What are Investment banks?
Investment banks are the financial institutions which help companies and governments to raise money either by issuing or selling securities. They help both private and public corporations to raise funds in the capital market. They also act as advisors and as intermediaries between the companies during mergers and acquisitions and other related financial transactions. Investment banks therefore become the link between the corporations and the investors.
Unlike the traditional banks, these banks do not accept deposits from the public but are involved in buying or selling of securities and reconstruction of organizations, corporate restructuring and underwriting.
In today’s context, when one uses the phrase ‘investment banking’ it is more likely that one is referring to the “sell-side”. This mainly includes the trading of securities like facilitating transactions and market-making or the promotion of the securities like underwriting, research etc.
The “buy-side” is made up of pension funds, mutual funds, hedge funds, and all those who are the consumers of the products and services of the sell-side. It is also possible that an investment bank perform both the functions.
Investment banks can be broadly divided into two tiers:
First-Tier Investment Banks
Second-Tier Investment Banks.
The first-tier investment banks, also known as the top-tier investment banks include Goldman Sachs, Credit Suisse First Boston, Salomon Brothers and Morgan Stanley Dean Witter.
The second-tier investment banks, also known as the mid-tier investment banks include firms like Bear Stearns, Lehman Brothers, Paine Webber and Donaldson, Lufkin and Jenrette.
This classification is done with the assumption that the total wealth gains are larger when either the target company (a company that is being acquired) or the acquiring company uses the first-tier investment banks. It also suggests the credibility (read reputation) of the advisor in acquisitions.
The Role of Investment Banks during M&As
The investment banks play a very important role during the Mergers and Acquisitions. They are in a position to advise the acquirer whether or not to go in for the merger or acquisition. They help the acquirer to value the target company. They are specialists in information production and processing. As advisors to both the target and the acquirer, the investment banks use their information gathering expertise to ascertain the potential for synergistic gains, as well as the risk of the transaction.
The roles played by the investment banks are many:
They help arrange the merger/acquisition
In case they are acting on behalf of the target company, the banks design methods to prevent such mergers/acquisition, if it is in the interest of the target company to do so
In valuing the target company/evaluating the synergy
Financing mergers/Acquisitions
Fair valuation
Arranging Mergers/Acquisitions
There are departments in the investment banking firms which identify firms with excess cash that are willing to buy other companies, preferably those that are willing to be bought. There will be companies which would like to be bought for various reasons like a better standing in the market i.e. a good market share, to achieve economies of scale etc. In the event of a company exploring the option of expansion of its business, an investment bank helps it to zero in on a potential company that would help it achieve this purpose. For example if a company is in the business of automobiles, it may intend to acquire the business of tyre and glass manufacturing (integration).
It can also be arranged by the shareholders of the company with a poor track record. This happens when the shareholders who are not happy with the performance of the company might wish to merge it with some other company, which is in a position to earn profits to its shareholders so that they can remove the current management from the office.
Preventing Mergers/ Acquisitions.
The target companies which do not wish to be taken over / acquired / merged with another company also seek the help of the investment banks along with law firms. They indulge into various methods so as to make the scenario hostile for an acquisition. Some of these techniques are:
- Changing the by-laws to ensure that there is no majority for the approval.
- Convincing the shareholders of the target company that the price offered for the acquisition is very low.
- Involving the governing bodies of the country to avoid the acquisition.
- Repurchase of shares in the open market so as to create high demand for the shares and increase the price of the shares above the price offered by the acquirer
- Arranging for a “white knight” (an ally of the target company to compete with the potential acquirer)
- Arranging for a “white squire” (an ally to the management who will buy a majority of the shares of the target company and hence block the merger)
- Taking a poison pill
Poison pill refers to committing economical suicide to avoid a takeover. They include borrowing heavily which requires immediate repayments so that the acquirer will have to take over all the liabilities if the acquisition were to take place. The company might resort in selling its assets at a lower price which attracted the acquirer / made the firm a desirable target. This would leave the company with assets of questionable value and a huge debt load. The most popular poison pill is to give its shareholders share purchase rights that allow them to buy the shares of the company at half the price of the acquiring company. Another defensive step is the employee stock ownership plan (ESOP). ESOPs are designed to give the lower-level employees an ownership stake in the company and fund them with the company’s common stock. Since the trustee of ESOPs generally support the current management and 85% of the votes are usually required to complete a merger, ESOP can act as an effective defensive step.
Fair Valuation
If there is a friendly merger between the management of the two companies, there has to be a fair valuation of the target company. At this point both the companies hire investment banks to value the target company and establish a fair value.
Financing Mergers
Quite often the mergers are financed with excess cash that the acquirer might have generated. If the acquirer does not have surplus cash in its reserves, the investment banks help the acquirer to raise funds either by issuing fresh shares to the public or by issuing shares to the existing shareholders in the new company which would be formed after the acquisition/merger.
The investment banks also advise the companies as to whether the company has to go in for debt by issuing bonds and debentures or issue shares. It helps in designing the debt structure, the interest rate, the amount of debt, maturity structure etc.
All these factors make the companies rely heavily on the investment bankers to tell them what the other company is worth. The valuation is likely to differ from one bank to another. "Companies that use Merrill Lynch pay premiums that are the same as other firms that use Merrill Lynch," says Pamela Haunschild, assistant professor of organizational behaviour at Stanford Business School, "The price is not tied to the value of the target but to what Merrill Lynch is recommending. Certain premiums are associated with certain firms." Hence one can say that the terms of acquisitions depends on the relationship the acquirer shares with the investment banks and not with the inherent value of the target company.
The company’s decision to work with a particular investment bank depends on the “success” of that particular bank in its past deals where the bank had given another company.
To sum up, the investment banks help the acquiring companies to value the target companies. They also act on behalf of the target companies in the process and sometimes advice companies when they want to avoid acquisitions. But lately, there have been some apprehensions towards the investment banks. Phillip Augur, group Managing Director of Schroeder’s has argued that the integrated investment banking model is inherently flawed since it seeks “an irreconcilable reconciliation between a plethora of inbuilt conflicts of interest”. The investment banks have also been accused of encouraging mergers and acquisitions as a means for increasing their own profits.
However one cannot deny that the investment banks provide professional help in the course of mergers and acquisitions and provide the acquiring companies with necessary guidance. They utilize their information gathering expertise to ascertain the value of the target company, the potential synergy gains as well as the risk involved in the transaction.
