Equity: ECM throws a shadow over European banks
Banks weigh shuttering ECM as volumes collapse; Much depends on UniCredit deal
Global equity capital markets volume fell 31% in 2011, with a notable decline in fee earnings from this business for banks in Europe of 24%. As banks struggle to adjust their operating models to constrained supply of funding and capital, many are quietly wondering what returns they can expect from continued investment in European ECM.
It remains a marquee business for any corporate and investment bank keen to maintain relevance with corporate chief executives and not one that banks are ever keen to exit. But the cuts at some banks are drawing ever closer.
Last month, Crédit Agricole announced its intention to withdraw from equity derivatives. UniCredit has outsourced Western Europe equity research and execution to Kepler Capital Markets in a strategic alliance that the bank says will support its continuing ECM business. The market is awash with talk of job cuts at many firms, even if they are not announcing complete withdrawal.
"There are probably 15 to 20 banks in Europe that would like to raise equity, just not at these values. Many will formalize their plans once they see the outcome of UniCredit"
Craig Coben, head of EMEA equity capital markets at Bank of America Merrill Lynch, and Oliver Holbourn, head of equity syndicate, presented the firm’s forecast for the business in 2012 last month. The volume charts paint a particularly disappointing pattern. EMEA equity capital markets volume was $301 billion in the first full year of the financial crisis in 2008; it rose to $374 billion in 2009, as banks and corporations repaired balance sheets; volume declined to $210 billion in 2010 and reached barely $180 billion for 2011.
The short-term trend is even more alarming, with just $33 billion raised in the five full months from July to November 2011. Annualize that and the outlook for 2012 would be a pitiful $80 billion of equity-raising volume. The firm projects volume of between $150 billion and £200 billion in 2012 but that’s just a guess. "In all honesty, no one has any idea," says Holbourn. He adds: "It’s hard to see the market for equity issuance recovering until investors see a credible plan for resolving the eurozone’s sovereign issues."
Equity is a bottom-up, stock-picking game. With the equity markets dominated by macro fears related to the eurozone sovereign debt crisis, all financial assets highly correlated, economists sharply cutting growth forecasts and 72% of fund managers that BAML surveys expecting an EU recession in 2012, conditions couldn’t be much worse for raising equity.
Holbourn points out that, even with institutions heavily underweight European equity and mindful that they could miss a sharp rally if eurozone leaders were finally to come up with a grand plan, institutions are long cash and not putting money to work yet. Rather, they have hedged themselves by buying out-of-the-money call options on liquid indices during periodic relief rallies. The rallies have usually run out of steam. "At an asset allocation level, almost no one is devoting more money to European equity," points out Coben. "So even if investors do want to buy something, they have to sell something else first."
In a slow year for equity-raising in 2011, the busiest stock market sector was, once again, financial institutions, as it also was in 2010 and as it regularly is. But for how much longer? As of December 2 last year, European bank stocks had lost 32.2% of their value in 2011. "A number of peripheral banks are uninvestable," says Holbourn. "And don’t forget that the European bank sector ex-UK is now quite small. It has a market cap of just €240 billion and, with the wholesale financing market closed to banks, banks would have to reduce assets by circa €2.8 trillion to get to their loan-to-deposit ratios down to 100%".
The question arises therefore: what on earth possessed the firm to underwrite the €7.5 billion rights issue for UniCredit in November when 10-year Italian government bonds were yielding 7.5%. The firm is on the hook for the rights issue, priced at a 43% discount to the theoretical ex-rights on January 3. After a three-week subscription period, an auction of any rights not taken up by existing holders of the stock will take place on January 27.
After this the firm will know if it is to be the proud owner of a chunk of UniCredit stock. Anything less than a 98% take-up will count as a failure.
The last quarter of 2011 showed the risks for underwriters when Banca Popolare di Milano’s delayed and reduced €800 million rights issue limped to completion with the share price below the underwriting price, a mere 81.7% take-up of the deal, and underwriters left holding a big block in a small and illiquid stock.
BAML obviously thinks it has made a reasonable bet on UniCredit, a long-standing client of the firm’s historically strong FIG franchise, because the Italian bank trades so cheaply on a book value multiple that its overwhelmingly Italian institutional and retail shareholders – most foreign investors sold out months ago – will prefer to stump up cash and support the deal at such a hefty discount rather than surrender ownership at distressed levels to international investors sniffing a bargain. Some core shareholders have announced their intention to take up rights accounting for maybe a quarter of the offer.
Investors won’t give too much credit before they see delivery on UniCredit’s turnaround plans to make a 12% return on tangible equity by 2015. But this is a bank with potentially valuable franchises in emerging Europe and a new chief executive who understands the importance of restoring the profitability of the Italian business. It is one of the most systemically important banks in Europe, with leading positions in Poland, Austria and Germany, as well as Italy.
Every ECM banker and indeed every bank in Europe will be following this deal. Many banks have boldly declared their intention to improve capital ratios by deleveraging. With equity markets closed to them, they can say little else. But unless they intend to sell off good assets – which are the only ones for which there are buyers – retain the bad and go into run-off, they will eventually need to raise equity to meet the costs of selling weaker assets.
"There are probably 15 to 20 banks in Europe that would like to raise equity, just not at these values," says Coben. "Many will formalize their plans once they see the outcome of UniCredit. There have been plenty of bigger European equity capital market deals but never one that has been followed so closely or that will be such a significant litmus test."
The notion that investors will provide yet more equity for banks to absorb losses from selling off existing bad assets, and to cushion against those set to turn bad if the worst fears of European recession are borne out, looks optimistic. One banker says: "Banking should offer GDP growth returns plus a little bit. It was the era of 20% plus annual returns in every geography and every business that was unsustainable and drew capital into banking. In future, capital will flow out of the banking sector. It simply has to."