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Understanding Investment Banking

Updated on January 3, 2010

Investment banking is the process by which capital is raised to buy the buildings, machinery, and tools needed by modem industry. In essence, the investment banking mechanism simply channels the savings of thousands of individuals into corporate and public enterprises.

When business was conducted on a small scale, the cabinetmaker or blacksmith financed the purchase of his own tools through savings or from loans made by relatives or friends. As commercial and manufacturing enterprises grew in size, it became necessary to collect the savings of many people to provide the capital. Instead of continuing as individual proprietorships, the larger business entities were organized as corporations or joint trading companies, and shares of stock or bonds were issued to the investors who put up the money to finance them. The giant industrial enterprises of today represent colossal accumulations of such capital.

Management of New Issues

Investment banking in the United States is in the hands of hundreds of independent firms, of which about 150 are large enough to undertake the management of large new security issues. Investment banking firms buy large blocks of stocks or bonds from corporations needing additional capital and then endeavor to resell the securities to hundreds or even thousands of individual investors at a slightly higher price to compensate themselves for the services performed.

Investment banking houses are in the business of buying securities at wholesale from the issuing corporation and reselling them at retail. They should not be confused with commercial banks.

Before most individual investors will buy a security, they must be assured that there is a ready market for resale. Investment bankers consequently must assure the prospective purchaser of a continuing market for the securities they underwrite. Because of the similarity between selling new securities and buying and selling securities that are already outstanding, virtually all investment banking firms also engage in the general securities brokerage business, and many of them are members of the various stock exchanges.

An investment banking firm seldom undertakes the underwriting of a large issue of securities without outside help. If the issue is very large, no single investment banking firm is likely to have enough capital. But even where the capital is available, investment banking firms generally prefer not to tie up a large proportion of their funds in a single underwriting. The managing underwriter calls in other investment bankers and asks them to join together in a buying syndicate. Usually the managing firm undertakes the largest commitment. Buying syndicates range in size from 3 firms to 100 or more.

The sale of the new issue by members of the syndicate may be completed in a few days if the issue has been correctly priced and looks attractive to investors in relation to the current cost of other similar securities. However, if the issue has been priced too high or if the market takes a sudden downward trend, it may be difficult or even impossible for the underwriters to dispose of their securities at the proposed offering price. This element of risk is an important factor in determining the compensation demanded by the members of a buying syndicate. Firms in the selling group are penalized if they sell at less than the public offering price during the life of the agreement. However, if it is impossible to sell the new issue after extended effort, the agreement will be terminated and individual members of the buying group either can hold the unsold issue as an investment, or sell it for whatever price they can get in the open market.

Special Types of Securities

Municipal, railroad, and public utility bonds are generally purchased by competitive bidding. In arriving at a bidding price, a syndicate must estimate with a high degree of accuracy the price at which it believes it can resell the securities to the public or to large institutional buyers such as life insurance companies, banks, and trustees. At the same time, each bidding group must try to outguess its competitors. As many as six groups may bid for the new securities, and the bidding prices often are refined to the fourth decimal place.
 
All bids are opened at some fixed time and the securities are sold to the highest bidder. Highly speculative enterprises are rarely underwritten by investment bankers. Instead, the corporation and the investment bankers usually enter into a "best efforts contract." The underwriter does not agree to buy securities from the corporation at a fixed price but rather agrees to sell as many securities as possible at some set price and turn over to the corporation the proceeds less an agreed-upon selling charge.

Investment Trusts

Investment trusts are companies that invest their funds in the securities of other companies. There are two types of investment trusts: open-end funds, or mutual funds, that constantly sell new shares to investors, and closed-end funds that on their original formation sell a fixed number of shares to investors. When an investor purchases a share of a mutual fund, a new share of stock is created. When he purchases a share of a closed-end fund, he must buy from a present holder.

The purpose of an investment trust is to provide the means for a person of small resources to gain the benefits of professional management and to spread his investment risk among a diversified list of concerns. A typical mutual fund may hold investments in 100 or more industrial, railroad, and public utility companies. A purchaser of a $50 share in an investment trust in effect will own a proportional fraction of the 100 or more securities held by the fund.

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