and Chrysler, two automakers that both filed for bankruptcy protection in 2009. These companies represent some of the largest bankruptcies in U.S. history.

Investment banking processes are a big reason why these companies still exist. Chrysler came out of the bankruptcy protection process and was ultimately sold to Fiat. GM took a much different route, but one that required the assistance of investment bankers, too. The company underwent a series of dramatic financial changes, which included the wiping out of its common stock and heavy investment from the U.S. government. Investment banking came into play later when the restructured GM was sold to the public in an IPO, shoring up the company and giving the U.S. government freedom to reduce its bailout of the company.

Other times the role of investment banks are even more direct. Failed savings and loan, Washington Mutual, was ultimately bought, in part, by JPMorgan Chase, to hold the mortgage market together in 2008. Failed brokerage firm Merrill Lynch was bought by Bank of America in 2008 during the financial crisis that year.

Planning for retirement

Perhaps one of the clearest ways regular investors interact with investment banks is during the retirement planning process. Rank and file employees understand that planning for retirement is a mammoth task that can take a long time. But it’s important not only to save for retirement, but also to put that savings to work by investing in an asset that will generate a decent return.

About the only way most people have even a remote chance to have enough money for retirement is by investing. Consider a 40-year-old who plans to retire at 65, but who hasn’t started at all. That investor will have needed to save and invest nearly $700,000 to have even a fighting chance at retiring comfortably, according to the Index Fund Advisors.

Getting that kind of savings is going to require returns that far exceed what’s available in a savings account. Financial products such as exchange-traded funds, stocks, bonds, and mutual funds are all key aspects of getting to retirement.

Some retirees may also be members of public pension plans. These massive pools of money are invested in a variety of assets, many of which are created or managed by investment banks. The investment banks are able to present investment opportunities that are likely to generate greater returns and allow people to afford to retire.

Fostering entrepreneurship

Perhaps the most glamorous role of investment banking is in the creation of brand-new businesses. Nothing is more American than the idea of an entrepreneur with a good idea starting a business that takes off and winds up generating thousands of jobs and profits.

But getting a company off the ground often requires huge investments that are beyond the means of the entrepreneur. And given the innate risks of starting a business from scratch, banks and other lenders are often reluctant to give entrepreneurs as much money as they need to get started.

Investment banks, by their very nature, are better positioned to raise capital from a diverse group of investors who might be more tolerant of risk. Investment banks can determine how to raise the money, be it through debt offerings or selling stock. The end result is that entrepreneurs can get the money they need to start.

Certainly, investment bankers benefit when new companies are formed and raise money, because they collect the fees. But the economy as whole benefits, too, because new businesses can be drivers of opportunities of growth and jobs.

Finding investments that deserve attention

There is no shortage of places for investors to place their money. Between stocks, bonds, options, commodities, private equity, and other investments, it can be difficult for a worthy project to stand out from the crowd and grab investor attention.

Investment bankers can often serve the role of selling opportunities to investors. If a company’s shares are undervalued and being ignored by investors, a savvy analyst in the research department of an investment bank might write up a report telling investors that the stock is a screaming buy.

Meanwhile, investment management professionals at investment banks may be in the position to identify assets, such as bonds, that might be ignored and therefore present a good value for investors.

The role of marketing is often disparaged with investment banks. And it can be abused. But investment banks can often be the only way for companies with compelling stories to get their messages to interested investors.