JIM FORESE IS no equities banker. He’s never worked in equities before, let alone traded a stock or managed an IPO. And he probably never thought he would. But at the end of May he was promoted from his role running Citigroup’s emerging markets local finance to become global head of the bank’s equities division.
“That’s a real wake-up call for all of us,” says a senior equities banker at a rival firm. He’s not referring to one of the rumours about why Forese displaced former co-heads Robert DiFazio and Arthur Hyde, both career-long equities bankers: that rumour ponders whether it was the loss on the Nextel-Motoral exchangeable earlier in the year that led to the change. Citigroup allegedly lost around $50 million on the deal. Some reckon it was more than that.
It probably didn’t help, but one bad deal wouldn’t have been enough to prompt Citi to ask Robert Rubin, chairman of its executive committee, to carry out a strategic review of the whole equities business.
Rather, what’s being referred to is the fact that Forese made his name running businesses at the time when they were going through severe margin pressures. Before running emerging markets local finance he was in charge of global interest rate and derivative products, a role he took on in 2001 after six years as head of European fixed income and global emerging markets. “His appointment is a sign that we in equities have to do the same,” says the equities banker. Citigroup’s saying nothing officially, but one insider says that Forese “is bringing a fresh set of eyes to the business. He’s got extensive experience running fixed-income businesses, and equities is starting to look more and more like those. He’ll be looking at the equities business from a profitability standpoint.”
Profitability is the new buzzword for equities bankers. Gone are the mantras of the 1990s that the business should be big and global. Instead it’s about how to add value and, more important, how to be profitable. And it’s that second goal that senior equities bankers are not so familiar with. In the past you were either already a top-tier equities house raking in the cash, or you were aspiring to be one and willing to run at a loss for as long as you could convince yourself that you still had a shot at the big league.
No more follow the leader There’s no obvious model for success in the equities business any more. Gone are the days when to aim to be a top-tier house involved winning lots of juicy underwriting mandates, trading as a principal on wide spreads and racking up a decent number of top-ranked equity analysts.
It’s a very different story now. “We believe many management teams are having a difficult time managing their cash equities businesses in a profitable fashion,” says Glenn Schorr, brokerage analyst at UBS in New York. “In fact, we believe that most are unprofitable in Europe, given the sharp fall-off in activity, and more than half are in the red in the US.” There is a general consensus among equity banker professionals that as few as two investment banks actually made money from their cash equities business in Europe this year if revenues from proprietary trading are excluded. Predictably, all the banks claim to be one of them but decline to say who else they thought made money.
A drop in trading revenue JPMorgan has been among the more honest about the profitability, or lack of it, of its cash equities business. Speaking at UBS’s financial-services conference in April, investment bank CEO David Coulter admitted that cash equities was the most problematic of its businesses, and one that “ought to be a break-even business in 2003”.
The reasons are so well known it’s almost a cliché to repeat them: a dearth of underwriting business, more fee-sharing on those deals that are getting done, costs of building new technology platforms, and much narrower spreads in secondary trading. Research published this June by Mercer Oliver Wyman and Morgan Stanley indicates that cash market revenues are down 30% in Europe and 24% in the US and the revenues of the top eight global brokerages are half the 2000 figure, though still 50% above 1998 levels. Second-tier brokerages have been hit even harder. Their revenues have fallen to just 75% of 1998 levels. Swiss private bank Julius Baer decided to give up on institutional brokerage this July after its Julius Baer Brokerage lost $14.5 million in the first half of the year. Some US investment banks are now making 20% to 30% of what they were two years ago.
Three years of poor returns have prompted most players into a fundamental rethink of what they want their equities business to look like. “Everybody’s going broke doing what they used to do,” says the head of equity sales at one of the major investment banks in New York. “You can’t just throw lots of stuff against the wall any more and hope something sticks.”
For some that has meant closing or significantly reducing parts of the business. Last autumn, JPMorgan announced that it was reducing its presence in cash sales and trading, equity capital markets and equity research after reporting losses of $254 million in equities trading in the third quarter. Henry McVey, a brokerage analyst at Morgan Stanley, estimates that before it took the decision to scale back its equities trading platform in the third quarter of 2002, JPMorgan’s equities business was losing between $400 million and $600 million a year on a shareholder-value-added basis. Earlier this year Banc of America Securities closed the European equities business that it had started less than three years before.
These were bold moves. Both banks, especially JPMorgan, had committed themselves publicly on numerous occasions to building full-service investment banks in the major geographic regions. Economic realities, though, have started to bite.
| Clark: the carnage “is an amazing opportunity to reposition the franchise” |
But it’s not all doom and gloom. The more canny executives have already realized that there are opportunities amid the carnage. “For the first time, we’re not following anyone else’s lead,” says Mike Clark, global co-head of equities at Credit Suisse First Boston. “This is an amazing opportunity to reposition the franchise.” For Clark, one of the more obvious ways of doing that is to stop chasing league table positions. “We can be fifth, sixth or seventh in the league tables but in the top three in share of wallet,” he says. Equity league tables used to be the purest of the lot, but not any more. “The league tables, in general, are less important than they were three years ago,” says Jeff Edwards, global co-head of equities at Merrill Lynch. “There used to be a very high correlation between the volume of new business you would do and revenues. That’s less the case now.”
It sounds ominously like the fixed-income markets a few years back. No wonder bankers were so intrigued with Forese’s appointment.
Some of the better ideas about equities profitability can be found in unlikely places, and those firms that are top-tier, or aspiring to that status, would do well to take a good look at what they are doing. One of the few firms touting the growth potential of its equities business, for example, is Barclays Capital.
It was the first financial institution in recent memory to get out of what gloating competitors referred to at the time as the higher-margin businesses of cash equities, equity underwriting, and mergers and acquisitions. In 1997, after years of underperformance despite large investment, it sold the European and Asian equity and M&A businesses to CSFB. In the past couple of years, though, the firm has been marketing its equity derivatives and convertibles skills, as well as maintaining an equity prime brokerage business. “We’ve been involved in most of the rights issues in Europe this year,” Bob Diamond, the investment bank’s CEO told Euromoney in May. “And we’ve worked on derivatives wraps and the like for several hedge funds and funds of funds. The equity niches we’re in are going to be an area of growth.”
It’s not making a large impact, at least not in the league tables, but that is the point: BarCap appears properly to be adhering to a strategy of building the business profitably rather than shooting for attention-grabbing deals to push it up the league tables. It has, for example, built a small convertibles team, but bankers’ desires to bulk up the desk were kept in check until the firm had actually won some business. After acting as joint bookrunner with Crédit Agricole Indosuez Lazard last month on a e295 million convertible for Essilor, it was authorized to hire another banker.
Niche does the job Diamond asserts that it’s a strategy that has served Barclays well across all the investment bank’s businesses, and that also holds the group back from getting back into the whole gamut of equities business. “From an industry wide point of view,” he says, “the cash part of the business has not, on the whole, right-sized itself for success.”
Commerzbank is another institution that appears to have found a profitable niche. The German bank began its Europe-wide push into the equities business just as Barclays was getting out of it. It enjoyed some success initially, although there were some questions as to just how profitable the division really was. As markets worsened, though, it became clear that a pan-European strategy to rival UBS or Merrill Lynch was not going to succeed, so the division has been restructured.
Commerzbank’s research unit, for example, has been partly integrated with credit research. The two teams sit together, share figures, and discuss the outlook and the impact of management initiatives of the companies they cover. In certain cases they will even produce combined reports.
In capital markets the bank created a capital structuring group that employs a small number of bankers with extensive experience across all products. Its head, Michael Williamson, has worked in debt capital markets, securitization, derivatives, equity capital markets and convertibles at several banks during his 25-year career. “For clients reviewing their approach to the capital markets it’s helpful to be able to discuss a wide range of options on a visit,” says Williamson, “and it doesn’t matter to us what product they finally take because there is no internal competition.” Deal execution is then handled by product specialists.
Commerzbank is trying, with some success, to carve out a rather unusual niche for itself. It is looking to be an adviser to issuers on large deals where it has little chance of being the bookrunner. It played this kind of role in the March 2003 e15 billion France Telecom rights issue. Commerzbank advised France Telecom on how it could manage an innovative competitive bidding process for the underwriting of the issue between the eight joint global coordinators and 13 other managers. In return, as well as winning a portion of the underwriting the bank got additional fees for its advisory work.
It’s a role that bulge-bracket firms have no interest in taking, because they want the glamour of being bookrunners, but it’s also one that isn’t necessary on many deals. “It’s not every deal but there will be a couple a year and we don’t even need to secure all of those before we start making money,” says Williamson.
Rivals may scoff at the lack of glamour, but Commerzbank Securities is making money from trading and according to executives is on course for close to a record year in terms of revenue generation and return on equity.
Others are focusing their efforts on the parts of the market they see being abandoned by the big City and Wall Street firms. One such area is coverage of small and mid-cap stocks. These have suffered from a lack of decent sell-side coverage as the larger houses pulled back to concentrate on larger companies that both need more capital markets advice and are more actively traded in the secondary market. Merrill Lynch is perhaps the most high-profile of the larger houses pulling back as it cut the number of Nasdaq stocks it was market-maker in from 10,000 to 2,400 last year.
It’s an area that boutiques and smaller banks can focus on. “Investment banks need to carve out a niche in equities,” says Rob Gales, head of equities at First Albany. “We’ve picked the small and mid-cap companies as ours – those with market caps of between $200 million and $2.5 billion. “There’s been a degree of apathy at larger houses towards this part of the market, and many have abandoned it.”
But it’s not just the smaller investment banks that regard this part of the market as an opportunity. ABN Amro is basing its European equities platform on a similar segment, explains Tim Boyce, CEO of the Dutch bank’s global equities division. “A lot of value for investors is in the small and mid-cap range, whereas most investment banks only cover the blue chips.”
CSFB’s Clark has also been looking at this part of the market. His bank’s idea is to cover such companies through clever use of Holt, the quant-based equity-research business the bank bought early last year. Clark and co-head Jim Kreitman explained the idea in a memo in mid-June outlining strategic initiatives the equities division was taking. The idea behind increasing research coverage of small- and medium-cap stocks in the US, they explained, “is to offer our clients investment advice on a multitude of companies – around 200 stocks initially – for which the coverage has been dropped or significantly curtailed by the large majority of bulge-bracket firms”.
Using technology to increase business while keeping costs down over the longer term is something most are trying, with varying degrees of success. Trading is where it’s being applied most aggressively. Goldman now talks about its equities business as a connectivity, execution and clearing business, in part thanks to its acquisition of Spear Leeds Kellogg at the top of the market in 2000. Lehman has invested heavily in automating its trading and wants to expand its presence in the equities business including prime brokerage. Its electronic platform has become the price discovery mechanism for its equities derivatives business and Lehman estimates that across its entire equities business about 50% of the volume is handled electronically.
CSFB’s Clark points out that it has now rolled out to clients the state-of-the-art trading black box that it formally used only internally. At the end of July the firm announced that it was combining its advanced execution services platform with its programme trading and portfolio analysis groups. What’s more, it appointed London-based global head of AES marketing, Richard Balarkas, to run a new group called equity trading services.
At first sight it doesn’t appear to be much more than a new marketing gimmick. But the point appears to be that CSFB will be able more readily to address the trading needs of the various types of client, be they hedge funds, pension funds, insurance firms or any others. So if an investor wants to unbundle sales trading and research, CSFB will be in a better position to meet such requests. It could also entail simply persuading clients that CSFB has as good, and as cheap, a platform for executing simpler trades as the direct-access companies do.
The benefits of the long-term planner The bank that appears to have had the most success with electronic trading is Morgan Stanley. “Back in 1994 the firm decided to build an electronic trading platform to make markets for our clients in an electronic, artificial intelligence way,” Vikram Pandit, co-president of the firm’s investment bank, told investors at UBS’s financial services conference in April. “Today over 90% of our cash equities business is traded electronically. It’s the same strategy on the options side, where we trade 50,000 instruments in 550 names, almost from a standing start in August 1999.” Average trade volume has grown every year since, 79% in the first year and then 41% and 33%. Thus far this year it’s up around 40% on 2002.
Banc of America Securities is hoping to emulate Morgan Stanley’s success. As with one or two other smaller equities houses that have done well in terms of profits in recent years, such as Société Générale, BofA has relied on its highly profitable equity derivatives business for the past three or four years before moving into cash trading and underwriting in a more significant way. On the trading side, last year it hired Peter Forlenza as global head of cash equities and Ciaran O’Kelly as global head of equities trading, both from Citigroup.
The two set about reconstructing the bank’s trading desk almost immediately. The first step was to get the right people in place. “We identified the best sector traders across the Street and believe we hired 19 out of the top 20,” says O’Kelly.
The bank now has 40 cash traders, for all US stocks whether on Nasdaq or NYSE. Some houses have that many traders just for Nasdaq stocks.
Next came the technology. They decided to buy rather than build, spending an undisclosed sum earlier this year to buy Vector Partners, a broker dealer specializing in programme-trading strategies.
Any bank with pretensions of having a full-service equities platform needs to be a player in programme trading, as such strategies regularly account for 35% or more of NYSE trading volume, occasionally hitting as much as 50%. But, says Forlenza: “Vector isn’t just about programme trading. We’re integrating those methods into the entirety of our trading platform.” The bank hired Raj Nagella to help; he was one of the key people who integrated the Hull options brokerage technology into Goldman Sachs. According to Forlenza, up to half of trades done by investors could be handled more effectively by algorithms such as those provided by Vector. “These could almost be considered maintenance trades,” says Forlenza. “But they’re high maintenance. You might be asked to sell 200,000 shares of a company in two hours, never be more than 20% of the volume, and make VWAP your target, for example. These trades are done according to a specific formula.” To put that trade on, a buy-side trader would have to participate actively in the market, with volume, and continually make intelligent decisions based on his view of the stock’s relative price levels. Forlenza says: “A trader using an algorithm, on the other hand, can work this trade much more efficiently.”
Keeping these trades, as well as the more simple maintenance trades, coming through is crucial for banks. It keeps them close to the flow and close to market information, which can be a huge benefit when bidding for overnight block trades with tight fees and re-offer prices. For some of them it also increases the possibility for internalizing order flow, thus cutting costs. The problem many banks have is how to execute these trades in a way that is cost effective for the client as well as that makes them money. Direct-access platforms can execute maintenance trades more cheaply, at least on paper. Using Vector and a smaller number of very experienced traders, Forlenza hopes to be able to process more of these kinds of algorithm-driven trades, leaving his traders free to focus on more sophisticated transactions. If they get it right, they’ll be able to get investors to use them both for the maintenance trades which pay just one or two cents per share as well as the ideas-driven, capital-intensive and other more complicated trades that can pay up to seven cents.
Ever tighter margins Having the right technology is not always enough, though. Even with so much more being traded electronically and bringing down costs, Morgan Stanley’s equity trading results in the second quarter were 9% lower than in the same period last year. The bank might not be doing as much prop trading, or it might have lost some money on it, but the economics of trading have changed dramatically in the past three years. Decimalization has cut spreads, asset managers are trying to cut costs, and programme trading, which can account for up to 50% of NYSE order flow in any given month, is generally transacted for lower fees than single stocks. According to a Greenwich Associates report published in June, investors handing out commissions of $20 million a year or more are paying 2.8 cents a share for programme trades, while those handing out $50 million or more pay 2.4 cents. That’s compared with a single stock average of around 4.5 cents a share.
“All this is causing the sell side to analyze profitability client by client in order to price its services and execution properly,” says UBS’s Schorr. “While time will tell if any broker dealer can afford to really fire a client, clearly we believe this is the next stage for the business and will be an integral part of improving profitability in the future.”
In fact, according to bankers in Europe, it has already happened. Goldman Sachs is now covering less than one-third of the institutional equity investors in Europe that it once did just a couple of years ago. The US investment bank has allegedly pared back the number of buy-side clients to around 150; at one point in the boom years that list reached nearly 600.
Goldman has also reduced the number of equity research analysts in Europe and, say competitors, has moved some of them over exclusively to aid their proprietary traders.
On the one hand that might not be as important as it sounds. For years now smaller institutional investors have complained that top-tier sell-side firms and their aspirant rivals only really cared about the 50 largest fund managers since they paid anything up to 80% of total commissions. But to make a policy actively to cut back institutions covered is a startling admission of the lack of profitability in trading. A firm such as Goldman Sachs finds it especially tough: it has neither a retail platform nor a large private banking network to share the costs of research, for example.
But it’s not just in trading that bankers are tiering clients more openly; it’s also happening on the capital markets side. To be profitable we all have to customize our relationships with issuers,” says John Havens, global head of equities at Morgan Stanley. “The way you cover GE is going to be very different to how you cover a company with a market cap of $2 billion that rarely uses the capital markets.”
It’s this kind of thinking that lay behind the decision several firms have taken over the past 18 months to merge in some form or other their debt and equity capital markets teams. Dresdner moved first, in the spring of 2002, followed by Morgan Stanley last summer. Goldman and Lehman have since followed suit, although Goldman only in Europe. Others are still pondering the move. Some deride the development as a bear market strategy, a way to cut costs. But in one respect it’s really little more than an attempt to formalize what bankers should have been doing in the first place: putting the needs of the client ahead of bankers’ product fiefdoms, political intrigue and bonus pool arrangements.
Lehman’s creation of its global finance platform in May fits that bill. It’s one of the few firms that really did seem to have senior debt and equity bankers, as well as M&A and derivatives bankers, who knew what each other was doing, and cooperated with each other. The global finance platform formalizes that by merging the functions of only the senior debt and equity staff and not merging teams all the way down, as others have done. Thus, they argue, they get the benefits of cooperation and coordination while keeping their product specialists in place.
But there have also been clear business benefits from merging debt and equity capital markets, as Morgan Stanley appears to have proved in the past year. After a sleepy 12 months before the merger, for example, the investment bank has become one of the most powerful convertible bond houses in the US. That, says Havens, is where the merger has most clearly worked.
Goldman Sachs, one of the more recent converts to the idea, seems to be hoping to find cross-selling opportunities even further afield. “If your offering is fragmented you cannot ensure that you are giving the best advice,” says Hugo Van Vredenburch, head of Goldman’s European equities business. “There is tremendous value in the seams,” he says. “By working together and having a more holistic view we can give more independent advice and spot more opportunities. For example, if a portfolio manager tells us he’s just won a new global mandate, our salesmen now have the chance and the knowledge to spot opportunities for transition management deals. Few of these types of connections would happen in the past.”
Greater coordination – at last Having single client captains coordinating across product groups is also supposed to help the firm to sell more complex higher-margin business to clients and to come up with more innovative trading ideas. Through greater coordination, a firm like Goldman can theoretically harness its view of what’s happening in the stock lending market to benefit its long-only clients. It can do this, for example, by seeing what’s hot in the stock lending market and then approaching long-only clients with a delayed settlement trade with itself that will allow them to benefit from the economics of a hedge fund play without shorting or lending stock directly.
The idea of coordination makes sense but how it works in practice is crucial. Goldman says that its product teams now sit together, but when pressed explain that they “virtually sit together”. In other words they don’t sit together at all. They’re encouraged to communicate more and are given the incentive of a shared bonus pool. That’s not quite a merger.
It sounds much more like trying to feel one’s way in the dark. And that is pretty much where many banks’ equities businesses are right now, and it’s not always their fault. “The fundamental managers, the mutual funds and the long-only managers don’t know what they want yet,” says a senior executive at one of the top investment banks. He’s referring to research, but it could just as easily apply to the whole equities business.
The truth is, no-one knows yet what the equities model will look like, or even if there will be a model for several or all to follow. “At this point in time I’d be suspicious of people knowing what the future of the business will be like,” says Sergio Ermotti, global co-head of equity markets at Merrill Lynch. “Who could have predicted things like CP176 a few years ago? You need to be as flexible as you can. How can we be an economically competitive provider of execution and provide a high quality of service at the same time? Well, it’s a balancing act. We need to think of how much we will be paid for advice and execution going forward, and what makes sense for us and for our clients in that regard.”
These aren’t the words of sure-footed bankers. But it could be the lack of a standardized model to ape that will make the equities business over the next year a more exciting place to be. “I do sometimes get sick of all the whingeing,” says one senior equitie banker. “And that makes me want just to quit and go and be a teacher or something. But these are exciting times, and it can be invigorating.”
That will all depend on what happens in the next five months, though. If markets remain in the trading lull of the last month, and if new equity issuance doesn’t pick up somewhat, there could be more whingeing, and more cutting of staff, to contend with.
