A Beginner's Map to the Finance Industry

Introduction

I have had the privilege of mentoring several students who were interested in careers in financial services. In doing so, I have found that many of them did not fully understand the industry’s structure but rather had a nebulous desire to be “investors” or “work in finance”. I wrote this article to help them, other aspiring financial professionals, or anyone else who might be curious about the industry to better understand what the financial services sector does, who the main actors are, and how they fit together. I have also included comments on what it is like to work in certain areas of finance, as well as on some of the most common career transitions between them. However, detailed career guides for each of these areas is a subject that is outside the purview of this article.

It should be noted that this piece, and its accompanying chart, present a simplified, high level, overview of the industry. Therefore, they do not perfectly capture every relationship between every industry actor. For instance, individuals can, and do, operate as both providers and users of capital. However, they are noticeably absent from the graph as I felt that their numerous interactions with banks, insurers, wealth advisors, and businesses would unnecessarily complicate an already crowded chart. Another example is private equity, which often buys stakes in companies directly (albeit with the help of an investment bank) without going through the traditional exchanges or broker-dealers. I should also point out that many individual firms operate across multiple segments of the industry, especially in banking. Therefore, this overview should be seen as a high-level mapping of the industry that can serve as a starting point for those interested in learning more about it.

What does the finance industry do?

At its core, the financial industry exists to match providers of capital with users of capital. Many entities – ranging from university endowments to sovereign wealth funds to individuals – often have excess capital which they seek to invest. Other entities need this capital to fund their various projects and operations. Investors (the providers of capital) only agree to fund these activities because they expect to earn a return from doing so. Financial markets function as a mechanism for funneling the providers’ capital towards the users in the most efficient way possible. In this context, efficiency refers both to the frictionless movement of funds and to the allocation of funds to the most profitable projects. Ultimately, every actor in the finance industry somehow serves to facilitate this process.

USERS OF CAPITAL

Businesses

Corporations need capital to fund their projects. This capital can take the form of either debt or equity. In either case, the company receives a large sum upfront which it uses to fund a profit-generating project. A portion of these profits are then used to repay investors. Banks play a crucial role in this relationship as they facilitate the practical procedures of moving funds between companies and capital providers. In some cases, the banks provide the capital themselves through loans from their corporate banking divisions.

It should be noted that all financial services firms are corporations. Therefore, all of the relationships described between businesses and the financial industry also apply to the financial companies themselves.

Many people start their careers in corporate finance. The bulk of their work focuses on evaluating the profitability of projects, managing the company’s cashflow, or conducting financial reporting tasks. Given that these professionals spend most of their time working with accounting systems and financial statements, career transitions to banking or audit are not uncommon. Furthermore, banks and consultants can value the industry-specific knowledge that arises from working directly in a given sector.  In any case, the broad financial analysis skillsets that corporate finance professionals develop are useful in most subsets of finance.

Governments

Most governments need to borrow money because they spend more than they earn in taxes. Unlike with business, where investors earn their return from a project’s profits, the source of return from governments is less straightforward. If the government spends the funds it receives from capital providers to improve the economy, future tax revenue should increase, allowing the government to repay the debt’s principal and interest. In any case, the government’s ability to print money and raise taxes is usually enough of a guarantee for investors to be willing to lend it their capital.

In the United States, government debt is issued through a Dutch auction in which large banks, known as primary dealers, are required to bid on each issuance. These primary dealers then resell the debt to investors on the secondary market.

PROVIDERS OF CAPITAL

While providers of capital are an extremely diverse group, they can all be characterized as possessing (or managing) a pool of capital on which they seek to earn a return. In general, these investors focus on high level portfolio construction rather than investing in individual assets. This process, known as asset allocation, involves analyzing asset classes and strategies with the goal of forming a strategic asset allocation which outlines how much of portfolio should be invested in each asset class and strategy. These allocator-type investors often have specific risk and return constraints which guide their portfolio construction. Because they mostly use third-party funds to deploy their capital, institutional investors spend a significant amount of time researching fund managers. While some organizations choose to bypass funds and directly invest in assets themselves, they are the exception rather than the rule.

In general, working for an institutional investor is less demanding than working for a bank or private equity fund because these organizations are not directly involved in the markets and do not have to cater to demanding clients. Their investments teams spend most of their time either managing/monitoring the portfolio or conducting due diligence on investment fund managers. It is not uncommon for some very large portfolios (usually endowments and foundations) to be managed by a small team of generalists despite having several billion dollars in assets. At the other end of the spectrum, those working in large teams are often specialized in specific processes or asset classes. Most people who work for institutional investors start their careers elsewhere in the industry (usually investment consulting) before migrating to a role with an allocator.

FINANCING FACILITATORS AND ADVISORS

Investment Consultants

Investment consultants act as advisors for institutional investors. Their research of investment funds is indispensable for many allocators who use these services as an initial screen for selecting managers. In addition to this coverage, consultants also publish analysis of broad market trends which are useful for forming asset allocation decisions. It is also common for investment consultants to directly manage some or even all of a smaller allocator’s assets.

Investment consulting is the most common pathway for breaking into a role with an institutional investor. This is because consultants not only do much the same work as allocators but also build relationships with them as advisors. In general, investment consulting firms have large teams which focus on specific asset class research or advising client portfolios.

Investment Funds

Investment funds are what most people think of when they say they want to be investors. These organizations receive capital from allocators and use it to buy individual assets. While individual retail investors can directly access some types of funds, most of the industry’s capital comes from institutions. There are as many types of investment funds as there are assets, markets, and strategies; a detailed explanation of each of them is a subject best reserved for more specialized articles.

While the exact career pathway into an investment fund depends on that manager’s strategy, most people find their way there through banking. This is especially the case in private markets as these entities execute their investments through direct deals with their target companies. Investment bankers, who advise these transactions, are thus natural fits. For public market funds, investment banking still provides a solid foundation in the skills needed for the job. However, people with experience in audit or investment operations are also commonly hired by these types of funds. Quantitative funds are notable exceptions in that they often hire people with strong mathematical and programming backgrounds who may have previously worked outside of finance. Finally, investment funds typically have more demanding work environments than allocators or corporations as their direct participation in the markets makes their work highly time sensitive.

Banks

Banks are the most complex and central participants in the financial industry. Large multinational banking groups have divisions that operate across multiple segments of the financial industry, making them difficult to neatly categorize in this article’s industry map. For the purpose of this piece, banks are the primary entities that match the users of capital with the providers of capital. Sometimes, banks make loans to business directly though their corporate banking divisions. For larger sums, the investment banking arm works with corporations to issue new securities (either debt or equity) which are sold to investors. The resulting proceeds are then used by the corporations to expand their operations. The investment banking division is also responsible for advising companies on mergers and acquisitions. Here, bankers analyze and negotiate the details of the deals to obtain the best possible terms for their clients.

While banking is often cited as the best place to begin a career in finance, it is also notorious for being the industry’s most demanding place to work. Banks’ strategic placement at the intersections of many industry participants, as well as their wide reach, make it easy for the people who work there to transition to other areas of the industry. It is common to encounter former bankers in investment funds, corporate finance, government debt management offices, consulting, and more. However, the intersectionality that gives banking this strength is also its greatest challenge. In order to meet the time sensitive and rigorous demands of all the parties that they work with, bankers routinely work extremely long hours in high stress environments.

Broker-Dealers

Broker-dealers are one of the main pillars that allow financial markets to function smoothly. In essence, these firms help buyers and sellers of securities to find counterparties to their trades. As their name implies, broker-dealers can facilitate this process by acting as either brokers or dealers. When acting as a brokers, broker-dealers act as matchmakers that pair buyers and sellers directly with each other, charging them a commission along the way. When acting as dealers, broker-dealers are themselves the counterparties, buying and selling securities with their own inventory. Investment banks work closely with broker-dealers when issuing new securities as these entities are able to distribute large quantities of financial assets to the markets.

Exchanges

Exchanges are the most efficient forums for investors to trade securities with each other. These platforms keep a limit book which displays all the prices and quantities for which each trader is willing to buy/sell a given security.  Modern exchanges use computers to automatically match traders, leading to a very fast and efficient process. However, securities which are not homogenous (bonds, certain derivatives, etc.) or are thinly traded are ill-suited for these systems and are thus exchanged through broker-dealer networks.

The technological sophistication of exchanges means that they often hire people with advanced mathematical and programming skillsets. This overlap in skillset with quantitative funds – which mostly operate on exchanges – makes career transitions between the two quite common.

Auditors

Auditors are primarily responsible for reviewing companies’ financial statements to ensure their accuracy and compliance with accounting standards and tax laws. Therefore, auditors possess advanced accounting skills which are sought after in other areas of the finance industry such as corporate finance, banking, and investment research.

Management Consultants

While management consulting is not typically considered to be a part of the financial industry, it nonetheless plays an important role in business and can serve as an entry point for finance. In essence, management consultants act as advisors to businesses and governments, helping them find solutions to their problems and develop corporate strategies. Through this process, many consultants become experts in specific industries. This expertise, combined with their analytical skills, allows consultants to transition to roles in corporate management, government, or banking.