We must shift our thinking away from short-term gain towrds long-term investment and sustainability, and always have the next generations in mind with every decision we make.-DEB HAALAND
What is Investment Banking & how is it different from Commercial Banking?
To understand this with an example, you start a company with some capital and you get some early success to go beyond the start-up stage. Considering the favorable environment and optimistic future, you decide to expand it and invest more capital. But you are not so rich as to put in all the necessary capital. (In general, there is none).
Your first step will be to go to the bank and ask for a loan. But private banks have strict rules that they cannot lend money at a lower interest rate than x%. What is the interest rate now? Suppose you go to the bank for the loan, and Bill Gates also goes to the bank for the loan, but here the less interest will be charged from Bill Gates, because there is less possibility that he cannot repay the loan.
If you believe that the bank is charging you a very high rate of interest, then you will look at your creditworthiness and if the public has more confidence in your creditworthiness, it may be better for you to take money directly from the public, the interest rate will be lower than that of the bank. The public will also be happy, because they will get a higher interest rate than what they earn from a fixed deposit in a bank.
It may be important to note that you / your firm is generally less creditworthy than the bank. But to compensate for this, you pay more interest to the public than what the bank pays for FDs. This form of raising money is known as raising funds in the form of “bonds”. You / your firm is obliged to pay the public interest and principal, irrespective of your firm’s performance. If not, you / your firm may need to consider taking bankruptcy protection.
What is Investment Banking
Another way to raise money from the public is to advertise by making them partners in your business. They invest a fixed capital, become partners and enjoy the profit and loss of the firm. Unlike bonds, here you are not obliged to pay any kind of “interest”, but, the person who has given you capital, gets a proportionate share of the profit, or a proportionate share of the loss. The capital raised in this way is “equity capital”
Thus the investment bank (IB) helps to raise capital of a firm mainly through the above two methods, apart from other less known but more complex methods.
The role of an investment bankers begins with identifying a business that will likely need capital / be able to raise capital at a lower cost than what a private bank would charge them, and show them, publicly.
Will suggest to the firm to raise capital. This would be more beneficial. Once the firm sees merit in the consideration, the investment bank decides / decides the right time, the right currency / exchange to issue bonds / equity. It is also the duty of IB to draft legal documents for bonds / issuance of equity.
Subsequently, the Investment Banks begins to identify potential investors who lend capital to the money-raising business. If it issues a bond, the IB assures the investor that the firm is very unlikely to go bankrupt, and therefore the investor will receive the principal and an interest that the FD will pay him. If it is an equity issue, the IB assures the investor that the profit is going to be very high, and raise capital for the parent firm.
The IB receives a fee for this amount provided. Also, most of the time, the IB itself becomes one of the investors and buys some of the bonds issued.
The IB has a more important role to handle mergers and acquisitions. For example, Amazon is a very large online shopping platform in many countries. In India, however, Flipkart has a large market share, and Amazon has difficulty establishing itself in India.
Therefore, Amazon will try to acquire a small firm in India like Jabong – an online apparel shopping center. So, Amazon has straight away all the infrastructure that Jabong is already in place, and can establish a hold in at least one area of online shopping – apparels.
Similarly, mergers can occur when two large firms merge to form one unit and therefore performance is increased compared to what can be achieved in the face of competition. It is the role of the IB to recognize that Amazon is trying to establish itself in India, and is therefore looking for acquisitions.
The IB suggested Amazon that an acquisition would be profitable for them, and identified the smaller firm that could be acquired. Then, there will be a large transfer of shares of the small firm to the larger firm – Amazon. Then, IB gets a fee for this merger / acquisition.
To be an investment banker, one must have the skills to understand the financial statements, identify opportunities for capital, mergers, acquisitions etc. In addition, the ability to talk, self understanding and can be able to explain to firms for capital raising, merger or acquisition etc. would be a very useful addition.