how investment banks earn their fees
investment banks work with companies governments and agencies to raise money by issuing securities an investment bank might help a company that has never issued stock to successfully complete its initial public offering ipo other typical services that investment bankers provide include offering merger and acquisition m a advice developing reorganization strategies or helping a company through a spinoff investment banks make money in various ways the can charge flat fees for each transaction earn commissions based on the dollar amount of the transaction or a combination of both in the case of an ipo an investment bank might provide underwriting services the bank might buy stock in the ipo and then sell the shares to investors the difference between what the bank purchased the ipo shares for and what they earn selling them to investors is the bank s profit some investment banks that underwrite an ipo undertake the risk that they will not be able to sell the ipo shares for a higher price to investors thus losing money on the trade examples of the lehman formulathe original structure of the lehman formula is a 5 4 3 2 1 ladder as follows today and to keep up with inflation investment bankers often seek some multiple of the original lehman formula such as the double lehman formula 1 this structure is also more common in middle market transactions because of their complexity and longer close periods 2lehman formula base methodsthere are several different ways the lehman formula can be used in terms of deciding what baseline dollar amount to use each of the three primary ways are discussed below the million dollar amount method known as mda is the traditional approach where percentages are applied to distinct value brackets in a transaction this is the example demonstrated above to further illustrate imagine a substantial 12 million stock transaction in this case the total fee using the mda method for this 12 million transaction would be 520 000 as the mda method aggregates the fees for each tier notice that the percentages and tiers do not need to be aligned firms can adjust either based on the deal or client mda is often preferred when dealing with smaller transactions due to its potential for generating higher fees in such cases the total value amount method or tva takes a different approach by applying the highest percentage fee to the entire transaction value for example consider a substantial 18 million stock sale where the highest applicable fee is 4 in this scenario the 4 fee is applied to the entire 18 million resulting in a fee of 720 000 tva is more efficient and straightforward for transactions that surpass a certain threshold and it is clearly much more transparent on what the ultimate fee may be clients may prefer the simplicity of the fee structure it also provides a certain level of guarantee of what the fee may be consider a company that may not know whether a stock sale will be 15 million or 25 million should there be a higher fee rate at the higher end it may be more favorable for a company to stick to a single fixed rate for every tier to better lock in forecasted fee amounts last pertinent value amount or pva functions similarly to tva but introduces a tiered fee structure for transactions exceeding a specified threshold this method really only works with larger deals that appear to cross over this threshold otherwise there is little incentive for the firm implementing the fee structure to agree to the deal let s take an example of a 10 million stock sale under the pva method the first 4 million might incur a 2 fee amounting to 80 000 the remaining 6 million may be subject to a 1 fee resulting in an additional 60 000 the total fee using the pva method for this 10 million transaction would be 140 000 in this situation it may not be known what the ultimate sale value will be a company may be wary to agree to fees without knowing what the base cost will be in this case the company can be assessed a higher rate on a lower dollar threshold then a single lower rate on a higher tier this method blends the two methods above by having both a tier structure but also a simplified more straightforward approach the concept of the lehman formula can be found in other industries for example financial advisors for personal investors may charge different fees for different services that may scale based on dollar amounts advantages and disadvantages of the lehman formulainvestment banking compensation is often performance based which means that a significant portion of an investment banker s earnings is tied to their individual and team performance this structure incentivizes bankers to work diligently generate revenue and create value for their clients and their firms by directly linking compensation to results the lehman formula encourages bankers to excel in their roles and strive for positive large outcomes investment bankers play a crucial role in helping clients achieve their financial objectives whether it s raising capital executing mergers and acquisitions or entering capital markets this compensation structure is designed to align with these client goals for example if an investment banker successfully advises a client on a large merger that enhances shareholder value their compensation is reflective of the value created for the client investment banking compensation structures can be flexible allowing firms to tailor packages to the unique needs and preferences of their employees and the specific demands of their business for example the lehman formula can be adjusted with different fee rates for different dollar tiers for different clients this flexibility enables firms to adapt to changing market conditions and evolving business strategies while still striving to land large clients performance based compensation can encourage a short term focus on immediate revenue generation and deal completion bankers may prioritize transactions that yield quick financial rewards over long term strategic considerations this can potentially lead to decisions that neglect the broader interests of clients and the firm as long as the upfront fee can be collected regardless of performance monitoring the pursuit of substantial fees and commissions may also create misaligned incentives individuals may prioritize their own financial interests over those of clients potentially resulting in conflicts of interest unethical behavior or lack of incentive to perform well as fees may not be based on outcomes the performance based compensation structures in investment banking have faced regulatory scrutiny particularly following the 2008 financial crisis regulatory reforms have been introduced to address concerns about excessive risk taking and incentive misalignment including the possibility of bonuses incentivizing risky behavior in the context of an ipo an investment firm deploying the lehman formula must be mindful of not only the fee they are to collect but the longer term market repercussions of its actions motivates higher performance and revenue generationaligns some client objectives with firm objectivesmay retain talent based on incentive compensationmay be flexible based on deal or clientmay encourage shorter term focus that derails true long term valuemay generate misalignment of incentivesmay come under further scrutiny in the face of financial downturnsa brief history of lehman brotherslehman brothers was previously considered one of the major players in the global banking and financial services industries however on sept 15 2008 the firm declared bankruptcy largely due to its exposure to subprime mortgages lehman brothers also had a reputation for short selling in the market a subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with relatively poor credit ratings these borrowers will generally not receive conventional mortgages given their larger than average risk of default due to this risk lenders will often charge higher interest rates on subprime mortgages lenders began issuing ninja loans a step beyond subprime mortgages to people with no income no job and no assets many issuers also required no down payment for these mortgages when the housing market began to decline many borrowers found their home values lower than the mortgage they owed interest rates associated with these loans called teaser rates were variable meaning they started low and ballooned over time making it very hard for borrowers to pay down the principal of the mortgage these loan structures resulted in a domino effect of defaults the bankruptcy of lehman brothers was one of the largest bankruptcy filings in u s history although the stock market was in modest decline prior to these events the lehman bankruptcy coupled with the prior collapse of bear stearns significantly depressed the major u s indexes in late sept and early oct 2008 after the fall of lehman brothers the public became more knowledgeable about the forthcoming credit crisis and the recession of the late 2000s 