What the Heck Is Investment Banking, Anyway?

Over the past five years, it's been pretty profitable to know names like Goldman Sachs (NYSE:GS) and Lehman Brothers (NYSE:LEH). Since this time in 2002, the two firms have returned 200% and 158%, respectively, easily outpacing the 50% that the S&P returned over that period. Although the Fool community seems to have a soft spot for Goldman, there are many market watchers who believe that -- like Paris Hilton in jail -- a good thing like this just can't last.

There's a lot of compelling evidence on both sides of the bull/bear tug-of-war over the investment banks, but before you can decide what's going to happen to these mavens of Wall Street, it's helpful to know what exactly they're doing. In recent years, the banks have grown and expanded in many different directions, and although they're still most often referred to as "investment banks," they do a heck of a lot more than investment banking.

Though it's now the smallest segment in most of the major brokerage houses, investment banking is still very important to these firms, and is considered to be a very strategic business segment.

So what is investment banking exactly?
To a large extent, investment bankers act as a kind of financial consultant to their clients. Bankers provide two principal categories of services: capital raising and strategic advisory.

Companies can raise money in a number of different ways. If a company is private, it can raise money from an institutional investor like a private equity or venture capital firm, or it can choose to go public through an IPO. If a company is already public, it can sell additional shares into the market, sell shares to an institution in a private placement, or choose to sell the whole shebang and go private. And whether a company is public or private, raising debt is often an option as well.

Investment bankers on the capital-raising side work in a number of roles. Initially, they are the salespeople convincing the company in question that raising money is a good idea, and that -- perhaps more importantly -- the company should choose that banker's firm to manage the deal. Once a company has decided that it is going to raise money, the bankers act as the ringleaders of the process and shepherd the deal from start to finish.

On the advisory side, bankers offer strategic and financial consulting to their clients. Among the better-known activities on the advisory side is merger and acquisition advising. As with capital raising, bankers on the advisory side have to sell clients on their ideas and their firm. Once a client mandate is won, the bankers work with the company to help it evaluate the situation, whether it be the purchase of another company, the negotiation of a sale price to a private equity buyer, or the defense of a hostile takeover bid.

Turning clients into dollars
The bulk of the revenue in the investment banking industry is based on transactional fees. When a bank works on a capital raise, it'll typically come home with some percentage of the total amount of money raised. In an M&A transaction, the bankers on each side of the transaction likewise get some percentage of the deal. Fee percentages on IPOs are often as much as 7% of the total deal, though this percentage tends to come down as the deals get larger.

Investment banking operations largely rely on good market conditions in order to do well. In a good market, there tends to be more receptivity to new IPOs and debt offerings, and more companies opt to raise money. Likewise, when companies are feeling more confident, they tend to make more acquisitions. Most of the larger investment banks also offer advisory services in the areas of bankruptcy and restructuring, which can help support the bank during lulls in the market.

The players
The investment banking playing field is huge. In addition to the major bulge bracket names like Lehman Brothers and Bear Stearns (NYSE:BSC) that everyone seems to know, many of the larger banks like Wachovia have investment banking divisions. There are also many smaller investment banks that focus on particular niches. And of course, in addition to all of the familiar names in the U.S., there are countless investment banks based elsewhere -- for example, Nomura Holdings (NYSE:NMR) in Japan, Macquarie in Australia, and Credit Suisse in Switzerland.

To help you continue digging into the investment banking industry, I've put together a list of 10 of the major players. I've also included the ratings for each of these stocks from The Motley Fool's CAPS service.

Fool on!

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Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy is not an investment banker, but it can whip out a mean comp set like nobody's business.