Investment Banks Flashcards
What do investment banks do?
They facilitate the issuing and trading of securities.
They advise buyers and sellers of information.
They underwrite securities.
Sell information.
How do informed investment banks differentiate themselves?
They only sell information when it is negative.
If banks invest positive amounts into risky assets, they also have an incentive to sell information even if they don’t have it. Hence investors observing this cannot be sure the bank actually has information.
Banks sell information if it is sufficiently negative
Why can’t uninformed investment banks sell information on a short position?
Uninformed banks assume the return on risky assets is larger than the return on gilts. Thus a long position is always optimal for these banks. The costs associated with switching to a short position (no longer optimal) are high, and therefore an uninformed bank needs to charge a high price to compensate them for this. Informed banks will set the price of information low enough to undercut these banks but high enough such that they still profit.
Why might selling information you do not have be dangerous?
Reputational risk - if consumers find out / if the information is wrong
Regulatory scrutiny?
Why could advice on M&A lead to a conflict of interest?
The advice given will be based on whatever is profit maximising to the bank. This may however not be optimal to the company.
The contract type and intro a breakout fee can align these interests.
Benefit of a company offering the best contract (from a clients perspective)
They are operating at a competitive advantage. Companies will prefer this bank since their advice will maximise the company’s welfare
Main piece of advice in M&A
Accept the deal or reject in the hope of getting a better (higher) offer.
Advice they give is often accepted since companies assume they are better informed.
Advice given is based on the valuations made by the company
Fixed fee contract
Bank will always advise to accept the first offer since they will incur additional costs if it is rejected, reducing their profit.
CONFLICT OF INTEREST
Conditional fee contract
Bank only gets a fee if the deal is completed.
Again will always advise to accept the first offer.
CONFLICT OF INTEREST - of which is more likely than in the case of a fixed fee contract
Contingent fee contract
Bank gets a proportion of the value of the deal.
Bank no longer always accepts the first offer. If they feel a second higher offer could be made, they will accept the cost of more negotiation + the potential cost of no deal.
Conflict of interest reduced - however stilk exists.
Break up fee
Bank gets money even if the deal does not go through. Helps align interests. This money unlikely to cover the full costs.
Needs to be set appropriately such that the investment bank is incentivised to abandon the deal (set too high) or the bank advises pushing for a deal not in the company’s interest (set too low) - the break up fee is too low such that it incentives accepting the lower offer since this means more money
Benefit of information
Can induce more effort from companies. They know information will alter an investor’s willingness to pay and hence price. Therefore induces more effort (is better governance, less risks etc) to raise the stock oruxe
What is Book building?
Investment banks ascertain tentative bids by selected investors to gauge interest in the issue before the securities are offered more widely.
Helps determine the offer price
Syndicate
Multiple banks work together to underwrite the security.
One bank is appointed as lead underwriter.
More access to different investors. More likely to find investors with a high signal / positive opinion of the offer price … leads to upward pressure on the issue price - good for issuer
Lead underwriter role
Distributes the fee income such that all underwriters exert effort. No free riding.
