Investment Banking

Although each investment bank takes a somewhat different approach, the principal businesses of most large investment banks include an (a)  investment banking business managed by the Investment Banking Division, which focuses on capital raising and  M&A transactions for corporate clients and capital raising for government clients; (b)  sales and trading business managed by the Trading Division, which provides investing, intermediating, and risk-management services to institutional investor clients, performs  research, and also participates in non-client-related investing activities; and (c)  asset management business managed by the Asset Management Division, which is responsible for managing money for individual and institutional investing clients.

Principal Businesses of Investment Banks

Private Equity

Private equity, in finance, is an  asset class consisting of  equity securities in operating companies that are not publicly traded on a stock exchange.

A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; each however providing working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership.

Among the most common investment strategies in private equity are:  Leverage buyouts,  venture capital, growth capital, distressed investments and  mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically venture capital firms or angel investors) invest in young or emerging companies, and rarely obtain majority control.

Leverage Buyout

Leveraged buyout, LBO or Buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of  financial leverage.  The companies involved in these transactions are typically mature and generate operating cash flows.

Leveraged buyouts involve a financial sponsor  agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt which ultimately looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often  non-recourse to the financial sponsor and has no claim on other investment managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits an LBO's financial sponsor in two ways: (1) the investor itself only needs to provide a fraction of the capital for the acquisition, and (2) the returns to the investor will be enhanced (as long as the  return on assets exceeds the cost of the debt).

As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according the financial condition and history of the acquisition target, market conditions, the willingness of  lenders  to extend credit (both to the LBO's  financial sponsor  and the company to be acquired) as well as the interest costs and the ability of the company to  cover those costs. Historically the debt portion of a LBO will range from 60%–90% of the purchase price, although during certain periods the debt ratio can be higher or lower than the historical averages. Between 2000 – 2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.

Simple example
A private equity fund, ABC Capital II, borrows $9bn from a bank (or other lender). To this it adds $2bn of equity – money from its own partners and from limited partners (pension funds, rich individuals, etc.). With this $11bn it buys all the shares of an underperforming company, XYZ Industrial (after due diligence, i.e. checking the books). It replaces the senior management in XYZ Industrial, and they set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the value of the company for a fast sale. The stock market is experiencing a bull market, and XYZ Industrial is sold two years after the buy-out for $13bn, yielding a profit of $2bn. The original loan can now be paid off with interest of say $0.5bn. The remaining profit of $1.5bn is shared among the partners. Taxation of such gains is often minimal. Note that part of that profit results from turning the company round, and part results from the general increase in share prices in a buoyant stock market. The latter is often the greater component, but of course shares are not guaranteed to go up!
Notes:

Committee on Uniform Security Identification Procedures

The acronym CUSIP historically refers to the Committee on Uniform Security Identification Procedures, which was founded in 1964, during the paper crunch in Wall Street.   This 9-character  alphanumeric code identifies any  North American Security   for the purposes of facilitating  clearing and settlement of trades. The CUSIP distribution system is owned by the  American Bankers Association and is operated by  Standard & Poor’s. The CUSIP Service Bureau acts as the National Numbering Association  (NNA) for North America, and the CUSIP serves as the  National Securities Identification Number for products issued from both the United States and  Canada.

In the 1980s there was an attempt to expand the CUSIP system for international securities as well. The resulting CINS (CUSIP International Numbering System) has seen little use as it was introduced at about the same time as the truly international  ISIN system. CINS identifiers do appear in the  ISID- Plus directory, however.

Description

The first six characters are known as the base (or CUSIP-6), and uniquely identify the issuer. Issuer codes are assigned alphabetically from a series that includes deliberate built-in "gaps" for future expansion. The 7th and 8th digit identify the exact issue. The 9th digit is an automatically generated checksum (some clearing bodies ignore or truncate the last digit). The last three characters of the issuer code can be letters, in order to provide more room for expansion.

Issuer numbers 990 to 999 and 99A to 99Z in each group of 1,000 numbers are reserved for internal use. This permits a user to assign an issuer number to any issuer which might be relevant to his holdings but which does not qualify for coverage under the CUSIP numbering system. Other issuer numbers (990000 to 999999 and 99000A to 99999Z) are also reserved for the user so that they may be assigned to non-security assets or to number miscellaneous internal assets.

The 7th and 8th digit identify the exact issue, the format being dependent on the type of security. In general, numbers are used for equities and letters are used for fixed income. For commercial paper the first issue character is generated by taking the letter code of the maturity month, the second issue character is the day of the maturity date, with letters used for numbers over 9. The first security issued by any particular issuer is numbered "10". Newer issues are numbered by adding ten to the last used number up to 80, at which point the next issue is "88" and then goes down by tens. The issue number "01" is used to label all options on equities from that issuer.

Fixed income issues are labeled using a similar fashion, but due to there being so many of them they use letters instead of digits. The first issue is labeled "AA", the next "A2", then "2A" and onto "A3". To avoid confusion, the letters I and O are not used since they might be mistaken for the digits 1 and 0.

The 9th digit is an automatically generated  check digit using the "Modulus 10 Double Add Double" technique.  To calculate the check digit every second digit is multiplied by two. Letters are converted to numbers based on their ordinal position in the alphabet.

National Security Identification Number

An ISIN consists of three parts: Generally, a two letter country code, a nine character alpha-numeric national security identifier, and a single  check digit. The country code is the  ISO 3166-1 Alpha-2 code for the country of issue, which is not necessarily the country where the issuing company is domiciled. International securities cleared through  Clearstream or  Euroclear, which are Europe-wide, use "XS" as the country code.

Issuance

The ISIN is based on the National Securities Identifying Number, or  NSIN, assigned by governing bodies in each country, known as the  National Numbering Agency (NNA). The NNA's are coordinated through the Association of National Numbering Agencies, ANNA  ISIN and  CFI information can be accessed through the ANNA Service Bureau  , run by Standard & Poor’s and  SIX TELEKURS.

The NSIN element of the ISIN can be up to 9 digits long. Shorter numbers are padded with leading zeros before the addition of the county code and a check digit transform the NSIN to an ISIN.

In North America the NNA is the  CUSIP organization, meaning that CUSIPs can easily be converted into ISINs by adding the US or CA country code to the beginning of the existing CUSIP code and adding an additional check digit at the end. In the United Kingdom and Ireland the NNA is the  London Stock Exchange  and the NSIN is the  SEDOL, converted in a similar fashion . Swiss ISINs are issued by  SIX TELEKURS  and are based on the  Valor Number. Most other countries use similar conversions, but if no country NNA exists then regional NNAs are used instead.

International Securities Identification Number

An International Securities Identification Number (ISIN) uniquely identifies a  security. Its structure is defined in  ISO 6166. Securities for which ISINs are issued include  bonds,  commercial paper,  equities and  warrants. The ISIN code is a 12-character alpha-numerical code that does not contain information characterizing financial instruments but serves for uniform identification of a security at trading and  settlements.

Securities to which ISINs can be issued include debt securities, shares, options, derivatives and futures. The ISIN identifies the security, not the  exchange (if any) on which it trades; it is not a  ticker symbol. For instance,  Daimler AG stock trades through almost 30 trading platforms and exchanges worldwide, and is priced in five different currencies; it has the same ISIN on each, though not the same ticker symbol. ISIN cannot specify a particular trading location in this case, and another identifier, typically MIC (Market Identification Code) or the three-letter exchange code, will have to be specified in addition to the ISIN. The Currency of the trade will also be required to uniquely identify the instrument using this method.

Euroclear

Euroclear  is a user owned and governed  Brussels,  Belgium based financial services company that specializes in the settlement of  securities transactions as well as the safekeeping and asset servicing of these securities. It was founded in 1968 as part of  J. P. Morgan & Co

Euroclear settles domestic and international securities transactions, covering bonds, equities, derivatives and investment funds. Euroclear provides securities services to financial institutions located in more than 90 countries.

In addition to its role as an  International Central Securities Depository (ICSD), Euroclear also acts as the  Central Securities Depository (CSD) for Belgian, Dutch, Finnish, French, Irish, Swedish and UK securities. Euroclear also owns EMX Co, the UK's leading provider of investment-fund order routing, and Xtrakter, owner of the TRAX trading matching and reporting system.

Euroclear is the largest international central securities depository in the world.

Regulation D

In the  United States  under the  Securities Act of 1933, any offer to sell  securities must either be registered with the  United States Securities and Exchange Commission (SEC) or meet certain qualifications to exempt them from such registration. Regulation D (or Reg D) contains the rules providing exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the securities with the SEC.  A Regulation D offering is intended to make access to the capital markets possible for small companies that could not otherwise bear the costs of a normal SEC registration. Reg D may also refer to an  investment strategy, mostly associated with  hedge fund, based upon the same regulation. The regulation is found under Title 17 of the  Code of Federal Regulation, part 230, Sections 501 through 508. The legal citation is 17 C.F.R. §230.501 et seq.

Overview
Reg D is composed of various rules dictating the qualifications needed to meet the SEC exemptions. Rule 501 of Reg D contains definitions that apply to the rest of Reg D. Rule 502 contains the general conditions that must be met to take advantage of the exemptions under Regulation D. Generally speaking, these conditions are (1) that all sales within a certain time period that are part of the same Reg D offering must be "integrated", meaning they must be treated as one offering, (2) information and disclosures must be provided, (3) there must be no "general solicitation", and (4) that the securities being sold contain restrictions on their resale. Rule 503 requires issuers to file a  Form D  with the SEC when they make an offering under Regulation D. In Rules 504 and 505, Regulation D implements §3(b) of the Securities Act of 1933 (also referred to as the '33 Act), which allows the SEC to exempt issuances of under $5,000,000 from registration. It also provides (in Rule 506) a "safe harbor" under §4(2) of the '33 Act (which says that non-public offerings are exempt from the registration requirement). In other words, if an issuer complies with the requirements of Rule 506, they can rest assured that their offering is "non-public," and thus that it is exempt from registration. Rule 507 penalizes issuers who do not file the  Form D, as required by Rule 503. Rule 508 provides the guidelines under which the SEC enforces Regulation D against issuers.

Exemptions
Regulation D establishes three exemptions from Securities Act registration.

Rule 504
Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. The company may use this exemption so long as it is not a  blank check company and is not subject to Exchange Act of 1934 reporting requirements. General offering and solicitations are permitted under Rule 504 as long as they are restricted to accredited investors. The issuer need not restrict purchaser's right to resell securities.
Rule 504 allows companies to sell securities that are not restricted if one of the following conditions is met:

Rule 505
Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, securities may be sold to an unlimited number of "accredited investors" and up to 35 "unaccredited investors" who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are restricted, in that the investors may not sell for at least two years without registering the transaction. General solicitation or advertising to sell the securities is not allowed.
Financial statement requirements applicable to this type of offering:

Rule 506
A company that satisfies the following standards may qualify for an exemption under this rule:

Accredited Investor Exemptions
Section 4(6) of the '33 Act exempts from registration offers and sales of securities to  accredited investors  when the total offering price is less than $5 million and no public solicitation or advertising is made. However, Regulation D does not address the offering of securities under this section of the '33 Act.

Valuation

Valuation  is the process of estimating what something is worth. Items that are usually valued are a financial asset or  liability. Valuations can be done on assets (for example, investments in marketable securities such as  stocks,  options, business enterprises, or  intangible assets such as  patents  and  trademarks) or on liabilities (e.g.,  bonds issued by a company). Valuations are needed for many reasons such as  investments analysis,  capital budgeting,  merger and  acquisition  transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Valuation Overview
Valuation of financial assets is done using one or more of these types of models:

Common terms for the value of an asset or liability are  fair market value,  fair value, and  intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts.                                                                                            
Business Valuation
Businesses or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely depends on the reliability of the firm's historic financial information.  Public company  financial statements are audited  by  Certified Public Accountants (US),  Chartered Certified Accountants ( ACCA) or Chartered Accountants (UK and Canada) and overseen by a government regulator. Alternatively, private firms do not have government oversight—unless operating in a regulated industry—and are usually not required to have their financial statements audited. Moreover, managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. Therefore, a firm's historic financial information may not be accurate and can lead to over- and undervaluation. In an acquisition, a buyer often  performs due diligence  to verify the seller's information.

Financial statements prepared in accordance with  generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm's  balance sheet  will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the fair values (which usually approximates market value) of some types of assets such as financial instruments that are held for sale rather than at their original cost. When a firm is required to show some of its assets at fair value, some call this process " mark-to-market." But reporting asset values on financial statements at fair values gives managers ample opportunity to slant asset values upward to artificially increase profits and their stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, equity investors and creditors prefer to know the market values of a firm's assets—rather than their historical costs—because current values give them better information to make decisions.

Usage
In finance, valuation analysis is required for many reasons including tax assessment, wills and estates, divorce settlements, business analysis, and basic bookkeeping and accounting. Since the value of things fluctuates over time, valuations are as of a specific date e.g., the end of the accounting quarter or year. They may alternatively be mark-to-market estimates of the current value of assets or liabilities as of this minute or this day for the purposes of managing portfolios and associated financial risk (for example, within large financial firms including investment banks and stockbrokers).
Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds have prices that are quoted frequently and readily available. Other assets are harder to value. For instance, private firms that have no frequently quoted price. Additionally, financial instruments that have prices that are partly dependent on theoretical models of one kind or another are difficult to value. For example, options are generally valued using the  Blacks-Scholes  model while the liabilities of  life assurance firms are valued using the theory of  present value. Intangible business assets, like goodwill  and  intellectual property, are open to a wide range of value interpretations.
It is possible and conventional for financial professionals to make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cash-flow and present value calculations, and analyses of bonds that focus on credit ratings, assessments of default risk, risk premia and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices, where applicable, and may or may not result in buying or selling by market participants. Where the valuation is for the purpose of  a  merger or acquisition  the respective businesses make available further detailed financial information, usually on the completion of a  Non-disclosure agreement.
It is important to note that valuation is part art and science because it requires judgment and assumptions:

Users of valuations benefit when key information, assumptions, and limitations are disclosed to them. Then they can weigh the degree of reliability of the result and make their decision.

Bond Financing

A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (coupon) to use and/or to repay the principal at a later date, termed maturity.  A bond is a formal contract to repay borrowed money with interest at fixed intervals (semiannual, annual, and sometimes monthly).

Thus a bond is like a loan:  The holder of the bond is the lender (creditor), the issuer of the bond is the borrower (debtor), and the coupon is the interest. Bonds provide the borrower with external funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure. Certificate of deposit (CDs) or commercial paper  are considered to be money market instruments and not bonds.
Bonds and stocks are both securities, but the major difference between the two is that (capital) stockholders have an equity stake in the company (i.e., they are lenders). Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely.  An exception is a consul bond which is a perpetuity  (i.e., bond with no maturity).

Bond Issuance
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate buy an entire issue of bonds from an issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged by book runners who arrange the bond issue, have the direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The book runner’s willingness to underwrite must be discussed prior to opening books on a bond issue as there may be limited appetite to do so.

In the case of government bonds, these are usually issued by auctions, called a public sale, where both members of the public and banks may bid for bond. Since the coupon is fixed, but the price is not, the percent return is a function of both the price paid as well as the coupon. However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of private placement bond. In the case of private placement bond, the bond is held by and does not enter the large bond market.

Government Bonds
One way the federal government finances its activities is by the sale of marketable Treasury bills, notes, bonds, and Treasury inflation-Protected Securities (TIPS) to the public. Marketable securities can be bought, sold or transferred after they are originally issued. Treasury uses an auction process to sell marketable securities and determined their rate or yield. The value of Treasury marketable securities fluctuates with changes in interest rates and market demand. You can participate in an auction and purchase bills, notes, bonds, and TIPS directly from the Treasury or you can purchase them through a bank or broker.  Marketable securities held in your account can be sold at current market prices through brokers and many financial institutions.

Treasury Bonds
The U.S. Treasury issues bonds to pay for government activities and service the national debt. Treasuries are considered to be extremely low-risk if held to maturity, since they are backed by “the full faith and credit” of the U.S. government.  Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.

Agency Bonds
Government-Sponsored Enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population-like farmers, students and homeowners-are able to borrow at affordable rates. Examples include Fanny Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some income from agency bonds, like Fanny Mae and Freddie Mac are taxable. Others are exempt from state and local taxes.

Municipal Bonds
States, cities, counties and towns issue bonds to pay for public projects (roads, sewers) and finance other  activities. The majority of munis  are exempt  from  Federal  income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax bracket.

Corporate Bonds
Corporations issue bonds to expand, modernize, cover expenses and finance other activities. The yield and risk are generally higher than government and municipal bonds. Rating agencies help to assess the credit risk by rating the bonds according to the issuing company’s perceived credit worthiness. Income from corporate bonds is fully taxable.

Mortgaged-Backed Securities
Banks and other lending institutions pool mortgages and “securitize” them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie  Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a “refinancing boom,” it could have an impact on the investment’s average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages .Mortgaged-backed bonds are fully taxable.

High Yield Bonds
Some issuers simply aren’t as credit-worthy  as others. These can include local and foreign governments, but generally high yield bonds refer to corporate bonds issued by companies that are considered to be at greater risk of not paying interest and /or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. Ratings agencies such as Standard and Poor’s, Moody’s and Fitch evaluate the financial health of a bond issuer and assign a rating that indicates their opinion of whether the bond is investment grade or not. Bonds rated below  investment  grade are considered speculative and higher risk.

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