THE CEO OF a leading investment bank recently offered Euromoney a telling judgement on the state of the sector. “There is now more talent outside the industry than inside it,” he noted, reflecting on the exodus from the big banks of some of their brightest and most successful people.
After a decade-long boom, the crash and retrenchment plus the exposure of wrongdoings and moral failure have created a revulsion against the wholesale financial services industry among its own.
Among the many tens of thousands quitting or being forced out from the big banks, many have squirrelled away the private wealth to found their own firms. New technology makes setting up easier than ever.
Previous market downturns have spawned new boutiques, but never before on this scale. The whole industry is re-inventing itself. In part this process marks a return to the old private-partnership model of investment banking. There are also new themes this time around.
The increasing specialization of financial markets makes it possible for those with a particular skill to thrive outside a large organization. Big banks, with their post-merger politics and their bureaucracy, can often stifle their best talent. They can miss large gaps in the market. And they have their own management problems to resolve.
A senior executive at a stand-alone investment bank has a theory about why Citigroup CEO Sandy Weill appointed Chuck Prince as his successor in July. “He’s a lawyer who knows nothing about banking.” (It’s slightly uncharitable since Prince has worked for Weill since the 1980s even if not actually running any businesses until last year.) “Lawyers are the military police of banking, it’s their job to make us miserable and say no, not to run the bank. But their biggest risk is legal risk, and that they might get broken up as a result. You’re going to need a good lawyer in charge if that happens.”
It’s not just the universal banks that clients are angry with. Disgusted at the slew of problems in which investment banking is mired, regardless of which model the bulge-bracket firms espouse, clients are increasingly looking for alternatives and for top-level, independent advice.
There is more than enough wrongdoing – real and suspected – to keep anyone enraged: tying loans to the promise of better fee-paying investment-banking business; misallocating IPOs to make a fast buck; publishing misleading research to win corporate business; front-running client trades; backing and arranging borderline illegal deals for fraudulent companies whose shares you’re tipping; recommending deals and trades because they suit the intermediary better than the client. The list goes on.
Fund managers in the dock Nor are the shortcomings limited to the sell side. There has been more than enough buy-side incompetence and complicity to indict the fund-management industry of, at the very least, stunning mediocrity – of being happy to score returns somewhere near an index or group of equally mediocre peers, regardless of actual returns to the poor souls who have entrusted managers with their money.
The buy side too is being reborn. Consider hedge funds, small outfits that often command more information on and better understanding of particular markets than any large investment bank.
It is exactly this kind of environment – one of retrenchment, lay-offs, discontent, regulatory uncertainty and technical innovation – that spawns change, sometimes radical change. And there are more than enough bankers and fund managers out there willing to try to effect it, among them some of the brightest people on the street.
These talented individuals are undertaking selective breeding, trying to identify the best characteristics of the banks they are leaving to create vibrant new entities.
Hardly a week has gone by in the past three years without at least a handful of bankers letting go of the security blanket of their large investment houses to set up a small advisory firm, a new trading firm, or, most appealing, a hedge fund.
Many of them are trying to exploit specialist niches. Some of the new firms, though, such as Integrated Finance Limited [see Euromoney September 2003: The new advisors] are set to take on the big guys on their own turf.
Consolidation has created large organizations, each focusing on the same larger clients that are among the most active capital-markets users and investors. One consequence is that a lot of corporates have been left without much decent coverage or none at all; another is that there are enough bankers who do not want the headache of working in the politically charged, administration-heavy environment of a big investment bank.
At the same time core client-based revenues for investment banks have got smaller. Technology has brought down margins in many formerly lucrative businesses while also forcing increased expenditure, at least in the short term, on IT upgrades. Meanwhile, fees are dropping, especially for capital markets bookrunners, as more debt and equity underwriting mandates are being shared among more players. Whether this particular change will reverse if and when issuance picks up is anyone’s guess.
The point, for now at least, is that the established investment banks have had to trim staff, chase smaller fees, shrink their coverage universe and concentrate resources on core clients, and rely increasingly on proprietary trading to make the numbers each quarter.
Smaller firms can step in here.
Their expense base is much lower, and their bankers have the luxury of not having to worry about public shareholders. In bear markets it can be a distinct advantage to have the old private-partnership structure.
Bulge-bracket investment-banking executives seem to comfort themselves with the thought that the growth in boutiques is the result almost exclusively of the huge number of bankers they have laid off in recent years. “Look back to the end of 2000,” says one such incumbent. “Each of the major investment banks in the US had an average of 1,800 people working in investment-banking advisory. Now that number’s down to 800. That’s 1,000 people per bank trying to figure out what to do when they can’t get a job at another bank.”
The clear implication is that they will be desperate to return when the market rallies.
The most powerful motive of all Maybe that’s so. But there may also be a more significant separation – between the talented, entrepreneurial and client-rich heading to their own firms and the second-rate foot soldiers left behind to churn falling volumes at the big bureaucracies.
And remember that many of those leaving the industry and setting up on their own are being driven by the oldest and most powerful motive of all: money.
The most popular destination is the hedge fund industry. In the bear market of the past three years hedge funds were among the few investment vehicles that managed to make money. The lure of big pay – the more successful, established hedge funds pay their traders 20% of their profits, or more – less regulation and less politics has proved irresistible to many.
Some are the bank prop desk traders wanting more control of their lives, and salaries. Others come from the traditional buy side. Tom Hughes and Andrew Parry are two such examples, CIOs of Deutsche Asset Management and Northern Trust respectively, who each left to set up their own shops in the past 12 months.
There are plenty of M&A bankers, capital markets professionals and strategists getting into the game: Barton Biggs, the renowned strategist for Morgan Stanley Asset Management, left earlier this year, with seed capital from his old firm, to set up his own hedge fund, Traxis.
There are now, so the estimates have it, at least 5,000 hedge funds out there. That’s a huge change. Sandra Manzke, co-founder and co-CEO of Tremont Capital Management, recalls: “When we started in 1983 we could find just 68 hedge funds. It was a billionaires’ club really, and you needed at least $100 million in assets to be taken seriously. Now there are so many out there, of vastly differing quality, and it’s so expensive to track them. And a lot of them have just $30 million, or less.”
As Gramercy Advisors co-founder Robert Koenigsberger tells us, there won’t be that many around for ever [see Transparent about distress, this issue]. And some estimate that the average lifespan of a hedge fund is just four years. But they are exerting a profound influence both on the markets they trade and on the shape of the asset-management business.
There’s a shift to focus on absolute returns rather than relative returns, for example, an approach Jonathan Compton took when setting up his asset-management business, Bedlam Asset Management [see Dealing with market madness, this issue]. Mainstream fund managers have set up internal hedge funds in an attempt to hold on to their best portfolio managers and also to reap some of the rewards, or they’ve outsourced and put money into fund of hedge fund products.
Soon it will be almost as easy to trade hedge fund indices as the S&P500.
The rise of hedge funds has also taught long-only traditionalists the benefits of being able to go short. More equity investors are cottoning on to this. In fixed income too a rapid rise in credit derivatives has opened up credit to efficient shorting.
That has profound implications for both corporates and investors, which means they need advice. And that’s not an area in which the investment banks necessarily excel, according to David Shimko, founder of Risk Capital Management Partners [see Anatomizing bankers’ advice, this issue]. “I have to laugh when banks say they offer risk-management advice,” he says of the big banks. “It’s just product-structuring advice.”
This hits dead centre the reason why there seems to be such a demand for, and willingness to set up, independent advisory firms. It has always been the M&A advisory companies that grab the headlines. A recent high-profile example was HSBC’s acquisition at the end of last year of US firm Household. Although both HSBC and Morgan Stanley were listed as advisers, it seems that a one-man show did a fair whack of the work: Rohatyn Associates, run by former Lazard man Felix Rohatyn.
But as Shimko points out, risk-management advice can often be of more strategic importance than a merger. Corporates are beginning to understand this more, and starting to demand better and more independent advice across capital markets and risk management.
Years ago JP Morgan used to run an advert of a blank tombstone, suggesting that sometimes the best advice it gave to a client was not to do a deal. No longer. The mantra for today’s investment banker is: whatever you say to the client, never, ever let go of the deal.
The issue of conflicts of interest is the single most repeated reason people have given for their decisions to leave big sell-side institutions to set up on their own, including many who until recently occupied senior debt and derivatives roles at several large investment banks.
Of course many are simply talking their own new book, but after all the corporate-governance scandals of the past two years it’s a theme that sticks in clients’ minds.
The big banks, of course, remain dismissive. “There’s always a place for the boutique, and there is always an appeal to having an independent adviser,” says one senior executive. “But it’s the big banks that are winning more and more market share.” He takes more comfort from his share of wallet figures, the percentage each bank earns from the combined investment banking fee pool. He points out: “the share among the top 12 investment banks in the US keeps growing, at the expense of the smaller firms.”
Yet the downturn has also brought smaller firms into the upper ranks of the advisory and IPO league tables.
As it turns out, one of the biggest industry sectors that stands to benefit most from the exodus of investment banking talent is banking itself.
Banks, especially investment banks, are notoriously bad at sticking to their knitting. Some, for example, are still determined to be technology providers, as opposed to traders and deal makers. And they’re usually bad at it, spending far too much trying to build systems that usually work nowhere near as well as the much cheaper, more advanced options they could buy from non-bank providers.
If departing bankers can provide these services and earn a living in the process, that’s probably a net gain for the industry that used to employ them.
Some large banks, according to Recovery Partners’ CEO Alex Jurshevski, have lost so many seasoned senior bankers and executives in the past couple of years that they are woefully ill prepared for some of the major issues in operational and enterprise risk, such as the impact of Basle II. There’s enough fear and uncertainty within the banks themselves to keep an army of boutique advisers with direct industry experience in business.
Trading drives advice The big question is whether the rapid growth in independent firms will have much of a lasting impact on the way investment banks conduct business. Already the big firms know they need to be seen to be providing unimpeachable advice, and have had to work out ways of bringing home the bacon without the easy money of IPO and M&A fees. “These days, we make much more from problem-solving than from advice,” says a senior investment banker. “We can be paid much more restructuring Commerzbank’s and Hypovereinsbank’s non-performing loans than we could from advising them on a merger.”
It’s unlikely, though, that they’d be willing to concentrate so much on advisory at the expense of trading, for example, which means that there will always be the fear that conflicts of interest will creep into advice. Only a touchingly naïve client would swallow the universal banks’ claims to be offering truly objective advice. And small firms that can put bright people to work closely with CEOs and CFOs might soon build strong relationships.
There is another possible response for the big banks, a tried and tested one: wait until the boutiques are more mature and then buy them out. For all their talk of wanting to offer independent advice, how many bankers would be willing to pass up the cash? In that sense, this could be smart money positioning itself outside the industry while preparing to make its next killing.
In the links below, Euromoney profiles 25 of the brightest new firms – spanning advisory, risk management, capital markets, fund management, emerging markets, technology and a range of other specialities – that are among those transforming the industry.
Consensus-shy Violy starts afresh
