Investment Banking Strategies: How They Compete and Profit

> The traditional investment banking (underwriting and M&A advice) is now less than one-quarter of
total net revenues at the major full-service investment banks.

> Most Wall Street houses have diversified business segments, including

> asset management,

> trading,

> merchant banking, and

> securities services. In addition, they have diversified geographically as well.

> They now operate in all major capital markets around the world.

> To achieve and maintain a leadership position in investment banking, a firm must have:

1. Deep client relationships to obtain a flow of businesses.

2. A strong product line to offer the best products and services
3. The ability to provide clients with an integrated solution to help them achieve superior results.
4. A strong global presence and local knowledge.
5. A strong financial strength to establish the confidence of clients and maintain long-term relationships.
6. An effective risk management process to ensure the firm’s financial soundness and profitability.
7. A solid governance structure to ensure compliance with internal policies and regulations.
8. Integrity and professionalism to create trust and provide superior services.
9. A performance-/risk-based compensation system that attracts and retains talents.
Investment Bank Revenues and Expenses
Investment Bank Financial Performance
Risk Management

> Major types of risks investment banks face include market risk, credit risk, operating risk, reputation
risk, legal risk, and funding risk.

Market risk
> refers to the risk of losses or a price decline for a specified position or portfolio that the firm owns.

> Market risk factors include interest rate, foreign exchange, equity prices, and commodity prices.

> Interest rate exposure results from maintaining market making and proprietary positions and trading
in interest rate-sensitive instruments.

> An investment bank is exposed to equity price risk by making markets in equity securities and equity
derivatives, and maintaining proprietary positions.

> The risk exposure to foreign exchange arises from making markets in foreign currencies and foreign
currency options and by maintaining foreign exchange positions.

> Furthermore, an investment bank is exposed to commodity price risk in connection with trading in
commodity-related derivatives and physical commodities.

> Investment banks manage these market risks by diversifying exposures, controlling position sizes, and
establishing hedges in related securities or derivatives.

Credit risk
> the possible loss that occurs when a counterparty or an issuer of securities or other instruments held
by the firm fails to meet its contractual obligations.

> To reduce credit risk, investment banks often establish limits for credit exposures and seek to enter
into netting agreements with counterparties that would permit them to offset receivables and payables
with such counterparties.

> Other safeguards include maintaining collateral and continually assessing the creditworthiness of
counterparties and issuers.

Operating and Reputation Risk

> An operational failure may result in financial loss, regulatory risk, or damage to a firm’s reputation.

Legal risk
> Legal risk includes the risk that a firm might fail to comply with applicable legal and regulatory
requirements and the risk that the counterparty’s obligations may be unenforceable.

> For example, Citigroup agreed to pay $2 billion to settle a class-action suit over its dealings with Enron
that led to the energy company’s collapse.

> Before dealing with a customer, the firm’s legal counsel will examine the counterparty’s legal
authority and capacity, the adequacy of the legal documentation, and the permissibility of a transaction
under applicable law. Counsel will also check to see whether applicable bankruptcy or insolvency laws
limit or alter contractual remedies.

Funding risk

> To reduce funding risk, securities firms maintain a cash position, borrow large sums in the debt
markets, and secure access to the repo and securities lending markets; in some cases, they may sell
securities and other assets.

> Investment banks depend on continuous access to the debt capital markets to finance their day-to-
day operations.

>
Venture Capital and Private Equity: Direct Investing in Companies

> VC investments are highly risky, but lucrative (Almost 20% returns as compared to S&P 500 returns of
10% during 25 year period ending 2010.

Topics covered

venture capital fundraising,

sourcing,

due diligence,

investing,

risk factors,
management fees,

profit-loss allocations, and exit strategies.

Venture Capital

> Venture capital (VC) firms make equity investments in entrepreneurial companies. The financiers
recoup their investments when the portfolio companies either go public or sell out to other
corporations. The VC market includes the merchant banking subsidiaries of large institutions such as
investment banks, bank holding companies, industrial companies, and insurance companies.