Investment Banking 101: How They Make Their Money

Do you know how investment banks make money on IPOs? Do you really know what "trading revenue" is?

In this clip from Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel break down the main revenue streams investment banks use to make money, and what investors should know about each one.

A full transcript follows the video.

This video was recorded on July 23, 2018.

Michael Douglass: Let's turn to our second topic, which is more of an overview of investment banking. First off, folks, head back to our December 11th, 2017 episode on the investment banks if you want more discussion as to how all this interplays with their underlying business model. That's where we did our deep dive on investment banks, and really understanding, running through our framework, figuring out how exactly all that works.

But we figured we would talk a little bit about investment banking itself, what those actions look like and how that all works, today. Matt, take it away.

Matt Frankel: After we did that episode, I got a bunch of questions to the effect of, what is trading revenue? What exactly does M&A advisory mean? Things like that. I figured we would take a few minutes and discuss the ins and outs of the main ways investment banks make money.

It can especially be confusing because different banks generally have different names for their business segments that do the same thing. In fact, I don't think any of the big banks have the same names for all of their business segments. For example, Goldman calls its trading desk Institutional Securities. Some other banks just call it Trading.

Generally, you can break down investment banking activities into four key areas that all investment banks generally participate in -- advisory revenues, underwriting revenues, trading revenues and wealth management. To go through those one at a time, let's start with advisory. Advisory generally refers to when companies want to acquire another company, when two companies want to merge. There's a whole lot that happens behind the scenes. For example, When AT&T and Time Warner merged recently, it wasn't just like a couple of people met in the room and said, "OK, all Time Warner Shares are going to be AT&T shares, let's all go home." There's quite a process to it. This is where investment banks come in. They do the behind-the-scenes of mergers and acquisitions and collect fee revenue for those services.

Douglass: To unpack that a little bit further, imagine that you're a business owner and you're looking to purchase another business that is operating in a similar area to what you do. You're going to want to understand, how much are you paying people? What costs do you have that I need to understand? How exactly does the business work? All that due diligence work.

Some of that is where the investment banks come in, and some of it's done by legal experts and things like that. It's a really powerful thing, in terms of modeling out, "If we paid this amount for this business, at what point are we going to have recouped our investment? What's the opportunity?" That's where the investment banks can come in with that strategy mindset, to help you understand both quantitatively and qualitatively what that looks like.

Frankel: Right. So, that's M&A advisory. It's a big deal for investment banks. I mentioned, Goldman had the No. 1 M&A market share. Morgan Stanley is definitely up there. JPMorgan is a big player in this market, too. This is a very key revenue stream for investment banks.

Underwriting is another one. Advisory and underwriting are generally what's traditionally called investment banking, even though investment banks can engage in other businesses, which we're about to talk about. Underwriting is a term that most people are familiar in more of an insurance context than in a banking context. In a banking context, this generally refers to an IPO when companies are making a follow-on offering of stock or when they're issuing debt.

It means that the investment bank is committing to sell a certain amount of shares or bonds on the open market on behalf of the company. When a company goes public, they don't just have a sale of their shares, they have investment banks. Generally, it's more than one, if it's a reasonably sized IPO. And they have these investment banks commit to sell certain numbers of shares each. For example, Goldman might commit to sell 1 million shares of a company's stock. No matter what the market conditions are, they say, "We're going to sell 1 million shares of your stock." That's how IPOs take place.

Goldman gets fee revenue for that, as well. Investment banking is very fee-driven, as opposed to interest-driven, traditionally, as we mentioned in that other episode. Underwriting is the other big area of traditional investment banking that people need to know about.

Douglass: Right. Thinking about investment banking underwriting, there's equity, there's IPO, as we've talked about, there's debt underwriting. There are a lot of opportunities for banks to make fee income, helping the company sell whatever it is it's looking to sell here.

Let's turn to our third piece, which is trading revenue. Investment banks will manage money for clients and trade on their behalf, and they'll also trade for themselves so that they can make money both ways.

Frankel: This is the least understood part of investment banking, among retail investors, at least. It's also very unpredictable. As we saw from Morgan Stanley's report this quarter, analysts usually get this wrong when they're predicting trading revenue one way or another, either on the plus side or the bottom side. It's very unpredictable.

There are two main ways that trading revenue comes about. The first is client trading. Investment banks will call their institutional clients or high-net-worth clients and suggest investments to them. The clients will then order the investments, the salespeople will call the bank's traders, and the traders will place the trades on the open market and earn commission revenue that way. The other way is called proprietary trading, where banks for trading on their own behalf to try to earn a profit. If you hear of high-frequency trading, algorithmic trading --

Douglass: Flash crashes. [laughs]

Frankel: Right. There are a bunch of different forms this can take, and there are way too many ins and outs of proprietary trading, too many things that can go wrong, to mention in just a short podcast. Proprietary trading is the reason why this is very unpredictable. That's why they call it proprietary, because no one really knows how it works for each individual bank and how they're trying to make money. It's very unpredictable how they're going to convert their proprietary trading strategies into revenue.

Douglass: As you noted, trading revenues are generally higher during volatile periods, lower during calm markets. That's one of the interesting countercyclical things that happens with these investment banks.

Let's turn to No. 4, wealth management. This is one that most people, probably, on some level, get. You give your money to one of these investment banks, they manage it for you, they charge a fee for doing so.

Frankel: It's not that different from when, say, you deposit money into your brokerage account, except that they're doing it for you. It's a fee-for-services business. They're earning commissions, they're earning asset management fees, depending on the exact arrangement. A lot of investment managers, I think 1% is still the standard fee for an actively managed investment account with one of these investment banks. So, these banks are earning recurring revenues from that. As their clients are authorizing trades, they're getting trading revenue, as I just mentioned.

Wealth management and trading complement each other nicely. They actually offset each other during volatile times. When trading revenue goes down because the market's doing really well, just going up and up, trading revenue tends to drop, wealth management revenue tends to rise, because clients' assets are growing. They have more assets under management, the securities in their portfolios are more valuable, etc., so they're generating higher asset management fees. On the other hand, when markets crash or get really volatile, wealth management revenue tends to drop, because the value of the assets they're managing tends to go down; but trading revenue tends to pick up, because traders like to take advantage of volatility. That's where the money is to be made, especially in proprietary trading. The wealth management and trading revenue of investment banks tend to offset each other and are very complementary. That's one big key for investors to know. Generally, one of those is stronger than the other.

Douglass: Right, and it just depends on how the broader market is doing, and how the bank is executing on its particular priorities.