Investment Banking Explained

Investment banking sits at the center of how companies raise money, combine with one another and establish what they are worth. Although most individual investors never deal with an investment bank directly, the results of investment banking work show up everywhere: in the shares that appear on an exchange after an initial public offering, in the bonds held by a retirement fund, and in the premium paid when one company acquires another.

This guide from the RTIBK editorial team explains the main activities of investment banks, how the key processes work step by step, how bankers approach valuation, and what all of this means for people investing their own savings.

What investment banks do

An investment bank is a financial institution, or a division of one, that helps corporations, governments and other organizations raise capital and carry out complex financial transactions. Unlike a retail bank, its core business is not taking deposits and making consumer loans. Instead, it earns fees for advice and for arranging and distributing securities.

Firms are commonly grouped into large global banks that offer the full range of services, mid-sized banks with a regional or sector focus, and smaller "boutique" advisory firms that concentrate on mergers and restructuring advice without a large lending or trading business. Activities are often described in terms of two sides:

• The advisory and underwriting side, sometimes called the "sell side" of corporate finance, which includes mergers and acquisitions (M&A) advice and capital markets work.
• The markets side, which includes sales, trading and research related to the securities the bank helps create and distribute.

Because these activities can create conflicts, for example between advising a company and publishing research on it, regulated firms maintain internal information barriers and compliance controls designed to keep non-public information from flowing where it should not.

Mergers and acquisitions advisory

M&A advisory is often the most visible part of investment banking. Banks advise companies that want to buy other businesses (buy-side mandates) and companies or owners that want to sell (sell-side mandates). They may also advise boards on defending against unsolicited offers or provide a fairness opinion on whether a proposed price is fair, from a financial point of view, to shareholders.

A typical sell-side process

1. Preparation. The bank studies the business, builds a financial model, and helps management prepare a confidential information memorandum describing the company.
2. Marketing. The bank identifies likely buyers, including strategic buyers in the same industry and financial buyers such as private equity firms, and contacts them with a short anonymous summary, often called a teaser.
3. Confidentiality and first-round bids. Interested parties sign non-disclosure agreements, receive the memorandum and submit non-binding indications of interest.
4. Due diligence. Shortlisted bidders gain access to a data room containing detailed financial, legal and operational documents and meet management.
5. Final bids and negotiation. Bidders submit binding offers with marked-up purchase agreements. The seller negotiates price, conditions and protections.
6. Signing and closing. After the agreement is signed, the deal may still require shareholder votes, antitrust clearance or other regulatory approvals before it closes.

Advisory fees are usually structured as a small retainer plus a larger success fee paid only if the transaction completes. That structure aligns the bank with getting a deal done, which is worth remembering when interpreting a bank's enthusiasm for a transaction.

How an IPO works

An initial public offering (IPO) is the first sale of a company's shares to the public, after which those shares typically trade on a stock exchange. Investment banks act as underwriters, guiding the company through the process and distributing the shares to investors.

Underwriting

The company selects one or more lead underwriters, often called bookrunners, who form a syndicate with other banks. In a firm-commitment underwriting, common for larger offerings, the underwriters agree to buy the shares from the company at a set price and resell them to investors, taking on the risk that demand falls short. In a best-efforts arrangement, used more often for smaller offerings, the banks agree only to try to sell the shares. Underwriters are paid through the gross spread, the difference between the price investors pay and the amount the company receives.

Registration and disclosure

In the United States, the company files a registration statement with the Securities and Exchange Commission, typically on Form S-1 for domestic issuers. It includes the prospectus, which describes the business, risks, financial statements, use of proceeds and management. Other jurisdictions have comparable prospectus requirements. The prospectus is the single most important document for anyone considering buying shares in an IPO.

Roadshow and book building

Once a preliminary prospectus with an indicative price range is available, management and the bankers go on a roadshow, presenting to institutional investors, now often partly or wholly online. During book building, the underwriters collect indications of how many shares each investor would buy and at what price. The resulting "book" shows the depth of demand and guides the final offer price, which is set shortly before trading begins.

Allocation, stabilization and the greenshoe

The underwriters decide how to allocate shares among investors. Many offerings include an over-allotment option, commonly called a greenshoe, that lets underwriters sell additional shares, historically up to about 15% of the offering, and use the option to support the share price in the early days of trading if it falls.

Lock-up periods

Company insiders and pre-IPO investors usually agree not to sell their shares for a period after the offering, commonly around 180 days. When a lock-up expires, a large number of shares can become eligible for sale, which some investors watch closely as a potential source of selling pressure.

Equity and debt capital markets

IPOs are just one part of equity capital markets (ECM). ECM teams also handle follow-on offerings by companies that are already public, block trades in which a large shareholder sells a sizable stake, convertible bonds that can turn into shares, and rights issues that offer new shares to existing shareholders first.

Debt capital markets (DCM) teams help issuers raise money by borrowing. Their work includes investment-grade corporate bonds, high-yield bonds for issuers with lower credit ratings, government and agency debt, and securitized products backed by pools of loans. Closely related leveraged finance teams arrange loans and bonds for acquisitions, particularly those led by private equity firms.

Choosing between debt and equity is a central corporate finance decision. Debt is usually cheaper because interest is often tax-deductible and lenders rank ahead of shareholders, but it adds fixed obligations and financial risk. Equity carries no mandatory repayment but dilutes existing owners. Interest rate conditions heavily influence this choice; our article on interest rates and markets explores the connection.

Corporate finance and restructuring

Beyond individual transactions, investment bankers advise boards on broader questions: the right mix of debt and equity, dividend and share buyback policy, whether to spin off a division, and how to respond to activist shareholders. When companies face financial distress, restructuring specialists help negotiate with creditors, arrange new financing, or guide a company through formal insolvency proceedings. These engagements often determine how much value different classes of investors recover.

Valuation methods bankers use

Almost every investment banking assignment involves valuation. Bankers rarely rely on a single method. Instead, they triangulate using several approaches and present the results as ranges, often in a chart sometimes called a "football field."

A closer look at DCF

A DCF analysis begins with a forecast of revenue, operating margins, taxes, capital expenditure and working capital, usually over five to ten years. The resulting free cash flows are discounted at the weighted average cost of capital, which blends the expected return required by shareholders and lenders. Because small changes in the discount rate or long-term growth rate can move the answer substantially, bankers present sensitivity tables rather than a single number. Individual investors reading a fairness opinion or proxy statement will often find these ranges disclosed.

Multiples in practice

Enterprise value multiples, such as EV/EBITDA and EV/revenue, compare the value of the whole business, including debt, with measures of operating performance. Equity multiples, such as price-to-earnings, compare the value of shares with earnings available to shareholders. Choosing the right multiple depends on the industry: asset-heavy businesses, banks and early-stage growth companies are typically valued on different bases. If you want to understand where the underlying figures come from, see our guide to reading earnings reports.

League tables and how banks compete

League tables rank banks by the value or number of deals they have worked on over a period, broken down by category such as global M&A, equity offerings or high-yield bonds. They are compiled by financial data providers from public deal information. Banks use their rankings in marketing, and clients sometimes consider them when choosing advisers.

League tables have limits. Credit for a deal is often shared among several banks, so rankings can reward participation rather than leadership. Large transactions can dominate the figures, and methodologies differ between providers. A high ranking indicates scale and market presence, not necessarily the best advice for a particular situation.

What investment banking means for individual investors

Individual investors are affected by investment banking in several practical ways.

• IPO access and pricing. Allocations in popular IPOs tend to go mostly to institutional investors. Investors who buy on the first day of trading pay the market price, which can differ substantially from the offer price. Academic studies have long found that IPOs, on average, have tended to underperform comparable companies over subsequent years, although results vary widely.
• Takeover premiums. When a public company agrees to be acquired, its shareholders typically receive a premium over the prior market price. Shareholders of the acquiring company, by contrast, bear the risk that the buyer overpays.
• Dilution. Follow-on offerings and convertible securities can increase the number of shares outstanding, reducing each existing shareholder's percentage ownership.
• Disclosure documents. Prospectuses, merger proxies and fairness opinions contain detailed information that is often more informative than headlines. Reading their risk factors and valuation summaries is time well spent.
• Research independence. Research published by banks that also underwrite or advise the same company may be subject to conflicts. Our guide to how market research works explains how to account for this.