Stowell an introduction to investment banks, hedge funds private equity (2010)

This book provides an overview of invest-ment banks, hedge funds and private equity firms and describes the relationships between these organi-zations: how they simultaneously compete wi

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

The New Paradigm

Companion Web SiteAncillary materials are available online at:

www.elsevierdirect.com/companions/9780123745033

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

The New Paradigm

David P Stowell

Kellogg School of ManagementNorthwestern University

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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

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

6 Asset Management, Wealth Management, and Research 115

7 Credit Rating Agencies, Exchanges, and Clearing

9 Convertible Securities and Wall Street Innovation 155

10 Investment Banking Careers, Opportunities, and Issues 173

13 Shareholder Activism and Impact on Corporations 241

19 Organization, Compensation, Regulation, and Limited Partners 347

vii

Section III Case Studies 381

1 Investment Banking in 2008 (A): Rise and Fall of the Bear 383

2 Investment Banking in 2008 (B): A Brave New World 403

4 The Best Deal Gillette Could Get?: Procter and Gamble’s Acquisition

5 A Tale of Two Hedge Funds: Magnetar and Peloton 451

6 Kmart, Sears, and ESL: How a Hedge Fund Became One of

7 McDonald’s, Wendy’s, and Hedge Funds: Hamburger Hedging?

Hedge Fund Activism and Impact on Corporate Governance 489

8 Porsche, Volkswagen and CSX: Cars, Trains, and Derivatives 511

The world of finance has experienced a paradigm shift following the global financial meltdown of2007–2009 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 createvalue in an environment of lower risk and greater regulation This book provides an overview of invest-ment banks, hedge funds and private equity firms and describes the relationships between these organi-zations: how they simultaneously compete with and provide important services to each other, and thesignificant impact they have on corporations, governments, institutional investors and individuals.Together, they have reshaped global financing and investing patterns, attracting envy and awe but alsocriticism 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 heavilyinterconnected 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 privateequity firms, revealing their key functions, compensation systems, unique role in wealth creation andrisk management and their epic battle for investor funds and corporate influence After reading thisbook, the reader should better understand financial press headlines that herald massive corporate take-overs, 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 modelsprovides an analytical framework that allows the reader to apply the book’s lessons to real-worldfinancing, investing and advisory activities

Target Audience

The target audience for this book includes MBA, MSF and Executive MBA students, and upper-levelundergraduates who are focused on finance and investments Investment banking classes can use thisbook as a primary text and corporate finance and investments classes can use the book either as a sec-ondary text or as a principal text to focus on hedge funds and private equity In addition, professionalsworking at investment banks, hedge funds and private equity firms can use the book to broaden under-standing of their industry and competitors Finally, professionals at law firms, accounting firms andother firms that advise investment banks, hedge funds and private equity firms should find this bookuseful as a resource to better understand and assist their clients

ix

Distinguishing Features

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

I wrote this book following a twenty year career as an investment banker at Goldman Sachs, JPMorgan and UBS, and an additional four years at O’Connor & Associates, a large hedge fund that isnow part of UBS As an investment banker, in addition to completing numerous M&A, debt and equityfinancing, equity derivative, and convertible transactions with corporate clients, I worked with privateequity firms (financial sponsors) as they acquired companies and pursued exit strategies through reca-pitalizations, M&A sales and IPOs Since 2005, I have been a professor of finance at NorthwesternUniversity’s Kellogg School of Management, where I have had the privilege of teaching what I learnedduring my pre-academic career, while completing ongoing research into the ever-changing landscape ofinvestment banks, hedge funds and private equity The opportunity to teach bright students at a firstclass business school has provided great feedback and a forum to refine concepts and make them morerelevant to students This book is therefore a product of both real world and academic experience, cre-ating 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 hur-dles and other subjects that are linked to chapter topics The cases include questions for studentsand case notes and teaching suggestions for instructors In addition, several cases include spreadsheetmodels that allow readers to create an analytical framework for considering choices, opportunitiesand 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 withchapter 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 ruptcy, Fannie Mae and Freddie Mac were placed into U.S government conservatorship, the U.S gov-ernment assumed majority control over AIG after injecting over $100 billion to keep it afloat, underduress, Countrywide and Merrill Lynch both sold themselves to Bank of America, Wells Fargo boughtWachovia at the brink of bankruptcy, Washington Mutual went into receivership with its branchesabsorbed 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 aspart of a larger $700 billion rescue program, guarantees of debt and asset pools by the FDIC totalingmany hundreds of billions of dollars, and an unprecedented expansion of the Federal Reserve’sbalance sheet by trillions of dollars as it provided credit based on almost any type of collateral

bank-x PREFACE

All of this occurred as the world experienced the most significant, globalized downturn since the GreatDepression of the 1930s.

The investment banking business, in many ways, will never be the same Leverage has beenreduced, some structured financial products have ceased to exist, and regulation has increased How-ever, the fundamental business remains unchanged: advising corporations and investors; raising andinvesting capital; executing trades as an intermediary and principal; providing research; making mar-kets; 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 tunities loom large, while issues such as public perception, compensation, and risk management must

oppor-be carefully worked through

Hedge funds and private equity funds suffered significant reversals during 2008, with hedgefunds recording investment losses of over 19% on average and private equity firms acknowledging sim-ilar potential losses to their investors Although these results were undesirable and caused some inves-tors to abandon funds, the global equity markets fared even worse, with the major U.S stock marketindices dropping by more than 38% and other equity and non-government debt indices throughout theworld posting similar, or greater, losses Hedge funds and private equity have had to adjust to a chang-ing 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 words during the global financial crisis as these funds fought to hold on to as many limited partners asthey could while considering new investment strategies for a credit-deficient world During 2009, manyhedge funds and private equity firms bounced back, with positive returns for most hedge funds and arefocus 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 developednew processes and business plans designed to maintain historical positions of power and influence Theworld has changed, but these institutions will continue to have a significant impact on global capitalmarkets and M&A transactions This book projects how they will achieve this, and the resultantimpact on corporations, governments, institutional investors and individuals

watch-Structure of the Book

The book is divided into three sections The first section is comprised of ten chapters that focus on ment banks The second section includes five chapters that discuss hedge funds and five chapters thatreview the activities of private equity firms The third section of the book includes ten cases that focus

invest-on recent transactiinvest-ons and developments in the financial markets These cases are cross-referenced inthe 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 sions of most large investment banks, including descriptions of the M&A and financing activities of thebanking division; the intermediation and market-making, as well as principal (proprietary) activities ofthe trading division; and the investment gathering and money management activities of the asset man-agement division In addition, the other businesses of large investment banks and the activities of bou-tique investment banks are reviewed Other chapters focus in more detail on financings, including theactivities of capital markets groups and the underwriting function, and discussion of IPOs, follow-onequity offerings, convertibles and debt transactions The role of credit rating agencies, prime brokeragegroups, structured credit, derivatives and exchanges is also explored Finally, regulations, leverage, risk

divi-Preface xi

management, clearing and settlement, international investment banking, career opportunities and theinterrelationship between investment banks, hedge funds and private equity is discussed The capstonechapters in this section of the book drill deeply into M&A, convertible securities and investment bankinnovation.

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 Onechapters 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 oncorporations; 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 theirlimited investor partners Finally, hedge fund competition with investment banks and private equity isreviewed, as well as the symbiotic relationship between all three parties

The second five chapters of Section Two examine private equity from the perspective of thosefirms that principally focus on leveraged buyouts (LBOs) and other equity investments in mature com-panies These chapters provide an overview of private equity; an explanation of an LBO model andhow it drives decision-making; private equity impact on corporations, including a case history of morethan a dozen LBO transactions; a description of organization, compensation, regulation and limitedpartner 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 Fundsand Private Equity It should be used in conjunction with cases in Part Three that are specifically refer-enced in Section Two chapters Section One’s investment banking chapters may also be used assupplemental material

Section Three: Cases

This section contains ten cases that are referenced in different chapters in Sections One and Two Thecases enable students to drill deeper into the subject matter of the chapters and apply concepts in theframework of real transactions and developments Case questions and teaching notes for each caseare provided, as well as several spreadsheet models that enable students to manipulate data The casesfocus on the following: the dramatic change in the global investment banking landscape that occurredduring the 2008 financial crisis; the use of equity derivatives by Porsche and CSX as these two corpora-tions interacted with investment banks and hedge funds in effecting significant corporate change; Cer-berus’s investments in Chrysler and GMAC (GM’s captive finance subsidiary); the divergent CDOinvestment 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, whichfocuses on M&A, risk taking and financing activities; the acquisition through a bankruptcy court pro-cess 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 ofcorporate governance and regulatory issues; the LBO of Toys R Us, focusing on the role of privateequity funds and investment banks; and activist hedge fund investor Pershing Square’s impact on thecapital and organizational structure of McDonald’s Corporation

xii PREFACE

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 twoyear process of researching and writing this book When I decided to become an academic, theyassumed that my investment banker work-week would drop from 70þ hours to less than half thatamount This has not been the case, as I learned that academics work long hours too, and the bookadded many hours to my schedule My oldest son, Paul, is a banker, derivatives structurer, and formerconvertibles trader, and I relied on and appreciated his wisdom in thinking through the organization ofthe book and benefited from technical suggestions he made I wish to thank Xiaowei Zhang, whoworked in my team at JP Morgan, for her very diligent and efficient contributions as my principal assis-tant during the editing and model production stage of this project I was very fortunate to be able torely 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 leagues and administrators at Northwestern University’s Kellogg School of Management offered sup-port for this project and me Special thanks to Kathleen Haggerty for her assistance from the Office

col-of the Dean and to senior finance department faculty members Robert Korajczyk, Robert McDonaldand 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 lent input to selected chapters:

excel-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 andprivate 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

xiii

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 andNorthwestern undergraduate research assistants Esther Lee, Tom Hughes, Anya Hayden and AshleyHeyer 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, DevelopmentEditor

xiv ACKNOWLEDGMENTS

I

Investment Banking

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 globalfinancial crisis that started in mid-2007 as market forces pushed banks from their traditionallow-risk role of advising and intermediating to a position of taking considerable risk for theirown 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 wererecorded, and many firms were forced to reorganize their business

Risk-taking activities of investment banks were reduced following large losses that stemmedprimarily from mortgage-related assets, bad loans, and an overall reduction in revenues due to thefinancial crisis This led to an industry-wide effort to reduce leverage and a string of new equitycapital issuances By the end of 2008, five pure-play investment banks headquartered in theUnited 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 otherbusinesses) had undergone significant transformations: Goldman Sachs and Morgan Stanley con-verted into bank holding companies; the U.S Federal Reserve (Fed) pushed Bear Stearns into thearms of J.P Morgan to avoid a bankruptcy; Lehman Brothers filed for bankruptcy protectionafter the Fed and Treasury Department ignored its pleas for government support; and MerrillLynch, presumably to avoid a similar bankruptcy filing, agreed to sell their firm to Bank ofAmerica (seeExhibit 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

EXHIBIT 1.1

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

© 2010 by Elsevier Inc All rights of reproduction in any form reserved. 3

Glass-Steagall Banking Act of 1933, which was enacted after the stock market crash of 1929 to tect depositors’ assets In 1999, the Gramm-Leach-Bliley Act overturned the requirement to keepinvestment banks and commercial banks separate, and led to the formation of U.S.-headquartereduniversal investment banks, including J.P Morgan, Citigroup, and Bank of America Two of themain arguments for rejoining these two kinds of businesses were (1) to provide for a more stableand countercyclical business model for these banks, and (2) to allow U.S banks to better competewith international counterparts (e.g., UBS, Credit Suisse, and Deutsche Bank) that were less encum-bered by the Glass-Steagall Act As a result, Citigroup, which was created through the 1998 merger

pro-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 ofAmerica followed the lead of Citigroup in combining businesses to create universal investmentbanks These banks rapidly developed a broad-based investment banking business, hiring many pro-fessionals from pure-play investment banks and strategically using their significant lending capabil-ity 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 bankingand deposit-taking businesses and operate throughout the world included J.P Morgan, Bank ofAmerica, Citigroup, Credit Suisse, UBS, Deutsche Bank, Barclays, Goldman Sachs, and MorganStanley SeeExhibits 1.2,1.3,1.4, and1.5for a summary of financial results, financial measures,and market capitalization for these nine firms

EXHIBIT 1.2

EXHIBIT 1.3

EXHIBIT 1.4

Chapter 1  Overview of Investment Banking 5

Other Investment Banking Firms

In addition to these nine key global investment banks, other large banks compete effectively inregional markets worldwide and, in some countries, have a larger market share for investmentbanking business than the nine designated global banks Examples of banks in the category oflarge regional investment banks include HSBC, Socie´te´ Ge´ne´rale, BNP Paribas, CIBC, MUFG,Sumitomo Mitsui, Mizuho, Nomura, and Macquarie Other firms that engage in investment bank-ing business on a more limited scale are called boutique banks Boutique banks principally focus onmerger and acquisition (M&A)–related activity, although some participate in other businesses such

as financial restructuring, money management, or proprietary investments Retail brokerage firmsare securities firms that narrowly compete with large investment banks in relation to retail clientinvestments in stocks and bonds They generally do not conduct a full investment banking business.SeeExhibit 1.6for a sampling of banks that compete in each of these areas

Investment Banking Businesses

Although each investment bank takes a somewhat different approach, the principal businesses ofmost large investment banks include an (a) investment banking business managed by the InvestmentBanking Division, which focuses on capital raising and M&A transactions for corporate clients andcapital raising for government clients; (b) sales and trading business managed by the Trading Divi-sion, which provides investing, intermediating, and risk-management services to institutional inves-tor 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 formanaging money for individual and institutional investing clients (seeExhibit 1.7)

Within the nine large global investment banks, Goldman Sachs and Morgan Stanley areexamples of more narrowly focused investment banks They operate each of the businesses

EXHIBIT 1.5

EXHIBIT 1.6

EXHIBIT 1.7

Chapter 1  Overview of Investment Banking 7

described above and recently added deposit-taking as a new business, following their tion to bank holding companies However, they do not participate in most non-investment bank-ing businesses that the other global firms conduct J.P Morgan and Barclays are examples of morebroadly focused financial organizations that operate a large investment banking business, but alsoconduct large non-investment banking businesses SeeExhibits 1.8and1.9for an overview of theprincipal businesses of Goldman Sachs and J.P Morgan, respectively.

transforma-Investment Banking Division

The Investment Banking Division of an investment bank is responsible for working with tions that seek to raise capital through public or private capital markets, risk-manage their exist-ing capital, or complete an M&A-related transaction In addition, at some firms, this division hasincreasingly provided financing through direct investments in corporate equity and debt securi-ties, and provided loans to corporate clients Finally, this division helps government-related enti-ties raise funds and manage risk Individuals who work in the Investment Banking Division arecalled 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&Aproduct group, bankers typically specialize by industry (and at some investment banks, they workwithin the industry coverage group) In the Capital Markets Group, bankers specialize by work-ing in either debt capital markets or equity capital markets Client coverage bankers are usuallyorganized into industry groups, which typically focus on the following industries: healthcare,

corpora-EXHIBIT 1.8

consumer, industrials, retail, energy, chemicals, financial institutions, real estate, financial sponsors,media and telecom, technology, and public finance, among others (seeExhibit 1.11).Exhibit 1.12pro-vides a summary of the product groups in Morgan Stanley’s Investment Banking Division.

JPMorgan Chase Business Segments

Commercial Banking

Asset Management

Retail Financial Services

Treasury &

Securities Services Businesses:

• Consumer Lending:

- Loan originations and balances (including home lending, student, auto and other loans)

- Mortgage production and servicing

Businesses:

• Credit Card

• Merchant Acquiring

Source: Extracted from JPMorgan Chase 2008 Annual Report

Businesses:

• Treasury Services

• Worldwide Securities Services

Businesses:

• Middle-Market Banking

• Commercial Term Lending

• Mid-Corporate Banking

• Real Estate Banking

Businesses:

• Investment Management:

- Institutional

- Retail

• Private Bank

• Private Wealth Management

• Bear Stearns Brokerage

Mergers & Acquisitions

Equity Capital Markets

Debt Capital Markets

FX, Debt Risk Mgmt., and Credit Rating Advisory

Equity Convertible Derivatives

Investment Grade High Yield Derivatives Private Placements Securitized Products

EXHIBIT 1.10

Chapter 1  Overview of Investment Banking 9

EXHIBIT 1.11

EXHIBIT 1.12

Client Coverage Bankers

Bankers assigned to industry teams are required to become global experts in the industry andunderstand the strategic and financing objectives of their assigned companies They help CEOsand 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 anothercompany These bankers also assist companies to achieve an optimal capital structure, with theappropriate amount of cash, equity, and debt on their balance sheet This often leads to a capitalmarkets transaction in which the company issues equity or debt, or repurchases outstandingsecurities In short, client coverage bankers develop an in-depth understanding of a company’sfinancial 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 managersand 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 coveragebankers and product bankers to execute the transaction for a corporate client Other investmentbanking services can also be introduced by the client coverage banker to the company, includingrisk 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 areresponsible for each of these product areas (which are a much smaller source of revenuecompared to the capital markets and M&A product areas) Sometimes the role of the clientcoverage banker is to encourage a corporate client to not complete a transaction if it is not inthe 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 rate risk

corpo-In order for client coverage bankers to be helpful to their clients, bankers must first developstrong relationships with CEOs and CFOs, and subsequently with corporate development and trea-sury groups The corporate development group usually reports to the CFO but sometimes directly tothe 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 andmaintaining 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 relation-ship with credit rating agencies SeeExhibit 1.13, which summarizes a client coverage banker’stemplate for providing investment banking products and services to corporate clients

Sometimes clients of the Investment Banking Division prefer being covered by bankers whowork in geographical proximity to the client As a result, some client coverage bankers may beassigned to cover clients based on a geographic coverage model rather than an industry coveragemodel Each investment bank attempts to coordinate the activities of industry coverage and geo-graphic coverage bankers in an effort to meet client preferences and achieve operating efficiencyfor the bank

Capital Markets Group

The Capital Markets Group is comprised of bankers who focus on either equity capital markets

or debt capital markets.1At some investment banks, these two groups coordinate their activitiesand 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 MarketsGroup operates either as a joint venture between the Investment Banking Division and the Trad-ing Division, or is included solely within the Investment Banking Division When issuers need toraise capital they work with a team comprised of a client coverage banker and a capital marketsbanker 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 inthe Trading Division, who are responsible for creating investment products that meet the needs

of their investing clients (seeExhibit 1.14)

Equity Capital Markets

The Equity Capital Markets (ECM) business is comprised of bankers who specialize in commonstock issuance, convertible security issuance, and equity derivatives Common stock issuanceincludes initial public offerings (IPOs); follow-on offerings for companies that return to the capi-tal markets for common stock offerings subsequent to issuing an IPO; secondary offerings formajor shareholders of a company who wish to sell large blocks of common shares for whichthe proceeds are received by the selling shareholders and not by the company; and private place-ments, which do not require registration with a regulator Convertible security issuance (seeChapters 3 and 9) usually takes the form of a bond or preferred share offering that is converted

Investment Banker's Template 1

Note 1: Some firms co-invest with corporate clients to facilitate M&A transactions.

Maximize

shareholder

value

Enhance operating performance

Optimize capital structure

Improve investor understanding

Implement appropriate takeover protection

Undertake strategic acquisition / expansion

Invest in core business

Clarify core business mix

Improve efficiency / organize personnel

Strengthen dialogue with analysts / investors;

Manage expectations Change dividend policy

Repurchase shares

Raise Capital

Highlight segment results

Adopt / update structural defenses

Increased disclosure

Legal

Sale

Spin-off 100% IPO / carve-out Tracking stock

Fixed-price tender

Dutch auction

(either by mandate or at the investor’s option) into a predetermined number of the issuer’s mon shares Equity derivatives enable companies to raise or retire equity capital, or hedge equityrisks, through the use of options and forward contracts.

com-Bankers in ECM work closely with client coverage bankers to determine suitable corporatetargets for equity-related products If a company decides to complete an equity financing, ECMassumes primary responsibility for executing the transaction This involves close coordination withsales and trading professionals in the Trading Division to determine the investment appetite of theirclients 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 consid-erable dexterity to balance competing interests and structure an optimal equity-related security.ECM and client coverage bankers must consider many issues with their corporate clientsbefore 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 oncapital 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); aswell 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 andgovernment clients Their clients can be grouped into two major categories: investment-gradeand non-investment-grade issuers Investment-grade issuers have a high credit rating from at leastone of the major credit rating agencies (Baa or stronger from Moody’s; BBB- or stronger fromStandard & Poor’s) Non-investment-grade issuers have lower ratings, and their debt offeringsare sometimes called junk bonds, or high-yield bonds

DCM bankers stand between corporate or government issuers (with whom relationships aremaintained 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

Capital Markets Group

Trading Division Sales & Trading Professionals

Investment Banking Division Bankers

competing price objectives of issuers and investors, while facilitating communication andproviding execution of transactions.

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

In the U.S., DCM bankers help clients raise debt in the public capital markets through registered bond offerings or through privately placed 144A transactions (investors limited toqualified institutional investors) They also serve as the conduit through which a bank loan can

SEC-be secured and provide debt risk management services (using derivatives) and advice regardingthe potential credit rating impact of a debt issuance

The principal products of the M&A Group include: (a) sell-side transactions, which involvethe 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 (orassets) of a company; (c) restructurings or reorganizations that focus on either carving out busi-nesses from a company to enhance shareholder value or dramatically changing a company’s capi-tal structure either to avoid bankruptcy or to facilitate a sell-side transaction; and (d) hostileacquisition defense advisory services (seeExhibit 1.15)

EXHIBIT 1.15

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

Trading Division

The Trading Division is responsible for (a) all investment-related transactions with institutionalinvestors, including financial institutions, investment funds, and the cash management arms ofgovernments and corporations; (b) taking proprietary positions in fixed income and equity prod-ucts, currencies, commodities, and derivatives; (c) market-making and clearing activities onexchanges; and (d) principal investments made both directly and through managed funds.This division typically operates in three different business areas: Fixed Income, Currencies, andCommodities; Equities; and Principal Investments At some investment banks, Principal Invest-ments activity is conducted from a different division Research on economics, fixed income, com-modities, and equities is also provided by the Trading Division to investing clients (see Chapter 6for 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 ties, asset-backed securities, currencies, and commodities (as well as derivatives on all of theseproducts) At some firms, FICC is also involved in the provision of loans to certain corporateand government borrowing clients (in coordination with the Investment Banking Division) Thebusiness 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 pro-ducts and hold them in inventory as a risk position, or sales professionals, who market trade ideasand bring prices from the traders to investors to facilitate purchases and sales of the products

securi-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 andclearing 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 servicessuch as securities borrowing and lending, financing (to facilitate leverage), asset custody, and clear-ing and settlement of trades to hedge fund clients and other fund managers Prime brokers providefund 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 diversifi-cation of strategies employed by hedge funds) A large part of Prime Brokerage–related revenuecomes from commissions from executing and clearing client trades by sales and trading profes-sionals 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

Chapter 1  Overview of Investment Banking 15

Non-Client-Related Trading and Investing

Principal Investing

Although an important role of large investment banks is to act as intermediaries to investingclients, they also invest in securities and real estate for their own account For example, the Prin-cipal 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 purchasingpublic companies using equity provided by Goldman Sachs (and its investing partners) and debtprovided through loans (from Goldman Sachs or other banks) or bonds underwritten by GoldmanSachs in the capital markets This process is called a leveraged buyout (LBO), or taking a companyprivate in the case of a publicly traded target In addition to control investments, Goldman Sachsalso purchases minority positions in companies For example, the firm owned common shares ofIndustrial and Commercial Bank of China Ltd (one of China’s largest banks), which has beenvalued 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 Sachsexceeded $21.7 billion at the end of fiscal year 2008 SeeExhibit 1.16for a summary of GoldmanSachs’ 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, com-modities, and derivatives for their own account This proprietary investment activity is similar tothe investment activities of hedge funds Indeed, investment banks’ proprietary investing activitycompetes directly with hedge funds for investing and hedging opportunities worldwide

During 2005 and 2006, investment banks’ proprietary investing contributed in a significantway to robust Trading Division earnings During 2007 and 2008, however, this same proprietarytrading 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 proprietaryequities-related losses during the fourth quarter of 2008 Other investment banks, includingUBS, Citigroup and Merrill Lynch, reported even larger losses As a result of significant lossesexperienced by most investment banks’ proprietary trading desks during 2007 and 2008, banksscaled back these trading operations However, during 2009, there was some recovery in proprie-tary trading activities

Depending on each bank’s compliance policy, proprietary traders at investment banks cansometimes be clients of their own firm’s client-related trading business These traders have theopportunity, 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 toachieve the best prices and execution Proprietary traders must be dealt with on an arm’s lengthbasis by internal salespeople, and confidentiality is paramount There are strict compliance guide-lines 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 tradersfrom 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 andpotential conflicts of interest, since the “best investment ideas” cannot always be shared with allinvesting clients without introducing excessive competition Investment banks carefully monitorthis situation and attempt to comply with all laws and internal policies, while finding a balancebetween 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 amore complete description of specific proprietary investment activity and corresponding opportu-nities and threats

Asset Management Division

The Asset Management business offers equity, fixed income, alternative investments (such as vate equity, hedge funds, real estate, currencies, and commodities), and money market investmentproducts and services to individuals and institutions Investments are offered in the form ofmutual funds, private investment funds, or separately managed accounts, and are sometimesco-mingled with the bank’s own investments Revenues are created principally based on fees thatare paid by investors as a percentage of assets under management (AUM), which varies depending

pri-on the asset class At times, investors pay an incentive fee to the investment bank when returnsexceed a predetermined benchmark Most firms have a private wealth management businessorganized alongside the asset management business, reporting to the same division head (seeExhibit 1.17) The professionals in the private wealth management business act as advisors to

Chapter 1  Overview of Investment Banking 17

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 orexternal) that best meet the risk and return objectives of investors Chapter 6 provides a moredetailed discussion of the asset management business.

Co-Investments in Asset Management Division Funds

Investment banks sometimes make direct investments in funds managed by their Asset ment 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 theirown capital alongside the capital of their high net-worth individual and institutional clients inthese funds (and they charge investing clients both management fees and performance fees based

Manage-on the clients’ AUM) This has become a very large business for some investment banks Forexample, as of January 1, 2009, two of the largest hedge funds in the world were managed bythe Asset Management Divisions of J.P Morgan and Goldman Sachs (seeExhibit 1.18)

Asset Management

Asset Management Division

Asset Management

Money management of mutual funds, separately managed accounts, annuities, alternative investments and other investments

Private Wealth Management

Helping high-net-worth individuals, families and foundations to invest, allocate and preserve wealth

EXHIBIT 1.17

1 Looking at the leverage ratios of former pure-play investment banks GS and MS inExhibit1.4, 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 AcceptedAccounting Principles) rules Many companies in Europe report according to IFRS (Interna-tional Financial Reporting Standards) rules There has been a movement for allcompanies to shift to an IFRS basis globally When this occurs, what may happen to theleverage ratios of U.S banks?

3 Why might a universal bank be better able to compete against a pure-play investment bankfor 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 isresponsible for balancing these competing interests?

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

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

EXHIBIT 1.18

Chapter 1  Overview of Investment Banking 19

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

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

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

of investment banking and regulation is discussed The second section looks at more recent eventsand regulations The third section summarizes the regulatory environment in the UnitedKingdom, 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 diary between issuers and investors so that one party can gain access to capital, while the otherparty can preserve and grow wealth These underwriting services were essential to the foundationand development of the United States George Washington, the first president, took office in

interme-1789 At this time the federal government had already incurred $27 million of debt, and the stateshad debts totaling $25 million Alexander Hamilton, the first U.S Treasury secretary, persuadedCongress and President Washington to assume the state debt and issue bonds to finance this obli-gation, in spite of strong opposition from Thomas Jefferson Investment bankers played a role innegotiating the terms and conditions of these bonds

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

As the new country began to spread over a vast continent, technological innovation fed intothe industrial revolution The benefits from increased economies of scale made large projectsessential and profitable Large-scale implementation of new technologies allowed for the extrac-tion of natural resources, which created a need for trains to transport people and resourcesbetween cities This and many other activities required capital that no individual or firm couldafford alone As a result, a more formal version of investment banking developed to intermediatebetween firms needing capital and individuals desiring to build wealth By underwriting

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

Copyright © 2010 by Elsevier Inc All rights of reproduction in any form reserved. 21

securities, investment banks made it possible for many investors to pool together their wealth tomeet the great capital needs of a growing nation.

Industrial growth created a new class of wealthy industrialists and bankers who helpedfinance their empires During this period, investment bankers operated in a regulatory vacuumand were largely free to respond as they saw fit to changing market forces The practices theydeveloped brought them power and influence From 1879 to 1893, the mileage of railroads inthe 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 limitedresources to incorporate in order to raise more capital than could otherwise be obtained Thisled to the use of investment banking services by an ever-increasing number of companies Thedemand 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 includedJ.P Morgan & Co.; Kuhn, Loeb & Co.; Brown Brothers; and Kidder, Peabody & Co The UnitedStates did not require separation between commercial and investment banks, which meant depos-its 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 bondissuance 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 ulation, strong demand for securities, and fierce competition resulted in weak internal controlswithin banks Despite their previous attempts at self-regulation, banks could not prevent scan-dals In response to growing criticism and societal desire for industry regulation, the bankingindustry formed the Investment Bankers Association of America (IBAA) in 1912 as a splintergroup of the American Bankers Association One of the ideas established by the IBAA was theconcept of non-price discrimination in the sale of securities, regardless of the investor and trans-action size

reg-Although there was limited federal regulation of investment banks before the Great sion started in 1929, banks had to adhere to state securities laws, or Blue Sky laws The first BlueSky law was enacted in Kansas in 1911 Among other features, it required that no security issued

Depres-in the state could be offered without previously obtaDepres-inDepres-ing a permit from the state’s Bank sioner Between 1911 and 1933, 47 states enacted similar state laws regulating the issuance ofnew securities (all of the existing states at the time except Nevada) As federal regulations wereenacted in the 1930s and 1940s, the state laws remained on the books while the federallaws mostly duplicated and extended the Blue Sky laws The passage of the National SecuritiesMarkets Improvement Act by Congress in 1996 effectively removed states from securitiesregulation of investment banks, except for antifraud matters

Commis-On October 28, 1929, the day referred to as Black Monday, a precipitous fall in the stockmarket began In spite of the 1929 crash and the ensuing economic malaise, President Herbert

22 INVESTMENT BANKING

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 dif-ficulties and instituted a variety of regulations that shaped the financial sector, and investmentbanks in particular, for the remainder of the century At Roosevelt’s urging, Congress passed sevenpieces 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 1934Securities Exchange Act, drastically altered the business environment in which investment bankspracticed The following discussion will detail the regulatory requirements found in these threepieces of legislation The other four legislative acts that impacted investment banking to a lesserextent will also be covered briefly

The Securities Act of 1933

The Securities Act of 1933 was meant to bring stability to capital markets and stop manipulative anddeceptive practices in the sale or distribution of financial securities The Securities and ExchangeCommission (SEC) states that the 1933 Act had two purposes: “[to] require that investors receivefinancial and other significant information concerning securities being offered for public sale; andprohibit deceit, misrepresentations, and other fraud in the sale of securities.”1To fulfill these objec-tives, the 1933 Act required investment banks that participated in the distribution of securities to dis-close a significant amount of relevant and important details regarding securities and the firms theyrepresented Prior to the enactment of this law, few investors received basic information regardingtheir investments The new law set a minimal requirement for providing information and ensuredthat all potential investors could access relevant issuer records

The 1933 Act has four main sections of regulation that impact investment banks The vant sections relate to (1) submitting a registration statement to the SEC; (2) providing an invest-ment prospectus to potential investors; (3) assuming civil and criminal liability for disclosure; and(4) having a post-filing waiting period before selling issues to the public

rele-The Registration Statement

Before a security can be sold in the United States, certain information regarding the issuer and thesecurities being issued must be provided to regulators and prospective investors through a filingwith the SEC.Exhibit 2.1is an abridged list of information regarding the issuer and the issuancethat must be included in the registration statement

There are certain exceptions or exclusions from the registration requirements of the 1933Act These include when the issuance will only be offered intrastate, making it solely the jurisdic-tion of state laws; when the issuance of securities is by a municipality, a state, or the federal gov-ernment; when the offering is below a certain value cutoff; and when the offering is madeprivately or is made to a small number of investors Generally, the 1933 Act provides for certainexceptions based on the type of security that is offered (security-based exceptions) and for certainexceptions based on the type of offering (transaction-based exceptions)

The Investment Prospectus

Companies are also required to provide investors with a prospectus, which contains certainelements of the information included in the registration statement The securities cannot bedistributed until after the issue has been registered with the SEC Any known misstatement or

1 www.sec.gov

Chapter 2  Regulation of the Securities Industry 23

omission of material information from the registration statement is a criminal offense and canleave the issuer and underwriter liable to investor lawsuits.

New Liabilities

Before the 1933 Act, there were no special laws assigning liability to investment bankers beyondthose that applied to the activities of all citizens After the 1933 Act was enacted, investmentbankers became liable for securities law violation if material facts are omitted from the registra-tion statement and investors suffer a loss that is attributable to that omission If this occurs, inves-tors can sue the banks to repurchase their shares at the original price and rescind the transaction.Underwriters’ liabilities have been broadly defined since, as intermediates between issuers andinvestors, banks have more information than do investors regarding a company To mitigate theirliability, bankers seek to be indemnified by the issuers for any losses (including any costs asso-ciated with litigation) arising from material misstatements or omissions, resulting in a sharedresponsibility to provide accurate and complete information to purchasers of securities SeeExhibit 2.2for sample indemnification language found in underwriting agreements

EXHIBIT 2.1

24 INVESTMENT BANKING