I used to know a socialite girl who worked at Holt Renfrew in Vancouver. As they have purchase allowances and because it is incumbent upon junior investment bankers to be immaculately dressed in no small part due to the toxic lifestyles endorsed by new finance Instagram accounts, I was happy to entertain her when she came to Toronto for a weekend.
“Hey Matt, you work in banking now right?”
“So you sell mutual funds?”
“There is a division of the bank that does that, yes.”
“Ok, well many thanks to me, my friend David is also coming to dinner tonight and he also sells balanced mutual funds with the 40% bonds for Scotiabank. You get to expand your network.”
As it turned out, David was actually in DCM and we had a laugh over her introductions, but there remains some sort of mystique when people are asked how to explain investment banking for the layman.
For some insecure junior bankers, of which there are many, they can get fairly geared up when people mistake them for being tellers or the guy who works at TD Waterhouse. They get even more geared up when a mutual fund salesman from World Financial Group or Manulife purports to be an investment banker.
It does not help when people ask “what is investment banking?” or “so what do you do?”, most junior investment bankers cannot spit out an articulate result without relying heavily on finance jargon. Outside of an interview with other financial professionals, you end up losing your audience fairly quickly. It does not help that investment banking is a poorly understood and well publicized staple of mass media. While you have to work in the space to be fully informed about any industry and artistic liberties are taken in television, people can usually grasp that doctors work in hospitals and heal people, policemen enforce the law and firefighters put out fires. Anyone who works in finance and has seen the Shia Lebeouf Wall Street sequel knows that film has not been representative of the work involved.
As a service to girlfriends, mothers and aspiring investment bankers in college who are in it for the money (which is a fine reason, just best left unsaid), I will try to untangle the investment banking conundrum the same way I explained it to my own mother.
What is Investment Banking? (For Dummies)
Investment banking is basically real estate brokerage – except with companies instead of properties. If anything, since commercial real estate looks at the value of properties as businesses, commercial real estate is just a subset of investment banking – and both are just a subset of being a broker or a middleman.
At its simplest form, pure or classic investment banking (also known as mergers & acquisitions) excluding financing arms (equity capital markets and debt capital markets) is helping a buyer and a seller come together and transact. In real estate, someone is buying a property and someone is selling a property. For real estate, you generally want to act as the real estate agent for the seller as you are relatively more certain that the transaction will close.
This is no different in investment banking as firms will jockey to represent a seller before running off to find potential buyers if the seller decides to enter into an Exclusive Listing Agreement with another broker.
Representing the Seller in Real Estate or Investment Banking
Once the seller has decided on their real estate or investment banker, the broker begins to market the property or the company. Advertisements on glossy paper, reaching out to buyer contacts that they have kept in touch with and uploading information to databases and websites is step one. Managing conversations between the selling party and the potential buying parties is step two.
Representing the Buyer in Real Estate or Investment Banking
The real estate agent or investment bank representing a potential buyer will advise on how much you can expect to pay to beat out competing bidders based on professional judgment and market data before entering into exclusive negotiations with the seller. While a real estate agent would say “the last four houses on this block sold at $1,200 per square foot,” and investment banker would say “the last four transactions were completed on 5x EBITDA.”
Should a buyer and seller be serious, there is the concept of caveat emptor or buyer beware. Once you buy the house, absent any serious representation, you have to live with your decision. This is why the process of due diligence is so important for the purchaser. Were there cracks on the ceiling, are renovations done to code – investment bankers will look at how long certain things are contracted out to (as well as physical documentation of the contracts), how many trucks are in the inventory and anything that would be relevant to the buyer’s financial forecasts.
Pitching for a Mandate in Real Estate or Investment Banking
As with commercial real estate, investment bankers will do a lot of pitches and market updates to compel buyers to enter into a transaction. Occasionally, clients will get bankers or real estate brokers on retainer to do work for them – random analysis, how much debt (or mortgage) should I have on the property, should I lease or should I sell. However, this is far less lucrative than a transaction and is a way to show support so that the broker is selected as the representative when the time comes to sell or buy.
Similar to the neighbourhood REMAX agent who has #1 in transaction volumes and over 300 homes sold in Coquitlam since 2005, investment bankers rely heavily on promoting their credentials to get more business. After all, if you are looking to sell your house on Cambie Street to a developer who is willing to pay top dollar, why would you take the risk on someone who has not sold many houses versus one who does one every week – especially if the fee is the same.
For an investment banker in the food or beverage space, you can expect that the banker who sold Burger King is far more likely to be entrusted with the sale of Wendy’s, especially if the aforementioned transaction was a recent phenomenon.
As you may surmise, there is an incentive to embellish these credentials so that bankers or real estate agents can find a way to #1. Not the top commercial real estate sales for this neighbourhood? Then we can narrow it down to just duplexes. And then we can narrow it down to just duplexes since 2016.
The Most Expensive Things are Free
Like real estate, the lower the transaction value and the shadier your broker. For the largest building, such as a 50-storey office tower in the middle of Manhattan, you can be assured that the buyer universe is sophisticated and has a team that understands the investment possibly better than the broker. You still need a broker, but would expect that the fee is a smaller percentage of the transaction value – although 0.40% of $3 billion is still $12 million.
At the lower levels of investment banking and real estate, these are where the more unscrupulous players live. A small time real estate agent is far more likely to have conflicts of interest when it comes to the sale than a large firm such as CBRE with a reputation on the line. Likewise, investment banking boutiques that deal with highly speculative securities are more likely to run into fraudulent management teams and unsavvy investors.
Of course, this applies for any other industry – you get what you pay for.
Differences Between Real Estate and Investment Banking
One part of investment banking that is not covered by this analogy is financing. Investment bankers are also underwriters of debt and equity. When corporates issue shares to the public, investment bankers will market and sell the shares for them while historically holding the risk in case the deal does not clear as expected. This has changed to some extent (read our equity capital markets and debt capital markets sections for more information) over the years.
However, the theme of client relationship management, financial advisory and handholding throughout the process is similar.
Also important to mention is that there is an additional layer of complexity for companies versus a property. As complex as a property can get, building a real estate model and understanding the business can be simplified to:
Getting the expected rent over a forecast horizon, taking out expenses such as HVAC and management (which are sometimes just added on to the rent and netted to the tenant) and suddenly you have your net operating income which 99% of properties transact on when compared against the purchase price (in what is called a capitalization rate or cap rate).
Valuing an oil and gas company or pharmaceutical can be more difficult.
Thank me later, mothers.