Investment Banker

Most corporations raise long term capital on an infrequent basis. Whereas the activities of working capital management go on daily, the attracting of long term capital is, by comparison, episodic. The monetary sums involved can be huge, so these situations are considered of great importance to financial managers. Since most financial managers are unfamiliar with the subtleties of raising long term hinds, they will enlist the help of an expert. That expert is an investment banker.

The investment banker is a financial specialist involved as an intermediary in the merchandising of securities. He acts as a middleman by facilitating the flow of savings from those economic units that want to invest to those units that want to raise funds, We use the term "investment banker" to refer both to a given individual and to the organization for which he works, variously known as an Investment bank ing firm or an Investment banking house. Although these firms are called "in vestment bankers," they are bankers in name only. They perform no depository or lending functions. The activities of commercial banking and investment banking as we know them today were separated by the Banking Act of 1933 (also known as the Glass Steagall Act of 1933). just what does this middleman role consist op. That is most easily understood in terms of the basic functions of investment banking.

The investment banker performs three basic functions: (1) underwriting, (2) distributing, and (3) advising. Each of these activities will be discussed briefly.

The term underwriting is borrowed from the field of insurance. it means "assuming a risk." The investment banker assumes the risk of selling a security issue at a satisfactory price. A satisfactory price is one that will generate a profit for the investment banking house.

The procedure goes like this. The managing investment banker and his syndicate will buy the security issue from the corporation that is in need of funds. The syndicate is just a group of other investment bankers who are invited to help buy and resell the issue. The managing house is the investment banking firm that originated the business because its corporate client decided to raise external funds. So, on a specific day, the firm that is raising capital is presented with a check in exchange for the securities being issued. At this point the investment banking syndicate owns the securities. The fund raising corporation has its cash and can proceed to use it in the predetermined manner. The firm is now immune from the possibility that the state of the security markets might turn sour. If the price of the newly issued security falls below that paid to the firm by the syndicate, then the syndicate will suffer a loss on this underwriting effort. The syndicate, of course, hopes that the opposite situation will result. Its objective is to sell the new issue to the investing public at a price per security greater than its cost.

Once the syndicate owns the new securities, it must get them into the hands of the ultimate investors. This is the distribution or selling function of investment banking. The investment banker may have branch offices across the United States or it may have an informal arrangement with several security dealers who regularly buy a portion of each new offering for final sale. It is not unusual to have 300 to 400 dealers involved in the selling effort. The syndicate can properly be viewed as the security wholesaler, while the dealer organization can be viewed as the security retailer.

Advising
The investment banker is an expert in the issuance and marketing of securities. A sound investment banking house will be aware of prevailing market conditions and can relate those conditions to the particular type of security that should be sold at a given time. Business conditions may be pointing to a future increase in interest rates. The investment banker might advise the firm to issue its bonds in a timely fashion to avoid the higher yields that are forthcoming. He can analyze the firm's capital structure and make recommendations as to what general source of capital should be issued., In many instances the firm will invite its investment banker to sit on the board of directors. This permits him to observe corporate activity and make recommendations on a regular basis.

Several methods are available to the corporation for placing new security offerings into the hands of final investors. The investment banker's role is different in each of these. Sometimes, in fact, it is possible to bypass completely the use of an investment banker. These methods are described in this section. Private placements, because of their importance, are treated separately later in the chapter.

In a negotiated underwriting the firm that needs funds makes contact with an investment banker, and deliberations concerning the new issue begin. If all goes well, a method is negotiated for determining the price the investment banker and his syndicate will pay for the securities. For example the agreement might state that the syndicate will pay $2 less than the closing price of the firm's common stock on the day before the offering date of a new stock issue. The negotiated purchase is the most prevalent method of securities distribution in the private sector. It is generally thought to be the most profitable technique as far as investment bankers are concerned.

The method by which the underwriting group is determined distinguishes the competitive bid purchase from the negotiated purchase. In a competitive underwriting several underwriting groups bid for the right to purchase the new issue from the corporation that is raising funds. The firm does not directly select the investment banker. The investment banker that underwrites and distributes the issue is in effect chosen by an auction process. The syndicate willing to pay the greatest dollar amount per new security will win the competitive bid.

Most competitive bid purchases are confined to three situations, compelled by legal regulations. These are (1) railroad issues, (2) public utility issues, and (3) state and municipal bond issues. The argument in favor of competitive bids is that any undue influence of the investment banker over the firm is mitigated and the price received by the firm for each security should be higher. Thus, we would intuitively suspect that the cost of capital in a competitive bid situation would be less than in a negotiated purchase situation. Evidence on this question, however, is mixed. 12 One problem with the competitive bid purchase as far as the fund raising firm is concerned is that the benefits gained from the advisory function of the investment .banker are lost. it may be necessary to use an investment banker for advisory purposes and then exclude him from the competitive bid process. In this regard many utilities have in the 1960s and 1970s obtained exemptions from the Federal Power Commission that permit them to raise capital by negotiated underwriting.

Here, the investment banker acts as an agent rather than as a principal in the distribution process, The securities are not underwritten. The investment banker attempts to sell the issue in return for a fixed commission on each security that is actually sold. Unsold securities are returned to the corporation. This arrangement is typically used for more speculative issues. The issuing firm may be smaller or less established than the investment banker would like in order to assume the underwriting risk. Because the underwriting risk is not passed on to the investment banker, this distribution method is less costly to the issuer than either a negotiated or competitive bid purchase. On the other hand, the investment banker only has to give it his "best effort." A successful sale is not guaranteed.

Occasionally the firm may feel that a distinct market already exists for its new securities. When a new issue is marketed to a definite and select group of investors, it is called a privileged subscription. Three target markets are typically involved: (1) current stockholders, (2) employees, or (3) customers. Of these, distributions directed at current stockholders are the most prevalent. Such offerings, called "rights" offerings, are discussed in detail in Chapter 19. In a privileged subscription the investment banker may act only as a selling agent. It is also possible that the issuing firm and the investment banker might sign a standby agreement, which would obligate the investment banker to underwrite the securities that are not accepted by the privileged investors.

In a direct sale the issuing firm sells the securities directly to the investing public without involving an investment banker in the process. Even among established corporate giants this procedure is relatively rare. A variation of the direct sale, though, has been used more frequently in the 1970s than in previous decades. This involves the private placement of a new issue by the fund raising corporation without the use of an investment banker as an intermediary. Texaco, Mobil Oil, and International Harvester are examples of large firms that have followed this procedure.