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Preface vii


    Chapter 1: The Origins of Investment Banking 1 (Chapter 1: The Origins of Investment Banking) Chapter 2: The History of Some Key Financial Products 19 (Chapter 2: The History of Some Key Financial Products) Chapter 3: The Business of Investment Banks 33 (Chapter 3: The Business of Investment Banks) Chapter 4: Charting the Course 57

    (Chapter 4: Charting the Course)

    Chapter 5: The Global Reach 69

    (Chapter 5: The Global Reach)

    Chapter 6: The Strategy of Relationship Management 85 (Chapter 6: The Strategy of Relationship Management) Chapter 7: Trading and Capital Markets Activities 101 (Chapter 7: Trading and Capital Markets Activities) Chapter 8: The Strategies in Trading 117

    (Chapter 8: The Strategies in Trading)

    Chapter 9: Equity Research 135

    (Chapter 9: Equity Research)

    (Chapter 10: The Business of Equity Offerings) Chapter 10: The Business of Equity Offerings 157 Chapter 11: Strategies in IPOs 173

    (Chapter 11: Strategies in IPOs)

    Chapter 12: Fixed-Income Businesses 191

    (Chapter 12: Fixed-Income Businesses)

    Chapter 13: Strategies in Fixed Income 209 (Chapter 13: Strategies in Fixed Income)

    Chapter 14: Mergers and Acquisitions: Getting the Deal 221 (Chapter 14: Mergers and Acquisitions: Getting the Deal) Chapter 15: Synergies in M&A 241

    (Chapter 15: Synergies in M&A)

    Chapter 16: Getting the Deal Done 265

    (Chapter 16: Getting the Deal Done)

    Chapter 17: The Business of Asset Management 291 (Chapter 17: The Business of Asset Management) Chapter 18: Alternative Investments and the Strategy


of Investment Banks 311

    (Chapter 18: Alternative Investments and the Strategy of Investment Banks) Conclusion 329


    Bibliography 331



    Index 335


    Investment banking is a complicated industry of traders, analysts, brokers, managers, hedgers, ??quant jocks,?? retirement planners, and, yes, even bankers! This business is as creative as it is mechanical, as qualitative as it is quantitative; its clients range from middle- American mom-and-pops to international billionaires, from newly created firms to multinational giants. Investment banks also work for governments.

    The business of an investment bank is to deliver a broad range of products and services to both issuing and investing clients. Its offerings go from strategic advice to the management of risk. In the last century, the main purpose of an investment bank was to raise capital and to advise on mergers and acquisitions. Investment-banking services were defined as either underwriting or financial advisory. We tend to use a broader definition today. This is how JPMorgan describes it: ??In the simplest terms, investment banking helps companies decide on their marketplace

    strategy. . . . Investment banking also provides access to public and private investment grade debt, high yield and bank markets for a wide range of high-profile clients from governments and multi-national companies to family-owned companies and individuals.?? 1 Investment banks also trade for their own account, and many are involved in managing third-party assets.

    The largest investment banks have been around for more than one hundred years, some of them even for two hundred years. However, their business has changed tremendously in the last ten years, as investment banks have innovated at a furious pace. This is probably why they still exist today, ??for as all organic beings are striving, it may be said, to seize on each place in the


    economy of nature, if any one species does not become modified and improved in a corresponding degree with its competitors, it will soon be exterminated.??2

    Forty years ago, if one could insure operational risks, investing on the stock market was rather like taking a bet. The stock market was the realm of speculators. In the 1960s, a new approach and new mathematical models, which could be run with recently invented computers, allowed financial service companies to develop revolutionary diversification techniques to manage the financial risks of investing. A good way for the investment banks to show their mettle in managing risks was to acquire asset managers.

    Over the last decade, however, the approach to risk has changed. Investing in diversified assets is still a tenet of money management, but a new approach has transformed the financial markets. Instead of diversifying the risks among various assets, investment banks now slice them up and package them into bits that trade on markets. These bits, which we call swaps, derivatives, CDOs, and credit-default swaps, allow the transfer of risk from one party who cannot manage it to another party who wants it.

    With this new approach to risk, investment banks have taken on more risk, and they have changed the mix of their business. They are now investing their own capital and trading more innovative products, and they have taken on more risk as they have moved away from the pure intermediary approach of their previous business model. This new way of doing business has, not surprisingly, created new kinds of conflicts of interest between the investment



    banks and their clients. In any of the big investment banks?? 10-K filings with the Securities and Exchange Commission (SEC), there are tens of pages on pending legal claims from customers or regulators.

    The late 1990s and early 2000s evoke many scandals in which investment banks were involved?Xthink of Enron, Global Crossing, and WorldCom (the telecommunications giant that filed for Chapter 11 bankruptcy protection in 2002 with $30 billion in debt). Moreover, before that, there was the collapse of the two-hundredyear- old Barings Bank, one of the ancestors of today??s modern investment banks, and the bankruptcy of Orange County.

    In fact no current-day business segment of investment banking has gone unscathed:

    ?E Research and the scandal involving Salomon Smith Barney and Merrill Lynch in 2001

    ?E Trading and the collapse of Long-Term Capital Management (LTCM)

    ?E Fixed income and the bankruptcy of Orange County or the special-purpose vehicles that Enron used to disguise its debt ?E Equity issues and the IPO allocation scandal involving Frank Quattrone at CSFB

    ?E The big mergers that turned sour, like DaimlerChrysler and AOL Time Warner

    ?E The 2003 mutual fund scandals involving Janus Capital Group Inc., Strong Financial Corp., and Putnam Investments (owned by Marsh & McLennan)

    The scandals have been exposed by dozens of books, and the investment banks have been easy targets for many scathing articles in the business press. Because investment banks are difficult institutions for outsiders to understand and there are few books that explain how they function, we know only the dark side of the picture without comprehending much else, let alone the ??whole picture.??

    To begin with, do you know the difference between investment banking, investment banks, and merchant banking? Or:



    everybody talks about globalization, but how do investment banks work outside of Wall Street? As a potential client, how do you choose a bank that is going to create value for you, not for itself? Or, on a professional level, if you want to work for an investment bank, what can you expect?

    This book tells how investment banks work most of the time?X i.e., very efficiently?Xand why they have survived. This book is a guide to investment banks. It explains the strategies of the global investment banks. It reviews how investment banks are organized and the interdependency among the various areas. I begin with the long-term history of investment banks (long before Wall Street) and then go on to describe the various businesses of investment banking, taking time to illustrate two different (but arguably equally successful) strategies?Xthose of Merrill Lynch and Goldman Sachs. We then travel across the capital markets around the world, and I explain how the banks develop their international strategy. The various market mechanisms are described, and it is interesting to see how the investment banks have influenced the consolidation of exchanges and electronic venues. The book then analyzes the strategy in each of the main functional areas of an investment bank: client-relationship management, equity research, equity capital markets, debt capital markets, M&A, and third-party asset management.



    2. Charles Darwin, On the Origin of Species (London: John Murray, 1859), chap. 4;





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The Origins of Investment Banking

    The NYSE traces its origins to shortly after the American Revolutionary War, when a small group of New York brokers traded a handful of securities on Wall Street. In May 1792, 24 brokers and merchants signed the historic ??Buttonwood Agreement,?? under which they agreed to trade securities on a commission basis. In 1865, the NYSE moved to its present location near Wall Street. In February 1971, the NYSE incorporated as a New York not-for-profit corporation and was owned by its broker-dealer users, known as members or ??seat holders.?? The NYSE was demutualized and converted from a not-for-profit entity into a for-profit entity when it merged with Archipelago on March 7, 2006 and became a wholly owned subsidiary of NYSE Group.??1

    Investment banking tends to be seen as an American phenomenon. Ask anyone on Wall Street where investment banking came

    from. If the answer is the Banking Act of 1933, then you asked the wrong person, a lawyer! If it is May 17, 1792, and the birth of the New York Stock Exchange outside of 68 Wall Street under a buttonwood tree, then you spoke to an investment banker (and an educated one). If your interlocutor says that she does not know, then she is perfectly normal: nobody really knows where investment banking came from, let alone what it actually is.

    In the traditional sense, investment banking is buying original issues of securities for resale to the public. But investment banks have many more activities than this, and many of these businesses are much older than the investment banks themselves.


    (Copyright c 2008 by The McGraw-Hill Companies, Inc. Click here for terms of use.) Copyright c 2008 by The McGraw-Hill Companies, Inc. Click here for terms of use.


Investment Banking Explained

    Let??s start with the financial products in which investment banks deal. Investment banks underwrite and trade government bonds. They finance themselves through repurchase agreements. They develop new instruments of structured finance, the first of which were mortgage-based securities. They participate in international bond syndications. They trade sophisticated options.

    Well, these very complex financial products have been around for more than five hundred years?Xsome of them for a few thousand years. And they were developed by the European ancestors of today??s investment banks to provide financing in a society that had very little liquidity. Strangely enough, the basic components of financial capitalism?Xpaper money, joint-stock corporations, and stock markets?Xare much more recent: two hundred to three hundred years old. Invented by European banks, they are the pillars of the industrialization of the economy.

    Money, corporations, and stock exchanges are also at the origin of the investment bank, which involves, simply put, an investment by a bank: the purchase of new securities from their corporate issuers and their resale to the public with a listing on a stock exchange. It should be noted that American investment banks have played an important role here, often by promoting a strategic vision for their corporate clients. For many people, it is John Pierpont Morgan who invented (without using the word) investment banking in the early 1900s.

    The Glass-Steagall Act of 1933 separated commercial banking from investment banking. It gave the big banks a year to choose between retail banking and issuing securities. They could not do both. Those that chose to specialize in financial markets and securities underwriting became known as investment banks. Protected by law from competition from commercial banks, American investment banks were able to concentrate on capital market activities and on financing the economy. However, while investment banking may have been refined in the United States after 1933, its origin goes back to many centuries before.


The Origins of Investment Banking

The Great Ancestors: The Merchant Banker and

    the Financier

    Success, as is well known, has many fathers, but failure is an orphan. Investment banking has many fathers. The first father is the merchant bank, a type of outfit that operated in the eighteenth century in France and later in the United Kingdom. The term merchant banker is a contraction of ??merchant and banker.?? It meant a merchant who extended his activities by offering credit to his clients, initially through the acceptance of commercial bills. The practice is very old: there were exchange bankers in Genoa in the twelfth century. The Genoese bankers received deposits and made giro, or international money transfers.2 They were dealers in bills of exchange, and they operated with correspondents abroad and speculated on the rate of exchange. But they also invested a portion of their deposits and took equity shares as partners in commercial firms and shipping companies. Thereafter, some firms gave up acting as goods merchants and concentrated on trade finance and securities, while others specialized in equity investments.

    Later, the Italian merchant bankers introduced into England not only the bill of exchange, but also the techniques used to finance international trade, like the acceptance of commercial bills. In England (and to a lesser extent in the United States afterward), chartered banks could not invest directly in commercial firms or underwrite new issues of corporate securities. The merchant banks also were loath to take a participation in industry or to deal in equity issues.3 As a result, the financing of firms came through the provision of short-term credit and acceptances, and also from the markets through issuance of bonds.

    The other ancestor of investment banks, the financier, was a lender to the prince. True, the Church prohibited usury, but not when lending to governments. For instance, the Order of Knights Templar lent money to the king of France, Louis VII, when he

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