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1.1.1.1.1Chapter Sixteen
Securities Firms and Investment Banks
1.1.1.2 I. Chapter Outline
1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview
2. Size, Structure, and Composition of the Industry
3. Securities Firm and Investment Bank Activity Areas
a. Investment Banking
b. Venture Capital
c. Market Making
d. Trading
e. Cash Management
f. Mergers and Acquisitions
g. Other Service Functions
4. Recent Trends and Balance Sheets
a. Recent Trends
b. The Balance Sheet
5. Regulation
6. Global Issues
II. Learning Goals
1. Know the different types of securities firms and investment banks.
2. Understand the major activity areas in which securities firms and investment banks engage.
3. Differentiate among the major assets and liabilities held by securities firms.
4. Know the main regulators of securities firms and investment banks.
1.1.1.3 III. Chapter in Perspective
Investment bankers assist borrowers in raising capital in debt and equity markets and provide
advice about mergers and acquisitions, corporate restructuring and general assistance in finance.
Bankers also provide many creative over the counter derivative products. Securities firms
provide brokerage and market making services. The investment banking and securities industries
are complementary and many firms provide a broad range of services. Some specialized entities
with advantages in certain market niches remain less diversified. The industry underwent
tremendous consolidation in the last decade due to increasing scale and scope economies and the
need for greater capital. The face of the industry was changed forever during the financial crisis
of 2007-2008 with forced buyouts of Merrill-Lynch and Bear-Stearns, failure of Lehman
Brothers and Goldman-Sachs and Morgan Stanley becoming commercial banks. Nevertheless,
working for many of these firms is often considered the penultimate finance career, with prestige
and remuneration to match. With industry profits down, firms on the Street are having a difficult
time maintaining their large salaries and bonuses. A very significant portion of profits are paid
out in the form of remuneration to executives. The chapter presents an overview of the size of the
industry and the general strategies of the participants, major activities, primary assets and
liabilities on the balance sheet, recent in the news events concerning breaches of ethics and the
trend toward globalization. There is some overlap with Chapter 8, The Stock Market.
1.1.1.4
1.1.1.5 IV. Key Concepts and Definitions to Communicate to Students
Brokers and dealers Best efforts underwriting
Underwriting Firm commitment offering
Discount broker Cash management account
Private placement Shelf registration
Venture capital Block or Position Trading
Pure arbitrage Risk arbitrage
Program trading Cash management accounts
Mergers & Acquisitions SIPC
Sarbanes-Oxley Ethical problems on Wall Street
Tombstone ad Market making
Front running Price fixing
1.1.1.6
1.1.1.7 V. Teaching notes
1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview
Investment banking involves market analysis, advising, securities pricing, underwriting,
distribution of newly created securities and venture capital. Investment banks often create
formal or informal syndicates to assist in sharing risk and expertise. Some bankers are stronger
in distribution, such as Bank of America (via former Merrill Lynch), some are stronger in
corporate negotiations, such as Morgan Stanley, and some are stronger in certain industries or in
certain aspects of restructurings such as Goldman Sachs. Corporate finance activities such as
spin-offs, divestitures, mergers and acquisitions, tender offers, and other financial restructurings
are often undertaken with the advice and assistance of investment bankers. Securities firms
provide brokerage, research and advising services and trade securities for their own account.
Full line firms provide both investment banking and brokerage services. Specialized firms may
concentrate on firms in a given region, focus on a trading method, such as over the Internet, or
specialize in a particular type of financing such as providing capital for startups and small firms
(venture capital).
2. Size, Structure and Composition of the Industry
Total assets in 2012 comprised $4.77 trillion. Equity capital, the more traditional measure for
this industry, was $223 billion.1 The industry underwent shakeouts in the 1970s after “May Day”
and again after the 1987 crash.2 The number of firms fell from 9,515 in 1987 to 5,063 in 2010.
Ever larger firms have also been created via intra and inter industry mergers. The amount of
capital firms employ has also grown dramatically and probably now represents a valid entry
barrier.
The industry can be broken down into three major subdivisions and a group of smaller
specialized firms:
Commercial bank holding companies that operate diversified national full line firms
that serve both retail and corporate customers such as Bank of America and J.P. Morgan
Chase. These firms’ income comes primarily from brokerage, lending, and underwriting and
trading activities.
National full line firms specializing in corporate finance such as Goldman Sachs. Their
income is primarily from underwriting, placement, mergers and acquisitions other consulting
services and trading income.
Large investment banks such as Lazard Ltd and Greenhill and Company
Specialized firms such as
regional investment bankers (D.A. Davidson, Raymond James), (sometimes labeled
‘boutiques’)
discount brokers (Schwab),
Internet brokers (E-Trade),
venture capital firms (New Enterprise) &
exchange floor specialists (LaBranche & Co.)
dealers in off exchange trading (KCG or Knight Capital Group)
3. Securities Firm and Investment Bank Activity Areas
a. Investment Banking
Investment banking is underwriting and distributing new issues of debt and equity. The top 5
underwriters are listed in Text Table 16-3. The top firms represented about 32.9% of the total
underwriting volume. A key factor of success in the investment banking industry is reputation
and bankers guard their firm’s name jealously.
Teaching Tip: One can see the pecking order in the banking industry in a tombstone ad. The
lead or managing underwriter(s)’ names will appear at the top of the list of bankers involved in
the issue. Where the bankers’ name appears in this list is very important to the banker’s
reputation.
1The size of investment banking and securities trading is not properly measured by industry
assets because, unlike bank or insurance financing, investment bankers and securities firms need
not permanently hold securities. Their purpose is to turn them over quickly. Equity capital
measures a firm’s ability to turnover large issues since firms will only risk limited amounts of
their capital at one time. Underwriting volume is also used to measure activity.
2In May of 1975 brokerage commission rates were deregulated leading to reduced commission
revenue. Lower commission revenue translated into lower profitability and caused a major
industry shakeout of less competitive firms.
U.S. corporate underwriting activity for debt issues is almost always many times larger than the
volume of equity underwriting though equity deals usually dominate the headlines. Investment
banking strategy elements can be discussed with the help of Text Table 16-3 which contains the
top underwriters for different security types. In 2012 Morgan Stanley was tops for IPOs and
Goldman Sachs for equity, Bank of America for syndicated loans and J. P. Morgan for global
debt. After declining precipitously during the financial crisis, $6.19 trillion of debt and equity
was underwritten in 2012 and $4.76 trillion in the first nine months of 2013.
Placement methods:
Firm commitment: In a firm commitment the underwriter buys the issue from the issuer
at a set price called the bid price and then attempts to sell the issue to the final buyers at a
slightly higher amount called the offer price. The banker acts as a principle in this
transaction and the banker bears the risk of a failed issue if it does not sell. The banker
may not raise the offer price during the offer period once it is announced. In this sense
the banker has a profit profile similar to a written put option with limited upside gains
and unlimited downside loss potential. Bankers slightly underprice issues and charge
fees to offset the risk of underwriting. A significant amount of pre-selling activity occurs
(the so called “road show”) to limit the investment banker’s risk of selling the issue. An
excellent interactive CD-ROM on the mechanics of going public (and secondary market
mechanics) is available from NASDAQ (for free) titled Market MechanicsSM which you
can order from academic@nasdaq.com.
Best efforts: The investment banker agrees to market and distribute the issue and use
their ‘best efforts’ to sell the issue to the public, but the banker does not buy the issue
outright and is not at risk if buyers do not want the securities offered.
Private placements: Issues sold to a few large primarily institutional investors are
termed private placements and are exempt from SEC registration requirements. Private
placements can now be traded among institutional and high net worth investors.
b. Venture Capital
It can be difficult for small firms to obtain sufficient capital to grow. Many banks are not willing
to lend to small firms who do not have a sufficient record of profitability and may not have
sufficient collateral. An alternative source of financing is through venture capital (VC) or angel
investors. Venture capitalists are typically limited partnership organizations that specialize in
financing and assisting in the management of small startup entities. VC investors purchase an
equity stake in the enterprise and usually are actively involved in the business management of
the firm in which they invest. The VC firm will have a well defined exit strategy and an exit
timeline. The exit strategy is usually to take the firm public or to find a buyer for the firm,
usually within 10 years. VC firms usually invest money in stages to limit their capital at risk.
VC capital is not uniformly distributed among different industries. A VC investor is looking for
the ‘next big idea’ and is often concentrated in whatever industry is ‘hot’ at the time, often in
technology and bioengineering firms. The typical VC investor has traditionally been looking for
a 20% to 30% annualized return on invested capital although in recent years returns on the
NVCA index have been less than returns on major stock indices.
Many small investors obtain funding from angel investors. Angel investors can range from
wealthy individuals who are willing to put up capital without requiring such a high return on
investment nor providing active management to professional investment firms that specialize in
smaller deals than VC firms.
Private equity (PE) differs from VC in funds sources and in types of investments. PE firms raise
funds by selling securities rather than commingling private funds as many VC firms do. Second,
PE firms often acquire established existing firms rather than purchase start ups. During and after
the crisis however there have been fewer promising startups so VC firms have begun engaging in
PE type investments.
The federal government provides funding through the Small Business Administration (SBA) to
assist in venture financing. The SBA licenses privately organized Small Business Investment
Companies (SBICs) to help finance entrepreneurs. SBICs can obtain funds from the Treasury so
they have a cost advantage over private VC firms.
Some banks operate VC firms (financial VCs) and some corporations such as Intel operate VC
firms as well.
Implementation of the Volcker Rule in July 2014 continues to lead to reduced investment in all
forms of private equity by banks. Bank of America has eliminated its private equity fund and
Goldman Sachs and Citigroup are reducing their investments. This may reduce the supply of
funds available to VC and private equity, at least temporarily.
c. Market Making
Market making is creating a secondary market for securities or contracts. These involve both
agency (brokerage) and principle (dealer) functions. Brokerage is typically remunerated with
commissions and dealers profit from the bid-ask spread. Dealers buy at the bid (low) and sell at
the ask (high). Dealers incur the risk of price changes on the stock since they must maintain an
inventory and bear inventory financing costs. On the NYSE, specialists are designated market
makers that have an affirmative obligation to ensure ongoing market liquidity and price
continuity. If the majority of investors wish to sell the stock, the specialist is charged with
buying in order to provide market liquidity. In the event of a large market move the exchange’s
circuit breakers may halt trading, relieving specialists of their obligation. In addition specialists
may petition the exchange to halt trading in a given security.
Teaching Tip: The size of the spread is determined by the security’s volatility, inventory
financing costs, the amount of trading and competition between non-colluding dealers and
regulations. Decimalization reduced the minimum stock spread from about 6 cents (1/16) to 1
cent. To the extent that reduced spreads encourage more trading volume, specialists and other
brokers could see an increase in commission revenue. Increased competition from ECNs and
other markets have led to an erosion of specialist profits however.
Goldman Sachs managed $43 trillion in derivatives in 2013 (about 18% of the total held by FIs).
The profit for the first six months of 2013 was $392 million. This is a major source of income for
banks and illustrates why they don’t like the new restrictions in the Dodd-Frank bill. Losses
from subprimes and derivatives were over $1 trillion as of 2009 so these are risky investments.
Implementation of Dodd-Frank rules on OTC derivatives came were phased in in 2013. The
main changes are that OTC derivative positions such as swaps must be traded on an exchange
and cleared through a clearing agency. This change will probably reduce profits per deal and
may lead to increased capital commitments to meet margin requirements. However over the long
run, one would expect a pickup in trading activity and perhaps volume which may create
opportunities for banks to generate profits.
d. Trading
Trading activities include:
Position trading: Holing a position for weeks or months
Pure arbitrage; arbitrage is taking advantage of a mispricing between two markets by
simultaneously buying and selling the same commodity. Spot futures arbitrage is a
common example.
Risk arbitrage; taking advantage of a real or perceived mispricing based on some
information the trader possesses without perfectly covering or eliminating all the risk.
Program trading; defined as simultaneous buying and selling of a portfolio of at least 15
different stocks valued at more than $1 million in total using a computer program to
initiate the trade. Some forms of program trading are either pure or risk arbitrage, such as
stock index futures arbitrage trades. Portfolio insurance is another form of program
trading.
Stock brokerage; processing buy and sell orders from the public. Many firms either buy
or lease seats on the NYSE and/or are NASDAQ members.
Teaching Tip: Full service brokers offer research and advice about which stocks to buy,
discount brokers process public orders for a reduced fee.
Electronic brokerage offers investors direct access to the trading floor, bypassing normal
brokers and offering even lower fees than discount brokers. Examples include E-Trade
and Ameritrade. Most large firms now offer clients a choice of full service brokerage or
reduced cost electronic trading.
e. Cash Management
Securities firms have long offered accounts called Cash Management Accounts (CMAs) that
were similar to bank checking accounts. As of 1999 securities firms were allowed to offer
federally insured deposits. These accounts have normally been checking accounts written on
mutual fund investments. Many of these accounts now offer ATM and debit card services.
CMAs make it easier and cheaper for brokers to process payments for security buy and sell
orders. Note that since the FSMA securities firms can also offer loans, credit cards and other
banking type services to customers and banks can offer traditional brokerage services. New rules
that will soon be in place are likely to force these accounts to change. Currently money market
investments have a fixed $1 net asset value (NAV). As part of increased oversight from the
Dodd-Frank bill these accounts will soon be forced to trade at varying NAV so that investors can
understand the risks they face in these investments. It remains to be seen whether investors will
no longer consider these accounts as close substitutes for bank deposits.
f. Mergers and Acquisitions (M&A)
Investment bankers help find merger partners, underwrite new securities to be issued as a result
of a restructuring or acquisition, assess the value of a potential target, recommend takeover
terms, or assist in fighting off a hostile takeover.
U.S. and global M&A activity boomed in the late 1990s and through 2000 topping out at $1.83
trillion in 2000, but activity declined substantially after that. In 2001 U.S. M&A activity totaled
$819 billion, down 53% from the prior year, and declined again in 2002 to $458 billion. M&A
activity picked up slightly in 2003 to $465 billion, but grew rapidly again in 2004 when the total
value hit $748 billion, led by mergers of financial institutions. M&A activity in 2007 was $1.59
trillion. While M&A activity brings large fees to bankers, this type of business remains very
cyclical and it declined during the financial crisis, picking up in 2011. See below:
M&A activity by year
US Global
2008 $903 billion $2.90 trillion
2009 713 1.70
2010 687 1.80
2011 861 2.33
2012 882 2.04
2013* 594 1.45
* First nine months
Teaching Tip: According to a very interesting piece by Michael Jensen, “Agency Costs of
Overvalued Equity,” M. Jensen, Spring 2005, Financial Management, pp, 5-19, many if not most
of the large number of acquisitions in the late 1990s destroyed shareholder value. He argues that
overpriced equity led to too low cost of capital and encouraged managers to engage in poor
investments such as acquisitions in order to meet analysts’ earnings expectations. Given that a
high P/E ratio predicts rapid earnings growth and/or low risk, too high a stock price then predicts
an impossibly high growth rate (and/or an unrealistically low level of risk). The manager,
expected to hit ever growing earnings targets, faces an impossible task, because with overvalued
equity management cannot deliver the expected level of performance except by chance. Hence
firms look for ways to keep the fiction of improving performance alive, even resorting to illegal
accounting practices and poor acquisitions. This is a very interesting argument. It helps explain
why there were extreme pressures on managers to produce short term performance. It is not that
managers suddenly decided to ‘lie, cheat and steal.’ The pressure to perform has been very high,
and brought about in part by too close a tie between Wall Street analysts and corporate
executives, a conflict of interest. With overvalued equity, stock price signals are faulty and
cannot be relied upon as indicators of long term value of the firm. Trying to do so when those
signals are wrong must lead to suboptimal decisions for long term shareholder wealth. Several
firms enlisted their professional consultants in accounting and finance to help them find ways to
hit performance targets, which of course could not continue to occur without some form of
‘cheating’ such as accounting manipulations. This argument does not excuse managers. They
should have known better. We have seen a major breakdown of corporate governance at the
board level. Too many managers had ethical failures even though they were highly paid to act in
shareholders interests.
g. Other Service Functions
In addition to the above functions, investment bankers and securities firms also provide security
custodian services, clearance and settlement services, escrow services, research and advice on
divestitures and asset sales. Fees for these services are often bundled together and allocated for
different activities. Some of these ‘soft dollar’ allocations have come under scrutiny as alleged
conflicts of interest have arisen between the underwriting and security selling functions of
investment bankers (see the ethics discussion below).
