Investment Banking – Meaning, Functions and More

When you need to buy 1 kg of wheat flour, you go to your neighbourhood grocery shop. But when you need to buy 1000 kg of wheat flour for your commercial bakery, you go to the biggest wheat flour wholesaler in the city!

Similarly, businesses with large, complex financial needs go to the country’s biggest banks. These banks are called investment banks. 

Let’s take an in-depth look at what an investment bank is, and how businesses benefit from them. 

What is Investment Banking?

Investment banking is a branch of banking that organizes and enables large, complex financial transactions for businesses, like mergers, IPOs or underwriting.

Here’s more detail into the services that investment banks provide to businesses.

Investment Banking Services

Initial Public Offering (IPO)

When a privately-owned business wants to become a publicly traded company, it goes through an IPO, or Initial Public Offering. 

Investment Banks help businesses plan and strategize their IPO to ensure success. How do they do this? Let’s understand with an example. 

Meena wants to take her fashion business public. She wants to raise at least Rs 10 lakh in her IPO. To do this, she approaches ABC Investment Bank. ABC conducts intensive research and study into the market and informs Meena that the value of her business is Rs 2 per share.

This means that to raise the capital she needs, she would have to issue 5 lakh shares to the public. But going public is risky – if the public does not respond as well as expected, the business could face huge losses.

ABC Bank will help Meena negate some of this risk by buying up a portion of her shares and then reselling them to the public. This is called underwriting. 

Underwriting is the process of assessing financial risk and committing to purchasing the shares from the issuing company to ensure the successful sale and distribution of the newly offered securities to investors.

Let’s say ABC Investment Bank agrees to underwrite 1 lakh shares out of the total 5 lakh shares that Meena’s business is offering. This means that Meena’s business is guaranteed to raise a total of Rs 2 lakh, even if the IPO fails.

In most cases, more than one bank underwrites a business’s shares to reduce risk as much as possible.

Mergers and Acquisitions

Investment Banks also help businesses with big mergers and acquisitions of other businesses. There is a lot of complex financial planning to be done when two businesses are about to strike a deal.

Investment Banks help businesses with valuations, deal negotiations, and more.

Let’s continue with the example of Meena’s fashion business!

Now that Meena has taken her business live with ABC Investment Bank, she has significantly upsized her company and now has a good amount of cash.

She wants to put this cash to good use, so she decides to acquire Daniel’s footwear business.

Meena once again goes to ABC Investment Bank and tells them of her interest in acquiring Daniel’s business.

ABC Investment Bank will analyze Daniel’s business, consult with industry experts and advise Meena on whether this would be a good deal for her or not.

ABC will also help Meena value Daniel’s business and come up with a purchase value – the amount that Meena will pay to buy Daniel’s business.

If Daniel wants a better price for his business, ABC will help Meena decide whether the higher price is worth it or not.

Once Daniel and Meena have agreed on a price, ABC Investment Bank will help Meena with the terms and conditions of the deal. It will also help Meena integrate the newly acquired business into her company in the most efficient way possible.

These functions seem very expensive, and they are! Investment Banking is a very profitable business, being one of the most highly paid careers in the world. But how do investment bankers make money?

How Do Investment Banks Make Money?

When an Investment Bank decides to underwrite an IPO, it usually sells the shares at a higher price.

In Meena’s example, ABC Investment Bank bought 1 lakh shares from Meena at Rs 2 per share. When ABC Bank sells those shares on the market, it might sell them at Rs 3.5 per share. This means ABC stands to make a profit of Rs 1.5 per share!

Investment Banks also charge a fee for services provided like valuing the business that is about to go public or in Mergers and Acquisitions.

There are a lot of other ways that investment banks make money, like Asset Management and proprietary trading.

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