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spikegifted - 'Investment Banking'


Many people have asked me - 'What do you do in your bank?' and 'What's the bank you work for again?' Well, I work for an investment banking. 'What is an investment bank?' I hear you ask... Investment banks are financial institutions where the process of 'investment' is facilitated. Essentially, investment banks, or brokerages and other banking or credit institutions that have investment banking activities, act as intermediaries in financial transactions. Many areas of finance can be classified as investment banking activities - mergers & acquisitions, advisory, capital markets (equity and debt), securitisation, syndicated lending, trade finance, proprietary trading, securities sales and brokerage activities, foreign exchange, factoring and forfeiting, repos and stock loans, prime brokerage, derivatives trading, etc... The order in which I've listed the above activities is no accident! They're clearly not in alphabetical order... They're, in fact, being listed in the 'markets' they belong to - 'primary market' (M&A, advisory, ECM, DCM, securitisation, syndicated lending, etc), 'secondary market' (proprietary trading, sales, brokerage, FX, factoring, forfeiting, repos, stock loans, prime brokerage, etc) and 'tertiary market' (any kind of derivatives).

So far I've worked in two very different areas of investment banking - Debt Capital Markets Origination and Credit/Counterparty Risk Management...

Debt Capital Markets Origination:

First of all, I want to break down the term "debt capital markets origination" down to its components.

Debt, as most people know, is one of the financing tools available to companies and individuals to further their activities. There are many forms of debt and the most common form is a loan. When a bank makes a loan to its client, it tends to keep the loan on its balance sheet. There is a market for loans, or portions of loans, to be sold on to other lenders, but that is a market that I'm not familiar with so I won't go into details. On the whole though, the market for buying and selling of loans is relatively small. So where is that market? Ok, let's imagine you make a loan to one of your clients and you don't want to keep it on your balance sheet. What can you do, apart from selling it on to another lender? Remember, not everyone has the same risk appetite and not everyone has the same amount of money to invest in a particular class of asset. What you can do is to issue a piece of 'paper' that is secured by the loan and sell this 'paper' to other lenders (investors). Now, this paper is structured in such a way that it can be bought and sold in small chunks. What you have got here is a 'loan participation note' (LPN). This is, in fact, a bond. Ok, it is a bond secured by a loan to a company, but it is a bond. Now, let's move one step further - instead of making a loan then use it to secure a bond, why not just get your client to issue that bond directly? That's what usually happens - companies issue bonds directly to the market. Now, there're lots of examples where companies don't issue directly to the market, usually due to tax reasons or legal peculiarities of the jurisdictions where the companies are registered, but all the structures involved don't take away the fact that the companies are borrowing from the bond market (as contrast to borrowing from the bank market). Don't forget, though, bonds are just another kind of debt, just like bank loans but structured differently.

Next, 'capital markets'... What are capital markets? Well, there are the 'extensions' of 'money markets'. On the whole, money markets are concerned with the financing on a short-term basis (up to 2 years) and capital markets are anything longer than 2 years. Money markets have a whole zoo of instruments available to the borrowers to borrow and investors to invest in - US Treasury bills, bankers' acceptances, commercial papers (CPs), promissory notes (prom notes), etc. But we're not interested in these! By the way, you'd probably notice that money market instruments are mostly debt instruments... As the name suggests, capital markets are ones that deal with 'capital' - long-term financing. (Usually the cut off between money market and capital market is 1 year, however, while where are lots of CPs with 2-year maturities, there aren't that many bonds issued with less than 3 years in maturities - therefore I've made the cut off at 2 years.) Long-term financing will also include equity financing, hence stocks (shares) are also part of the capital markets. Again, we're not interested in these... After all, the debt market is several thousands of times, if not millions of times, larger than the equity market. Both money market instruments and capital market ones are usually exchange-trade.

Origination, as the name derives from originate, is where the whole shebang begins. So what is origination? Within that name, there is a whole process underway what brings a company who need to borrow to the market. Now, by far the largest part of debt capital markets is for 'high grade' issuers - those who are considered at 'investment grade' - meaning rated at or above BBB- (or equivalent) by internationally recognized credit rating agencies (Moody's Investors Service or Standard & Poor's or FitchRating). And within this part of the market, most of the issuers issue frequently and they usually have an issuance program in place, commonly known as medium-term note (MTN) program. Execution in this part of the market takes hours or, at most, couple days. It is not often that the whole execution process, from start to finish, taking more than a week. But that's not the interesting part of the market. For new issuers or issuers from sub-investment grade (any from BB+, or equivalent, and down), the issuance process takes a lot longer than that. The job of the origination team starts with talking to the client, either through face-to-face presentations or pitch letters. A lot of the time, these potential issuers have no understanding of a bond or how the bond market function, what potential investors are looking for in a bond and how to issue a bond. The key is to educate the company to make it, as an organization, ready to issue a bond, and once the bank has obtained a mandate to manage the issuance of the new bond, to guide the company through the process of issuance.

For a debut issuer, the process of of issuing a bond can be very intrusive. Most of the time, borrowers who utilize bank loans can rely on their 'relationship banks' to provide the necessary financing. Relationship banks tend to know the borrower very intimately and hence the level of disclosure is relatively low, given that as long as the bank is happy with the credit, the company will obtain the loan. However, for the bond market, the number of investors (lenders) is in the range of tens to thousands, depending on the size of the issue. Not all of them have any understanding of the company and its business. Therefore, it essential for the company to provide sufficient amount of information to provide investors a level of confidence of the credit they're buying into. Therefore investors would expect the company to do things in some certain accepted standards - financial accounts being published under IAS (International Accounting Standards) or US GAAP (Generally Accepted Accounting Procedure), audited by internationally reputable auditors (one of three or four companies), a letter of comfort given by the auditors, etc. At the end of the day, the company is trying to convince the investors that what they're seeing is indeed an accurate representation of the credit they're buying into and the investors are not unnecessarily exposing themselves to risks that they're not aware of. However, not all companies are that forthcoming in providing information, since disclosure of this information give its competitors great depths of insight into the shape and functioning of the company.

So, why do companies want to go through the bond process, if it is so intrusive? There are many reasons for such a move, but it can be summarized into four:
1) A bond diversifies a company's funding base to beyond the bank loan market.
2) Additionally, once it has been introduced into the bond market, the company obtains an additional source of future long-term financing.
3) Since a bond is usually distributed to a broad range of investors, it raises the profile of the company amongst investors. In addition to that, it is likely to receive research coverage by other investment banks and brokerages that cover the segment of market and hence further enhances the company's exposure to the market.
4) It can be used to minimize the company's funding costs and/or improves its liquidity profile.
Therefore, there are compelling reasons for companies to go through the bond process. Obviously, while the reasons for going through the bond process can be compelling, some companies are less ready or less willing to disclose information to the public, therefore it is the job of the lead manager to make sure that the level of disclosure is 'acceptable' to that of investors' expectation.

Aside from disclosure, it is often that the lead manager to structure the bond to attract investors and achieve the level of borrowing required by the company. There are many different forms of structuring, the most obvious is the actually 'physical property' of the bond - the currency of issuance, the maturity, the size (bond investors, in general, like large issues where they can move in and out of a position without worrying about liquidity of the issue; generally, investors consider a minimum issue size of $150-200m or equivalent to be liquid) and the kind of interest payment (fixed rate vs. floating rate). The 'physical property' of the issue is often influenced by the depth of a particular market, investor appetite, funding needs of the issuer and its ability to generate revenue in a given currency. Another form of structure is the issuance structure where the bond can be issued directly by the company or by a special purpose vehicle (SPV) or even through a bank secured by a loan to the company (as we've already seen, LPN). The issuance structure is often driven by the taxation regime under which the borrower operates. Finally, there is the level of subordination of the new debt which relates to the 'seniority' of the proposed bond. Many companies have bank loans and supplier contracts which are tied to the revenues generated or secured on assets of the companies. In these cases, the new bond will be 'structurally subordinated' to the existing loans and advances. It is the job of the lead manager to guide its client through all these choices and ensure that the new bond is structurally sound and that it is both acceptable to the company's existing lenders, the investors and the company itself.

To give comfort to investors, a certain level of restriction on the company's activities is required. To put these restrictions into place, lead managers introduce 'covenants' (or sometimes 'restrictive covenants') to limit what the issuers can or cannot do. I think this term originates from the world of bank loans where banks attempt to safeguard its loans against borrowers who wish to defraud the bank. I won't go into details as to what these covenants are as they can be rather tedious. In summary, they are essentially to give comfort to investors that the issuer will not be in a position to strip the company of its cashflow which will be used to service its debt or strip the company of its operating assets and not allow the company to be ran irresponsibly. However, covenants sometimes can be too restrictive and/or there are times when they are imposed will drive the company out of business. Hence there are such things called 'carve outs' which are simply exceptions to the covenant restrictions which give the issuer room to manoeuvre without causing an 'event of default' by failing one or more of the covenants. In the end, the drawing up of covenants and carve outs is a fine act of balancing the wish of investors wanting comfort and allowing the management getting on running the business.

When all the structuring and negotiation of the terms and conditions of the notes are completed, it is time to introduce the issuer to the potential investors of the new bond. This marketing exercise is generally called a roadshow. Not all roadshows are used to market transactions to potential investors, there are times when people go on 'non-deal roadshows'. On the whole, roadshows are used as a tool to expose the client to a broad range of targeted investors and generally raise the profile of the company and investor awareness. The roadshow presentation is usually delivered by the management of the client as well as senior bankers of the lead manager involved in the transaction. The format of these presentation varies from location to location: sometimes it is a breakfast/brunch/lunch presentations, sometimes one-to-one meetings. The list of potential investors are usually drawn up by the lead manager's sales force and syndication teams. The locations of the roadshow are designed to expose the client to as many investors who have show interest in similar credit as possible in a very tight schedule. Usually this means a one to two-week roadshow, visiting between half dozen (1 week) to a dozen (2 weeks) of locations. At the same time, the lead manager will be taking in potential orders for the new issue - a process that is called 'book building'.

When all the marketing is completed, it is time to launch the issue. In any transaction, there are two opposing expectations present, in the case of debt issuance, these are those of the issuer and the investors. For the issuer, its motivation is to obtain funding at as low a level of interest payment as possible; on the other hand, for the investors, they want to obtain the best yield possible. On the issuers side of the argument, pricing of the issue is done by comparing itself with similar credits and arrive at a yield lower or higher than currently traded comparable issues (usually lower, of course, as all companies see themselves better than those being used in the comparison). On the investors' side, they are, again, comparing the issuer against a range of comparable credit and arrive at a pricing that they think is appropriate for the issue. Both camps have their own perceived 'fair values' for the new issue and it is the job of the lead manager to bring the two sides together.

How is this done? This areas is really the job the Debt Syndicate people not Origination, but I'll give a quick roundup of what generally happens. We mentioned that potential orders are taken in what is known as the book building process. These orders will be in the shape of "if yield is at 8%, we want $7.5m; at 8.5%, $10m and at 7.5%, $5m". The various yields mentioned there is what is commonly known as 'price talk'. In this way, there is now a 'grid' of what the likely demand is at a certain yield. The issue will be launched at a yield that will give a slight over-subscription.

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Credit/Counterparty Risk Management:

The process of risk management can be broken down to four very distinct stages - identification, classification, assessment & monitoring and mitigation. In a banking environment, there are several major areas of risk that constantly managed - market risk, credit risk, counterparty risk, operation risk, legal risk and reputation risk.

The identification of risk is obviously the very first step in the management of risk. It pretty much involves having some very clear headed people who carry out, at a strategic level, examination of the various activities of the organization in an attempt to find and locate where risks lie. Once a risk or potential area of risk is identified, it needs to be classified so that the particular responsibility can be assigned to risk specialists who understand the nature of the risk and who can continually assess and monitor the risk exposure. In order to effectively reduce or eliminate particular risk exposures, policies and practices are put into place to mitigate the risk. Of course, in an investment banking environment, it is impossible to completely eliminate risks as risk taking is in the very heart of the act of investment and facilitation of investment. However, if checks and provisions have been designed carefully and implemented correctly, most of the exposure can be reduced to the extent that an organization becomes comfortable with the amount of a given activity carries.

When I was involved in risk management, I was working in counterparty risk management, which means that I looked after a portfolio of banks and non-bank financial institutions (insurance companies, investment funds, pension funds, hedge funds, brokerages, etc). For many people, counterparty risk is one and the same as credit risk, which is not entirely true. First, let me define credit risk. Credit risk is a measure of exposure as a function of the credit worthiness of your client and the level of 'leverage' of the product - ie. if you lend or trade with two different entities (either companies or people), even though the amounts outstanding ('notional amounts') may be the same, the credit worthiness of the entity will have a direct effect on the amount of 'exposure' my bank faces; and if the bank do two different type of instrument (say, a trade finance letter of credit and buying of an exchange traded option) with the same entity, the notional amounts may be the same, but the exposures are going to be different.

Now, I mentioned that credit risk arises whenever you transact with another entity; counterparty risk is like an extension to that. Counterparties, as defined above, are professionals operating in the financial markets. The moment an entity is classified as a counterparty, we are already assuming a lot, e.g. the entity knows what it's doing, it qualifies to participate in a certain market segment or to utilize certain financial instruments and if a regulator exists for that class of financial institution in a jurisdiction where it operates, it will be regulated. But the line that separate counterparties and other types clients that you deal with can be a blur one - some large corporations have subsidiaries that act like in-house banks to operating entities.

A counterparty risk analyst will have to assess the credit worthiness of his/her counterparty and based on this assessment arrived at potential maximum exposure that he or she feels comfortable. This maximum exposure is derived from the strength of the counterparty's financial health, the type of business it does, its business track record and the likely level of business with the bank. Once this maximum is calculated, the exposure limit is then split (allocated) to various business lines. These allocations are based on the likelihood of certain types of businesses being carried out with the counterparty. Of course, if the situation allow, the analyst will always keep a small 'warehouse limit' so that if activities increase, there's room to allocate additional amounts to further business. These limits are most likely to be 'risk weighted' which means that the credit exposure to a counterparty is calculated based on the potential maximum exposure of a given traded instrument, which also means that the true exposure to a counterparty is not the outstanding notional amount. Once the exposure limits are allocated, the analyst will have continually monitor their utilization - a) to facilitate the smooth running of the relationship by allocating from 'warehouse' and b) reduce or eliminate the allocated limits to reduces the bank's potential exposure. Over the course of several years, business goes through business and economic cycles, which means that counterparties that were in good shape may find themselves in less fortunate positions or see their financial position and credit worthiness improve. Due to these changes, it is important for the analyst to continually monitor the financial and credit standings his/her portfolio of counterparties. In most cases, counterparties are reviewed on an annual basis, but there're times when special situations arise, interim reviews are not uncommon.

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These are but two areas of investment banking I've been involved in. Needless to say, there're lots of other activities within investment banking that I'm in no position to provide you with an understanding. The problem is that there is no such thing as a 'learning text' for investment banking. Each area is so specialized that it is impossible to use a broad stroke to describe or explain all the activities. With the above descriptions, I hope to provide you with an insight to the kind of work I've been involved in. For those who have more experience than I do in these areas and find that I've omitted some details or managed to get some of the information wrong, please feel free to let me know. Also, you can find my résumé here.

While saying that there is no 'learning text' for investment banking, I've come across a number books written by ex-bankers or people who have had close contacts with them. For those who have some understanding of investment banking, these are excellent stories. On the other hand, for those who don't know much about the subject matters, they give the readers informative glimmers into the world of investment banking. This list is not exhaustive, but they are books that I've read and enjoyed.
Bruck, Connie, The Predators' Ball (The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders), 1989 (Drexel Burnham Lambert; junk bonds; LBOs; mergers & acquisitions)
Burrough, Brian & Helyar, John, Barbarians at the Gate, 1991 (RJR Nabisco; mergers & acquisitions)
Das, Satyajit, Traders, Guns & Money (Knowns and Unknowns in the Dazzling World of Derivatives), 2006 (various; derivatives; risk mismanagement)
Fox, Loren, Enron: Rise and Fall, 2003 (Enron; energy derivatives, SPVs, risk management, etc.)
Lewis, Michael, Liar's Poker (Two Cities, True Greed), 1989. (Salomon Brothers; trading and sales)
Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management, 2001 (Long-Term Capital Management; hedge fund management)
Partnoy, Frank, F.I.A.S.C.O.: Guns, Booze and Bloodlust: the Truth About High Finance, 1998 (Morgan Stanley; derivatives)
Rolfe, John & Troob, Peter, Monkey Business (Swinging Through the Wall Street Jungle), 2000 (Donaldson, Lufkin & Jenrette; corporate finance)
Vines, Stephen, Market Panic (Wild Gyrations, Risks and Opportunities in Stock Markets, 2003 (Stock market crashes and the opportunities that they present)

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