Oh, hello there. Long time no see. Sorry for being MIA for a while but I hope you’ve all been staying up to date with our Facebook group. I promised that 2014 would be a big year for UnderageInvestor.com, so I hope this post can get it started! I want to clarify the opacity of investment banks and the sell side by breaking down its components. This will be Part 1 of a two part series on the Sell Side vs. The Buy Side. It’s important to have a basic understanding of how the financial services industry is set up, and how its components interact with each other. In the case that one of you wishes to start an Occupy Wall Street 2.0, I hope you can at least competently explain your discontent for the financial services industry after reading this. 🙂
THE SELL SIDE
The Sell Side is where you find your investment banks (IB)—Goldman Sachs, Morgan Stanley, J.P. Morgan, etc… (Cue the sophomores’ and juniors’ mouths watering). Let it be known that these gigantic banks now have trading, equity research, and asset management units under their umbrella so they are essentially diverse investment houses. In any case, they are in the business of raising capital, providing financial advisory to companies, selling research to the other side of Wall Street, and facilitating trading between Buy Side parties. These massive investment banks, also known as “bulge brackets” or “BB’s”, are separate from the everyday banks you deposit money into. Those are called commercial banks and have been strictly separated from IB’s since the Volcker Rule in the cornerstone Dodd-Frank Act. However, you can work with investment bankers to help take your company public (IPO), issue debt, or even advise you on a merger or acquisition (M&A). Let’s define the corporate finance services, a.k.a. underwriting, which is the core of traditional investment banking.
- M&A: This is where pitch books come into play because you need to get hired by a company to help them merge or sell the company, and then need to convince another company to merge with or acquire the company you are representing. This is called a sell-side M&A deal. A Buy Side deal requires you to locate a company and finance its acquisition for your client. If it’s a broad deal and your client is not sure of the acquisition target, then you run an auction to get the best price from potential acquisitions. If it’s a targeted deal and the client is pretty sure which company they want to approach, then you work more on negotiation. Clearly, this requires tons of due diligence.
- Debt Capital Markets: This group advises a client on raising debt for an acquisition, as well as refinancing and/or restructuring of existing debt. The bank leverages its relationship with lenders to organize new purchases of debt for the client. Debt is used more often than equity to finance transactions because it is cheaper and more readily available (liquid). It also helps diversify and improve the capital structure of the company.
- Equity Capital Markets: This group works with a client to organize and structure their equity offerings (IPO or a secondary offering) to investors, and to update and improve valuation to entice new investment.
BB’s have so many employees with so much work that they usually divide their corporate finance business into two groups: product groups and coverage groups. The aforementioned services would be offered through the product groups since they are services. Coverage groups cover certain industries to maintain relationships with executives within those industries to continue bringing business in to the investment bank. Typical coverage groups are Healthcare, Technology, Media, and Telecommunications (TMT), Financial Institutions Group (FIG), and Energy amongst others. They reel clients in with pitch books that outline why their team is better and more knowledgeable than their competitors to advise on an acquisition or to raise capital. The book includes an overview of the IB and also previous work, such as the underwriting of an IPO for a similar company. More often than not, if the bank is not too rigidly structured, it will employ a generalist analyst program and spread the workload of both coverage and product groups over a pool of analysts. These analysts tend to have 6-7 projects going on at once. They don’t say 100+ hour work weeks for no reason!
Nowadays, many smaller banks have popped up and focus only on M&A or restructuring, which entails capital and management structure advisory to try and pivot a declining company in the right direction. These are called boutique IB’s and tend to work on smaller deals of up to $1 billion. The Bulge Brackets work on deals of $1 billion and upwards. There are also middle market banks that offer full services, just like BB’s, but generally work on deals around $500 million or less. It is interesting to track the increasing trend of deals moving from BB’s to boutiques because companies like the relationship management of advisory firms. All of these services play an integral role in today’s capital markets and for the progress of many of our favorite corporations (e.g. Facebook’s WhatsApp acquisition), but investment banks provide additional services as well.
These large banks also have Sales & Trading teams that facilitate the buying and selling of fixed income, commodities, currencies, and equity securities for their clients. The trader acts as a market maker, which means that they quote appropriate buy and sell prices, or a bid-ask spread, to provide a liquid way for clients to buy or sell securities.
For Example, let’s say you’re a trader in Goldman’s S&T internet technology team and your friend who runs Baller Capital, a SF-based hedge fund, approaches you because he wants to sell $100 million worth of Netflix (NFLX) stock. Your job is to facilitate the execution of the trade because he’s not going to be executing this trade from his Scottrade account…it’s difficult to find a buyer for this amount. He quotes a certain selling price and you set the bid and offer prices to create liquidity in the market. Once you set the prices, a buyer will agree to purchase, and then you execute the trade. If you did not make this market, then it would be difficult for your friend to sell his NFLX shares.
On a firm level, the sales team brings in business by contacting the Buy Side to trade with their group. Once orders have been received, the sellers pass the orders to the traders who will execute the trade. Trading is usually the source of around 2/3 of an investment bank’s revenues.
The BB’s also have an in-house department called Equity Research that deal with selling analyst research on public stocks. They sell these for a fee to investment managers who use the information and models to purchase the best securities for their clients. Now that I’ve mentioned Investment Management, I think the Buy Side feels left out…
Now that you know the ins and outs of the Sell Side, we’ll mosey on over to the Buy Side in Part 2 of this series. After all, most investment banking analysts and research analysts jump over to the “greener pastures” of the Buy Side after their 2-3 year analyst programs any way. See you soon!