South Africa - Too many banks, too few deals

Until the early nineties, the investment banking business in South Africa was divided between established local names such as FirstCorp, the former merchant banking arm of First National Bank (FNB), Standard Merchant Bank, UAL Merchant Bank, Rand Merchant Bank, Investec, the Board of Executors (BoE) and a host of stockbrokers.

Few members of this cozy coterie anticipated the shakedown they would witness when South Africa was suddenly reintroduced to the global community following the country's first free elections in 1994. Hot on the heels of these elections came an invasion of foreign investment banks. They quickly snapped up local stockbrokers or formed alliances that were often precursors to outright acquisitions.

Alan Hartdegen, banking analyst at ING Barings Southern Africa, says: "Local banks used to dominate top-tier corporate advisory work until the leading international banks arrived with their massive balance sheets, strong brands, global distribution and research capabilities and bundled the locals out of this segment."

Now local firms are regrouping to achieve the critical mass needed to hold their own against the foreigners. Most obvious has been an initial consolidation process in the last half of the nineties among the top banks, particularly the clearing banks.

FirstCorp, whose parent company FNB is ultimately controlled by mining house Anglo American, was merged with Rand Merchant Bank (RMB) when Anglo American and RMB Holdings combined their financial services operations in 1998 to form FirstRand, now the country's largest banking and financial services group.

Standard Merchant Bank was merged with the corporate banking division of parent company Standard Bank Investment Corporation (Stanbic) to create Standard Corporate and Merchant Bank (SCMB). UAL Merchant Bank, the first such bank in the country which was established in 1955 by Anglo American and Lazards, was merged with its Nedcor banking group sister companies Syfrets, an asset manager, and Nedbank's own investment banking arm to create Nedcor Investment Bank (NIB).

Only Investec remained untouched by the foreign invasion but it was one of the first to take the competition back onto foreign soil when it embarked on a shopping spree in London, acquiring Guinness Mahon and Hambros among others.

The initial consolidation process at the top end of the market bought time and protected a share of the deal flow for the main local investment banks but, as a result of aggressive recruitment by the incoming foreign firms and fall-out from the newly-merged local groups, there was a high degree of staff turnover as deal-makers and analysts went in search of better deals. The local banks' intellectual capital was suddenly depleted when it literally walked out the door. Senior executives say talent is now spread a little too thinly around the sector.

And the first wave of consolidation worsened this fragmentation because some of the departing staff set up niche ventures of their own. In South Africa's entrepreneurial marketplace, it only took an improvement in stock market conditions in 1998 to trigger a listing frenzy of numerous small but ambitious investment banking wannabes.

Steven Nathan, director and head of research at Deutsche Bank Securities in Johannesburg, says the newcomers originally believed they were capitalizing on what was expected to be a flow of corporate unbundlings of which emerging black economic empowerment firms would be the chief beneficiaries. But the expectations of these groups proved ill-founded because the conglomerates being unbundled by-passed the newcomers and appointed investment banks with research credibility and distribution capability.

The question now in analysts' minds is whether there really is enough business in the local market to keep these smaller firms gainfully occupied. Some have criticized the new kids on the block as being little more than glorified pension schemes for senior banking retreads.

Nathan sees a more pressing challenge for the smaller firms. "The big problem these small banks have is that they generally have too much capital compared with their deal flows and it's going to be difficult for them to sustain returns on equity (ROE) that meet investors' expectations." Although there will always be room for niche players, the reality is that whenever a prominent South African corporate contemplates a major transaction, especially one with cross-border consequences, it nearly always opts for the cachet and experience of a leading global investment bank.

So it is that Merrill Lynch, Deutsche Bank, Warburg Dillon Read, ING Barings, HSBC and Flemings have garnered an ever greater slice of local investment banking business. JP Morgan, best known locally for its fixed income business, has recently emerged as adviser to Stanbic, which is the target of a hostile bid from Nedcor, its smaller rival.

Local investment banks have carved out a profitable niche for themselves targeting companies outside the top 100. The issue this raises in investors' minds is the quality and sustainability of their earnings. A particular feature of South African investment banks - and a surprising one given the entrepreneurial nature of the market and its participants - is their inability to view fees as their main income source. Almost without exception, local investment bankers tell of their need for annuity income.

Some analysts point to the notorious difficulty of getting local corporates to pay fees, others say it is merely a case of conservative bankers seeking to smooth the peaks and troughs of volatile emerging market income streams. But the obsession with annuity income also indicates that, in their hearts, investment bankers recognize the scarcity of northern hemisphere-style deals in their small market.

Duff & Phelps, the credit rating agency, recently calculated that only 8.4% of local banks' non-interest income is derived from knowledge-based fees. Of the larger local houses, Rand Merchant Bank, now enlarged by the incorporation of FirstCorp, wins most of the big ticket domestic merger and acquisition (M&A) advisory roles. In addition to using its own balance sheet, it can call on three tiers of connected private equity funds. RMB has led the charge into the Australasian market with a strong presence in the cross-border M&A business as well a specialist presence in the region's deregulated energy sector.

Investec recently followed RMB into Australia but its predominant international focus has been on London, where it has aggressively expanded through selected acquisitions into asset management, stockbroking and classic merchant banking. FirstRand, RMB's parent company, and Investec are likely to retain their independence in the longer term, consolidating their profitable niche positions. But the same cannot be said with any degree of certainty of their local peers.

SCMB is without doubt a significant force in investment banking locally, working closely with its Standard Bank London and New York operations in providing an informed and experienced African investment portal. Its sheer size in the treasury and corporate banking market also give it easy access to top companies locally. But, until Nedcor's bid for Stanbic has run its course through South Africa's complicated regulatory and legal bid framework, SCMB's future will remain uncertain.

NIB's own independence is by no means guaranteed. It has been searching unsuccessfully for a foreign partner for all or parts of its business for a number of years. Despite having a dominant position in the local structured and project finance arenas and a strong treasury function, it has had difficulty in retaining corporate advisory talent and its asset management and property divisions have underperformed.

BoE Merchant Bank has maintained a low profile ever since parting company with NatWest after the British bank's restructuring in 1998. BoE has disappointed in recent years by failing to capitalize on BoE Securities' first-class research resources, in which Royal Bank of Canada Dominion Securities has a stake. RBC DS is unlikely to want to increase its South African exposure if, as expected, the BoE group as a whole becomes a break-up bid target for a cash-rich financial services house such as Liberty Life. The sorely neglected merchant banking and securities arms would be spun off, perhaps to SCMB or even a foreign buyer. Yet BoE Merchant Bank has just confounded its doubters by setting up its own London-based corporate finance capability.

Gensec, the investment house, also maintains a low profile and retains some of the more established investment banking talent. Its focus is on a significant private equity portfolio and it has recently expanded into banking. It is difficult to imagine it ever losing its independence and far easier to envisage it facilitating consolidation within its own sector

At the lower end of the market, early action can be expected. AMB Holdings was South Africa's flagship black-controlled investment bank until New Africa Investments (Nail), its controlling shareholder, decided to unbundle it. It is widely known that AMB Holdings has been offered to potential purchasers and its independence is far from assured. Its future probably now lies with DLJ, the US investment bank that has been its partner in AMB-DLJ Securities, a stockbroking joint venture.

Brait, created from the merger of a former empowerment bank and Capital Partners, a leading private equity house, are becoming ever more focused on core competencies of investment banking and private equity, the least understood asset class in South Africa. Brait is likely to remain independent although the private equity activity could well dominate the earnings mix over time as it becomes more of an investment trust.

Peregrine is a highly-profitable owner-managed group that could end up in the hands of a larger but not dissimilar local house such as Gensec. In the meantime it has been on its own shopping spree, buying McCarthy Bank early last year and turning it into South Africa's first information technology investment bank. The bank's balance sheet has enabled it to conduct classic investment banking and private equity transactions.

Real Africa Durolink (RAD), once a highly-rated empowerment-flavored structuring house, appears to have become a bid target in recent months. It fell from grace when it issued a profit warning that reinforced analysts' concerns about small over-capitalized banks and low returns on equity. RAD would also fit well in the Gensec stable.

Mettle, yet another owner-managed structured finance house, recently caused a stir when it was thought to be poised to lead the break-up of TBB Holdings, a small banking and investment group. In the event, following a confused bidding process, the more established PSG Investment Bank emerged successful. Its acquisition of TBB Holdings could yet herald the long-awaited wave of consolidation among the smaller banks.

PSG Investment Bank, like sector peer AMB Holdings, has a demandingly-large capital base but believes it can deliver a high ROE. PSG adheres strictly to the traditional fee-earning interpretation of investment banking and only wants to increase the annuity income element of its earnings if it can do so without swelling its asset base. As André la Grange, PSG's group chief executive, says: "There's certainly scope for industry rationalization and a shake-out...I think there's a fun period ahead in banking."

He may be right, but with the benefit of hindsight, the Johannesburg Stock Exchange may just have allowed too many insubstantial newcomers onto the market and the Reserve Bank may have been too quick to issue banking licenses. Sadly, the principal obstacle to consolidation will most probably be injured egos.