An Introduction to Investment Banks, Hedge Funds, and Private Equity

An Introduction to Investment Banks, Hedge Funds, and Private Equity

The New Paradigm

David P. Stowell

Kellogg School of Management, Northwestern University

Table of Contents

Cover image

Title page

Front matter

Companion Web Site

Copyright

Dedication

Preface

Target Audience

Distinguishing Features

Cases

The World Has Changed

Structure of the Book

Section One: Investment Banking

Section Two: Hedge Funds and Private Equity

Section Three: Cases

Acknowledgments

Section I: Investment Banking

1. Overview of Investment Banking

Post-Crisis Global Investment Banking Firms

Other Investment Banking Firms

Investment Banking Businesses

Investment Banking Division

Trading Division

Non-Client-Related Trading and Investing

Asset Management Division

Questions

2. Regulation of the Securities Industry

Introduction

U.S. History and Regulations

Recent Developments in Securities Regulations

Securities Regulations in Other Countries

Questions

3. Financings

Capital Markets Financings

Financing Considerations

Financing Alternatives

Fees to Bankers

Distribution Alternatives

Shelf-Registration Statements

Green Shoe Overallotment Option

Questions

4. Mergers and Acquisitions

The Core of M&A

Creating Value

Strategic Rationale

Synergies and Control Premium

Credit Ratings and Acquisition Currency

Regulatory Considerations

Social and Constituent Considerations

Role of Investment Bankers

Other M&A Participants

Fairness Opinion

Acquisitions

Due Diligence and Documentation

Breakup Fee

Alternative Sale Processes

Cross-Border Transactions

Tax-Free Reorganizations

Corporate Restructurings

Takeover Defenses

Risk Arbitrage

Valuation

Questions

5. Trading

Client-Related Trading

Equity Trading

Fixed Income, Currencies, and Commodities (FICC) Trading

Market-Making

Proprietary Trading

Risk Monitoring and Control

Value at Risk (VaR)

Questions

6. Asset Management, Wealth Management, and Research

Asset Management

Wealth Management

Research

Questions

7. Credit Rating Agencies, Exchanges, and Clearing and Settlement

Credit Rating Agencies

Exchanges

Over-the-Counter Market

Clearing and Settlement

Questions

8. International Banking

Euromarkets

Japan’s Financial Market

China’s Financial Market

Emerging Financial Markets

Global IPO Market

American Depository Receipt (ADR)

Standardized International Financial Reporting

International Investors

Questions

9. Convertible Securities and Wall Street Innovation

Convertible Securities

Wall Street Innovation

Nikkei Put Warrants

Accelerated Share Repurchase Program

Questions

10. Investment Banking Careers, Opportunities, and Issues

Investment Banking

Trading and Sales

Private Wealth Management

Asset Management

Research

Principal Investments

Other Investment Banking Functions

Investment Banking Opportunities and Issues

Questions

Section II: Hedge Funds and Private Equity

11. Overview of Hedge Funds

Leverage

Growth

Composition of Investors

Industry Concentration

Performance

2008 Slowdown

Market Liquidity and Efficiency

Financial Innovation

Illiquid Investments

Lock-ups, Gates, and Side Pockets

Comparison with Private Equity Funds and Mutual Funds

High-Water Marks and Hurdle Rates

Public Offerings

Fund of Funds

Questions

12. Hedge Fund Investment Strategies

Equity-Based Strategies

Macro Strategies

Arbitrage Strategies

Event-Driven Strategies

Summary

Questions

13. Shareholder Activism and Impact on Corporations

Shareholder-Centric vs. Director-Centric Corporate Governance

Activist Hedge Fund Performance

Activist Hedge Fund Accumulation Strategies

CSX vs. TCI

Changing Rules That Favor Activists

Daniel Loeb and 13D Letters

Lehman Brothers’ Erin Callan vs. David Einhorn of Greenlight Capital

Carl Icahn vs. Yahoo

Bill Ackman vs. McDonald’s, Wendy’s, Ceridian, Target, and MBIA

Summary

Questions

14. Risk, Regulation, and Organizational Structure

Investor Risks

Systemic Risk

Regulation

Organizational Structure

Questions

15. Hedge Fund Issues and Performance

Hedge Fund Performance

Fund of Funds

Absolute Return

Benefits Revisited

Transparency

Fees

High-Water Mark

Searching for Returns

Future Developments

Merging of Functions

Questions

16. Overview of Private Equity

Characteristics of a Private Equity Transaction

Target Companies for Private Equity Transactions

Private Equity Transaction Participants

Structure of a Private Equity Fund

Capitalization of a Private Equity Transaction

Assets Under Management

History

Financing Bridges

Covenant-Lite Loans and PIK Toggles

Club Transactions and Stub Equity

Teaming Up with Management

Leveraged Recapitalizations

Secondary Markets for Private Equity

Fund of Funds

Private Equity Goes Public

Impact of Financial Services Meltdown on Private Equity

Questions

17. LBO Financial Model

Determining Cash Flow Available for Debt Service and Debt Sources

Determining Financial Sponsor IRR

Determining Purchase Price and Sale Price

LBO Analysis Example

LBO Analysis Post-Credit Crisis

Questions

18. Private Equity Impact on Corporations

Private Equity-Owned Companies: Management Practices and Productivity

Private Equity-Owned Company Failures

Private Equity Purchase Commitment Failures

Private Equity Portfolio Companies Purchased During 2006–2007

Private Equity Value Proposition for Corporations

Corporate Rationale for Completing Private Equity Transactions

Private Equity as an Alternative Model of Corporate Governance

Private Equity Influence on Companies

Questions

19. Organization, Compensation, Regulation, and Limited Partners

Organizational Structure

Compensation

Regulations

Limited Partners

Questions

20. Private Equity Issues and Opportunities

PIPEs

Equity Buyouts

Distressed Assets

M&A Advisory

Capital Markets Activity

Hedge Fund and Real Estate Investments

2008 Losses and Future Expectations

Boom and Bust Cycles

Annex Funds

Limited Partner Pull-Backs

Risk Factors

Asian Private Equity Activities

Strategic Alliances

Private Equity IPOs

Focus on Portfolio Management

Comparison of Private Equity Firms

Profile of The Carlyle Group

Future Issues and Opportunities

The New Landscape

Questions

Section III: Case Studies

21. Investment Banking in 2008 (A): Rise and Fall of the Bear

Bear Stearns

Long Term Capital Management

The Credit Crisis

Bear Stearns Asset Management

The Calm Before the Storm

Run on the Bank

Bear’s Last Weekend

22. Investment Banking in 2008 (B): A Brave New World

The Aftermath of Bear Stearns

Gramm-Leach-Bliley and the Fall of Glass-Steagall

Lehman Brothers

Merrill Lynch

Goldman Sachs and Morgan Stanley

23. Freeport-McMoRan: Financing an Acquisition

Metals Heating Up

Enter Freeport-McMoRan

Role of the Investment Banks

Inside the Wall

Outside the Wall

Mandatory Convertible Preferred Shares

FCX Post-Allocation

24. The Best Deal Gillette Could Get?: Procter & Gamble’s Acquisition of Gillette

A Dream Deal

Deal Structure: An All-Stock, 60/40, No-Collar Acquisition

Valuation of the Deal

Key Stakeholders: Beantown, Wall Street, DC, and Main Street

Conclusion

25. A Tale of Two Hedge Funds: Magnetar and Peloton

What a Year

What a Nightmare

Magnetar’s Structured Finance Arbitrage Trade

The 2007–2008 Financial Crisis

The CDO Market

Rating Agencies

Correlation

CDO Market Evolution

Bank Debt and the Cov-Lite Craze

26. Kmart, Sears, and ESL: How a Hedge Fund Became One of the World’s Largest Retailers

The Unusual Weekend

Flash Forward: November 2004

The Rise and Fall of Kmart

Bankruptcy and Inefficient Financial Markets

Financial Buyers vs. Strategic Buyers

Private Equity

Hedge Funds

ESL: The Hedge Fund That Could Not Be Categorized

2002–2003 Decision: Should ESL Seek to Gain Control of Kmart during Bankruptcy?

Lampert’s Kmart Play

November 2004 Decision: Should Kmart (under ESL’s Control) Acquire Sears?

27. McDonald’s, Wendy’s, and Hedge Funds: Hamburger Hedging? Hedge Fund Activism and Impact on Corporate Governance

Growing Hedge Fund Activism

A Tale of Two Activists: Carl Icahn and William Ackman

Pershing Square’s Initial Involvement: Wendy’s and McDonald’s

McDonald’s Management and Franchisees Respond

Rating Agency Concern

Unlocking McDonald’s Real Estate Value

Aftermath of McDonald’s Rejection

The Truce

Retrospective

28. Porsche, Volkswagen, and CSX: Cars, Trains, and Derivatives

Using Derivatives to Obtain Control Positions

CSX Equity Derivatives

CSX Collides with TCI and 3G

Porsche and Volkswagen: Brothers Reunited

Cash-Settled Options

29. The Toys R Us LBO

Case Focus

Emergence of Club Deals in a Maturing Industry

Dividends and Fees Paid to Private Equity Firms

U.S. Retail Toy Industry in 2005

European Retail Toy Industry

Infant, Toddler, and Preschool Market

Overview of Toys R Us

Challenging Times for Toys R Us

Toys R Us Strategic Review and Sale

The Toys R Us Club

The Assignment

30. Cerberus and the U.S. Auto Industry

Introduction

What’s Good for GM?

Cerberus Capital Management to the Rescue … Maybe

GM’s Supplier Relationships

Cerberus Builds an Even Bigger Auto Stage

The Dream Becomes a Nightmare

Exhibit Sources

Reading List

References

Index

Front matter

Companion Web Site

Ancillary materials are available online at:

www.elsevierdirect.com/companions/9780123745033

Copyright

Academic Press is an imprint of Elsevier

30 Corporate Drive, Suite 400, Burlington, MA 01803, USA

525 B Street, Suite 1900, San Diego, California 92101–4495, USA

84 Theobald’s Road, London WC1X 8RR, UK

Copyright © 2010, Elsevier Inc. All rights reserved.

All Case Studies are copyright © Kellogg School of Mangement. To request permission for these, please contact cases@kellogg.northewestern.edu.

No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher.

Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, E-mail: permissions@elsevier.com. You may also complete your request online via the Elsevier homepage (http://elsevier.com), by selecting Support & Contact then Copyright and Permission and then Obtaining Permissions.

Library of Congress Cataloging-in-Publication Data

Stowell, David.

An introduction to investment banks, hedge funds, and private equity : the new paradigm / David Stowell.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-12-374503-3 (casebound : alk. paper)

1. Investment banking. 2. Hedge funds. 3. Private equity.

4. Finance–History–21st century. I.Title.

HG4534.S76 2010

332.66–dc22

2009050831

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

ISBN: 978-0-12-374503-3

For information on all Academic Press publications visit our Web site at www.elsevierdirect.com

Printed in the United States of America

10 11 12 9 8 7 6 5 4 3 2 1

Dedication

For Janet, Paul, Lauren, Audrey, Julia and Peter

Preface

The world of finance has experienced a paradigm shift following the global financial meltdown of 2007–2009. Market participants have been significantly impacted and attitudes about risk, transparency, regulation and compensation have changed. Investment banks, hedge funds and private equity firms are at the epicenter of a transformed financial landscape, forging new roles and seeking new ways to create value in an environment of lower risk and greater regulation. This book provides an overview of investment banks, hedge funds and private equity firms and describes the relationships between these organizations: how they simultaneously compete with and provide important services to each other, and the significant impact they have on corporations, governments, institutional investors and individuals. Together, they have reshaped global financing and investing patterns, attracting envy and awe but also criticism and concern. They dominate the headlines of the financial press and create wealth for many of their managers and investing clients. This book enables readers to better understand these heavily interconnected organizations, their impact on the global financial market, principal activities, regulatory environment, historical development, and risks and opportunities in the post-crisis world.

Ultimately, the objective of this book is to demystify investment banks, hedge funds and private equity firms, revealing their key functions, compensation systems, unique role in wealth creation and risk management and their epic battle for investor funds and corporate influence. After reading this book, the reader should better understand financial press headlines that herald massive corporate takeovers, corporate shareholder activism, large capital market financings and the myriad strategies, risks, and conflicts in the financial market landscape. The inclusion of case studies and spreadsheet models provides an analytical framework that allows the reader to apply the book’s lessons to real-world financing, investing and advisory activities.

Target Audience

The target audience for this book includes MBA, MSF and Executive MBA students, and upper-level undergraduates who are focused on finance and investments. Investment banking classes can use this book as a primary text and corporate finance and investments classes can use the book either as a secondary text or as a principal text to focus on hedge funds and private equity. In addition, professionals working at investment banks, hedge funds and private equity firms can use the book to broaden understanding of their industry and competitors. Finally, professionals at law firms, accounting firms and other firms that advise investment banks, hedge funds and private equity firms should find this book useful as a resource to better understand and assist their clients.

Distinguishing Features

This book is unique for two reasons. First, it is the product of a long career working for and with investment banks, hedge funds, and private equity firms, combined with five years in classrooms teaching students about these institutions. Second, by addressing investment banks, hedge funds, and private equity firms in the same book, and focusing on their simultaneous competition and cooperation the book provides a more holistic view of the changing boundaries and real-world impact of these institutions than has previously been available.

I wrote this book following a twenty year career as an investment banker at Goldman Sachs, JP Morgan and UBS, and an additional four years at O’Connor & Associates, a large hedge fund that is now part of UBS. As an investment banker, in addition to completing numerous M&A, debt and equity financing, equity derivative, and convertible transactions with corporate clients, I worked with private equity firms (financial sponsors) as they acquired companies and pursued exit strategies through recapitalizations, M&A sales and IPOs. Since 2005, I have been a professor of finance at Northwestern University’s Kellogg School of Management, where I have had the privilege of teaching what I learned during my pre-academic career, while completing ongoing research into the ever-changing landscape of investment banks, hedge funds and private equity. The opportunity to teach bright students at a first class business school has provided great feedback and a forum to refine concepts and make them more relevant to students. This book is therefore a product of both real world and academic experience, creating a new educational offering that more fully opens the door to understanding the key participants in the global financial and advisory markets.

Cases

The inclusion of ten cases facilitates greater understanding of the concepts described in the chapters. These cases focus on recent actual financial and advisory transactions and include a summary of risks, rewards, political considerations, impact on corporations and investors, competition, regulatory hurdles and other subjects that are linked to chapter topics. The cases include questions for students and case notes and teaching suggestions for instructors. In addition, several cases include spreadsheet models that allow readers to create an analytical framework for considering choices, opportunities and risks that are described in the cases. The cases are assembled together at the end of the book, but are all linked to preceding chapters. As a result, cases are designed to be used in conjunction with chapter reading to reinforce concepts and enhance learning.

The World Has Changed

During 2008, Bear Stearns collapsed into a fire-sale to JP Morgan, Lehman Brothers declared bankruptcy, Fannie Mae and Freddie Mac were placed into U.S. government conservatorship, the U.S. government assumed majority control over AIG after injecting over $100 billion to keep it afloat, under duress, Countrywide and Merrill Lynch both sold themselves to Bank of America, Wells Fargo bought Wachovia at the brink of bankruptcy, Washington Mutual went into receivership with its branches absorbed by JP Morgan, Goldman Sachs and Morgan Stanley became bank holding companies, and banks all over the world had to be rescued by their respective governments. In the United States, this included the rapid provision to banks of over $200 billion of equity capital by the U.S. Treasury as part of a larger $700 billion rescue program, guarantees of debt and asset pools by the FDIC totaling many hundreds of billions of dollars, and an unprecedented expansion of the Federal Reserve’s balance sheet by trillions of dollars as it provided credit based on almost any type of collateral. All of this occurred as the world experienced the most significant, globalized downturn since the Great Depression of the 1930s.

The investment banking business, in many ways, will never be the same. Leverage has been reduced, some structured financial products have ceased to exist, and regulation has increased. However, the fundamental business remains unchanged: advising corporations and investors; raising and investing capital; executing trades as an intermediary and principal; providing research; making markets; and providing ideas and capital directly to clients. As investment banks reinvent some aspects of their business and learn to live in a world of decreased leverage and increased regulation, new opportunities loom large, while issues such as public perception, compensation, and risk management must be carefully worked through.

Hedge funds and private equity funds suffered significant reversals during 2008, with hedge funds recording investment losses of over 19% on average and private equity firms acknowledging similar potential losses to their investors. Although these results were undesirable and caused some investors to abandon funds, the global equity markets fared even worse, with the major U.S. stock market indices dropping by more than 38% and other equity and non-government debt indices throughout the world posting similar, or greater, losses. Hedge funds and private equity have had to adjust to a changing landscape and re-explain their value proposition while contending with downsizing in the number of funds, assets under management and return expectations. Reinvention and patience were the watchwords during the global financial crisis as these funds fought to hold on to as many limited partners as they could while considering new investment strategies for a credit-deficient world. During 2009, many hedge funds and private equity firms bounced back, with positive returns for most hedge funds and a refocus on smaller and less leveraged investments the hallmark of private equity investment activity.

Investment banks, hedge funds and private equity firms have redefined their roles and developed new processes and business plans designed to maintain historical positions of power and influence. The world has changed, but these institutions will continue to have a significant impact on global capital markets and M&A transactions. This book projects how they will achieve this, and the resultant impact on corporations, governments, institutional investors and individuals.

Structure of the Book

The book is divided into three sections. The first section is comprised of ten chapters that focus on investment banks. The second section includes five chapters that discuss hedge funds and five chapters that review the activities of private equity firms. The third section of the book includes ten cases that focus on recent transactions and developments in the financial markets. These cases are cross-referenced in the preceding chapters and are used to illustrate concepts that benefit from more rigorous analysis.

Section One: Investment Banking

This section includes ten chapters that provide an overview of the industry and the three principal divisions of most large investment banks, including descriptions of the M&A and financing activities of the banking division; the intermediation and market-making, as well as principal (proprietary) activities of the trading division; and the investment gathering and money management activities of the asset management division. In addition, the other businesses of large investment banks and the activities of boutique investment banks are reviewed. Other chapters focus in more detail on financings, including the activities of capital markets groups and the underwriting function, and discussion of IPOs, follow-on equity offerings, convertibles and debt transactions. The role of credit rating agencies, prime brokerage groups, structured credit, derivatives and exchanges is also explored. Finally, regulations, leverage, risk management, clearing and settlement, international investment banking, career opportunities and the interrelationship between investment banks, hedge funds and private equity is discussed. The capstone chapters in this section of the book drill deeply into M&A, convertible securities and investment bank innovation.

Section One is designed to be used as the text for a full course on investment banking. It should be used in conjunction with cases in Section Three that are specifically referenced in Section One chapters. Section Two’s hedge fund and private equity chapters may be used as supplemental material.

Section Two: Hedge Funds and Private Equity

The first five chapters of Section Two focus on hedge funds, including an overview of the industry; a focus on selected hedge fund investment strategies; shareholder activism and impact of hedge fund activists on corporations; risk, regulation and organizational structure of hedge funds; and a review of performance, risks, threats and opportunities, as well as the changing value proposition offered by hedge funds to their limited investor partners. Finally, hedge fund competition with investment banks and private equity is reviewed, as well as the symbiotic relationship between all three parties.

The second five chapters of Section Two examine private equity from the perspective of those firms that principally focus on leveraged buyouts (LBOs) and other equity investments in mature companies. These chapters provide an overview of private equity; an explanation of an LBO model and how it drives decision-making; private equity impact on corporations, including a case history of more than a dozen LBO transactions; a description of organization, compensation, regulation and limited partner relationships; and a discussion of private equity issues and opportunities, diversification efforts, IPOs, historical performance and relationships with hedge funds and investment banks.

Section Two is designed to be used as the text for a full course that focuses on Hedge Funds and Private Equity. It should be used in conjunction with cases in Part Three that are specifically referenced in Section Two chapters. Section One’s investment banking chapters may also be used as supplemental material.

Section Three: Cases

This section contains ten cases that are referenced in different chapters in Sections One and Two. The cases enable students to drill deeper into the subject matter of the chapters and apply concepts in the framework of real transactions and developments. Case questions and teaching notes for each case are provided, as well as several spreadsheet models that enable students to manipulate data. The cases focus on the following: the dramatic change in the global investment banking landscape that occurred during the 2008 financial crisis; the use of equity derivatives by Porsche and CSX as these two corporations interacted with investment banks and hedge funds in effecting significant corporate change; Cerberus’s investments in Chrysler and GMAC (GM’s captive finance subsidiary); the divergent CDO investment strategies of two hedge funds, which, in the first case, resulted in excellent returns, and in the second case, caused bankruptcy; Freeport McMoRan’s acquisition of Phelps Dodge, which focuses on M&A, risk taking and financing activities; the acquisition through a bankruptcy court process and management of Kmart and Sears by ESL, one of the world’s largest hedge funds; Procter & Gamble’s acquisition of Gillette, including the advisory role of investment bankers and discussion of corporate governance and regulatory issues; the LBO of Toys R Us, focusing on the role of private equity funds and investment banks; and activist hedge fund investor Pershing Square’s impact on the capital and organizational structure of McDonald’s Corporation.

Acknowledgments

I am very grateful to many who have contributed to this publication. My wife, Janet, and children (Paul, Lauren, Audrey, Julia and Peter) have been patient and supportive during the more than two year process of researching and writing this book. When I decided to become an academic, they assumed that my investment banker work-week would drop from 70+ hours to less than half that amount. This has not been the case, as I learned that academics work long hours too, and the book added many hours to my schedule. My oldest son, Paul, is a banker, derivatives structurer, and former convertibles trader, and I relied on and appreciated his wisdom in thinking through the organization of the book and benefited from technical suggestions he made. I wish to thank Xiaowei Zhang, who worked in my team at JP Morgan, for her very diligent and efficient contributions as my principal assistant during the editing and model production stage of this project. I was very fortunate to be able to rely on her many talents during an interlude in her investment banking career.

As I transitioned from practitioner to academic over past 5 years, many finance department colleagues and administrators at Northwestern University’s Kellogg School of Management offered support for this project and me. Special thanks to Kathleen Haggerty for her assistance from the Office of the Dean and to senior finance department faculty members Robert Korajczyk, Robert McDonald and Mitchell Petersen for providing valuable suggestions regarding the content of the book.

I am indebted to the following colleagues and friends from investment banks who provided excellent input to selected chapters:

John Gilbertson, Managing Director, Goldman Sachs

Mark Goldstein, Managing Director, Deutsche Bank

Cary Kochman, Managing Director, UBS

David Topper, Managing Director, JP Morgan

Jeffrey Vergamini, Executive Director, Morgan Stanley

Jeffrey Zajkowski, Managing Director, JP Morgan

Xiaoyin Zhang, Managing Director, Goldman Sachs

The following professionals provided greatly appreciated information regarding hedge funds and private equity firms, as well as suggestions regarding legal, regulatory and tax topics in the book:

Bryan Bloom, Principal, W.R. Huff Asset Management Co.

Deirdre Connell, Partner, Jenner & Block

Thomas Formolo, Partner, Code Hennessy & Simmons

Margaret Gibson, Partner, Kirkland & Ellis

Jason Krejci, Vice President, Standard & Poor’s

Anna Pinedo, Partner, Morrison & Foerster

James Neary, Managing Director, Warburg Pincus

Joel Press, Managing Director, Morgan Stanley

James Rickards, Senior Managing Director, Omnis

Chirag Saraiya, Principal, Training the Street

Phillip Torres, Portfolio Manager, ForeSix Asset Management

Catherine Vaughn, Managing Director, Highbridge Capital Management

Julie Winkler, Managing Director, CME Group

Elaine Wolff, Partner, Jenner & Block

I express appreciation to Kellogg PhD candidates Fritz Burkhardt and Jonathan Brogaard and Northwestern undergraduate research assistants Esther Lee, Tom Hughes, Anya Hayden and Ashley Heyer for their work on this book. Finally, I appreciate the patience and guidance extended to me by my contacts at Elsevier, especially Scott Bentley, Executive Editor and Kathleen Paoni, Development Editor.

Section I

Investment Banking

1. Overview of Investment Banking

2. Regulation of the Securities Industry

3. Financings

4. Mergers and Acquisitions

5. Trading

6. Asset Management, Wealth Management, and Research

7. Credit Rating Agencies, Exchanges, and Clearing and Settlement

8. International Banking

9. Convertible Securities and Wall Street Innovation

10. Investment Banking Careers, Opportunities, and Issues

1

Overview of Investment Banking

The material in this chapter should be cross-referenced with Case Study 1, Investment Banking in 2008 (A), and Case Study 2, Investment Banking in 2008 (B).

Investment banking changed dramatically during the 20-year period preceding the global financial crisis that started in mid-2007 as market forces pushed banks from their traditional low-risk role of advising and intermediating to a position of taking considerable risk for their own account and on behalf of clients. This high level of risk-taking, combined with high leverage, transformed the industry during 2008, when several major firms failed, huge trading losses were recorded, and many firms were forced to reorganize their business.

Risk-taking activities of investment banks were reduced following large losses that stemmed primarily from mortgage-related assets, bad loans, and an overall reduction in revenues due to the financial crisis. This led to an industry-wide effort to reduce leverage and a string of new equity capital issuances. By the end of 2008, five pure-play investment banks headquartered in the United States that did not operate deposit-taking businesses (unlike large universal banks such as J.P. Morgan, which operated a large investment bank, a deposit-taking business, and other businesses) had undergone significant transformations: Goldman Sachs and Morgan Stanley converted into bank holding companies; the U.S. Federal Reserve (Fed) pushed Bear Stearns into the arms of J.P. Morgan to avoid a bankruptcy; Lehman Brothers filed for bankruptcy protection after the Fed and Treasury Department ignored its pleas for government support; and Merrill Lynch, presumably to avoid a similar bankruptcy filing, agreed to sell their firm to Bank of America (see Exhibit 1.1).

Exhibit 1.1

Historically through 1999, U.S. banks with deposit-taking businesses (commercial banks) were barred from operating investment banking businesses. This rule was created by the Glass-Steagall Banking Act of 1933, which was enacted after the stock market crash of 1929 to protect depositors’ assets. In 1999, the Gramm-Leach-Bliley Act overturned the requirement to keep investment banks and commercial banks separate, and led to the formation of U.S.-headquartered universal investment banks, including J.P. Morgan, Citigroup, and Bank of America. Two of the main arguments for rejoining these two kinds of businesses were (1) to provide for a more stable and countercyclical business model for these banks, and (2) to allow U.S. banks to better compete with international counterparts (e.g., UBS, Credit Suisse, and Deutsche Bank) that were less encumbered by the Glass-Steagall Act. As a result, Citigroup, which was created through the 1998 merger of Citicorp and Travelers Group (which owned the investment bank Salomon Brothers), did not have to divest Salomon Brothers in order to comply with federal regulations. J.P. Morgan and Bank of America followed the lead of Citigroup in combining businesses to create universal investment banks. These banks rapidly developed a broad-based investment banking business, hiring many professionals from pure-play investment banks and strategically using their significant lending capability as a platform from which they were able to capture investment banking market share.

Post-Crisis Global Investment Banking Firms

As of 2009, the surviving nine key global firms that encompass both investment banking and deposit-taking businesses and operate throughout the world included J.P. Morgan, Bank of America, Citigroup, Credit Suisse, UBS, Deutsche Bank, Barclays, Goldman Sachs, and Morgan Stanley. See Exhibits 1.2, 1.3, 1.4, and 1.5 for a summary of financial results, financial measures, and market capitalization for these nine firms.

Exhibit 1.2

Exhibit 1.3

Exhibit 1.4

Exhibit 1.5

Other Investment Banking Firms

In addition to these nine key global investment banks, other large banks compete effectively in regional markets worldwide and, in some countries, have a larger market share for investment banking business than the nine designated global banks. Examples of banks in the category of large regional investment banks include HSBC, Société Générale, BNP Paribas, CIBC, MUFG, Sumitomo Mitsui, Mizuho, Nomura, and Macquarie. Other firms that engage in investment banking business on a more limited scale are called boutique banks. Boutique banks principally focus on merger and acquisition (M&Amp;A)–related activity, although some participate in other businesses such as financial restructuring, money management, or proprietary investments. Retail brokerage firms are securities firms that narrowly compete with large investment banks in relation to retail client investments in stocks and bonds. They generally do not conduct a full investment banking business. See Exhibit 1.6 for a sampling of banks that compete in each of these areas.

Exhibit 1.6

Investment Banking Businesses

Although each investment bank takes a somewhat different approach, the principal businesses of most large investment banks include an (a) investment banking business managed by the Investment Banking Division, which focuses on capital raising and M&A transactions for corporate clients and capital raising for government clients; (b) sales and trading business managed by the Trading Division, which provides investing, intermediating, and risk-management services to institutional investor clients, performs research, and also participates in nonclient-related investing activities; and (c) asset management business managed by the Asset Management Division, which is responsible for managing money for individual and institutional investing clients (see Exhibit 1.7).

Exhibit 1.7

Within the nine large global investment banks, Goldman Sachs and Morgan Stanley are examples of more narrowly focused investment banks. They operate each of the businesses described above and recently added deposit-taking as a new business, following their transformation to bank holding companies. However, they do not participate in most non-investment banking businesses that the other global firms conduct. J.P. Morgan and Barclays are examples of more broadly focused financial organizations that operate a large investment banking business, but also conduct large non-investment banking businesses. See Exhibits 1.8 and 1.9 for an overview of the principal businesses of Goldman Sachs and J.P. Morgan, respectively.

Exhibit 1.8

Exhibit 1.9

Investment Banking Division

The Investment Banking Division of an investment bank is responsible for working with corporations that seek to raise capital through public or private capital markets, risk-manage their existing capital, or complete an M&A-related transaction. In addition, at some firms, this division has increasingly provided financing through direct investments in corporate equity and debt securities, and provided loans to corporate clients. Finally, this division helps government-related entities raise funds and manage risk. Individuals who work in the Investment Banking Division are called bankers and are assigned to work in either a product group or a client coverage group (see Exhibit 1.10). The two key product groups are M&A and Capital Markets. In the M&A product group, bankers typically specialize by industry (and at some investment banks, they work within the industry coverage group). In the Capital Markets Group, bankers specialize by working in either debt capital markets or equity capital markets. Client coverage bankers are usually organized into industry groups, which typically focus on the following industries: healthcare, consumer, industrials, retail, energy, chemicals, financial institutions, real estate, financial sponsors, media and telecom, technology, and public finance, among others (see Exhibit 1.11). Exhibit 1.12 provides a summary of the product groups in Morgan Stanley’s Investment Banking Division.

Exhibit 1.10

Exhibit 1.11

Exhibit 1.12

Client Coverage Bankers

Bankers assigned to industry teams are required to become global experts in the industry and understand the strategic and financing objectives of their assigned companies. They help CEOs and CFOs focus on corporate strategic issues such as how to enhance shareholder value. This sometimes leads to an M&A transaction in which clients sell the company or buy another company. These bankers also assist companies to achieve an optimal capital structure, with the appropriate amount of cash, equity, and debt on their balance sheet. This often leads to a capital markets transaction in which the company issues equity or debt, or repurchases outstanding securities. In short, client coverage bankers develop an in-depth understanding of a company’s financial problems and objectives (within the context of its industry) and deliver the full resources of the investment bank in an effort to assist their clients. They are the key relationship managers and provide a centralized point of contact for corporate clients of the investment bank.

A financing or M&A assignment usually results in a partnership between client coverage bankers and product bankers to execute the transaction for a corporate client. Other investment banking services can also be introduced by the client coverage banker to the company, including risk management and hedging advice in relation to interest rate, energy, or foreign exchange risks; credit rating advice; and corporate restructuring advice. There are product bankers who are responsible for each of these product areas (which are a much smaller source of revenue compared to the capital markets and M&A product areas). Sometimes the role of the client coverage banker is to encourage a corporate client to not complete a transaction if it is not in the best interests of that client. The banker’s mission is to become a trusted advisor to clients as they complete appropriate transactions that maximize shareholder value and minimize corporate risk.

In order for client coverage bankers to be helpful to their clients, bankers must first develop strong relationships with CEOs and CFOs, and subsequently with corporate development and treasury groups. The corporate development group usually reports to the CFO but sometimes directly to the CEO. Their role is to identify, analyze, and execute strategic transactions such as mergers, acquisitions, or divestitures. The treasury group reports to the CFO and focuses on acquiring and maintaining appropriate cash balances, achieving an optimal capital structure for the company, and risk managing the company’s balance sheet. This group also manages the company’s relationship with credit rating agencies. See Exhibit 1.13, which summarizes a client coverage banker’s template for providing investment banking products and services to corporate clients.

Exhibit 1.13

Sometimes clients of the Investment Banking Division prefer being covered by bankers who work in geographical proximity to the client. As a result, some client coverage bankers may be assigned to cover clients based on a geographic coverage model rather than an industry coverage model. Each investment bank attempts to coordinate the activities of industry coverage and geographic coverage bankers in an effort to meet client preferences and achieve operating efficiency for the bank.

Capital Markets Group

The Capital Markets Group is comprised of bankers who focus on either equity capital markets or debt capital markets.¹ At some investment banks, these two groups coordinate their activities and report to the same person, who oversees all capital markets transactions. At other banks, the two groups report to different individuals and remain fairly autonomous. The Capital Markets Group operates either as a joint venture between the Investment Banking Division and the Trading Division, or is included solely within the Investment Banking Division. When issuers need to raise capital they work with a team comprised of a client coverage banker and a capital markets banker. The capital markets banker executes the capital raising by determining pricing, timing, size, and other aspects of the transaction in conjunction with sales professionals and traders in the Trading Division, who are responsible for creating investment products that meet the needs of their investing clients (see Exhibit 1.14).

Exhibit 1.14

Equity Capital Markets

The Equity Capital Markets (ECM) business is comprised of bankers who specialize in common stock issuance, convertible security issuance, and equity derivatives. Common stock issuance includes initial public offerings (IPOs); follow-on offerings for companies that return to the capital markets for common stock offerings subsequent to issuing an IPO; secondary offerings for major shareholders of a company who wish to sell large blocks of common shares for which the proceeds are received by the selling shareholders and not by the company; and private placements, which do not require registration with a regulator. Convertible security issuance (see Chapters 3 and 9) usually takes the form of a bond or preferred share offering that is converted (either by mandate or at the investor’s option) into a predetermined number of the issuer’s common shares. Equity derivatives enable companies to raise or retire equity capital, or hedge equity risks, through the use of options and forward contracts.

Bankers in ECM work closely with client coverage bankers to determine suitable corporate targets for equity-related products. If a company decides to complete an equity financing, ECM assumes primary responsibility for executing the transaction. This involves close coordination with sales and trading professionals in the Trading Division to determine the investment appetite of their clients. In essence, ECM intermediates between the Investment Banking Division’s issuing clients, who want to sell securities at the highest possible price, and the Trading Division’s investing clients, who want to buy securities at the lowest possible price. This poses a challenge that requires considerable dexterity to balance competing interests and structure an optimal equity-related security.

ECM and client coverage bankers must consider many issues with their corporate clients before initiating a transaction, including credit rating impact and whether the offering will be bought by the investment bank (with the resale price risk borne by the bank), or sold through a book-building process (with the price risk borne by the issuer). In addition, they focus on capital structure impact (including cost of capital considerations); earnings per share dilution; likely share price impact; shareholder perceptions; use of proceeds; and, if it is a public offering by a U.S. company, filing requirements with the SEC (Securities and Exchange Commission); as well as other issues. This process can take several weeks to several months to complete, depending on the vagaries of the market and potential issues raised by regulators.

Debt Capital Markets

Bankers in Debt Capital Markets (DCM) focus principally on debt financings for corporate and government clients. Their clients can be grouped into two major categories: investment-grade and non-investment-grade issuers. Investment-grade issuers have a high credit rating from at least one of the major credit rating agencies (Baa or stronger from Moody’s; BBB- or stronger from Standard & Poor’s). Non-investment-grade issuers have lower ratings, and their debt offerings are sometimes called junk bonds, or high-yield bonds.

DCM bankers stand between corporate or government issuers (with whom relationships are maintained by client coverage bankers in the Investment Banking Division) and investors (covered by sales professionals in the Trading Division). Their role is to find a balance between the competing price objectives of issuers and investors, while facilitating communication and providing execution of transactions.

Bankers in DCM work closely with client coverage bankers to determine suitable corporate and government issuer targets and to help clients decide timing, maturity, size, covenants, call features, and other aspects of a debt financing. Of critical importance is the determination of the likely impact that a new debt offering will have on the company’s credit ratings, and investor reaction to a potential offering.

In the U.S., DCM bankers help clients raise debt in the public capital markets through SEC-registered bond offerings or through privately placed 144A transactions (investors limited to qualified institutional investors). They also serve as the conduit through which a bank loan can be secured and provide debt risk management services (using derivatives) and advice regarding the potential credit rating impact of a debt issuance.

M&A Group

At some investment banks, the M&A Group is an independent group from the client coverage group, although at other banks the two are blended. Regardless, most bankers specialize in one or more industries. Unlike the Capital Markets Group, which at some firms is a joint venture between the Investment Banking Division and the Trading Division, the M&A Group always falls under the sole responsibility of the Investment Banking Division.

The principal products of the M&A Group include: (a) sell-side transactions, which involve the sale or merger of an entire company or disposition of a division (or assets) of a company; (b) buy-side transactions, which involve the purchase of an entire company or a division (or assets) of a company; (c) restructurings or reorganizations that focus on either carving out businesses from a company to enhance shareholder value or dramatically changing a company’s capital structure either to avoid bankruptcy or to facilitate a sell-side transaction; and (d) hostile acquisition defense advisory services (see Exhibit 1.15).

Exhibit 1.15

M&A bankers develop strong valuation analysis and negotiation skills, and they usually work directly with a company’s CEO, CFO, and corporate development team. Fees are typically paid to M&A bankers only upon successful completion of a transaction (although in the case of buy-side, restructuring, and defense advisory services, a nominal retainer fee may be charged during the period of the engagement).

Trading Division

The Trading Division is responsible for (a) all investment-related transactions with institutional investors, including financial institutions, investment funds, and the cash management arms of governments and corporations; (b) taking proprietary positions in fixed income and equity products, currencies, commodities, and derivatives; (c) market-making and clearing activities on exchanges; and (d) principal investments made both directly and through managed funds. This division typically operates in three different business areas: Fixed Income, Currencies, and Commodities; Equities; and Principal Investments. At some investment banks, Principal Investments activity is conducted from a different division. Research on economics, fixed income, commodities, and equities is also provided by the Trading Division to investing clients (see Chapter 6 for more information on the research function and its regulatory history).

Fixed Income, Currencies, and Commodities (FICC)

FICC makes markets and trades in government bonds, corporate bonds, mortgage-related securities, asset-backed securities, currencies, and commodities (as well as derivatives on all of these products). At some firms, FICC is also involved in the provision of loans to certain corporate and government borrowing clients (in coordination with the Investment Banking Division). The business also engages in proprietary (non-client-related) transactions in the same product areas. Individuals who work in the client-related area of FICC are either traders, who price these products and hold them in inventory as a risk position, or sales professionals, who market trade ideas and bring prices from the traders to investors to facilitate purchases and sales of the products.

Equities

Equities makes markets in and trades equities, equity-related products, and derivatives in relation to the bank’s client-related activities. The business generates commissions from executing and clearing client transactions on global stock, option, and futures exchanges. Equities also engages in proprietary (non-client-related) transactions in the same product areas. As is the case in FICC, individuals who work in the client-related area of Equities are either traders or sales professionals.

Investment banks typically have a Prime Brokerage business that provides bundled services such as securities borrowing and lending, financing (to facilitate leverage), asset custody, and clearing and settlement of trades to hedge fund clients and other fund managers. Prime brokers provide fund managers with a centralized location for the clearing of securities, reporting, and financing, while also allowing them to trade with other firms. Although initially an equity-centric business, Prime Brokerage has expanded its capabilities to many other asset classes (in step with the diversification of strategies employed by hedge funds). A large part of Prime Brokerage–related revenue comes from commissions from executing and clearing client trades by sales and trading professionals. Other revenue sources include earning spreads on financing and lending activities. Refer to Chapter 5 for a more detailed discussion of Prime Brokerage and its services.

Non-Client-Related Trading and Investing

Principal Investing

Although an important role of large investment banks is to act as intermediaries to investing clients, they also invest in securities and real estate for their own account. For example, the Principal Investments division within Goldman Sachs invests directly in public and private companies in the same way that KKR, a large private equity firm, invests. This frequently involves purchasing public companies using equity provided by Goldman Sachs (and its investing partners) and debt provided through loans (from Goldman Sachs or other banks) or bonds underwritten by Goldman Sachs in the capital markets. This process is called a leveraged buyout (LBO), or taking a company private in the case of a publicly traded target. In addition to control investments, Goldman Sachs also purchases minority positions in companies. For example, the firm owned common shares of Industrial and Commercial Bank of China Ltd. (one of China’s largest banks), which has been valued in excess of $5 billion, and preferred shares of Sumitomo Mitsui Financial Group (one of Japan’s largest banks), which has been valued in excess of $1 billion. The fair market value of equity securities and real estate owned by the Principal Investments area of Goldman Sachs exceeded $21.7 billion at the end of fiscal year 2008. See Exhibit 1.16 for a summary of Goldman Sachs’ Principal Investments positions.

Exhibit 1.16

Proprietary Trading

In addition to making long-term, non-client-related principal investments as described above, most major investment banks make short-term, non-client-related investments in securities, commodities, and derivatives for their own account. This proprietary investment activity is similar to the investment activities of hedge funds. Indeed, investment banks’ proprietary investing activity competes directly with hedge funds for investing and hedging opportunities worldwide.

During 2005 and 2006, investment banks’ proprietary investing contributed in a significant way to robust Trading Division earnings. During 2007 and 2008, however, this same proprietary trading activity contributed to very large losses at some banks: Deutsche Bank, for example, reported $1 billion in proprietary credit-related losses and another $500 million in proprietary equities-related losses during the fourth quarter of 2008. Other investment banks, including UBS, Citigroup and Merrill Lynch, reported even larger losses. As a result of significant losses experienced by most investment banks’ proprietary trading desks during 2007 and 2008, banks scaled back these trading operations. However, during 2009, there was some recovery in proprietary trading activities.

Depending on each bank’s compliance policy, proprietary traders at investment banks can sometimes be clients of their own firm’s client-related trading business. These traders have the opportunity, but not the obligation, to trade with the firm’s internal sales professionals. Covered by salespersons at other firms as well, these traders often deal with competitor firms in order to achieve the best prices and execution. Proprietary traders must be dealt with on an arm’s length basis by internal salespeople, and confidentiality is paramount. There are strict compliance guidelines that wall off proprietary traders from certain information that is available to the client-related areas of the firm. Some firms go even further and completely wall off proprietary traders from any interaction with client-related sales and trading persons within their firm.

Sometimes, outside clients of the firm are concerned about the effectiveness of the wall and potential conflicts of interest, since the best investment ideas cannot always be shared with all investing clients without introducing excessive competition. Investment banks carefully monitor this situation and attempt to comply with all laws and internal policies, while finding a balance between the interests of external and internal clients.

At some investment banks, proprietary investment activity can be a very meaningful source of revenue and earnings. At other firms, this activity is considerably smaller. See Chapter 5 for a more complete description of specific proprietary investment activity and corresponding opportunities and threats.

Asset Management Division

The Asset Management business offers equity, fixed income, alternative investments (such as private equity, hedge funds, real estate, currencies, and commodities), and money market investment products and services to individuals and institutions. Investments are offered in the form of mutual funds, private investment funds, or separately managed accounts, and are sometimes co-mingled with the bank’s own investments. Revenues are created principally based on fees that are paid by investors as a percentage of assets under management (AUM), which varies depending on the asset class. At times, investors pay an incentive fee to the investment bank when returns exceed a predetermined benchmark. Most firms have a private wealth management business organized alongside the asset management business, reporting to the same division head (see Exhibit 1.17). The professionals in the private wealth management business act as advisors to investors, helping them decide how to invest their cash resources. In most cases (but not all), investors will be encouraged to invest in funds managed by the firm’s asset management teams. However, advisors have a fiduciary obligation to direct investments into the funds (internal or external) that best meet the risk and return objectives of investors. Chapter 6 provides a more detailed discussion of the asset management business.

Exhibit 1.17

Co-Investments in Asset Management Division Funds

Investment banks sometimes make direct investments in funds managed by their Asset Management Division that focus on: (1) private equity (LBOs and other equity control investments); (2) hedge-fund-type investments; and (3) real estate. Investment banks typically invest their own capital alongside the capital of their high net-worth individual and institutional clients in these funds (and they charge investing clients both management fees and performance fees based on the clients’ AUM). This has become a very large business for some investment banks. For example, as of January 1, 2009, two of the largest hedge funds in the world were managed by the Asset Management Divisions of J.P. Morgan and Goldman Sachs (see Exhibit 1.18).

Exhibit 1.18

Questions

1. Looking at the leverage ratios of former pure-play investment banks GS and MS in Exhibit 1.4, why were these banks able to operate at higher leverage ratios as investment banks, compared to as bank holding companies?

2. U.S. companies currently report their financials based on U.S. GAAP (Generally Accepted Accounting Principles) rules. Many companies in Europe report according to IFRS (International Financial Reporting Standards) rules. There has been a movement for all companies to shift to an IFRS basis globally. When this occurs, what may happen to the leverage ratios of U.S. banks?

3. Why might a universal bank be better able to compete against a pure-play investment bank for M&A and other investment banking engagements?

4. Investment bank clients can be categorized into two broad groups of issuers and investors. These two groups often have competing objectives (issue equity at highest possible price vs. acquire stock in companies at lowest possible price). Who within the investment bank is responsible for balancing these competing interests?

5. What is a key consideration in determining the cost and other parameters of a corporate debt offering, and why is it important?

6. Why might an investment bank place higher priority on sell-side M&A engagements over buy-side engagements?

7. Many investment banks have a principal investment group that invests directly in public and private companies. What conflicts of interest might arise from operating this type of business?

8. What conflicts might exist between the proprietary trading division and the rest of the investment bank?

9. What conflicts might exist as a result of having both an Asset Management (AM) business and a Private Wealth (PW) Management business?

¹Banks may subdivide the Capital Markets Group even further, for instance, by having a leveraged finance group that is separate from debt capital markets.

2

Regulation of the Securities Industry

Introduction

Activities of investment banks impact the global economy and are very important to the smooth functioning of capital markets. Given their significance, it is no surprise that the business of investment banking has been subject to a great deal of government regulation. This chapter discusses the regulatory environment of investment banking. In the first section, the U.S. history of investment banking and regulation is discussed. The second section looks at more recent events and regulations. The third section summarizes the regulatory environment in the United Kingdom, Japan, and China.

U.S. History and Regulations

Early Investment Banking

The essence of what an investment bank does in its underwriting business is to act as an intermediary between issuers and investors so that one party can gain access to capital, while the other party can preserve and grow wealth. These underwriting services were essential to the foundation and development of the United States. George Washington, the first president, took office in 1789. At this time the federal government had already incurred $27 million of debt, and the states had debts totaling $25 million. Alexander Hamilton, the first U.S. Treasury secretary, persuaded Congress and President Washington to assume the state debt and issue bonds to finance this obligation, in spite of strong opposition from Thomas Jefferson. Investment bankers played a role in negotiating the terms and conditions of these bonds.

The firms conducting these premodern investment banking activities were referred to as loan contractors. Their services were to guarantee issuers’ security offerings and sell them to investors, hopefully at a profit. The loan contractors’ business was performed by speculators, merchants, and by some commercial banks. In addition, professional auctioneers were often intermediaries in the sale of investment products, taking bids and selling securities to the highest bidder. Finally, there were private bankers and stockbrokers who also performed the functions of modern-day investment banks.

As the new country began to spread over a vast continent, technological innovation fed into the industrial revolution. The benefits from increased economies of scale made large projects essential and profitable. Large-scale implementation of new technologies allowed for the extraction of natural resources, which created a need for trains to transport people and resources between cities. This and many other activities required capital that no individual or firm could afford alone. As a result, a more formal version of investment banking developed to intermediate between firms needing capital and individuals desiring to build wealth. By underwriting securities, investment banks made it possible for many investors to pool together their wealth to meet the great capital needs of a growing nation.

Industrial growth created a new class of wealthy industrialists and bankers who helped finance their empires. During this period, investment bankers operated in a regulatory vacuum and were largely free to respond as they saw fit to changing market forces. The practices they developed brought them power and influence. From 1879 to 1893, the mileage of railroads in the United States tripled, and investments in railroad bonds and stocks rose from $4.8 billion to $9.9 billion, keeping investment bankers busy underwriting these new issues. At the same time, other industrial growth was emerging that required family-owned businesses with limited resources to incorporate in order to raise more capital than could otherwise be obtained. This led to the use of investment banking services by an ever-increasing number of companies. The demand for capital had grown, as had the supply of capital, including capital provided by foreigners, which doubled from $1.4 billion to $3.3 billion between 1870 and 1890.

The Growth of Investment Banking

Investment banking practices expanded further between 1890 and 1925. During this period, banks were highly concentrated and the industry was largely run by an oligopoly, which included J.P. Morgan & Co.; Kuhn, Loeb & Co.; Brown Brothers; and Kidder, Peabody & Co. The United States did not require separation between commercial and investment banks, which meant deposits from the commercial banking side of the business often provided an in-house supply of capital to deploy in the bank’s underwriting projects.

From 1926 to 1929 equity issuance jumped from $0.6 billion to $4.4 billion while bond issuance decreased, as companies increasingly took advantage of a seemingly unstoppable rise in the stock market by preferring equity issuance to debt.

Limited Regulation

During the investment environment of the first three decades of the 20th century, the lack of regulation, strong demand for securities, and fierce competition resulted in weak internal controls within banks. Despite their previous attempts at self-regulation, banks could not prevent scandals. In response to growing criticism and societal desire for industry regulation, the banking industry formed the Investment Bankers Association of America (IBAA) in 1912 as a splinter group of the American Bankers Association. One of the ideas established by the IBAA was the concept of non-price discrimination in the sale of securities, regardless of the investor and transaction size.

Although there was limited federal regulation of investment banks before the Great Depression started in 1929, banks had to adhere to state securities laws, or Blue Sky laws. The first Blue Sky law was enacted in Kansas in 1911. Among other features, it required that no security issued in the state could be offered without previously obtaining a permit from the state’s Bank Commissioner. Between 1911 and 1933, 47 states enacted similar state laws regulating the issuance of new securities (all of the existing states at the time except Nevada). As federal regulations were enacted in the 1930s and 1940s, the state laws remained on the books while the federal laws mostly duplicated and extended the Blue Sky laws. The passage of the National Securities Markets Improvement Act by Congress in 1996 effectively removed states from securities regulation of investment banks, except for antifraud matters.

On October 28, 1929, the day referred to as Black Monday, a precipitous fall in the stock market began. In spite of the 1929 crash and the ensuing economic malaise, President Herbert Hoover did not promote any meaningful new regulation of the financial markets. In contrast, Franklin Roosevelt, who became president in 1933, took an active approach to the economic difficulties and instituted a variety of regulations that shaped the financial sector, and investment banks in particular, for the remainder of the century. At Roosevelt’s urging, Congress passed seven pieces of legislation that significantly impacted the business of investment banking.

Three of these laws, the 1933 Securities Act, the 1933 Glass-Steagall Act, and the 1934 Securities Exchange Act, drastically altered the business environment in which investment banks practiced. The following discussion will detail the regulatory requirements found in these three pieces of legislation. The other four legislative acts that impacted investment banking to a lesser extent will also be covered