The Corner for March 7, 2014

{This is the first in a two-part series on investment banking}

Investment banking is the process by which new securities are brought to market in order to raise capital for businesses. In a broad sense, investment banking embraces all the institutions by which capital formation takes place, including: (1) the transfer of ownership of a corporate entity through investment banks which are usually brokerage houses; (2) security substitution, such as is involved in the issuance of securities by investment companies; and (3) security management, or the decision as to where investors’ funds are to be placed. In a narrower sense, investment banks are security firms which originate, underwrite and distribute new security issues of corporations and government agencies.

Corporations obtain funds from two major sources on the basis of the term of the contract with the supplier of the funds. Short-term funds which must be repaid within one year are obtained from commercial banks, form trade creditors and from the government in the form of accrued tax liabilities. Long-term funds are obtained from individual and institutional investors through the sale of securities to these investors. These funds may be acquired from investors as creditors through the sale of funds and mortgages, or from equity investors through the sale to owners of shares of stock or through the retention in the business of earnings which might have been paid to the owners as dividends. It is the function of the investment banking firms operating in the new-issue market to assist corporations to acquire new long-term funds.

Corporations use these finds to enlarge their operating assets or to pay of maturing security issues (i.e. debt).
The investment banking house operates by purchasing all of the new security issue from a corporation and selling the issue in smaller units to the investing public. It buys from the corporation at one price and attempts to sell to investors at higher price, a price sufficiently high enough to cover expenses of the sale and leave a profit. Since the expenses of undertaking the sale may be relatively large for small issues, small and new corporations often find it uneconomical to pay the required “spread” of the investment bankers. Such corporations may obtain funds privately by the sale of stock and bond issues without the intermediation of an investment banking firm.

In many cases investment banking houses decline to assist new and small companies because they believe that the risks of investment in these companies are too great, and they are unwilling to recommend to their clients that the securities be purchased. As a result, investment banking firms are used to a much greater extent by companies which have lived through the first few difficult years, are now able to present a good earnings record and show promise of being able to make profitable use of additional funds. However, from time to time more speculative companies have issued stock, especially during long of the bull (up) market. This occurred during the dot-com bull maker of the late 1990s which even saw the creation many new high-risk investment banking firms. Check in next week for “the rest of the story.”

Quote of the Week: “Good people are good because they’ve come to wisdom through failure.  We get very little wisdom form success, you know.” – William Saroyan

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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