Securities Firms and
Investment Banks
Securities Firms and Investment Banks
Help net suppliers of funds transfer their funds to net
demanders of funds at a low cost and with high
efficiency
Main functions
▪Broker-dealers
▪Investment banking
Securities Firms and Investment Banks
▪ Securities firms
– Specialize in the purchase, sale, and brokerage of existing
securities
– Retail
▪ Investment banks
– Specialize in originating, underwriting and distributing issues
of new securities
– Advising on M&As and restructuring
– Commercial
Key Activity Areas
▪ Investment Banking
▪ Mergers & Acquisitions (M&A)
▪ Venture Capital
▪ Market Making
▪ Trading
▪ Investing
▪ Cash Management
▪ Back-Office and Service Functions
Investment Banking
Activities related to underwriting and distributing new
issues of debt and equity
 Primary or secondary issues
 Public or private placement
▪ Public offering: placement of securities with the public at large
▪ Private placement: placement of securities with one or several
large institutional investors
Investment Banking
Types of issues:
▪ Primary issue: An initial, or first time, public offering of debt or equity
by a corporation (IPO or initial public offering)
▪ Secondary issue: the new issues of seasoned firms whose debt or equity
is already trading (seasoned or secondary offering)
Compensation:
▪ Best efforts: act as agents on fee basis related to success in placing issue
▪ Firm commitment: act as principals, purchasing securities from issuer
at one price and seeking to place them at higher price
Best Efforts vs Firm Commitment
An investment bank agrees to underwrite an issue of 15 million shares of
stock for Looney Landscaping Corp. on a firm commitment basis. The
investment bank agrees to pay $12.50 per share to Looney Landscaping
Corp. for the 15 million shares of stock. It can then sell those shares to the
public for $13.25 per share.
▪ How much money does Looney Landscaping Corp. receive?
▪ What is the profit to the investment bank?
Best Efforts vs Firm Commitment
An investment bank agrees to underwrite an issue of 15 million shares of
stock for Looney Landscaping Corp. on a firm commitment basis. The
investment bank agrees to pay $12.50 per share to Looney Landscaping
Corp. for the 15 million shares of stock. It can then sell those shares to the
public for $13.25 per share.
▪ How much money does Looney Landscaping Corp. receive?
$12.50 x 15,000,000 shares = $187,500,000
▪ What is the profit to the investment bank?
($13.25 - $12.50) x 15,000,000 shares = $11,250,000
Best Efforts vs Firm Commitment
An investment bank agrees to underwrite an issue of 15 million shares of
stock for Looney Landscaping Corp. on a firm commitment basis. The
investment bank agrees to pay $12.50 per share to Looney Landscaping
Corp. for the 15 million shares of stock. It can then sell those shares to the
public for $13.25 per share.
▪ If the investment bank can sell the shares for only $11.95, how much
money does Looney Landscaping Corp. receive?
▪ What is the profit to the investment bank?
Best Efforts vs Firm Commitment
An investment bank agrees to underwrite an issue of 15 million shares of
stock for Looney Landscaping Corp. on a firm commitment basis. The
investment bank agrees to pay $12.50 per share to Looney Landscaping
Corp. for the 15 million shares of stock. It can then sell those shares to the
public for $13.25 per share.
▪ If the investment bank can sell the shares for only $11.95, how much
money does Looney Landscaping Corp. receive?
$12.50 x 15,000,000 shares = $187,500,000
▪ What is the profit to the investment bank?
($11.95 - $12.50) x 15,000,000 shares = -$8,250,000
Best Efforts vs Firm Commitment
Suppose, instead, that the investment bank agrees to underwrite the 15
million shares on a best-efforts basis. The investment bank is able to sell
13.6 million shares for $12.50 per share, and it charges Looney
Landscaping Corp. $0.275 per share sold.
▪ How much money does Looney Landscaping Corp. receive?
▪ What is the profit to the investment bank?
Best Efforts vs Firm Commitment
Suppose, instead, that the investment bank agrees to underwrite the 15
million shares on a best-efforts basis. The investment bank is able to sell
13.6 million shares for $12.50 per share, and it charges Looney
Landscaping Corp. $0.275 per share sold.
▪ How much money does Looney Landscaping Corp. receive?
($12.50 - $0.275) x 13,600,000 shares = $166,260,000
▪ What is the profit to the investment bank?
0.275 x 13,600,000 shares = $3,740,000
Best Efforts vs Firm Commitment
Suppose, instead, that the investment bank agrees to underwrite the 15
million shares on a best-efforts basis. The investment bank is able to sell
13.6 million shares for $12.50 per share, and it charges Looney
Landscaping Corp. $0.275 per share sold.
▪ If the investment bank can sell the shares for only $11.95, how much
money does Looney Landscaping Corp. receive?
▪ What is the profit to the investment bank?
Best Efforts vs Firm Commitment
Suppose, instead, that the investment bank agrees to underwrite the 15
million shares on a best-efforts basis. The investment bank is able to sell
13.6 million shares for $12.50 per share, and it charges Looney
Landscaping Corp. $0.275 per share sold.
▪ If the investment bank can sell the shares for only $11.95, how much
money does Looney Landscaping Corp. receive?
($11.95 - $0.275) x 13,600,000 shares = $158,780,000
▪ What is the profit to the investment bank?
$0.275 x 13,600,000 shares = $3,740,000
Mergers and Acquisitions
Involves providing advice and assisting in activities related
to mergers and acquisitions such as
▪ finding merger partners
▪ assessing the value of target firms
▪ recommending the terms of the merger
▪ underwriting new securities to be issued by the merged firms
▪ help target firms prevent a merger
Venture Capital
Professionally managed pool of money used to provide capital
financing to new and often high-risk firms, as well as advice
▪ VC firms receive an equity interest in the firm
▪ They are active investors i.e. provide expertise, connections
▪ Types of institutional venture capital firms
 Venture capital limited partnerships
 Financial venture capital firms
 Corporate venture capital firms
Market Making
Involves creating a secondary market in an asset
▪ Principal transactions: market maker seeks to profit on price
movements and takes either long or short inventory positions on
own account
▪ Agency transactions: on behalf of customers (acting as
stockbroker or dealer for a fee or commission)
Trading
Involves taking an active net position in an underlying asset
▪ Stock brokerage: involves trading on behalf of individuals
▪ Electronic brokerage: involves direct access via internet to trading
floor, therefore bypassing traditional brokers
▪ Position trading: involves maintaining long or short positions in assets
on the expectation of favorable price moves
▪ Pure arbitrage: involves the buying and selling of same or similar
assets trading at different prices in different markets
▪ Risk arbitrage: involves establishing speculative positions prior to
some information release or event
▪ Program trading: involves simultaneous buying and selling of a large
portfolio of different stocks using computer programs to initiate trades
Investing
Involves managing pools of assets such as closed- and
open-end mutual funds, pension funds
 As agents for other investors
 As principals for themselves
▪ Choose asset allocation to beat some performance benchmark
▪ Fees are based on size of the pool of assets managed
Cash Management
Involves offering deposit-like cash management accounts
(CMAs) to individual investors, as well as direct deposit
accounts
▪ CMAs allow writing checks against some type of mutual fund
account, also offer debit cards, ATM services
▪ Advantage relative to commercial banks’ deposit accounts: make it
easier to buy and sell securities
Back-Office and Service Functions
Involves provision of services like custody and escrow,
clearance and settlement, and research and advisory
▪ Act as agents for fee
▪ Soft dollars: portion of fee allocated to research and advisory
services
▪ Conflicts of interest
Broker-Dealers Balance Sheet
Balance Sheet Size of all US BDs: $ 4,461.6 B (as of 2015)
Primary Assets
Primary Liabilities
▪ Receivables from
▪ Repurchase agreements
$1,761.0 B
other brokers-dealers
$1,326.6 B ▪ Payable to customers
$791.6 B
▪ Reverse repurchase
▪ Payable to other
agreements
$1,316.3 B
brokers-dealers
$ 660.8 B
▪ Long positions in securities
▪ Other nonsubordinated
and commodities
$1,041.1 B
liabilities
$423.5 B
▪ Receivable from customers $241.7 B
▪ Short positions in securities
▪ Cash
$116.2 B
and commodities
$369.8 B
▪ Capital
$345.8 B