Investment Banks: How Do They Work?
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When you think about finance, one of the first things that may come to mind is investment banking—working long hours on Wall Street, coming home to a high-rise apartment in Manhattan, maybe even the Wolf of Wall Street movie. However, a lot of people don’t actually understand what investment banking is, let alone how these firms (a business organization/company) make money.
An investment bank, in simple terms, helps advise large companies. For example, Morgan Stanley served as Elon Musk’s lead financial advisor during his acquisition of X. The transaction required billions of dollars in financing, and Musk didn’t want to liquidate that much of his wealth. So, Morgan Stanley and other lenders lent up to $13 billion for the acquisition, while Musk also provided some of his own money. This allowed Musk to have 100% equity (ownership) in X.
Investment banks also help with mergers and acquisitions. A merger is when two companies combine, while an acquisition is when one company purchases another company or its shares to gain control. In these situations, investment bankers can help determine how much a company is worth, evaluate potential deals, negotiate terms, and figure out how the transaction should be financed.
However, transactions like these are far more complicated. While we won’t go into all the details, we can expand on the role of investment banks and some of the most important services they provide.
Trading Services
Investment banks connect large institutional investors (firms with lots of capital) with buyers and sellers in markets. This means that they can help find buyers for companies that want to sell stock or sellers to help other investors buy stock.
For example, imagine an investor wants to purchase $50 million worth of Apple stock. Rather than finding individual investors, the investor could use an investment bank to find sellers to make the transaction possible. For individual investors, buying and selling $100 worth of Apple can happen instantly. On the other hand, there may not be enough liquidity (the ability to turn something, in this case, an investment, into cash) for a transaction worth hundreds of millions of dollars. That’s where investment banks step in to help execute trades. This role of providing market liquidity that investment banks play is called being a market maker.
Investment banks also have trading divisions that deal with other types of markets as well, which we won’t get into in this article. These markets are much more complicated than stocks, so institutions rely on investment banks for their expertise.
While they sound similar, brokerage and trading services are distinct from one another. Brokerage involves helping a client execute a transaction, while trading involves the bank buying and selling securities as a market maker to provide liquidity. These services often work together to execute one large transaction. Going back to our previous example, if Investor X wants to purchase $50 million worth of Apple, there may not be enough outstanding shares to do so. So, Investor X hires Investment Bank Y to help out.
Here are two possible scenarios that could play out:
Scenario 1: Bank Y owns enough Apple shares
If Investor X wants to buy $50 million of Apple, and Bank Y has $50 million of Apple shares available, Bank Y could sell some or all of those shares to Investor X. In that case, Bank Y is providing liquidity by being the seller.
Scenario 2: Bank Y doesn't own enough Apple shares
This is where the investment bank’s market access becomes an advantage.
If Bank Y only has $5 million of Apple, Bank Y can help find sellers. The transaction could go somewhat like this:
Investor A → sells $10M of AAPL
Investor B → sells $15M of AAPL
Investor C → sells $20M of AAPL
Bank Y → sells $5M of AAPL
However, Investor X won’t be buying these shares at the same price. At the time of writing this article, Apple is worth $336 per share. Investor A might sell its shares at $340 per share, while Investor B might sell at a price of $338 per share. This means that Investor X has to be ready to negotiate and potentially buy at a premium price for shares of Apple.
*AAPL is the ticker symbol for Apple, which is like a symbol/code to identify a stock on the stock market
Two more examples of this:
Microsoft = MSFT
Amazon = AMZN
Underwriting
This is one of two pillars of the Investment Banking Division (IBD) within a firm. Underwriting is responsible for helping corporations and governments raise capital by issuing stocks and bonds (IPOs). An IPO, also called an Initial Public Offering, allows everyday people to buy shares of a company. For example, Goldman Sachs led the transaction for SpaceX, handling regulatory filings, pricing, and pitches to investors. Morgan Stanley acted as a stabilizer to protect the stock price from extreme fluctuations. This helped SpaceX raise roughly $85.7 billion from the offering.
Advisory
The second pillar of IBD is Mergers and Acquisitions. We can take a look at Amazon’s acquisition of Whole Foods Market in 2017 for this example. Goldman Sachs acted as the lead financial advisor for this $13.7 billion acquisition. Amazon’s primary requirement for the deal was that it be kept secret. If any rumors leaked or bidding wars started, Amazon would walk away from the deal. Goldman Sachs helped keep this deal private and helped negotiate a price. Whole Foods countered Amazon’s initial price of $41 per share with a higher price of $45 per share. To avoid driving up the price, Goldman Sachs stepped in with an offer of $42 per share, which Whole Foods accepted. Just like a financial advisor would help someone with their investments, investment banks help companies with their investment decisions, just at a much larger scale.
The Bigger Picture
Investment Banks are complicated; there are a lot of functions and roles that they play that I didn’t mention in this article. They help companies buy other businesses, raise capital for corporations and governments, and serve as advisors through major financial decisions.
Ultimately, investment banks serve as a bridge between companies looking for capital, investors looking for opportunities, and businesses looking for growth. The purpose that investment banks play can be put simply: they help money move.
