If you’ve ever leafed through the pages of the Wall Street Journal, visited New York City, or even stood within earshot of an evening news bulletin, you’ve almost certainly heard the term “investment banker” referenced and repeated ad nauseam. Pundits and political commentators hurl this moniker on anyone with a history of working in or around financial institutions, and it almost always carries a “four-letter word”-like connotation within the context of main street politics. But seldom are these references accompanied by any meaningful explanation of what an investment banker actually does, which only serves to compound the confusion around the term, and the general skepticism towards those who carry it.
In essence, investment bankers are financial advisors to businesses and the people who run them. Rather than providing advice to individuals and families about where to invest their money, how to finance their new home, or how best to save for their retirement, these “corporate financial advisors” provide this kind of advice to the executives who oversee companies. So instead of discussing how they can finance the purchase of their new dream home, investment bankers advise corporations on how they can finance the growth and success of their businesses.
And much like many families, businesses have highly complex financial needs and circumstances, which means that, in turn, investment bankers have come to offer specialized expertise on many different areas of corporate finance. Full-service investment banks typically offer a broad array of advisory services, but typically focus on the following two primary categories:
- Underwriting: Advising corporations as they look to raise equity and debt financing in the public or private capital markets. Translation- they help companies sell stocks and bonds to investors. Initial public offerings, or “IPOs” are one example of how investment banks help companies raise money.
- Mergers & Acquisitions: Assisting in the negotiation, structuring and execution of “M&A” transactions. Translation- they help companies buy and sell other companies. Whereas an IPO involves the sale of a company’s stock to many investors at once, the traditional merger or acquisition involves the sale of all (or most) of a company’s stock to one buyer.
At the large global investment banks that most people reflexively think of when the term enters the conversation (e.g. Goldman Sachs, Morgan Stanley, JPMorgan Chase, etc.), these categories barely scratch the surface. These “bulge-bracket” investment banks usually supplement these services with sales and trading desks, equity research coverage, asset management arms, and a laundry list of highly-specialized services designed to meet the needs of major corporations from Apple Inc. (AAPL) to Zurich Insurance Group (ZURN). But just like virtually any business, these banks are designed to most effectively serve the customers that provide them with the biggest and most lucrative opportunities.
Of the approximately 29 million businesses in the US, however, over 99 percent are classified as “small businesses”, defined as having less than $50 million in annual revenue . And while the bulge bracket investment banks provide meaningful value to the remaining one percent of businesses who can afford to pay a small fortune for their services, the companies that make up the “middle market” are left to solve many of these same challenges with far more limited resources.
Enter The “Boutique” Investment Banks
These advisors provide one or a few of the services offered by full-service investment banks, and typically serve segments of the market that are underserved or entirely overlooked by the bulge-brackets (aka. small to mid-sized businesses). And as most of the businesses that require complex underwriting services inherently tend to be larger, the majority of boutique investment banks focus on advising clients through mergers and acquisitions.
Some boutique investment banks develop a special niche in serving one or a small handful of industries, and this focus comes to be known as their “vertical”. Common boutique verticals include aerospace and defense (A&D), healthcare and bio-technology, or technology, media and telecommunications (TMT) to name a few. While large bulge-brackets all have divisions within their banking groups dedicated to serving each of these industry verticals, boutique advisors often focus their entire advisory practice on a particular vertical, enabling them to channel their marketing and business development efforts within a more focused network of potential clients.
Other boutique advisors are “industry-agnostic,” meaning they are not focused on a specific vertical, but may offer some form of specialized expertise in a particular type of transaction, such as bankruptcy and restructuring, private placements, or sell-side M&A.
Let’s stop here and drill down on another term that gets thrown around almost as ubiquitously as investment banker – “sell-side.” Throughout the entire universe of investment banking, but especially in the M&A segment, all activity can be classified as either “buy-side” or “sell-side.” The former refers to instances when the investment banker is advising clients that buy financial products or services. Common buy-side clients include private equity funds, hedge funds, insurance companies, and mutual funds, to name a few.
The “sell-side,” on the other hand, captures the vast majority of traditional investment banking services, and refers to the creation, promotion, and ultimately, the sale of stocks, bonds, and other financial instruments to investors. Within the M&A context, the sell-side moniker is reserved for those investment banks that are hired by companies to strategically market that company for sale to the universe of potential third-party buyers.
In return for their services, these sell-side M&A advisors are typically compensated in the form of a payment that corresponds to a pre-determined percentage of the total price paid to acquire the company, which is known as a “success fee.” These success fees, which can range anywhere from 0.5% to upwards of 5% depending on the size and specific nature of a transaction, are, as their name implies, only paid if and when the transaction is successfully closed. In many instances, these success fees can take months or even years to be realized, and if the deal falls apart altogether, even at the eleventh hour, the sell-side advisor can walk away with thousands of hours poured into the deal, and virtually no compensation to show for it.
If it sounds risky, that’s because it is. But there are actions the investment banker can take to significantly increase the probability of success. So, to reiterate the original question – what does the investment banker actually do to earn their success fee? While every situation is different, the sell-side investment banking process typically moves through the following steps:
- Goal-Setting: Like any organized financial advisory process, personal or corporate, the exercise begins with the definition and organization of goals and objectives. At the outset, the investment banker seeks to understand the motivating factors behind the exploration of a sale, as well as the unique personalities and perspectives of the key players involved. Is price the sole motivation? Or will consideration be given to those other than the highest bidder? What about preservation of company culture? How important is tax avoidance? Will the current management team stay in place, or look to transition out? Honest answers to these questions will help the advisor formulate a strategy to bring about the optimal result.
- Exploration of Alternatives: During this stage of the process, the advisor will present and explore various options for meeting the goals and objectives of the selling shareholders. While the banker may initially be hired to explore an outright sale of the business, there are often strategic alternatives that satisfy the original objectives, without having to market the company to outside buyers. These options tend to include management buyouts, leveraged recapitalizations, or sale to an employee stock ownership plan (ESOP). Alternatively, if and when it becomes clear that a sale of the business is the right strategy, the exploration doesn’t end there. The advisor will assess the trade-offs between different categories of potential buyers, including strategic buyers (aka. companies that provide a similar or related product or service, which are often competitors, customers or suppliers), as well as financial buyers (aka. private equity funds and other entities seeking to generate an investment return via the subsequent sale of the business). The type of buyer in an M&A transaction often has meaningful bearing on the offer price (strategic buyers will often pay more to achieve post-transaction “synergies”), the structure of the transaction (financial buyers are far more likely to accept a stock purchase vs. an asset sale, which can have meaningful tax consequences), and the form of consideration ultimately paid (strategic buyers, especially those that are publicly traded, often seek to pay a large portion of the purchase price in the form of their own stock).
- Pre-Diligence & Preparation: During this step, the investment banker takes a deep dive into the company, investigating the finer details of the business model, as well as the potential areas of focus or scrutiny by the would-be buyers later in the process. Virtually any buyer is likely to perform rigorous due diligence on the company’s financial, operational, and compliance information, along with any other areas that could impact their willingness to make an investment in the company. As these transactions are highly negotiable, advance preparation and identification of potential issues can be paramount to the ultimate success of the deal. What’s more, as the company is most likely closely-held, with no publicly traded shares on an active stock exchange (e.g. NYSE, NASDAQ, etc.), this step also informs an estimation of the value that the sellers can expect to receive in the marketplace. For certain businesses, this is an easier and more precise estimation than others, but in almost all instances, it is highly dependent on who the most likely buyer is, and how well the banker can position the company in the eyes of potential acquirers.
- Marketing Materials: Once the banker has gained a comprehensive understanding of the business, and has identified the key drivers of value to a prospective investor, the next step, and one of the most vital in the entire sell-side process, is the creation of written marketing materials to facilitate outreach to the universe of potential buyers. While there are several key documents created at this point in the process, no two are more essential than the teaser and the confidential information memorandum (CIM). In the teaser, which tends to be a one page document, the banker seeks to present the key information in the most succinct and intriguing way possible, while simultaneously masking the specific identity of the company being marketed. The goal of this step is solicit enough interest that potential buyers are willing to sign and return confidentiality agreements (NDAs) before reviewing the CIM. Once these NDAs are executed by a prospective buyer, the banker provides the CIM, which is the key document of reference from which buyers evaluate the company and formulate their initial indications of interest (IOIs). The CIM typically ranges from 20-50 pages in length, and describes, in great detail, all aspects of the business, from products and services, to customers, suppliers, personnel, financial characteristics, risk factors, competitive advantages, and most importantly, opportunities for growth. The CIM will be referenced throughout the diligence process as a key source of information and narrative surrounding the business, and can make a significant difference in the level of interest received at the outset of the process.
- Outreach & Screening: After what typically amounts to a few months of detailed preparation, a coordinated effort is undertaken to distribute these marketing materials to a carefully selected list of potential buyers. Specific deadlines are set forth for these parties to respond with their IOIs, and in this timeframe, the investment banker is tasked with rapidly and judiciously responding to requests for additional information. In doing so, the investment banker must attempt to gauge the potential parties’ level of legitimate interest and financial wherewithal to actually execute the transaction, and weigh those judgments against the fact that, ultimately, the goal is to close a transaction with one successful bidder, and all others will have been provided with highly sensitive information about the business, and trusted to honor their confidentiality agreements. The goal of this process is to foster an “auction” among potential buyers, in which the interested parties feel compelled to make the best possible offer for the company, because they know, or at least suspect, that they are involved in a competitive bidding process. The investment banker then screens the indications of interest as they are received, ranking them on various axes of importance, including price, structure, and other deal terms, as well as cultural fit, stated transaction rationale, and planned approach to due diligence.
- Management Meetings: Assuming sufficient interest is received, the banker then works with the selling shareholders to slim the list of IOIs to a small handful of potential suitors with the most enticing offers, and facilitate in-person meetings between these parties and the company’s senior leadership team. While the banker is heavily involved in preparing, and oftentimes rehearsing the presentation, this is the management team’s show. The team should make every effort to highlight the most attractive and differentiating attributes of the business, while simultaneously assessing each suitor’s reasons for interest, as well as their vision for life after the transaction. Each of these presentations can last upwards of 5-6 hours, and include very detailed Q&A from both sides, which is partially why the list of parties invited to these meetings is deliberately short. These presentations can quickly cannibalize an entire week of the senior leadership team’s calendar, and it is the banker’s job to shoulder the burden and mitigate fatigue, to the extent possible.
- Negotiation & Letter of Intent: Following these presentations, the banker will directly solicit letters of intent (LOIs) from each party that remains interested in the company, and in whom the company remains interested as a potential acquirer. These LOIs will set forth, in much greater detail than the IOIs, the key economic terms, proposed transaction structure, and other aspects of the transaction framework. If the auction process has been managed correctly, the company should now be in a position to leverage these offers off of one another, and negotiate the best possible overall transaction. Following these negotiations, the company and the banker will generally come to terms with one buyer, and jointly execute the LOI. At this point, all other interested parties are typically thanked for their involvement, and notified that their bids were unsuccessful. The prevailing LOI is non-binding as to the majority of proposed terms, as they all remain subject to a comprehensive due diligence process, but the provisions of the LOI that relate to confidentiality and exclusivity (that is, the company may no longer entertain any other potential acquirers while the LOI remains in effect) are considered legally binding.
- Due Diligence: This is the process by which the buyer investigates every known or knowable aspect of the company, which typically entails heavy involvement from additional diligence resources, including the buyer’s legal counsel, accounting and tax advisors, IT experts, and other parties that assist the buyer in evaluating potential areas of risk. This will require an acute attention to detail on the part of the investment banker, as well as significant input from the company to quickly respond to excruciatingly detailed information requests. The buyer will seek to leverage their discoveries to enhance the transaction economics from their perspective, so expert guidance is key to successfully navigating this step in the process.
- Transaction Documents & Closing: During the final stages of due diligence, a process that may involve several rounds of in-person meetings, seemingly countless conference calls, and can last upwards of a few months depending on the level of complexity and risk in the company, the transaction documents are drafted and heavily negotiated by both parties and their respective legal counsel. The banker typically remains heavily involved at this stage, both to ensure that there is no material degradation of transaction economics to the sellers, as well as to encourage all parties to adhere to their pre-determined deadlines, and keep the group oriented towards their common goal of successfully closing the transaction. This is one of the key areas where the bankers’ success fee structure adds significant value to the process, as they are heavily incentivized and effectively “on-call” for anything and everything that may arise as an obstacle to closing. If they are successful, this process culminates in the execution of final transaction documents, and disbursement of sale proceeds from the buyer to the sellers. This, by extension, typically results in the type of celebratory dinner for which no one would like to be the final recipient of the bill.
In summary, the sell-side investment banker in an M&A transaction is chiefly responsible for making the deal happen, from start to finish. While the process of doing so typically follows the steps listed above, the real challenge in achieving this goal arises from the various competing personalities, conflicting objectives, dynamic financial incentives, and other complex realities of transitioning the ownership of a business. Selling a company will likely be one of the most financially impactful events in a business owner’s lifetime, and the emotional complexities surrounding the sale of what likely amounts to a lifetime of blood, sweat and tears can make every minor decision feel like the difference between life and death. The investment banker is there to provide advice, perspective, counsel, and often emotional support to the selling shareholders. The sophisticated financial expertise is, really, only a prerequisite to being considered for the role.
So what does an investment banker really do? Well, hopefully, they work extremely hard to be given the chance to pay for a very nice dinner.