Seeking bright spots

Jon Sandelman is a rarity in these equity markets. While his competitors seem to do nothing but get rid of staff, cut back on coverage and worry about conflicts of interest between research and investment banking, Sandelman is convinced that his firm, Banc of America Securities, is well positioned to grow the business. "While my competitors are thinking about how to shrink, I'm looking to build," he says.

Sandelman, who was promoted to the post of global head of securities in June, got a list of those areas of the business that he regards as the sweet spots: prime brokerage, equity derivatives (his own speciality), convertible bonds and programme trading.

Across the industry many of his counterparts are concentrating their resources on the same products now that they're all convinced that the heady equity capital raising days of the late 1990s are not coming back. "It's like the ice age," says Rafi Berber, global head of the equity-linked group at Merrill Lynch. "No-one wants to be a mammoth. Everyone's heading south, looking for warmer climes."

Unlike in the 1990s, few equity firms believe they must be in all products and all regions. Conventional equity sales, trading, research and new issues are all being cut back. But there's no easy answer as to what new equity business model to build towards. "I'm not expecting us suddenly to discover a dramatic new pot of revenues," says Alan Hodson, global head of equities at UBS Warburg.

Merrill Lynch is one firm that hasn't shrunk from hard decisions. Last month it announced that it would cease trading in 7,500 Nasdaq and OTC stocks as they were too illiquid and were a drain on resources. It's a cause of some embarrassment, since Merrill spent $1 billion on Nasdaq market maker Herzog Heine Geduld in June 2000 precisely to increase the number of stocks it traded. The firm still trades 2,500, though, about 90% of Nasdaq volume.

Goldman Sachs actually reported an increase in prime-brokerage revenues in the third quarter despite the generally dismal equity market environment. Expertise, investment and scale seem to be paying off.

Any equities house worth its salt ought to be jumping in with both feet, surely. Not any more, it seems. "We absolutely need to be bigger in the prime-brokerage space," says Berber. "Undoubtedly, margins are coming in. So we're going to build on our existing relationships, and we'll do so in a balanced and controlled manner, with no outsized exposure either to one particular fund or one particular strategy."

Even Goldman executives speak with unexpected circumspection. "We're focusing on execution services," says Erich Mindich, global co-head of equities at Goldman. "Prime brokerage and clearing give us stickiness and market presence. As we like to say, we get paid, all the time, including Saturdays, Sundays and public holidays." His colleague and co-head Eric Schwartz adds: "It's the basis of what we are. A dollar of profit from execution services is worth a lot more than a dollar from customer business or prop trading. Companies that specialize in automatic data processing trade at a higher multiple for a reason."

It's a compelling argument but if they're looking to help get the stock up they might want to tell colleagues in proprietary trading, which has been exceptionally successful so far this year, to slow down a bit.

Lehman Brothers is finding the going somewhat tougher. It pulled back from prime brokerage after the 1998 Russia crisis and is now rebuilding. It's not a large player and has lost some traction in the last quarter. "Certainly we saw a decrease in prime-brokerage balances as hedge funds started to de-lever their balance sheets and their portfolios," CFO David Goldfarb told investors on the company's earnings conference call in September.

In trading in general Goldman has been expanding through acquisition as well as organically. All of the deals it has struck since going public three years ago have been to improve or increase trading capabilities: options traders the Hull Group; New York Stock Exchange specialists, Nasdaq market makers and clearing house Spear Leeds Kellog; and specialist Walter Frank.

Hodson at UBS Warburg says that the key is to be able to develop "scalable, efficient trading processes, adding value with analysis and capital." He says: "It's an unattractive phrase, but essentially you build a factory." Warburg, which has always had a good presence in trading, has been taking some pointers from its foreign exchange colleagues on how to do that. "We learnt a lot from them, especially about structuring the back office," says Hodson. "We wanted to create a low-cost business process before it became a commodity."

Lehman's Goldfarb stated on his conference call the dilemma all the second-tier banks face on equities trading in general. "If you want to stay in the game it's too cost prohibitive and margins would continue to compress if you didn't have an efficient way to process through technology. Cash trading is an important piece, but it's not necessarily the highest-margin business. To continue to get share in equity derivatives and equity finance you need to be able to execute. The more market share you get in cash trading leads to a lot of other opportunities in equities which are very, very high margin."

One head of equities is taking an even tougher line. "I take a three-year view of the business, and I think we're going to end up in a zero-commission environment. So we're building the technology and analytics with that as our backdrop." If he's right, and the rest of his business model works, he'll have a distinct advantage over competitors that haven't overhauled their legacy fixed costs. If he's wrong, he'll still be okay, as he'll be paid commissions.