Here is a sobering thought for those involved in the present round of Wall Street mergers, something they should all consider carefully before congratulating themselves on getting ahead of the pack of middle-rank investment banks. Before they start believing the hype that the joint market share of their combined entities will catapult them to first, second or third place in any particular market, they should ponder how far ahead the leading Firms already are and how they got there.
There are three market leaders in investment banking at present, at least in the high-profile, big-fee world of underwriting and M&A: Goldman Sachs, Merrill Lynch and Morgan Stanley Dean Witter. Between them, in 1999, according to a report by UBS Warburg analyst Clare Nickson, they were involved in 79.4% of global M&A deals (announced and completed), and, as lead managers, controlled 28.4% of debt underwriting, 47.9% of IPOs and 43.6% of secondary equity offerings in the US (based on full credit to bookrunners and equal apportionment to joint leads).
And they have not achieved this by merging with other securities firms, although on the international front Merrill has been a prolific buyer of small local brokers and Morgan Stanley’s purchase of Dean Witter gave it scale and added retail distribution. They did it by being focused and ruthless, by hiring the best people and inculcating distinctive identities and cultures.
That’s not to say that they will remain the top three for ever. Merrill has slipped of late, and does not have a tech franchise to match those of the other two yet. But the chances of in-market mergers of second-tier firms in an egotistic, people-driven business such as investment banking overturning their lead any time soon are pretty slim.
It puts middle-tier firms in a quandary. For all their talk of other businesses that make money in investment banking – derivatives is a favourite of banks such as Deutsche, Chase and JP Morgan – almost all crave to have the league-table presence and the cachet of being a full-service firm along the lines of the big three. They all know that to get there is painful. Mergers are disruptive, building is expensive, and either way usually means undercutting on fees, overpaying staff and taking risks with capital.
League table rankings and a full-service franchise are the glowing lights to the moths of investment banking: too alluring to resist, and too dangerous to approach. But they still do it. Chase is a prime example of a firm that has recently racked up a series of M&A deals to fulfil a mission it has concocted for itself. Despite not having an equities franchise, it still made more money from investment and wholesale banking than most brokers. Yet it was determined to plug what it chose to regard as a gap in its coverage. So it bought First Hambrecht&Quist, then Flemings, and last month JP Morgan.
CSFB for its part has decided that the only way to catch up with the big three is to buy Donaldson, Lufkin&Jenrette, a fiercely independent smaller firm, and hope it can avoid too much internecine warfare over jobs and roles, while tacking DLJ’s league table status onto its own. It sounds like the investment-banking version of trickle-down economics.
At first sight, it looks as if the deal that set off the recent merger mania was UBS acquiring PaineWebber in July for $12 billion.
In fact that was not an investment banking merger at all, rather it harked back to institutional-retail tie-ups like Morgan Stanley’s with Dean Witter and Salomon Brothers’ with Smith Barney. UBS Warburg had in February taken over responsibility for all non-Swiss distribution, and had an obvious hole in the US that PaineWebber’s high net worth retail salesforce could fill. UBSW can reciprocate by feeding PaineWebber’s brokers with equities and bonds from its primary market businesses.
UBS Warburg’s US investment-banking presence still lacks any kind of scale. Aside from the usual selling of European stocks and bonds to US investors, it’s only real domestic franchise is in healthcare. The bank hired Ben Lorello from Salomon Smith Barney last year.
It managed to take inter-dealer broker e-speed public at the end of last year, partly because Lorello is good friends with Howard Lutnick, CEO of Cantor Fitzgerald, e-speed’s parent.
But Warburg has made no significant in-roads into domestic underwriting or M&A, the big money spinners and high-profile markets. This is something of a turnaround for the bank, which signaled its intentions to improve its US coverage at the time of the UBS/SBC merger in December 1997.
The chief executive of another large European bank has some interesting observations on the usefulness of acquiring or merging with middle-tier firms.”What we lack in the US domestically is a solid securities underwriting capability and M&A,” this CEO told Euromoney in July, and thus before the recent spate of investment-banking deals. He continued: “None of the independent firms [at the time DLJ, Lehman, Bear Stearns] can offer us what we need, especially in M&A, but we don’t regard this as a major weakness for us, we can still hire the best people”.
Worse still for the merging middle-rank investment banks, they may be basing their strategies on a reaction to what they believe to be fundamental shifts in customer requirements but might actually be little more than urban myths. That, certainly, is the view of Guy Moszkowski, brokerage analyst at Salomon Smith Barney, who published a report last month entitled Merger mania – writing on the wall, or something they ate?
In it, he seeks to debunk the widely held belief that investment banking is being driven inexorably by the need for huge scale, capital commitment and one-stop shopping. He writes: “There is a notion which has taken hold that, in order to survive and thrive in the investment banking and brokerage arena, a firm will have to be huge in scale and geographical scope. This idea is based on the following thoughts: that clients will frequently need their investment bankers to tap capital markets simultaneously, across the globe; that the clients are seeking ‘one-stop shopping’ for all their investment-banking needs; and that the business will become increasingly capital intensive as clients will demand that their investment bankers make available large amounts of credit as a quid pro quo for directing their lucrative equity and merger business.”
Brains beat brawn
There is something to the first one, he says, but on the others he is more sceptical. First, he says, clients actually like to shop around and indeed are unhappy at seeing their options narrow as competitors merge. Second, only in the highly commoditized debt markets are corporates trying to demand greater capital from investment banks.
For equity new issues and for M&A deals, where the appointment of lead banks is a major decision which company CEOs and boards take, not more cost-conscious CFOs, deals are much less commoditized, as evidenced by the fees.
The average fee on an IPO in the US has dropped from 6.24% in 1991 to 5.46% last year; by contrast high-grade debt deals fell over the same period from 0.54% to 0.35%. There is less margin pressure than in debt markets and more room for specialist providers. Brains count for more than brawn.
Were the arguments truly compelling, he continues, it would show up in the middle-tier investment banks’ net revenue and income figures as well as return on equity. Those that lack scale, capital and a full product set should be doing noticeable badly. As it is, and as the table below indicates, none show any compellingly dire figures warranting their selling or closure, although JP Morgan has performed poorly on a relative basis.
Moszkowski then turns to the three major deals of the summer. First, UBS/PaineWebber, which he ascribes to the fact that PaineWebber lacked product and UBS lacked US distribution and was unhappy with its position in the US wealth management business. “While there are elements of the “mega” argument here, he writes, “the issues addressed were more of complementarity than of sheer mass.”
As for the Chase-JP Morgan deal, Chase is buying skills it lacked – that is, equities – whereas JP Morgan’s reason for selling “had less to do with size per se than with management willingness to take strategic (as opposed to trading) risks. The bank charter could have been abandoned, the business radically restructured, visionary mergers carried out. The sale is about the inability to continue the execution of a strategic vision because it was not pursued aggressively enough, not because of one-stop-shopping or capital intensity.”
He saves his most acerbic comments for the CSFB-DLJ deal: “perhaps the least obvious transaction and the most likely to run into problems”. The reasons for selling, he says, rest solely with Axa, and were “largely pragmatic and opportunistic” – to exit a non-core business. “DLJ as an independent entity would likely not have felt pressure to move now. And it probably would not have acceded to a deal in which it was completely subsumed, given the type of revenue and earnings growth which it had achieved…”
As for CSFB, Moszkowski cannot help but feel this is the institution that has fallen into the trap of reading truth into urban myth. “CSFB may very well have accepted the logic of the scope/scale/capital argument to justify a bulking up deal; but the possibility cannot be ruled out that it is not, in itself, the best rationale for a merger in this industry.”
The trouble is that rationale soon gives way to a herd mentality. Did Chase decide to buy JP Morgan because it had first tried DLJ, rejected the price, discovered someone else was willing to pay it, and simply come to fear being left behind? That’s what Joe Roby, DLJ’s CEO has expressed to the firm’s worried staff.
Is that a good reason to engage in a merger?
As those merging get distracted, competitors will poach their best staff. Within hours of the CSFB-DLJ deal being announced, Salomon Smith Barney had set up an impromptu interview room in a hotel around the corner from DLJ’s office in mid-town on Park Avenue. Lehman is picking up DLJers in Europe.
Leading firms keep acquiring
While those who aspire to compete with them engage in potentially destabilizing mergers, the leading firms are not only likely to consolidate their hold, but are also branching out into businesses that may well keep them ahead of the pack as market dynamics evolve.
Both Merrill Lynch and Goldman Sachs have recently bought market makers in Nasdaq stocks, for example. In June Merrill paid just under $1 billion for Herzog Heine Geduld, and last month Goldman paid $6.5 billion for Spear Leeds Kellogg, which also has a New York Stock Exchange specialist business, an electronic order platform and a clearing business.
For the most part these two deals are complementary to existing businesses at the investment banks, allowing the two to trade many more stocks – HHG increases Merrill’s trading coverage from 650 to over 8000 stocks.
More important, these two additions will allow Merrill and Goldman to internalize order Flow much more, so cutting costs as well as increasing commissions. They will also grant the investment banks access to a much greater level of information on patterns of trading and distribution as the growing influence of smaller professional players and retail investors change the dynamics of equity markets. Such knowledge will play a key role in how banks will distribute equity offerings and play the secondary market.
Meanwhile, it remains to be seen whether the CSFB/DLJ and JP Morgan/Chase deals will provoke further consolidations. Bear Stearns and Lehman Brothers are the only middle-tier US brokers left now. Moszkowski mentioned Bear Stearns as a merger or takeover candidate following the PaineWebber deal, after he met with CEO Jimmy Cayne. It is not an immediate and obvious fit for anyone, however, unless Lehman wanted to do a pre-emptive deal to prevent any unwelcome offers from elsewhere.
Lehman is still enjoying the fruits of independence: it split from its disastrous merger with American Express in 1994, spent three years restructuring, and the last two (bar a mini-blip in the 1998 meltdown) making money hand over fist. Its most recent results beat analysts’ estimates by a mile, and CEO Richard Fuld is apparently loath to sell out, though he may not be averse to having a little takeover speculation boost his stock price.
So if there is any more activity, where will it come from, and will it be justified? The biggest rumours at the end of September involved, separately, Goldman Sachs and Merrill Lynch. Gossip that the former was about to buy Charles Schwab surfaced again.
They have an excellent working relationship, especially for Schwab to distribute Goldman-led debt deals to retail investors, but it’s not clear whether Goldman is ready fully to take the plunge into retail, or that Schwab would want to give up its independence again.
It was, for a time in the 1970s and 1980s, a part of Bank of America, a link it viewed as disastrous.
And speculation is still rife about Merrill. Links to Chase pretty much died out after the latter bought Flemings in April, but now HSBC is the big rumour. The two have an ex-US on-line mass-affluent banking and investment joint venture, and many expect a more formal link between the two firms at some point. But Merrill prefers to control its own destiny and executives would feel swamped by a merger with such a large bank, and a foreign one at that.
Deutsche Bank has even been mentioned as a possible buyer. Lacking a US stock listing, it is unlikely to be able to afford Merrill, and the US investment bank is unlikely to surrender to a bank where one of its former employees, Edson Mitchell, now sits on the Vorstand. Merrill’s debt markets operation would cease to exist once Mitchell finished with it.
| Net income of US investment banks (1995-1999) | ||||||
