Corporate and investment banking

Rodolfo Vanzini

10/30/2018

Commercial and corporate & investment banking

What is commercial banking? And how can we define it in an as concise way as possible? Commercial banking is basically deposits taking and loans making. Why are we defining commercial banking when in fact we’re interested in corporate and investment banking? Because investment banking is easily defined by opposing it to commercial banking. Hence, investment banking is rather a non-homogeneous range of activities, although the so called “core” services can be summarised as:

• underwriting and merger-and-acquisition (M&A) advisory services;
• securities trading;
• asset management
• and financial research.

With underwriting services the investment bank helps firms, among other institutions, raise funds by issuing securities like stocks, bonds, hybrid notes, ABS, etc. and by arranging other lending facilities through syndicate structures. With M&A advisory services the investment bank helps client firms with M&A transactions and corporate restructuring. As commercial banking mainly features typical activities like credit screening and credit monitoring, so does investment banking in performing due diligence, verifying financial data, challenging the firm’s business model and pricing enterprise value.

In this context, an investment bank by providing a “certification effect” credibly validates the “good quality” of the securities involved. By “good quality” it is intended that investors “know what they get”: low risk–low return as well as high risk–high return securities. The potential of an investment bank’s underwriting as well as M&A advisory services is marketed via league tables that are a very important tool of marketing for players in the corporate and investment banking arena.

In the banking industry banks that undertake both commercial banking and investment banking are labelled “universal banks” and are exposed to a potential conflict of interests that needs to be focused on (at least by regulators): universal banks – by taking advantage of their higher potential of information production in the combined commercial and investment banking services – might misuse private information and acquire superior competitive advantages. Banks, regardless of whether investment or commercial, face a common problem that can be summarized as: lack of information.

Underwriting services

Equity offerings come in different shapes and colours as they can be classified according to the type of shares being sold, the market where shares wiil be listed on, the investors the offer will be addresed to, etc. Initial public offerings (IPOs) are probably the ones easier to be found and defined. An IPO is the sale of a company’s shares to the public and the listing of the shares on a stock exchange. For a company the advantages of going public are better access to capital and greater liquidity for investors. The reasons of going public from a shareholder’s perspective with an IPO may be to get liquidity, either for the succession of entrepreneurial generation and for selling the company. The drawbacks of going public are direct and indirect costs as well as increased disclosure requirements and compliance costs. In a primary offering newly issued shares are sold and the proceeds go to the firm, whereas in a secondary offering the proceeds go to the existing shareholders.

A notable anomaly in IPOs is “underpricing” whereby the first day of trading the stock over performs the market or its return is in general positive. In underwriting services investment banks – as part of their “certification effect” – help to set the offering price using three different price-setting mechanisms: (1) book-building, (2) fixed-price and (3) auction.

The most popular price setting-mechanism used in IPOs is book-building (also known as open-price) whose key feature is that the allocation of shares occurs in a discretionary basis – at least for institutional investors. Moreover, also the price is set in a discretionary basis so that both the issuing firm – or its shareholders – and final investors meet their selling and buying goals. A seasoned equity offering (also known as SEO or follow-on offering) is an offering by which shares of an already publicly listed company are sold to investors either being issued by the firm to raise more capital or by existing shareholders to get liquidity. IPOs, or in general security offerings, are managed by a group of investment banks called syndicate. In the syndicate a global coordinator, that acts like a general manager and that is usually part of both tranches (institutional and retail), coordinates the whole syndicate.

In an IPO shares are usually “overallotted”, that is are over allocated to assist in the stabilisation effort immediately after the closing of the offering. Stabilisation is the buying and selling of securities immediately after the IPO to prevent a price drop (that would leave a bad taste to the market). IPOs are usually assisted by provisions like lock-ups, clauses that contractually restricts some shareholders from selling shares for a certain interval of time. Equity offering fees for a syndicate range between 2% and 8% on average.

M&A transactions

M&As is a rather comprehensive term that refers in general to operations that facilitate a company’s capacity to continuously grow, evolve, and re-focus while keeping up with ever-changing market conditions, shareholders demands, industry trends. M&A transactions can be classified according to different perspectives. Based on which counterpart’s side an investment bank is hired, buy-side and sell-side are distinguished.

The mostly cited motivations to account for an M&A transaction are cost and revenue synergies that mainly come as economies of scale (“size matters in terms of costs per units”“) and economies of scope (”two CFOs, two CEOs, two accounting departments aren’t needed after an M&A transaction“). The kind of acquisition strategies involved in M&A transactions are horizontal, vertical and conglomerate — horizontal implies extending a company’s reach by adding more production and sale capacity, vertical means integrating in the same production process operations by moving backward towards suppliers or forward towards customers, conglomerate is a diversification strategy that pulls together unrelated businesses.

In an M&A transaction “consideration” refers to the “currency” used to accomplish the transaction, being it cash, stock or both (hybrid). Investment banks charge clients retainer fees and success fees for providing them with M&A advisory services. The former are fees the investment bank pockets unconditioned on the successful completion of the deal, whereas the latter are dependent on the successful completion of the transaction.

In an M&A sell-side transaction bidders (or acquirers or buyers) fall under two categories: strategic and financial bidders. In a sell-side M&A transaction the sale process is arranged as a trade sale – with one or few potential bidders – or as an auction process with many potential acquirers. Always from the sell-side perspective, an M&A transaction, the marketing material being prepared consists of a “teaser” and a CIM (confidential information memorandum), containing detailed information about the target – legal, business and financial data are provided. Before the deal is finalised in an M&A transaction, the definitive merger agreement (DMA) is negotiated between the target and the seller and contains information such as purchase price, when and how the price will be paid and covenants.

In a pure stock deal consideration, the theoretical exchange price of two publicly listed firms is defined as the ratio of the target’s stock price and the bidder’s stock price. Moreover, in a M&A transaction dilution/accretion analysis centres on measuring the effects of a transaction on a potential acquirer’s earnings, given a financing structure. Albeit dilution/accretion analysis is fundamentally an accounting issue most of the times based on historical earnings rather than projected earnings affected by the synergies pursued in the deal, markets seem to welcome more the announcement of accretive deals as if they tend to short-sightedly look more at current (past) earnings.

A leveraged buy-out (LBO) is an M&A transaction whereby the acquisition of a company is achieved by deploying debt to finance a large portion of the purchase price. The high level of debt incurred by the target in an LBO is backed by the (levered) free cash flow available for debt repayment mainly. A typical investment horizon for a buyout transaction is usually 3–5 years, at least (I should add). In an LBO financing structure one may find that investment banks compete with one another to provide “commitment letters” promising to fund the debt portion of the purchase price in exchange for various fees.

LBOs feature mostly in M&A transactions in which private equity funds are involved. Specifically, private equity industry consists of two major categories: venture capital and buy-out funds. The former are specialised in taking minority stakes – by purchasing stock in subsequent series of funding rounds – in companies that need to invest substantially to grow organically (i.e. not by undertaking M&A transactions), whereas the latter – the buy-out funds – buy majority stakes in companies with stable and predictable cash-flows. Buy-out funds are mostly engaged in LBO transactions.

The common types of compensation in private equity are management fees and carried interest. The first is a fee charged yearly by the private equity firm on committed or investment capital, the second is subtracted by paid back capital at maturity – or during the investment horizon – and initial capital invested: it represents a performance fee that aligns the asset management company’s (or general partners) and the investors’ (or limited partners) interests.

Corporate restructuring

Corporate restructuring is triggered by a condition of financial distress or the intention to enhance value creation for shareholders. Restructuring transactions fall under two categories: asset restructuring and debt restructuring. By looking at a company as a “bunch of contracts” – with employees, suppliers, customers and bondholders beside shareholders, for example – the jurisdiction in which the contracts have to be restructured play a major role.

Under a financial distress condition a firm is reasonably unable to meet its financial obligations and when a firm enters financial distress two forms of restructuring may be available: workout or bankruptcy. Workout or bankruptcy both end up with liquidation or restructuring. A workout is an out-of-court informal procedure, while bankruptcy is a formal legal procedure. In a liquidation the goal is to sell the assets and pay back creditors according to absolute priority rule (the order of payment in case of bankruptcy). Liquidation and bankruptcy have drawbacks, that is they disrupt the firm value as a “going concern”.

Debt restructuring consists in changing the terms of outstanding debt contracts: extending their maturities, reducing the principal amount, changing the interest rate setting mechanism or converting into equity. In debt restructuring controversies among creditors are often hard to solve and an issue known as “holdout problem” complicates matters even more. In case some creditors don’t approve the proposed restructuring plan and retain the original claims they might be better off than the ones approving it. If many creditors figure out the same outcome then the plan wouldn’t be approved. This is the so called “holdout problem” resembling the renowned “prisoner’s dilemma”: bondholders (or in general creditors) who do not participate might benefit at the expenses of those who do, but if nobody participates then the deal is called off.

In case a company is restructured with the goal of enhancing shareholders’ value stock break-ups are common examples of asset restructuring. Stock break-ups are a type of ownership restructuring and the most typical are equity carve-outs, spin-offs, tracking stocks. Equity carve-outs are IPOs of a subsidiary’s stock; cash is involved. Spin-offs are a pro rata distribution of the subsidiary’ shares to the firm’s existing shareholders; they involve no cash. Tracking stocks are shares whose cash flows are linked to the performance of a subsidiary; cash is involved (as in ECOs) and there’s a pro rata distribution of the subsidiary’s shares.

Real estate investments, securitisation and fundamentals of valuation

Real estate and specifically lease contracts are the ideal context to illustrate valuation methods. This is so because landlords and tenants enter multi-year contracts by negotiating fixed rents that are the generating base of cash-flows for the recipient (the landolord). Hence, cash-flow projections for valuation purposes are more easily credible especially for “intralease” investment-horizons — interval of time during which lease contracts are fixated.

What is the space market? The space market is the market for the usage of real property (built space and land). On the demand side of the space market are households and firms that want to use space for consumption or production purposes. The space market is location and type specific. The goals of a real estate market analysis are trying to quantify and predict supply and demand of specific markets for “space use”. Where to locate a branch office or how many residential units to build might be the purposes of a real estate market analysis. Claiming that the typical market analysis is focused on a few indicators or variables regarding only the supply side of the real estate market is false — a typical market analysis has to concentrate on both the demand and the supply side.

The market descriptive variables in real estate are vacancy rate, rent level, new construction started, new construction completed and absorption of new space. The vacancy rate is the percentage of the stock of built space in the market that is not currently occupied. By comparing net construction completed to net absorption we get an indication of whether demand and supply are growing at the same rate with implications for changes in the balance between demand and supply in the market.

Commercial mortgage bond securities (CMBS) are bonds sold to investors backed by mortgage loans on individual commercial properties. It’s an asymmetric reallocation of risks among the different seniority rankings in the bond tranches sold to investors. Default risk is allocated among the different tranches of securities issued by the vehicle in a peculiar way: before senior tranches investors have to suffer credit losses a certain percentage of borrowers in the underlying portfolio has to default.

The basic idea for valuation is that an asset’s value is the present value of its expected future cash flows. The prices investors pay for assets determine their expected returns because the future cash flows the asset can yield are independent of the prices investors pay today for the property. In a DCF analysis the first major step is to predict the expected future cash flows over the planned investment horizon. Then, a required rate of return has to be applied to discount those cash-flows at the present time. Finally, by adding up the projected cash-flow present values we get an estimate of the asset value.

Financial statement analysis

Firms have to issue financial reports on a regular basis because they have to communicate financial information to the investment community at large. Reports about a company’s performance must be understandable and accurate. The four types of statement in a financial report are the balance sheet, the income statement, the statement of cash flow and the statement of stockholders’ equity.

Stockholders’ equity is a residual claim on the firm’s assets after having paid back all liabilities. A firm’s enterprise value measures the value of the underlying business assets, unencumbered by debt and separated from cash or marketable securities. Earnings before interests and taxes (aka EBIT) is defined as gross profit – operating expenses –/+ other sources of income or expenses (with the exception of interest expense). Earnings before interests, taxes, depreciation and amortization (aka EBITDA) is defined as EBIT + depreciation and amortisation.

The firm’s statement of cash flows uses the information from the income statement and the balance sheet. Net working capital from a financial report’s perspective can be defined as accounts receivable + inventory – accounts payable. Capital expenditure are expenses related to purchases of new equipment, plant, property that do not appear immediately in the income statement. The current ratio can be defined as a firm’s current assets to current liabilities ratio.

The interest coverage ratio is computed by dividing a firm’s margin (usually EBIT or EBITDA) by interest expenses. An interest coverage ratio greater than 2.0 means the firm has enough margins to meet its interest expenses comfortably. A leverage ratio (debt-to-equity ratio) greater than 3.0 warns of high level of indebtedness.

The price-to-earnings ratio (or more simply price-earnings ratio, PE) considers the value of the firm’s equity (or its price if publicly listed). The enterprise value-to-EBITDA ratio allows us to compare firms with markedly different leverages. Return on equity (ROE) is an investment returns’ ratio. ROA or return on assets ratio is usually computed as (net income + interest expense)/total assets (book value). ROE’s decomposition into the so-called “Du Pont’s identity” is useful because it relates return on equity to net profit margin, asset turnover and equity multiplier.

Behavioural finance

Our beliefs and opinions are only assumptions, affected by a number of elements we do not have control on. What do we use to help ourselves make decisions (like financing decisions)? We use mental shortcuts called “heuristics”. Optical illusions are useful in the context of making decisions under uncertain conditions because they help us understand why our mental shortcuts sometime fail.

Three biases of judgment featuring our decision-making processes are overconfidence, hindsight and overreaction to random events. Overconfidence in the field of decision-making is the tendency to rely excessively on our skills even when they may not affect the outcome of our choices whatsoever. Hindsight in the field of decision-making is the tendency to see past events as being more predictable than what they are. Overreaction to random events in the field of decision-making is disproportionate reaction to random events as though they’re caused by a pattern driving them.

Individuals are reluctant to realise their losses while are more willing to realise their gains, this the so called disposition effect in decision-making. Narrow framing in decision-making implies that people are affected by the way decisions are framed. Regret, in the field of decision-making, makes losing money more hurtful and regretful investors/clients tend to blame their advisers more. There are two kinds of regret: regret for omission and regret of commission. What’s the difference between regret for omission and regret of commission? People brood over the actions that led to unfavourable outcomes more than the “inactions” that led to similar unfavourable results.

Capital requirements under Basel 3

Basel 1 provided uniform definitions of capital as well as minimum capital adequacy. Basel 2 was based on a three-pillared framework (capital requirements, supervisory review and market discipline) to improve the original accord of Basel 1. A bank’s regulatory capital is divided in CET1, AT1, T2 and additional capital buffers.

According to Basel 3, a bank’s regulatory capital is divided into categories (or tiers): TIER 1 and TIER 2. The minimum capital requirement for CET1 (common equity tier 1) in relation to RWA (risk-weighted assets) is 4.5%. The minimum requirement for TIER 1 capital in relation to RWA (risk-weighted assets) is 6.0%. The minimum requirement for TOTAL CAPITAL RATIO (TCR) in relation to RWA (risk-weighted assets) is 8.0%. Currently the capital conservation buffer is applied only to corporate exposures and is 2.5% of RWA.

TIER 1 consists of, according to Basel 3, common equity TIER 1 capital (CET1) and additional TIER 1 capital (AT1). TIER 2 capital function is to take in the losses that cannot be absorbed by TIER 1 capital. According to Basel 3 banks are required to meet liquidity requirements, and specifically the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). As for the LCR under Basel 3, banks are required to hold a pool of high quality and liquid assets (HQLA) sufficient to cover net cash outflows over the 30-day period of time in stressed conditions. Banks are required to meet a funding ratio (NSFR) designed to address liquidity mismatches between funding and asset durations.