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Issue Management Services
Investment banks were created as separate entities after Banking Act of 1933 in USA. The great depression in 1929 revealed the failure of commercial banks in their security operations. This led to separation of commercial banking, investment banking and insurance companies into separate entities.
Investment banks have a variety of opportunities in the form of venture capital financing, mergers and acquisitions, underwriting of securities, asset securitization, investment management, private placement, project finance and corporate advisory services.
Investment banks have become financial supermarkets providing one stop need for insurance, securities and fund management services.
Investment banks are organized with divisions dealing with investment banking, sales and trading and research. Their main functions include agency, market‐making, corporate advisory and underwriting services.
Investment banks also arrange venture capital for new firms with little or no operating history. This investment requires active personal involvement in the project. The investment becomes locked for three to seven years. The project requires multiple rounds of financing.
Underwriting function assures client firms with adequate capital through public subscription when they issue equity shares. An underwriter advices the client firms, shares the risk of issue, helps in the distribution of securities and in the stabilization of market. The underwriter charges a commission usually between 2.5% to 5% of the offer price.
Underwriting involves entering into an agreement with the client or manager of the issue, fixing management fees, advising clients on the choices available, filing of registration statements with Securities Board of India and distribution of preliminary prospectus. They decide on the offer price, identify dealers for distribution, due diligence between underwriting and corporation and price support after the issue.
Investment bankers organize road shows for the public issue they have undertaken. Where the issue price determination involves risk the investment bankers undertake book building process wherein they assess the market by inviting price quotations from investors and also their intention regarding the quantity of shares they would like to invest. The final price is decided on the basis of these bids before the issue of shares.
Sometimes price fixing may lead to agency problem as the investment banker may try to set a low price for the issue to make the issue easy to sell and to avoid commitment in those shares.
Corporate Advisory Services
Investment bankers perform a variety of corporate advisory services such as mergers, acquisitions, corporate restructuring, financial engineering, securitization and debt financing.
Corporate restructuring is a king of merger reversal and it may take different forms. These are attempted with a view to meet increasing competition to align the interest of shareholders and managers, to reverse conglomerate mergers and to make the firm attractive to investors.
The various types of corporate restructuring include spin‐offs wherein a company creates a subsidiary retaining ownership of the subsidiary. Equity carve‐outs are another form of corporate restructuring wherein the subsidiary is encouraged to go for public issue and the parent company gains.
Split‐ups are another form of restructuring wherein a firm splits into two or more entities. Divestitures involves sale of a segment of the company to a third party for cash or securities. The purpose of divestitures is to dismantle conglomerates, changing strategies, discord unwanted business, ward off takeovers and meeting government requirements.
LBOs (leveraged buy outs) are purchase of a company financed heavily with debt. Hostile mergers involve taking over unwilling firms by unwanted bidders. Sometimes the target firm agrees to buy back some shares from the bidder at a premium. In this buy back arrangement certain targeted shareholders may be excluded.
Investment Management of Banks
Investment management is an important function carried out by banks to stabilize their income, reduce credit risk exposure and to enhance liquidity. When deposits are low and loan demand is high investments are used as collateral to borrow additional funds to meet increased loan demand. When loan demand is weak; investments are used to increase the earning capacity of banks. Banks usually invest their surplus funds in government bonds and other debt securities. This involves analysis of interest rate and studying the behavior of yield curve.
Yield curve is a graphical statement of the relationship between bond yields and maturity. It is a reliable indicator of economic activity and is used for forecasting interest rates, pricing bonds and creating strategies Normally yield curve shows an upward movement indicating the expectation of investors that the interest rates will increase in future.
There are three theories that explain the pattern of yield curve. The pure expectation theory holds that the upward movement of yield curve reflects investors’ expectation for future short term interest rates. Liquidity preference theory asserts that investors expect a premium for long term commitments of funds in the market and hence long term rates will be higher than the short term rates. The preferred habitat theory explains that investors have distinct investment horizons and require a meaningful premium to invest in bonds with maturities higher than their preferred maturity.
Riding the yield curve is a strategy where a bank holds its investments in bonds for a period of time and sells them just before maturity to realize the gain. The investment strategies in debt securities using maturity differentials are ladder or spaced maturity policy, front end load maturity policy, back end load maturity policy, the Barbell investment portfolio strategy and the rate expectations strategy. Sometimes a combination of these strategies will be used to enhance returns and reduce risk.
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Pro Rata Consolidation Banking Insurance Securities (60%) Unregulated Total Capital required 42 12 12 12 78
Actual capital 50 15 15 10 90 Surplus (Deficiency) 8 3 3 -2 12
Insurance Securities Unregulated Bank Specific capital required 15 15 14 32 Actual capital 18 20 10 70 Surplus (Deficiency) 3 5 -4 38
Bank capital 70 Deduction of capital investment in dependants Insurance - Securities - Unregulated -
Additional dependants deficit Unregulated -
Adjusted Bank capital 34 Bank specific capital requirement 32 Bank surplus capital 2
Parent Bank
Insurance Securities Unregulated
Down streamed capital
Banking Insurance Securities Unregulated Total
Capital required 42 12 20 12 86 Actual capital 50 15 25 10 100 Surplus (Deficiency) 8 3 5 -2^14
Bank Capital 70
owned)
Capital investment 15 12 5 32
Bank Capital
70
Full Consolidated
Insurance Securities Unregulated Bank
Down streamed capital
Group capital
Specific capital required 15 15 14 32 76
Actual capital 18 20 10 70 -32 86
Surplus (Deficit) 3 5 -4 38 -32 10
Pro Rate Consolidation
Insurance Securities Unregulated Bank
Down streamed capital
Group capital
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Questions
- What is issue management?
- What are the various services rendered by banks in issue management?
- What is underwriting?
- Explain the need for underwriting.
- What are investment management functions of banks?
- Explain the salient features of investment management in banks.
- What is a yield curve?
- How does yield curve analysis help in investment decisions?
- What are the various strategies for investment in bonds?
- What are corporate advisory services?
- What is corporate restructuring?
- What are the methods of corporate restructuring?
