MN50412 Investment Banking 1

General information Lecturer: Dr Richard Fairchild Office: Wessex House Lecture time: Thursdays 9.15 – am Office hours: Tuesday 14.15pm pm 2

What is investment banking? 3

The banking function The banking function can be decomposed into: –Central banking: Monetary policy (interest rates, money supply) In the UK: Bank of England –Commercial banking: Lending to the public (businesses, individuals, banks) Receiving deposits from businesses and individuals In the UK: HSBC, RBS, Barclays, HBOS –Investment banking 4

Investment banking activities Investment banking activities include: Mergers and acquisitions (+ divestitures) –Advise potential buyers on which companies to target –Help sellers screen potential buyers –Suggestions about what price to offer/accept –Negotiation support –Structuring the deal ( pay in cash vs. pay in stock) 5

Debt underwriting –IB help companies and governments raise money by issuing corporate or government bonds –Underwriting: IB act as intermediate between the issuer and investors (individuals, banks, mutual funds, hedge funds, sovereign funds etc.) Act as primary dealers for the government Have a certification role for companies that want to issue bonds Proprietary trading: Trading with the bank own money 6

Equity underwriting - Evaluate the issuer -Determine the offering price -Buy the shares from the issuer -Find investors and sell the shares -Initial public offering (IPOs) Asset management -Managing short-term cash flows of corporate clients -Management of long-term bonds and equity portfolios of investors -Institutional investors: insurance companies, pensions funds etc. -Private investors 7

Asset securitization -Issuance of securities using a pool a similar assets as collateral -Mortgage-backed securities, asset-backed securities Private equity: refers to shares in companies that are not publicly traded -Venture capital -LBOs: using borrowed money for a substantial portion of the purchase price of the buyout company -IB can raise funds for private equity funds or manage these funds themselves 8

Investment banks Investment banks are financial institutions that engage primarily in IB activities Investment banks engage in public and private market transactions with corporations, governments and institutional investors. Main differences with commercial banks: - IB have a marginal role in deposits and loan activities. - IB usually take short-term positions, i.e. few days (except in the non-core business of venture capital). Commercial banks take longer term positions. 9

Investment banks are intermediary between those needing funds and those having them: –Need funds: Corporations, government –Have funds: Corporations, investment vehicles such as mutual funds, pension funds etc. How do they make money? –Fees (underwriting, M&A, asset management) –Trading revenues Main IB up to early 2008: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns 10

Commercial banks Institutions whose current operations consist mostly in granting loans and receiving deposits from businesses and customers Universal banks Banks that combine commercial and investment banking Example: UBS, Citibank, Bank of America 11

Content of the course 12

Content of the course Introduction Equity underwriting –Why go public? –The IPO process –Syndicates in IPOs –Market shares in IPOs –Underwriting spread in IPOs –Underpricing of IPOs –Long-run performance of IPOs 13

Debt underwriting –Pricing of bonds –Yield curve –Corporate vs. government bonds –Callable bonds, convertible bonds Derivatives products –Futures –Options –SWAPS, CDO, CDS 14

Mergers and acquisitions –M&A valuation –Determinants of market shares –Who gains from mergers? –Financing: cash vs. stock –Why use IB? Investment banks vs. commercial banks Role of IB in the financial and economic crisis Asset management: -Active vs. passive management -Performance measurement 15

Contribution of financial services to the UK economy 16

Sectors' share in UK GDP 17

Financial services jobs in central London City of LondonCanary WharfCity-typeUK Fin. servsTotalFin. servsTotal

UK sector trade balances 19

Tax contribution of UK financial services CorporationIncomeTotal Corporation (share) Income (share)

International financial markets in the UK 21

IB revenues 22

Funds under management Institutional2,4002,556 - Insurance Corporate pension funds Other (local authority, charity, etc) Retail Hedge funds Property funds Private Equity funds3429 Private client funds Total funds under management in the UK3,8124,118 23

Sovereign wealth funds under management (global) 24

Global private equity 25

UK market shares % shareUKUSJapanFrance Germa ny Cross-border bank lending (Mar 2008) Foreign exchange turnover (Apr 2007) Exchange-traded derivatives turnover Over-the-counter derivatives turnover International bonds - secondary market70... Fund management (as a source of funds, end-2007) Hedge funds assets (end-2007) Private equity - investment value (2007) IPOs (Jan-Sep 2008) Securitisation - issuance (2007)

Turnover of London based derivatives exchanges ICE Futures Europe LiffeLMEEDXTotal ,

UK vs. US ( ) 28

Investment banking in the US The modern concept of “Investment Bank” was created by the Glass-Steagall act (Banking Act of 1933). Following the 1929 stock market crash, large banks went bankrupt. Glass-Steagall separated commercial banks, investment banks, and insurance companies. In 1999 the Glass-Steagall Act was waived (Graham-Leach- Bliley Act). 29

Investment banking in the UK In the past, separation between: 1.Brokers: Rout the orders of customers to the stock exchange, give advices on investments. They cannot take positions in the stocks that act as brokers for. 2.Jobbers: Market makers that could trade only with the brokers, not with the general public. 3.Merchant banks: Commercial banks that offer corporate finance services (M&A advisory, underwriting etc.). Did not own the brokers. In 1986: Big bang: 1.Abolition of fixed commission to increase competition 2.Dual capacity: Jobbers, brokers and merchant banks can integrate 30

1990s: The failure of UK investment banks Problems –The US had deregulated fees in 1975 –Business became much more complex, more difficult to manage –Lack of managerial experience –Clash of cultures brokers/jobbers/merchant banks Markets became volatile after the 1987 crash Results became volatile and UK banks made substantial losses 1995 saw many UK banks fail amid losses 31

Reasons for US success since the 1990s Large financial and management resources, meaning that they were less exposed Huge profits in the US market allowed cross- subsidisation in Europe Economies of scale for underwriting activities 32