The Investment Banker: Capital Markets
Why this chapter
To understand how a company borrows not from a bank but from thousands of strangers at once, and who earns on that.
An analogy
Picture a farmer who needs money for a new orchard. They can go to the moneylender next door — that will be a conversation between two people. Or they can go out to the fair and sell a thousand townspeople an IOU each against the future harvest. The fair is cheaper, because each person risks only a little. But the fair is not always open, and if it is shut on the day the old IOUs have to be repaid, the farmer goes bust in front of the whole town. The fifth chapter is about the people who run that fair. They buy almost nothing for themselves: they build a bridge between those who have money and those who need it, and they charge a toll for crossing.
How it works
An investment bank holds almost no assets — it builds bridges between money and business for a fee: underwriting (buying an issue outright and reselling it), a bridge loan (short money until the long money arrives), syndication (slicing a loan and handing the pieces to other banks).
A convertible bond is debt with the right to become shares: the coupon is lower, and in exchange the investor gets an option on the upside. On conversion the debt disappears and equity grows — no money moves at all.
A buyback is a company repurchasing its own shares (equity ↓). Done with debt, it changes the structure: debt ↑, equity ↓, earnings per share ↑. That is how Apple lifted its EPS, borrowing more than $100 billion over a decade (peak debt ~$120 billion) at 1–3%.
The words of this chapter
An investment bank
An institution that holds almost no property and takes no deposits. It arranges deals — share issues, bond issues, takeovers — and lives on fees.
It was invented because bringing an issuer together with a thousand investors is a profession of its own: you have to value the deal, find the buyers, and take on the risk that it does not place.
Underwriting
A placement guarantee: the bank undertakes to buy the whole issue at an agreed price, resell it to investors and keep the difference.
It was invented so that the issuer gets its money on a known day and in a known amount, without depending on the mood of the market.
A bond
An IOU cut into thousands of identical pieces and sold to many lenders at once, bypassing a bank's balance sheet.
It was invented for the price: many small lenders together demand less than one bank, because each of them risks a small share and can sell their piece on.
A bridge loan
A short and expensive loan until long money arrives: the bank gives real money against a future issue or a sale of an asset.
It was invented for deals where the money is needed today and the market will open a quarter from now. It buys time rather than financing a business.
Syndication
Slicing a large loan into pieces and handing them out to other banks: the arranger structures the deal, keeps a piece and a fee for itself, and sells the rest.
It was invented because of size: a project can be bigger than any one institution is prepared to take on, and walking away from the deal is a pity.
A convertible bond
Debt with the right to swap it for a stake in the company: the coupon is low, but the lender gets the right to become a co-owner if the business grows.
It was invented for growing companies that have no cash flow for an ordinary interest payment but do have hope that their stake will grow more valuable.
Conversion
The moment when an obligation turns into a stake with not a single movement of money: the debt disappears and the owners' share grows.
It was invented as a way of paying with future success instead of today's money.
What happens to the balance sheet
Compare two ways of borrowing. In the first the money comes from a bank: the bank gets a claim, the borrower gets a new balance in their account, and there is more money in the economy. In the second the money comes from investors: their balances fall by exactly as much as the issuer's balance grows, and the total amount of money does not change. In both schemes the arranger creates nothing — it takes a fee for having got the deal done. Conversion stands apart: there nothing moves at all, a line simply travels out of the debts into the owners' share.
Where the money comes from here
The arranger earns on the difference between the price at which it bought the issue and the price at which it sold it, plus fees for structuring. It needs neither an owners' cushion nor money raised from anyone — as long as the deal sells. The issuer wins a lower price for money, the investors a yield above a deposit. The one who loses is whoever is left with an issue that did not sell: the bank is stuck with somebody else's company among its property and with its capital tied up. The issuer loses too, if it borrowed counting on borrowing again and the fair was shut in the year it mattered. Here is why this matters to you: cheap money always arrives with a condition nobody thinks about at the moment of receiving it — the need to come back to that same market once more.
What people usually get wrong
The common belief. An investment bank is just a very large bank, only for rich people.
What is actually true. It is a different profession. It holds almost no property and takes no deposits; it earns a fee for arranging other people's deals. It does not create money — it moves money that exists.
The common belief. A low coupon on a bond means the company borrowed very cheaply.
What is actually true. Part of the price may have been paid not in interest but with the right to swap the debt for a stake. Tesla borrowed at 0.25% per annum — and gave up in exchange the possibility of future dilution.
The common belief. When a company buys back its own shares, it is returning money to shareholders out of profit.
What is actually true. Often it borrows to do it. Over the years Apple has bought back more than 700 billion dollars of its own shares, taking on debt while debt is cheaper than equity.
After this chapter you will be able to
- judge the moment at which an intermediary stops being an intermediary and becomes the owner of the risk
- tell raising money from the market apart from a bank loan by whether money is created or only changes owner
- judge how much risk stays with the arranger after it has handed out participations
- predict how an obligation leaves the balance sheet without a single payment
- read a capital structure as a choice between cheap debt and expensive equity
Check yourself
A company placed bonds on the exchange. Is there more money in the economy?
No.
The investors handed over money that already existed: their balances fell by exactly the amount by which the issuer's balance grew. Only a bank can create new money, by buying an asset from someone who is not a bank.
The bank guaranteed the placement of an issue, but fewer buyers turned up than were needed. What is on its balance sheet?
Somebody else's company.
A placement guarantee means an obligation to buy the whole issue. The unsold part stays among the bank's property and ties up its owners' cushion until a buyer is found.
An investor swapped a company's debt for its shares. How much money moved across accounts?
None at all.
Conversion is a line moving out of the obligations and into the owners' share. The obligation vanished and no payment took place. The same trick is used to rescue banks, turning lenders' claims into their stake.
In short
A company can borrow in two ways: from a bank or from many people at once. A bank is simpler but more expensive, and the market is cheaper but sometimes shuts at the worst possible moment. Whoever arranges a loan like that usually gives none of their own money — they bring the sides together and take a fee. But if there were not enough buyers, they have to buy the rest themselves, and then somebody else's business becomes their problem. Sometimes a debt is never repaid in money at all: the lender simply becomes a co-owner.
Reading is half the job. In the academy this chapter is worked through by posting entries: you run the operations yourself and see whether the balance sheet still balances.