The Difference Between Investment Banks, Commercial Banks, Hedge Funds, and Private Equity Firms
Background Story (Personal Rant)
The other day I was sitting in my money and banking class in a top 20 (U.S. News Undergraduate Rankings) business school. So far the class introduced me to monetary policy, the US commercial banking system, and touched upon the history and causes of financial bubbles. The book, Mishkin’s Money, Banking, and Financial Markets, is fairly simple to read and understand. I am grateful for this especially since the professor seems strikingly ignorant on the subject of banking. Forgiving the fact that he is one of the worst teachers in the school, and his class is completely pointless since I gained access to the test bank through the Pearson website- I still happily attend his class every week hoping to learn something new.
Recently, we were on the subject of the recent financial crisis and the professor mentioned private equity wasn’t doing so well, suggesting transactions made right before the 2008 crisis hit were steeply overvalued and it would be difficult for the firms to regain their capital, let alone profit from their targets. A student raised his hand and asked about the differences between private equity, investment banks, commercial banks, and hedge funds. I got excited to contribute, but my teachers response was completely wrong and he decided to strategically move on from the question quickly. Deciding it wasn’t worth correcting him, or even worse, insulting him in class, I kept my mouth shut. Below is an answer I would have given to my peer’s question.
Buy-side vs Sell-side (The Answer)
There are two general sections that divide the financial industry. The buy-side includes savers (people putting money into commercial banks), investment advisers who invest the savings, and funds that are given money to make specialized investments; and the sell-side consists of investment banks who are split into the sales and trading division and corporate finance division.
Here are more details on each of the parts:
- Investment bank’s corporate finance department underwrites securities for companies, participates in IPOs for companies wanting to raise capital, and advises companies on mergers and acquisitions. Another part of the bank engages in sales and trading activities. The last part, the researchers, aid the traders in making decisions. All three departments sell services to companies and high net worth individuals, and are therefore, are on the sell-side.
- Commercial banks take deposits and make loans for the public. By pooling small sums of money, these banks are able to make more significant investments. They are on the buy-side.
- Hedge funds raise money from the public, pool the money, and follow a predefined investment strategy to minimize their risk and increase their returns. Hedge funds deal with publicly traded companies and are on the buy-side.
- Private equity firms also raise money from the public, but uses it to buy private companies, manages them, and tries to exit with a profit. They are located on the buy-side.
Note: When I say raising money from the public, I mean anyone- companies, individuals, or institutions.
The Chinese Wall (The Investment Banking Division)
As highlighted earlier, there is a division in the investment banking (sell-side) department. The image above demonstrates this with an invisible wall in between corporate finance on one side and sales and trading and research on the other. This is set up intentionally to avoid conflicts of interest. Since the corporate finance department’s clients are companies, they hold access to insider information. Using the knowledge to publish research reports or trade would be against SEC and NASD regulations.
Hope that helps clear up this common question. I wanted to add the fact that picture above shows research on the sell-side (i.e. to complement sales and trading); however, there is also buy-side research sold to pension funds and mutual funds.
Regulation pertaining to the separation between commercial banks and investment banks is Glass Steagall Act, which was repealed by the Gramm-Leach-Bliley Act in 1999. Also, there is the Vocker Rule recently passed in 2010 separating investment banks and proprietary trading in banks. The main reasons for these regulations is to minimize conflicts of interest within a bank, to limit the size, and thus risk of the financial institutions.
Before I sign off, I also wanted to point out that private equity is recovering from the financial crisis, contrary to what my professor suggested. This trend is evident by the $3 billion J. Crew deal at the beginning of this month. However, PE trends are a discussion for another post, it is now time for me to attend another one of his lectures.
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