Investment Banks Security

Explain the main business areas of Investment Banks and discuss their importance in the financial system with particular reference to hedge funds.

The term ‘merchant bank' has historically been the UK term for investment bank, but it has far narrower meaning in the US. (Wood et al. 2003)

Securities firms that are retained to advice issuing entities on equities and bonds offerings and that take an advice role in distribution of the securities to ultimate investors. In short, firms that facilitate the issues of shares and bonds are called investment bank. Investment bankers give an advice as to the type of the security that should be issued, the size and pricing of the offering, and even its timing. The client firm pays a fee for this service; the investment banker assumes some of the risk in selling the issue. This distribution activity is called underwriting. (Johnson, H., 1993)

Investment banks can be local or global. It can be niche operators or full product. Some of the well-known investments banking firms are Morgan Stanley, Merrill Lynch, Citicorp, Goldman Sachs, Barclays, Deutsche Bank, HSBC, UBS, and Credit Suisse. Investment bankers assist issuing firms by providing advice, filling documents, and marketing issues. Investment bankers often assist in mergers and acquisitions in private placements as well. The investment banking firm is clearly taking a huge risk at this point. One way that they can reduce risk is by forming a syndicate. A syndicate is a group of investment banking firms each of which buys a portion of the security issue. Each firm in the syndicate is then responsible for reselling its share of the securities. Most securities issues are sold by syndicates because it is such an effective way to spread the risk among many firms.

In the film ‘Wall Street', the speech made by Gordon Gecko to shareholders in his planned victim company was said to be based on an actual speech made by Ivan Boesky. He is reported have coined the infamous phase, ‘greed is good'. (Wood et al. 2003)

Investment banks have been active in the mergers and acquisitions market since the 1960s. Mergers and acquisitions refer to the process where two firms are combined to form one. Often this process is friendly, and the firms agree that certain economies can be captured by combining resources. Firms planning to takeover will turn to investment banks for help and advice regarding price, timing, and tactics and so on. Equally, the object of the takeover will turn to these bankers for help in fending off the predators. In the UK, Guinness took over the Scottish whisky company Distillers after a long and acrimonious battle. Unhappily, personnel in Guinness and their advisers, Morgan Grenfell, were bought to trail charged with various misdemeanours. In the course of trail, it was revealed that Morgan Grenfell and associates had been paid £65m and lawyers, Freshfields, paid £2m. The fees involved can be substantial. In a large takeover, like this one, there may be three investment bankers or more on each side. In the US, the notorious ‘junk bond' era saw small companies raising huge sums with bonds to buy much bigger companies. The fees earned by Drexel Burnham Lambert for bond issues and takeover bids during this era made them quickly one of the highest earning firms on Wall Street. (as long as it listed). M&A activity has slowed a little with recent stock market falls, but is buoyed by the continuing trends globalisation of industry and commerce and consolidated in specific industry sectors.

‘The long run is the sum of the short runs. If we get them right, the long run will be right too'. Anonymous

Another important division the investment funds, which these managers are controlling, may be the bank's own funds or they may be, in effect, ‘looking after other people's money'. These may be: High net worth individuals, Corporate, Pension funds and Mutual funds. High net worth individuals may approach by a commercial bank to handle their affairs, including investments. This type of business is also handled by stockbrokers but with lower minimum sums than an investment bank would require. Corporate may either have good cash flow and wish to pay someone else to handle their investments or may build up a large file ‘war chest', ready for some takeover activity later and, temporarily, pay an investment bank to handle this. The entity need not be a conventional corporate as such. An excellent example is the Saudi Arabian Monetary Authority (SAMA). Pension funds having economies (for example US, the UK, the Netherlands, Switzerland and Japan), then they feel that they lack the skill to manage the funds and pay others to do so. In these economies, pension funds will usually be the biggest client of the investment management department. Mutual funds are collective investments in money market instruments, bonds or equities. The bank may run its own fund and advertise its attractions to small investors. In addition, it will manage mutual funds for others. Independent organisations provide regular statistics on fund performance and, if the manger has performed less well than comparable funds, they may find themselves being dismissed. This has led to charges of ‘short-termism' in their investment decision. Typically, fund managers will charge a small percentage fee for handling the fund and the client will meet costs like broker's commission. Competition for the investment bank comes from the forms of independent fund managers, who specialise totally in this business, or large pension funds that will look after the money of smaller funds as well as their own.

The last few years have seen an increasing convergence of activity between Europe's hedge funds and investments, or put another way hedge funds are moving into the banking arena. Faced with a shortage of suitable investment opportunities in the more conventional investment strategies, they have moved into such areas such as debt factoring, primary lending, derivatives trading and M&A activity, traditionally the realm of the investment banks. (IMRENews European - Hedge funds - are they investment banks of the future, Meilor, R. & Payne, D., PricewaterhouseCoopers)

They invest money - in anything that they think will make profits. (Robert Brown, 2005)

Hedge funds are investment vehicles that explicitly pursue absolute returns on their underlying investments. The appellation "Absolute Return Fund" would be more accurate, not least as not all hedge funds maintain an explicit hedge on their portfolio of investments. However the "Hedge Fund" definition has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc) and/or applying non-traditional portfolio management techniques including, but not restricted to, shorting, leveraging, arbitrage, swaps, etc. Hedge funds can invest in any number of strategies and they are perhaps most readily identifiable by their structure, which is typically a limited partnership (the manager acting as the general partner and investors acting as the limited partners) with performance related fees, high minimum investment requirements and restrictions on types of investor, entry and exit periods. (Source: Eurekahedge Research Data) Hedge funds are usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allow them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits usually 20%. (Source: Investorsworld.com). Hedge funds are a special type of mutual fund that has received considerable attention due to the near collapse of Long Term Capital Management. Hedge funds often attempt to be market-neutral, protected from changes in the overall market, they are not risk less. Hedge fund managers invest money - in anything that they think will make profits. Typically they focus on generating positive ‘absolute returns' (or returns greater than zero). Hedge funds embrace a wide variety of skills and strategies, generally grouped under the four following, Long/short equity, Relative value, Event-driven and Trading strategies. Long/short equity aim to profit from superior research and stock picking skills by buying the best ideas and reducing the resulting stock market exposure by shorting (selling stocks they do not own) those they believe will perform less well. Relative value use computer systems to calculate the “fair” value of one asset relative to another and then shorting the more expensive asset and buying the cheaper one. Event-driven means they seek investment opportunities surrounding corporate events, for example, investing in bankrupt or merging companies. Trading strategies- for example, taking positions on the direction of markets, currencies and commodities. Hedge fund managers are essentially a group of active investment managers who invest in a variety of asset classes, with the license to invest in a very flexible way. (Source: BBC New| Business| So what are hedge funds? By Brown, R. & Wyatt, W.)

Hedge funds accumulate money from many people and invest on their behalf, but several features distinguish them from traditional mutual funds. First, Hedge funds have a minimum investment requirement of between $100,000 and £20million, with the typical minimum investment being $1 million. Long Term Capital Management required a $10 million minimum investment. Most hedge funds are setup as limited partnerships. Federal law limits hedge funds to no more than 99 limited partners with steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their homes. Funds may have up to 499 limited partners if each has $5 million in invested assets. All of these restrictions are aimed at allowing hedge funds to exist largely unregulated, on the theory that the rich can look out for themselves. Many of the 4000 funds are domiciles offshore to escape all regulatory restrictions. Second, hedge funds are unique in that they usually require that investors commit their money for long periods of time, often several years. The purpose of this requirement is to give managers breathing room to attempt long-range strategies. Hedge funds often charge larges fees to investors. The typical fund charges a 1% annual asset management fee plus 20% of profit. Some charge significantly more. (Mishkin et al. 2000)

If hedge funds were a country, it would be the eighth-biggest on the planet. They can sink whole economies, and have the potential to crash the entire global financial system. Yet they are beyond regulation. We should be very afraid. (NewStatesman, Janet Bush, 2006)

Conclusion

To conclude we can say that, Investment banks are firms that assist in the initial sale of securities in the primary market and, as securities brokers and dealers, assist in the trading of securities in the secondary markets, some of which are organised into exchanges. Security brokers act as go-betweens and do not usually own securities. Securities dealers do buy and sell securities and by doing so make a market. By always having securities to sell and by always being willing to purchase securities, dealers guarantee the liquidity of the market. Investment funds pool the funds of many small investors and purchases large quantities of securities. These funds offer a wide variety of funds designed to appeal to most investment strategies. Hedge funds gained a rapid reorganization among professional investors as an investing medium. Hedge funds encourage the investors to stick to it rather than diving in mainstream of share and bond investment. However Hedge fund is considered to be one of the main options of investment designed for the professional investors with increasingly variety of investment strategies along side other alternatives such as private equity, property and commodities.

Reference:

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Mushkin, F. & Eakins. S., 2000. Financial Market and Institution. 3^rd Ed. NJ: Addison-Wesley.

Johnson, H., 1993. Financial Institution and Markets: A Global Perspective. US: McGraw-Hill.

Turnbull, P. & Moustakatos, T., 1996. Marketing and Investment Banking 1: Practical and Theoretical Challenges. International Journal of Banking Marketing. Vol.14. pp 27-37. Emerald Insight. Available at: http://www.emeraldinsight.com/Insight/viewContentItem.do;jsessionid=62121B36EC46D71AA5A03C6E644DFD59?contentType=Article&contentId=854893 [accessed on 14^th April 2008]

Brown, R. & Wyatt, W., 2005. So what are hedge funds? BBC News, Money Talk, [Online]. 14^th December. Available at: http://news.bbc.co.uk/go/pr/-1/hi/business/4499290.stm [accessed on 10^th April 2008

Bush, J., 2006. Sell-out: Why hedge funds will destroy the world. Newstatesman, [Online]. 31^st July. Available at: http://www.newstatesman.com/print/200607310033 [accessed on 10^th April 2008]

Gangahar, A. & Guerrera, F., 2008. Hedge funds keep safe distance from bear. Financial Times, [Online]. 17^th March. Available at: http://search.ft.com/ftArticle?queryText=hedge+funds+keep+safe+distance+from+bear&y=0&aje=true&x=0&id=080317000258&ct=0 [accessed on 15^th April 2008]

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European|IMRENews. 2006. Hegdefunds - are they investment banks of the future? , Price Waterhouse Coopers Publication. June. Available at: http://www.pwc.com/Extweb/pwcpublications.nsf/docid/92408BECB54B15F385257185007F6E77/$File/imrenewseurope.pdf [accessed on 14^th April 2008]

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