Investment Banking Business PDF

Investment Banking Business 5 CONTENT AREAS Introduction Structure of an Investment Bank Front Office Functions Trends and Challenges Summary LEARNING OBJECTIVES 1 | Describe th...

Investment Banking Business 5 CONTENT AREAS Introduction Structure of an Investment Bank Front Office Functions Trends and Challenges Summary LEARNING OBJECTIVES 1 | Describe the structure of an investment bank. 2 | Identify the various functions that an investment bank performs to generate revenue, and explain how those functions are linked. 3 | Discuss the major trends, challenges, and success factors in the investment banking industry. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 3 INTRODUCTION In the previous chapter, we discussed discount and online investment management models that cater to retail investors. Given the additional compliance considerations and risks involved, dealer member’s leaders operating in this branch of the securities industry must understand all aspects of the business to ensure that risk management policies and procedures are appropriate and adequate. In this chapter, we discuss investment banking, which is geared towards institutional clients in need of specific related services. The structure of the investment banking industry has evolved over the years, but the nature of the business has remained the same. Full-service dealers offering investment banking services provide clients with a range of services, including traditional corporate and government finance underwriting, merger and acquisition (M&A) advice, trading, merchant banking, research, financial engineering, and securities services such as prime brokerage. Independent boutique investment banks, on the other hand, specialize in particular segments of the market. They focus on specific functions of the investment banking business, such as M&A, or on a specific market segment, such as advising and raising money for firms in the junior mining sector. In this chapter, we discuss the structure, the various functions, and the sources of revenues pertaining to the investment banking business. The material covered should help you understand the success factors, market trends, and ongoing challenges in the investment banking environment. STRUCTURE OF AN INVESTMENT BANK In the United States, wealth management and asset management may also be considered parts of the investment bank’s services. In Canada, however, investment banking is typically a division of a full-service investment dealer (i.e., a dealer member), which is likely to have separate wealth management and discount brokerage divisions. An investment bank may also be a stand-alone boutique. Retail-related services are often captured under the banner of wealth management, whereas investment banking and its related services are captured under the capital markets line of business. An investment bank is generally divided into three main areas: front office, middle office, and back office. The different functions of each area are described briefly below. To avoid confusion, we use the term investment bank generally in this chapter to refer to the entity providing front office services. FRONT OFFICE The front office of an investment bank normally consists of the following functions: Finance Finance helps raise capital for customers through operations in the debt and equity markets (e.g. underwriting). Investment banking is often considered synonymous with corporate finance. Corporate finance functions are generally divided by industry. The different divisions focus on maintaining close relationships with firms in specific industries, such as mining, oil and gas, technology, and telecommunications. Outside Canada, the group may also be divided by broad geographic area, with different divisions responsible for the United States, Europe, and Asia. Mergers and acquisitions (M&A) and divestitures Merger and acquisition services include structuring and execution of domestic and international transactions in acquisitions, divestitures, mergers, and joint ventures, as well as corporate restructurings and defences against unsolicited takeover attempts. Fees on these services are usually negotiable. Another source of fee income is rendering a fairness opinion, which is a professional judgment on the fairness of the financial terms of a particular transaction. © CANADIAN SECURITIES INSTITUTE 5 4 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Trading services and sales (including structuring products) Equity trading desks comprise both agency traders (also known as coverage traders) and liability traders (also known as proprietary traders). Agency traders execute large, so-called block trades for institutional clients. Liability traders assist in facilitating client orders by taking offsetting positions using the firm’s capital. Often, liability traders complete whatever might be left of an order that could not be filled by entirely the agency trader. Agency traders typically are responsible for particular institutional accounts, but liability traders, particularly at the large dealers, have no such account coverage. Instead, they are usually assigned sectors of the market, such as oil and gas or technology. Research Traditionally, along with order execution and reporting, investment bank research (often called sell-side research) has been a key element of the service that dealer members offer to their buy-side institutional clients. These offerings are not paid for with traditional consideration. They are typically part of a soft-dollar commission arrangement, where the buy-side client sends its trading business and needs to the firm based on the quality of the offering. Often, a buy-side client spreads its business among more than one dealer member for strategic reasons, but may reserve some discretionary business for the firm that provides the best service offering. Corporate and Merchant banking Corporate banking normally includes the structuring and execution of credit transactions such as bridge loans. Merchant banking, on the other hand, involves principal investments (meaning the capital of the bank itself). Securities services Another source of revenue-producing business for investment banks is a group of securities services often referred to as prime brokerage. Prime brokerage offers tools and services desired by clients looking to support their operations in trading and portfolio management. It provides clients such as hedge funds with custody, clearance, financing, and securities lending. These services make it possible for clients to have multiple brokers while maintaining one brokerage account. MIDDLE OFFICE The middle office normally consists of the following functions: Risk management Compliance Corporate treasury BACK OFFICE The back office normally consists of the following functions: Operations Information technology We explore the front office functions in greater detail in the next section. Middle office and back office functions, particularly risk and compliance, are discussed in several chapters throughout the course. FRONT OFFICE FUNCTIONS The traditional functions of an investment bank are finance, including both corporate and government finance, and M&A. As stated, investment banking is often considered synonymous with the functions of corporate finance, but a broader definition includes all other activities listed as front office functions, as discussed below. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 5 CORPORATE FINANCE The primary activity performed by the equity underwriting group is raising capital for clients through new issues, secondary offerings, and private placements. During the offering process, the investment bank advises the issuer with respect to the type of security that should be offered and negotiates the offering price with the issuer. It often forms and manages a syndicate composed of various other investment banks and dealers to help sell the new securities. The investment bank leading the underwriting also prepares the registration statement and related offering documents to be filed with the securities commissions and performs other necessary regulatory steps in the securities distribution process. Regarding the actual distribution, the investment bank sometimes purchases the whole or a partial block of new securities from the issuer and distributes it to institutional and individual investors. In return, the firm earns an underwriting spread, which is the difference between the price it receives from investors and the amount it pays to the issuing firm. This type of offering is usually referred to as a bought deal (or firm commitment deal). On occasion, the investment bank may also receive compensation in the form of warrants, which give the right to purchase the shares of the issuing company at a fixed price. A major risk for the investment bank in a bought deal is the risk of tying up of capital for longer than expected when market conditions make sales of the securities challenging. In such cases, the firm may ultimately be forced to sell the inventory of stock at a loss. Investment banks often undertake bought deals when they are confident that enough buyers are interested in purchasing the shares. In these instances, the risk of the deal is borne by the investment bank rather than the issuer. In transactions other than bought deals, the underwriting syndicate will have pre-marketed the deal to evaluate client interest. DID YOU KNOW? The purpose of an underwriting syndicate is to mitigate the risk of a price decline in a bought deal by spreading the risk among the various members. The lead underwriter also goes to great lengths through premarketing to determine whether sufficient client demand exists to reduce the risk further. This precaution helps the entire syndicate to understand the general market and the appetite of individual investors for the securities under consideration and to price deal accordingly. In other cases, the investment bank operates on a “best effort” rather than a bought-deal basis, whereby it acts as an agent and commits to selling the securities to its best ability. On such a basis, there is no guarantee of sales or price, and the compensation earned is made up of commissions on sales. The investment bank markets the offering to investors who might be willing to purchase the securities from the company. If all of the offered securities are not purchased by the public, the agents are not obligated to purchase the balance from the company. Without sufficient demand, the issue may be withdrawn from the market. In Canada, deals are split relatively evenly between best effort and bought deals. Best effort deals are more likely to come from smaller, riskier issuers who cannot arrange a firm commitment deal with the investment bank. In the United States, there is a greater tendency for deals to be done on a bought-deal basis. FIXED INCOME UNDERWRITING Similar to equity underwriting, investment banks help entities to raise debt financing by underwriting all levels of corporate and government fixed income securities and distributing them to individual and institutional investors. The investment bank also provides expertise in creating the issue and advises the issuer regarding yield and maturity. The investment bank may earn a fee for this work. For Government of Canada (GOC) bonds, the Bank conducts auctions on behalf of the Department of Finance, to which only recognized government securities distributors (GSDs) and primary dealers (a subset of GSDs) are permitted to submit bids. © CANADIAN SECURITIES INSTITUTE 5 6 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 Primary dealers have greater responsibilities and privileges than other GSDs. In exchange for the responsibility of participating in each auction and maintaining secondary markets in GOC securities, they have higher bidding limits on their own behalf and on behalf of their clients. They are also counterparties to Bank’s open market operations. The primary dealer category can be attained in either Government of Canada treasury bills or marketable bonds. There are only a small number of primary dealers in Canada. In contrast, other GSDs do not have to participate in every auction, nor do they have to maintain a market. However, they do not have the same privileges given to primary dealers. As with equity underwritings, corporate debt deals may be either bought deals or fully marketed deals. In some cases, investment banks attempt to pre-sell issues to clients before bringing them to market. Unlike government issues, there may not be a retail allocation in corporate new issues, because many corporations prefer not to pay the extra discount fee for the wider distribution. As a result, some corporate issues are targeted specifically at the institutional market. After new issues are established in that market, retail investors gain access to corporate bonds in the secondary market. FIXED-INCOME MARKET TRADING As with most other developed nations, Canada has no centralized exchange for bond and money market trading; instead, transactions occur over the counter. Investment banks and other market participants interact through direct negotiations over computer networks or by telephone. In the secondary market, investment banks quote a bid (i.e., the price at which they are prepared to buy) and an offer (i.e., the price at which they are prepared to sell). The process of interaction between investment banks and other participants, either directly or through interdealer bond brokers, determines overall market pricing. Investment dealers primarily earn their profits from the bid/offer spread, which represents compensation for the significant amount of capital tied up and put at risk in the debt market. They may also profit from the fees generated by providing advice in bringing new issues to market, and by proprietary trading when the issue is distributed. DID YOU KNOW? In proprietary trading, the firm uses its own capital to make bets on the direction of the market. In the course of their activities, investment banks help to generate market liquidity, with the spread between bid and offer prices indicating the liquidity of the underlying security. The spread takes into account expectations about future price movement, the competition between participants, and the cost to investment dealers of carrying inventory. The smaller the spread, the easier it is to move positions in the security. The bulk of bond and money market trading is carried out between investment banks and institutional clients, such as pension funds, insurance companies, large corporations, and mutual funds. The size of the assets managed by these investors requires their active presence in the markets. Given the amount of business these clients conduct, investment banks go to great lengths to develop relationships with them. MERGERS AND ACQUISITIONS Advice on M&As includes strategic recommendations about which target corporations are worth pursuing, tactical suggestions about what price to offer, and the best way structure a deal. Targets of acquisitions also seek investment banking advice on how to negotiate the best price or how to defend themselves from potentially unprofitable transactions. Transactions in M&A generate large sums of fee revenues for investment banks, as well as fees for advising, lending money, and divesting unwanted assets. Fees are usually negotiable and contingent on the success of a deal. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 7 After a suitable candidate or target corporation has been identified, the investment bank conducts a valuation of the merger candidate to determine what price to offer. The valuation techniques are used only in determining the price range for the target company. Each acquirer uses the technique that fits its objective. Of equal importance, a risk analysis is performed, such as a scenario or sensitivity analysis. The valuation is not complete until the impact of the acquisition on the acquirer is carefully examined. Investment banks may use the following techniques to value a target: Discounted cash flow The widely used discounted cash flow (DCF) technique determines the value of technique a targeted acquisition by projecting its future cash flows and discounting those projections to the present value. The DCF approach is future oriented; it begins with a projection of sales and operating profit based on an assessment of historical performance and on certain assumptions regarding the future. The usefulness of this technique depends on several assumptions, including the impact on the company’s other areas of business, the length of the projection period, the amount of additional working or fixed capital required, the discount rate, and the residual value. The value of the DCF approach should be estimated under different scenarios. Comparable-transaction A comparable-transaction analysis is an analysis of the transactions involving analysis companies in the target’s industry or similar industries over the previous several years. Acquisition multiples are calculated for the universe of the comparable transactions. These multiples are then applied to the target’s financial results to estimate the value at which the target would likely trade. This technique is effective when data on truly comparable transactions is available. Comparable-company With the comparable-company approach, the value of the potential acquisition approach candidate is assessed in comparison to the market prices of publicly traded companies with similar characteristics. This method is similar to the comparable- transaction approach in that it identifies a pricing relationship and applies it to the candidate’s earnings, cash flow, or book value. A change-of-control premium is added to the value identified by this method to arrive at the estimated valuation range for the target. One weakness of this technique is that it works well only when there is good comparable information for the target available. Another weakness is that accounting policies can differ substantially from one company to another, which can result in material differences in reported earnings or balance sheet amounts. Breakup valuation The breakup valuation technique involves analyzing each of the target’s business technique lines and adding up the individual values to arrive at a value for the entire company. Breakup analysis is best conducted from the perspective of a raider initiating a hostile takeover. The value of the target in the raider’s hands is determined initially, and then the acquisition cost is estimated. If value exceeds cost, the raider computes the rate of return. Target stock price-history Analysis of the target stock’s price history involves examining the stock trading range analysis of the target over a certain period. The target price performance is analyzed against a broad market index and comparable-company performances. The offering price is based on the price index plus some premium. If the transaction is a stock-for- stock exchange, similar analysis is performed on the acquiring firm to determine the exchange ratio. This approach fails to account for future prospects of the company. Nevertheless, it does provide historical information many find useful in framing a valuation proposal. © CANADIAN SECURITIES INSTITUTE 5 8 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 M&A multiples The M&A multiples technique involves analysis of the current and past broad acquisition multiples and the change-of-control premium. This technique is used when comparable transactions or comparable companies are not available. The limitation is in the fact that a broad market average may be inapplicable to a single transaction. Leveraged buyout analysis A leveraged buyout (LBO) analysis is performed when the target is a potential candidate for an LBO. The objective is to determine the highest price that an LBO group would pay. This price is often the floor price for the target. On the other hand, it may set the upper value for the target company if a corporate buyer cannot be identified. The LBO analysis includes cash flow projections, rates of returns to capital providers, and tax effects. The primary difference between the LBO analysis and the DCF technique is that the LBO approach incorporates financing for the LBO. The availability of financing depends on the timing of cash flows, particularly in the first several years after the deal is completed. Clearly, the value derived by the LBO approach can be materially affected by temporary changes in financing conditions. Leveraged recapitalization Leveraged recapitalization is aimed at identifying the maximum value a public company can deliver to its shareholders today. In general, the analysis is performed in the context of a probable or pending hostile offer for the target. The value in a recapitalization is delivered to the shareholders through stock repurchase, cash dividends, and a continuing equity interest in a highly-leveraged company. This technique focuses on the target’s capital structure and is largely affected by the availability of debt financing at a particular time. Gross revenue multiplier The gross revenue multiplier is also called the price-to-sales ratio. The basic concept is that the value is a multiple of the sales the target generates. This method assumes that there is a relatively consistent relationship between sales and profits for the business. Obviously, the usefulness of the technique depends on this revenue-to- profit relationship. In practice, it may be useful when the acquisition is a private company where gross sales are the only reliable data available. Book value approach The book value approach is an accounting-based concept, which may not represent the earnings power of the target. The value of intangible assets may also not be reflected in the balance sheet. However, the technique can help to provide an initial estimate of goodwill in a transaction. Multiplier-of-earnings- The multiplier-of-earnings-per-share method involves taking the past or future per-share method income per share and multiplying that figure by an earnings multiplier derived from publicly traded companies in the same industry. One difficulty is that the known multipliers do not reflect control premiums, as evidenced by the rise in the multiplier in the event of an acquisition. Another problem is that income does not necessarily represent cash flow from operations. Liquidation analysis Liquidation analysis can be used to establish a floor for valuation. This approach is relevant if a business is being acquired for its underlying assets, rather than for its going concern. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 9 FAIRNESS OPINIONS Most companies involved in M&A activity obtain a second opinion, in the form of a fairness opinion, to determine whether the transaction being proposed is fair from a financial standpoint. Fairness opinions are established based on a valuation report. They require an in-depth analysis of the companies involved, as well as the terms and conditions of the transaction. The average fee paid for a fairness opinion is small relative to the overall fees paid to investment banks on M&As. However, when the investment bank providing advisory services also offers the fairness opinion, a potential conflict of interest can arise. Obviously, the bank has an incentive to see the transaction completed to receive the success fee. For this reason, the special board committee working on behalf of the target should use a different investment bank for an independent opinion. An unbiased opinion provides value to executives and boards as an additional form of due diligence. It also provides a mechanism to ensure quality transactions that are fair to shareholders. A fairness opinion acts as an insurance policy by offering directors a first line of defence against shareholders’ lawsuits. A timely, independent analysis may establish, for the record, that the board has properly exercised its business judgment by having adequately considered the proposed transaction and the potential alternatives. FINANCIAL RESTRUCTURING Financial restructuring often involves transactions for distressed companies, both in and out of bankruptcy. Advisors in this area must provide a structure for a broad array of options for company owners, executives, creditors, and other parties. The complex restructuring process requires comprehensive analyses and creative solutions and must be managed to maximize value and minimize delay. A financial restructuring may require that assets be divested quickly under extremely distressed circumstances. Many distressed sale transactions are consummated in bankruptcy, which means that the investment bank must calm the fears of buyers and convince them of the benefits of purchasing the assets of the distressed company. Often, the valuation of the company in bankruptcy requires modifications to traditional valuation techniques for healthy companies. The sale must be done quickly because the value may decline further as time passes, leaving liquidation as the only available alternative. Restructuring is sometimes more strategic than transactional. In those cases, the pressing job is to create and execute a total solution for the company to grow and return to profitability. First, the investment bank evaluates the company’s finances thoroughly, along with industry condition and the capital market environment. The investment bank then explores and presents to the company all strategic alternatives and processes, and explains the impact on various stakeholders. After this comprehensive review, the investment bank recommends and executes a value- maximizing strategy. TRADING SERVICES AND LIABILITY TRADING Investment banks earn commissions on their agency trading business. Their success in attracting agency business from institutional clients is usually dependent on order execution, particularly in difficult situations. They provide research to clients, along with access to deal flow or IPOs. The agency trader’s relationship with the institutional client is also very important. Liability traders trade the firm’s capital to make a profit. Proprietary trading occurs not just with equities, but also with bonds, options, commodities, and derivatives. The traders may use a variety of strategies to earn the firm (and themselves) profits, including arbitrage and trading on fundamental or technical analysis. Liability trading is a crucial part of the trading services offered by investment banks. The liability trader’s role is to maintain a balance between market share and profitability. Firms want to be seen as the go-to liability trader with respect to a particular stock or sector to drive order flows. To ensure a well-functioning secondary market, and to be seen as the go-to firm for a particular stock, liability traders sometimes execute trades that cost the firm trading capital. However, commitment to making a market for this stock may help secure future agency business from © CANADIAN SECURITIES INSTITUTE 5 10 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 institutional clients, or even underwriting business from the issuer of the stock for the next equity financing. When choosing an investment dealer, issuers of new securities consider the ability of a firm to make secondary markets for their securities. Accordingly, most investment dealers have substantial investments in personnel and technology so they can compete effectively in the secondary markets. Another consideration is the fact that the investment bank’s reputation suffers if the price of the IPO security declines after the issuance. To protect its reputation, the bank may support the stock with its own capital and keep it at, or just above, the issuance price for some time. The costliness of this strategy reinforces the need to price the issue properly and build in a good underwriting spread. Most notably, however, it underscores the critical importance of a robust due diligence process during underwriting so that risks are identified and the deal can be priced accordingly. INSTITUTIONAL SALES The institutional sales representative is the relationship manager between the institutional client and the investment bank’s service providers. The client is typically a money manager, and the services provided include order execution, research, and investment banking advice. Institutional sales reps are responsible for building strong relationships with clients, which can drive business to the firm. FINANCIAL ENGINEERING AND STRUCTURED PRODUCTS Financial engineering is the term used to describe an investment bank’s innovations in security design. The rapid pace of financial innovation is driven by the competition among investment banks in response to increased price volatility, tax and regulatory changes, and the demand for new funding sources, arbitrage, and yield enhancement. The application of mathematical and statistical modeling, together with advances in computer technology, provides the necessary infrastructure for financial engineering. Through financial engineering, investment banks strive to meet the needs of borrowers and investors, including the need for hedging, funding, arbitrage, yield enhancement, and tax reduction. This branch of investment banking drives the explosive growth in the markets for structured products and derivatives and allows dealers to offer customized products based on what they perceive as end-client demand. The development of the high-yield bond and asset-backed securities markets provides borrowers with additional funding sources at lower costs. Structured notes add another dimension in the funding and investment spectrum. Transactions in repurchase agreements provide lower funding costs for borrowers and give legal title to the collateral to lenders. Through swap contracting, borrowers and investors obtain more flexibility in asset-liability management at better terms. Credit derivatives have widespread applications in hedging credit risks. SECURITIZATION The principle of asset or product securitization is theoretically simple: financial products are repackaged to change the risk-to-return characteristics of the resulting securities. Investors typically hold these securities for any of three main purposes: They seek a higher or lower risk-return mix than the underlying security itself. For example, an institutional investor might want to invest in a AAA-rated security with real estate as the underlying asset. A hedge fund, on the other hand, might hold an equity tranche for speculative purposes. They seek the higher returns that these high-securities provide. For example, a AAA tranche would pay more than an equivalent Treasury bill with similar features. As new investors, they have access to certain asset classes that were previously unavailable. For example, many investors are unable to enter commercial real estate physically by purchasing entire buildings. However, by holding the securitized instruments, they are able to hold a percentage of the pool – small or large, as needed. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 11 Typically, securitized products have three tranches that provide cash flows to the holders: a AAA tranche, a mezzanine tranche, and an equity tranche. Fees to the issuer are generated from the cash flows. Although great revenues are generated from securitization, the risk is that securitized products are highly specific, without a ready secondary market. Holders must therefore accept illiquidity as a cost, which increases the risk component in the return-to-risk ratio. Importantly, investment banks that structure and issue these products could also experience difficulty unloading them in times of market stress. In particular, when default probabilities are high, securitized products can become overrated and overpriced. For example, if the probability of default is seen as far higher on the securitized products than on the products they are based on, the price of the instruments will plummet. With far fewer buyers than expected, bid prices are pushed down. Consequently, those who structured the products have excess supply, which pushes ask prices down as well. In addition, and as history has taught us, although the product itself may have an appropriate design and satisfactory offering documents, the product itself must still be properly sold to the end client. The sales process places obligations such as the KYP requirement on the selling broker, whereby registered representatives and dealer members must properly explain the products they sell to clients. Additional liability may arise if clients sustain losses and then claim that they did not understand what they were purchasing. This situation occurred during the asset-backed commercial paper (ABCP) crisis, and more recently, with principal protected notes (and similar products) and leveraged exchange-traded funds. DID YOU KNOW? Outcomes of the Sub-Prime Crisis Structured and securitized products have contributed strong revenue growth to a number of investment banks, but with unintended consequences. The collapse of the venerable Lehman Brothers, arguably the oldest investment bank, is a good case in point. Although Lehman was a diversified, full-service investment bank, its roots and core strength were in the area of fixed income, loans, and mortgages. Because of its ready access to loans, it developed strong expertise in a securitized product called mortgage-backed securities (MBS). In 2006 and 2007, it became the top MBS originator in the United States, with more than 10% of market share. Lehman and other investment banks realized that high revenues could come from the securitization business in several ways. First, they could originate the loans and generate fees from that activity. Then, they could generate more fees by securitizing the loans and reselling them to other institutions. The 2008 sub-prime crisis dramatically revealed the high cost of these financial innovations and the consequences of failing to understand the character and strength of the underlying assets that collateralized the loans in question. Weaker markets pushed investment banks and Wall Street firms away from securitized products, which put downward pressure on the sector. At the same time, those already holding the instruments were trying to unload them, further creating a price collapse. Lehman Brothers suffered heavy losses from holding on to large positions in sub-prime and other lower- rated mortgage instruments. Rating agencies downgraded the firm, and eventually it lost the confidence of the market and was forced into bankruptcy. Although this crisis arose in the United States, the issues it revealed are equally applicable to the Canadian marketplace. The investment banks that manufacture these products must design them in such a fashion that the risks can be properly explained. Additionally, where the underlying assets themselves (e.g., the mortgages underlying an MBS) are improperly valued, additional market stress occurs. As history has shown, additional stress can escalate into a full blown market collapse. For these reasons, dealer members with investment banking operations must conduct proper diligence when creating such products. © CANADIAN SECURITIES INSTITUTE 5 12 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 NEW PRODUCT APPROVALS AND THE KNOW-YOUR-PRODUCT RULE As part of their internal control system, dealer members must have formal, written policies and procedures appropriate to their business regarding the sale of new products. The purpose of these measures is twofold: 1. To ensure that no new product is introduced to the marketplace before it has been thoroughly vetted from a regulatory, risk management, and business perspective 2. To ensure that dealer members and their RRs know and understand the products they offer so that they can conduct a proper suitability assessment with every client Guidance Note 3300-21-001, Product Due Diligence and Know-Your-Product, outlines CIRO’s expectations regarding the due diligence that investment dealers must conduct on all securities they make available to clients. According to the guidance, a dealer member’s product due diligence procedures are expected to include: defining a new security the level and depth of assessment required the type of information to be collected who is responsible for assessing the security The guidance suggests that an effective product due diligence program should include the following elements: A standardized process that requires a written proposal for new products A preliminary assessment of a proposed product or concept by personnel or a department designated in the firm’s policies and procedures to determine the following factors (among others): Whether it is a new product or a material modification of an existing product The appropriate level of internal review For complex or novel securities, a detailed review by a committee or working group made up of representatives from all relevant sectors of the firm, including compliance, legal, finance, marketing, sales, and operations A formal decision to approve, disapprove, or table the proposal by a new-product committee or other decision- making group that includes members of the firm’s senior management An assessment of the extent of training in product features and risks necessary to ensure that RRs and supervisors can judge the suitability of the recommendations and sales to clients The development and implementation of the necessary training If the product is approved, the appropriate level of post approval and follow-up must be determined and a process put in place, which should include the following aspects: Monitoring of customer complaints and grievances related to the product Reassessment of training needs on a continuing basis Monitoring of compliance with restriction placed on the sale of the product Periodic reassessment of the suitability of the product To fulfill their suitability obligations, registrants must have a complete understanding of the products that are available for recommendation. Registrants should have an in-depth understanding of each of the following items before recommending a product to clients: General features and structure, including returns, use of leverage, conflicts of interest, time horizon, and overall complexity of the product Risks, including the possibility that clients may lose some or all of the principal invested, liquidity risk, redemption risk, risks from underlying derivatives or structured products, and risk of conflicts of interest © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 13 Costs, including fees paid to registrants or other parties such as commissions, sales charges, trailer fees, management, incentive fees, referral fees, embedded fees, or executive compensation Parties involved, including the issuer’s financial position and history, qualifications, and reputation and track record regarding key aspects of the product Legal and regulatory framework, including frequency, completeness, and accuracy of the issuer’s disclosure RESEARCH Sell-side research has faced considerable challenges in recent years. Some clients on the buy-side view research reports as an oversupplied commodity, with many analysts covering the same company or industry, and with little additional insight provided by each report. As well, some buy-side clients choose to pay lower commissions and buy the research with hard dollars from independent research houses, thereby unbundling research from the commission they pay. Finally, many large buy-side clients have developed their own research departments. Nevertheless, research is still considered a crucial element of an investment bank’s service offering. In particular, buy-side clients clearly value having timely analyst insight into industry trends and company-specific trading ideas. It is therefore important for clients to have access to top analysts when needed. Money manager clients also value the access that analysts provide to the key personnel of the companies being covered. Furthermore, clients greatly value the ability of the research department to customize the research to their needs. In addition to institutional clients, analysts have a key internal customer for their work in the corporate finance department. Analysts can provide corporate finance professionals with general financial forecasts and technical insight into particular companies and their products. Because analysts may service both internal corporate finance needs and the needs of buy-side clients, a number of regulatory initiatives have been introduced that are designed to eliminate or minimize possible conflicts of interest. The IDPC rules address the need to separate research and research reports from influence by the firm’s corporate finance division. ANALYST STANDARDS When setting up a compliance regime for dealer members that produce and distribute research reports, it is necessary to place certain restrictions on these activities to avoid conflicts of interest and to control the dissemination of these reports. To be compliant with the rules, dealer members must have written policies and procedures in place to control potential conflicts of interest that may arise in the preparation and publication of research. The first step towards compliance is to designate a supervisor to ensure that every employee adheres strictly to the policies and procedures that apply to their role or particular situation. Dealer members must develop procedures that place trading restrictions on persons who are directly involved in preparing research reports. These persons are prohibited from trading in the securities of an issuer, or in a derivative based on the value of a security of an issuer, for a period of 30 calendar days before and five calendar days after they issue a research report. This requirement can be waived if the person has received the written approval of a designated supervisor. Quiet periods must also be established for the issuance of research reports. Specifically, dealer members are prohibited from issuing research reports for equity or equity-related securities of an issuer for 10 calendar days after an IPO, or for three calendar days after a secondary offering. This requirement does not apply when the securities involved are exempted from restrictions relating to legislation regarding market stabilization or under UMIR rules. © CANADIAN SECURITIES INSTITUTE 5 14 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 DIVE DEEPER Subjects such as compensation disclosure must also be covered by policies and procedures. Refer to the IDPC rules regarding research restrictions and disclosure for a complete list of requirements. CORPORATE AND MERCHANT BANKING Corporate banking was once separate from investment banking, but, in recent years, lower regulatory barriers and corporate synergies have led to a merging of the two divisions. Corporate banking normally includes the structuring and execution of the following credit transactions: Bridge loans Money market lines Project finance Institutional term loans Acquisition financing Merchant banking involves the commitment of the firm’s capital to equity-level investments and participation. Its activities include guarantee financing, venture capital, leveraged buyouts, and restructurings. Major investment banks all have private equity operations, the benefits of which include management fees, capital gains, and contributions to underwriting and M&A business. A firm may simply raise money for external private equity funds, such as venture capital or buyout funds, or it may manage the fund itself. Even though many private equity investments fail, the successful ones are so profitable that overall annual returns are often quite attractive. Data on private companies is limited, but early-stage companies usually experience a period of negative cash flows and earnings before they produce positive net income. It is difficult to value private companies because the timing and the amount of future profits are highly uncertain. The following private equity valuation approaches are commonly used: Comparables (i.e., both comparable transaction and comparable company analysis) DCF analysis Option valuation Venture capital method Comparables and DCF approaches are used as in M&A valuation and were discussed earlier in this chapter. Option valuation and venture capital methods are explained below. OPTION VALUATION The option valuation method assigns a value to the flexibility the venture capitalist has in making follow-on investments. This method is similar to a call option on a company stock in that the venture capitalist has a right, but not an obligation, to acquire an asset at a certain price, on or before a particular date. Unlike the DCF approach, the options valuation method captures the value of this option to either invest or not invest in the project at a later date. The main drawback of this method is that many business people are not aware of this real option concept. Furthermore, real-world problems are often too complex to be captured in this model. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 15 DID YOU KNOW? The Black-Scholes model was the first widely accepted method to value European options. This approach uses the following variables: Exercise price Stock price Time to expiration Standard deviation of stock returns Time value of money The variables are used to calculate the following information, from which the value of the firm is then derived: Present value of expenditures required to undertake the project Present value of the expected cash flows generated by the project Length of time that the venture capitalist can defer the investment decision Riskiness of the underlying assets Risk-free rate This approach is useful because it specifically incorporates the option to wait, learn more, and then make the investment decision. VENTURE CAPITAL VALUATION The venture capital valuation method takes into account negative cash flows and uncertain future profits. It considers the cash flow profile by valuing the target company at a time in the future, when it expects to generate positive cash flows and earnings. The terminal value at that projected target date is discounted back to the present value by applying a target rate of return (TRR) rather than cost of capital. The TRR is the rate of return that the venture capitalist requires when making an investment in the portfolio company. The terminal value is generally obtained by multiplying the price-to-earnings ratio by the projected net income in the year. The amount of proposed investment is divided by the discounted terminal value to give the venture capitalist’s required percentage ownership. The final step is to calculate the current percentage ownership, taking into consideration the dilution effects when the portfolio company goes through several rounds of financing. This step is done by calculating a retention ratio that factors in the dilutive effects of future rounds of financing on the venture capitalist’s ownership. EXAMPLE Assume that the portfolio company will sell 30% in the second round, and then another 25% in the third round, before it goes public. The retention ratio is 61.5% because that 1% ownership in the initial investment is diluted to only 0.615% after two rounds of financing. Assume also that a venture capitalist invests $10 million and requires a final percentage ownership of 10%. In this case, the venture capitalist will require a current ownership percentage of 16.26%, which is necessary to realize the target rate of return. © CANADIAN SECURITIES INSTITUTE 5 16 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 SECURITIES SERVICES In prime brokerage, the investment bank acts as the back office for the fund by providing the operational services necessary for the money manager to manage his or her business effectively. This function enables the client to focus on investment strategies, rather than on operational issues. A good prime broker provides the following services and advantages: Centralized custody Clearance Securities lending Competitive financing rates A single debit balance and credit balance Real-time and periodic portfolio accounting Position and balance validation Electronic trade download Wash sale reports Office facilities in selected markets DID YOU KNOW? In security lending services, investment banks find and lend securities for clients to facilitate settlement of a trade and make good delivery, thus covering their short positions. Regarding financing rates, financing services provide funds to finance clients’ purchases of securities. In addition, new financial products designed by the financial engineering team often enhance the firm’s services to clients. TRENDS AND CHALLENGES The securities industry by its nature subject to volatility. Shifts in the competitive landscape, changes to interest rates and foreign exchange rates, and global economic and political trends all have an impact on businesses that operate in the industry. The menu of services on offer is also changing as investment banks are forced to keep up with trends, meet new challenges, and contend with intense competition. In this section, we discuss the factors that make the difference between success and failure in this environment. We also discuss some market trends that competitive firms should be aware of, and we touch on the key risks they face in this rapidly changing environment. KEY SUCCESS FACTORS Investment banks that manage to achieve and maintain a leadership position in the securities industry tend to have the following characteristics: Deep client relationships to obtain a long-term flow of business Strong product lines to offer the best products and services Ability to provide clients with integrated solutions to help them achieve superior results Strong global presence and local knowledge Strong financial strength to establish the confidence of clients © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 17 Effective risk management processes to ensure the firm’s financial soundness and profitability A solid governance structure to ensure compliance with internal policies and regulations Integrity and professionalism to create trust and provide superior services Appropriate compensation system that attracts and retains talent MARKET TRENDS Investment banking is a fluid and dynamic business in which several essential functions are performed in the marketplace. Origination and strategic advisory are two of these core functions. As the market evolves, some full-service firms are diversifying and balancing their revenue streams. They have chosen to pursue a more focused strategy and have liquidated none-core assets. Successful firms constantly anticipate market trends and opportunities, and then align resources to ensure that they take the best advantage of those opportunities. They also perform ongoing analysis of each client to provide smart solutions, so that clients achieve superior performance. In this environment, the following important market trends have emerged: Regulatory compliance and high standards of governance have become an integral part of the business. Recent industry challenges have resulted in regulatory demand for ongoing and continuous disclosure, as well as enhancements to the know-your-product requirements. Globalization is providing opportunities for faster growth. To fortify their competitive position and attract and maintain the best employees, many firms have begun deleverage their balance sheets and adjust their methods of compensation. Technological advancements are constantly forcing firms to either keep up or risk being left behind. COMPLIANCE AND GOVERNANCE With respect to compliance and governance, the focus has generally been in the areas of corporate accountability, standards of corporate governance, and conflicts of interest. For example, NI 52-109 Certification of Disclosure in Issuers’ Annual and Interim Filings seeks to enhance transparency and impose responsibility at the highest levels of public companies. Under this instrument, public companies must certify that they have established reasonable internal control systems and procedures to ensure that financial reporting is carried out correctly. Accountability and transparency have received more attention following the 2007 asset-backed commercial paper (ABCP) crisis in Canada and the 2008 sub-prime crisis in the United States. Another important element for investor confidence relates to analyst conflicts of interest. The importance of addressing such conflicts properly through identification, avoidance, and management is applicable to all dealer member operations. Conflicts of interest must be managed carefully and disclosed to clients. In the context of investment banking for example, analysts are subject to rules which spell out the expected behaviour when they prepare and disseminate their reports. It is in this area that separation of business lines is often discussed to ensure that analysts operate independently from a dealer’s investment banking function. EXAMPLE A striking example of the impact of regulatory change came in May 2005. Merrill Lynch withdrew from underwriting the IPO of Warner Music Group after its media analyst told Merrill Lynch’s senior bankers that they were overpricing the shares. This type of independent commentary and resolution was rarely seen in the past. © CANADIAN SECURITIES INSTITUTE 5 18 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 GLOBALIZATION In addition to expanding the products and services they offer at home, large investment banks are also expanding geographically to become financial supermarkets to the world. With rapid advances in information technology and greater co-operation among financial regulators, international capital markets are now closely linked. Larger sums of money than ever before are moving across national borders, and more countries have access to international finance. By going global, investment banks not only serve their clients better, but also benefit from the higher growth potential of international markets. Big Wall Street banks all have a strong global presence and have established leadership positions in core products. Large Canadian banks, helped by their well-deserved reputation for resilience through the financial crisis and their general financial strength, are looking abroad for opportunities. Major U.S. banks earn a significant portion of their net revenues from international operations, and foreign financial institutions have also established and investment banking presence in North America. CORPORATE FINANCES AND COMPENSATION Recent financial crises have led to many changes in the investment banking business, including staff reductions, dividend cuts, and dilution of shareholders through massive share issuance. For some firms, the turbulent markets ultimately led to bankruptcy. For others, mergers to larger commercial banks, extraordinary government assistance, or conversion to commercial banking charter became necessary. As a result, most financial institutions have raised capital and downsized assets to reduce leverage and increase the tangible common equity ratio. To maintain a competitive edge and meet the expectations of clients, investment banks must attract, retain, and motivate employees. Performance-based compensation that rewards results is fundamental to the operations of an investment-banking firm. Therefore, employee compensation and benefits make up a large portion of expenses, reaching almost 50% of total net revenues at many firms. Both in Canada and in the United States, there is pressure to align pay so that not just profits are rewarded, but also adherence to sound risk management principles in pursuit of those profits. We discuss the issue of compensation in detail further on in the course. INTERNET AND INFORMATION TECHNOLOGY Changes in investment banking have been assisted in part by the advent of the internet and advances in information technology that allow for e-commerce. Many firms now use the internet for extended trading in markets around the world. Clients have online access to research, data, and valuation models around the clock. Some have gone a step further to allocate shares of IPOs through online auctions. The online auction approach brought out many IPOs for small businesses and some for large businesses. For example, Google’s IPO was undertaken using the online auction process. Investment banks are also developing software and information technology systems that enable them to enhance their service to clients, better manage risks, and improve overall efficiency and control. New software has made it possible for firms to tailor their research and services to each client’s particular needs. Furthermore, technological advances enable investment banks to design and price complex contracts and derivatives, and to analyze their underlying risks. Every firm has software that enables it to monitor and analyze markets and credit risks. Risk management software can analyze market risk at the firm, division, and trading desk levels. It can also break down a firm’s risk into its underlying exposures, which permits management to evaluate the firm’s exposure in the event of changes in interest rates, foreign exchange rates, equity prices, or commodity prices. Without such software, ventures into international markets and complex trading would carry much greater risk. Finally, information technology has been a significant factor in improving the overall efficiency of investment banks (as well as many other businesses). Computerized and electronic trading is both more efficient and more accurate. Management now has real-time information on the firm’s operations worldwide, which supports globalization. Overall, improvements to technology make better decision making possible and can improve a firm’s competitive edge. © CANADIAN SECURITIES INSTITUTE  CHAPTER 5      INVESTMENT BANKING BUSINESS 5 19 ONGOING CHALLENGES Given the scope of new products on offer and the increasing complexity of regulations, the risk landscape in the securities industry is changing as well. Constant monitoring of this landscape to create effective risk management programs is of primary importance to the success of an investment bank. All investment banks must establish a comprehensive risk management process to monitor, evaluate, and manage the risks that the firm assumes in conducting its businesses. They must also establish a risk culture in which all employees are aware of the risks in everything they do. Important areas include market, credit, liquidity, operational, legal, and reputation exposures. With rapid advances in digital technologies and a corresponding rise in cyber-crime, cybersecurity is a particularly relevant concern. Throughout this course, we discuss risk these multiple risks in various contexts, and we explain how dealer members can create an effective risk management framework that captures all risks to which they are exposed. © CANADIAN SECURITIES INSTITUTE 5 20 PARTNERS, DIRECTORS AND SENIOR OFFICERS COURSE      SECTION 2 SUMMARY In this chapter, we focused on the following key aspects of the investment banking business, with a particular focus on risk management: An investment bank is generally divided into three main areas: front office, middle office, and back office. In this chapter, we focused on the following front office functions: Finance (equity and fixed income underwriting) M&A (strategic advice, fairness opinions, and restructuring) Research (analytical services to buy-side clients and internal corporate finance) Trading services and sales (including structuring products) Corporate banking (structuring and execution of credit transactions) Merchant banking (financing guarantees, venture capital, leveraged buyouts, and restructurings) Security services (prime brokerage) We also discussed the various ways in which each area of investment banking generates revenue and the ways in which the different areas are interconnected. Success in investment banking depends on strong interconnections. One of the key success factors is the ability to provide clients with integrated solutions. Other success factors include deep client relationships, a strong product line, strong global presence, and an appropriate compensation system that attracts and retains talent. One of the most important success factors is an effective risk management process. Key investment banking risks include market, credit, liquidity, operational, legal, and reputational exposures. An important point to remember is that the proliferation of new products and increasing complexity of regulation has made effective risk management a must, particularly given the significant impact that failures can have on dealer members. Investment banks face increasing competition and increasingly restrictive government regulations. To stay competitive and maintain stable earnings, they be client-focused and innovative. They must seek diversified revenue streams and, above all, they must have effective compliance regimes and risk management processes. The material in this chapter should help you develop a holistic view of the securities industry in the context of risk management at your particular firm. The next chapter, the final one in this section, we will explore the processes involved when securities are distributed in the market. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 5 Review Questions. © CANADIAN SECURITIES INSTITUTE