Small can be beautiful at America’s regional investment banks
Regional banks in the US are posting record capital markets income, putting them in a strong position to fend off challenges from bigger firms.
Regional banks corporate banking arms used to be focused on lending with the occasional bit of hedging. Not any more. They now have to keep pace with clients whose needs are becoming ever more sophisticated.
Many of those clients are still small enough to stay under the radar of the bulge-bracket firms. The US boasts a dynamic cohort of small and medium-sized companies that are seeking innovative capital solutions, particularly in sectors such as tech and healthcare. They therefore offer an opportunity for those regional banks that are able to build out a fuller capital markets and advisory platform to serve them.
Equally, those same clients also offer tempting prospects for a regional bank looking to expand into the territory of a more sluggish rival – something that could also act as another driver for M&A.
Banks that don’t react will find themselves squeezed from both directions. Not only are many small banks stepping up their game in response to this maturing client base, but the big Wall Street firms – on the hunt for growth wherever they can find it – are looking to move into new regional markets or broaden the provision of investment banking services in those markets where they already play in retail, commercial banking or wealth.
Our approach is to be focused on defending our relationships. And if we can go head to head, we can win - Bob Marcus, Fifth Third
Increasingly, the likes of Bank of America Merrill Lynch or JPMorgan are looking at the potential of regional corporate clients. And unlike many regional banks, they do not have to build out their capital markets platforms. Smaller clients might not need all the complexity that a bulge bracket can offer, but if that bank is prepared to onboard them, the client will not turn it down if no local alternative exists.
Happily for the regional banks, 2018 is demonstrating that a carefully positioned business can grow handsomely even within these competitive pressures. The four firms that Euromoney has focused on in this story – Fifth Third Bancorp, Citizens Bank, Regions Financial Corporation and KeyCorp – have all made huge strides in their capital markets operations since the financial crisis.
The timing is no coincidence. Many firms were encouraged to broaden their franchises in this way not only by the need to diversify away from the retail and commercial lending that hurt them when recession hit but also by the pull-back of bigger banks to their large-cap client franchises.
Ten years on from the crisis, these regional banks are posting record investment banking and capital markets revenues. And they are just getting warmed up.
The regional banks’ capital markets businesses all have distinct origin stories; and those origins often explain why a certain franchise is the way it is.
“Unlike the bulge brackets, which tend to offer everything, the capital markets businesses at the regional banks can be quite different, because for all of us the leadership will have a different perspective on what they want,” says one capital markets head. “And that difference is often dictated by the way in which each firm has entered the business.”
Sometimes that difference can make comparisons difficult – particularly in a sector that has long been used to annuity-style income flows rather than businesses subject to the whims of the markets. “One of the challenges every quarter is explaining our results versus our peer group,” says another banker. “My CEO will call me and ask: ‘Why did we do better or worse than them?’ And my answer will be: ‘Here’s what our business is and here’s what theirs is’ – it’s not an apples to apples comparison.”
Those at the regional banks are aware that the bulge brackets are increasingly looking to play on their turf and are generally sanguine about where they will lose out.
“Let’s say we have a $1 billion client and we are competing against one of the Wall Street banks,” says the same banker. “If the client’s number one focus is on breadth of distribution, we will lose every time. We can’t win that argument. But what happens in a lot of those situations is that while they might be pushing their markets capabilities, we will be pushing our bespoke advice and focus.
“That is why the people aspect is so important. Many of ours have come from those institutions and our advice has to be on a par with those firms. That is how we win.”
The great thing about the marketplace as we see it is that there is no important product or industry that we don’t have at this point, but we still have plenty of headroom to grow across the majority of our industry groups and product areas - Randy Paine, KeyCorp
Another puts it more succinctly. “It is hard to lose when you go into the board and say: ‘Goldman’. But if we have a long relationship, we still hope that a client will trust us to take the next step – providing strategic advice.”
There is one clear advantage to being small – less regulation. But there is still plenty and that scrutiny has the often overlooked effect of encouraging M&A rather than organic development. This is not true of every bank; some have still preferred to build from scratch rather than try to integrate an existing operation – witness what Regions Financial did with broker-dealer Morgan Keegan, which it bought in 2000 and then sold in 2012. But there are distinct advantages to buying off the shelf.
“Acquisitions are sometimes easier than the organic efforts from the regulatory perspective,” says one capital markets head. “When you acquire a platform you get all the compliance structure with it. But when you build from scratch there is a lot of additional regulatory scrutiny.”
That matters, because what regional bankers dislike most about regulation is often the resource it consumes in building systems for compliance, particularly when the regulation itself is ostensibly targeted at a different kind of bank altogether.
Changes to the Volcker rule are an example. The fact that bankers at smaller firms cite its easing as important to them seems surprising. But the burden for many was the procedures that had to be put in place to demonstrate that a certain activity was not proprietary trading, rather than any restriction on prop trading itself. Now that the starting assumption will no longer be that short-term positions are proprietary, for example, life is simpler.
With conditions and results apparently buoyant, what do investment bankers worry about at the smaller firms? First, the sector is traditional: leadership teams will usually have their grounding in traditional banking – loans and deposits. For them the volatility and variability inherent in capital markets businesses can be tough to stomach. Commitment to it may wane.
In today’s market everyone has an abundance of capital. If you are not bringing something different, you will not succeed. You are not going to get anywhere without ideas - Ted Swimmer, Citizens
A second, related point is the lower tolerance of loss. “We don’t take a lot of risk, but we do take some,” says one banker at a regional firm. “This business will not be right 100% of the time. You will have a transaction where you lose money or inventory goes the wrong way, and there will be a lower tolerance for this than at a large bank.”
The third element is the sheer size of investment in technology needed to keep clients satisfied – particularly in comparison with the bulge bracket firms that can scale up such innovation quickly. If JPMorgan can spend $10 billion in a year, what hope do smaller firms have?
When it comes to the nuts and bolts of servicing regional corporates, however, most reckon they can ride out the competition from the big banks – although Euromoney wonders how much is wishful thinking. Surely there will be casualties from the competitive pressure?
“I think that is a little over-blown,” says one. “You see it in all cycles – guys come in and guys come out. If you have a good relationship with a sponsor, then yes that may help. But, in general, for a corporate deal, unless you have really been there, you can’t just show up.
“All banks move into the middle market when they are looking for growth. But when the market turns, they move back to where their niche is.”
Fifth Third Bancorp
If the capital markets division at every US regional bank has an origins story, they don’t come much more illustrative than at Cincinnati-based Fifth Third Bancorp, formed through the merger of Third National Bank and Fifth National Bank in 1908 but whose hesitant first attempts at building a capital markets business paradoxically made it easier to step up a gear in the aftermath of the financial crisis.
In 1998 the bank bought a small broker dealer in Columbus called The Ohio Company. It was around the time when the 1930s Glass-Steagall Act restrictions on banks owning brokers were gradually being eroded, culminating in the Act’s repeal in 1999. For Fifth Third, however, integration of The Ohio Company wasn’t really a priority; as long as it performed, it was largely left alone.
But over time Fifth Third began to seek more clout in the corporate banking business. The idea was that clients would begin with a loan, then bring deposits and a need for treasury management, then for capital markets product, advice on selling a business or how to hedge their foreign exchange risk.
Then came the crisis and its attendant recession. Fifth Third found it had loan problems. The bank had tried to mitigate credit risk by keeping its commitments low – it had few over $25 million, let alone $50 million. It was, after all, playing very much in the small end of the market. It thought it would therefore be protected, but it wasn’t. The homogeneity in the portfolio meant that a lot went bad at the same time.
When the dust settled the major realization was that the firm was much too dependent on loan revenue within its corporate bank. It needed to diversify. It needed higher fee income.
This was about where the firm had got to when it hired Bob Marcus in 2009. He had worked in loan syndication at Wachovia and debt capital markets origination at SunTrust Robinson Humphrey, among other shops. At that time Fifth Third’s capital markets fees were in the region of 25% to 30% of the revenues of the commercial bank. It wanted to get that closer to 40% to 45%. The target presented an opportunity to take a step back and ask: if the firm was getting into commercial relationships and industry verticals like healthcare and energy, what did the capital markets platform need to look like?
It was at this point that the distinct lack of integration of The Ohio Company into Fifth Third became an advantage. “The acquisition had been a small discrete transaction and so it meant that when we wanted to build from the ground up we were able to,” says Marcus. “That was a big advantage for us – we didn’t have to tear a lot down first.” Bolting new resources and new expertise onto the existing broker-dealer was a lot more straightforward than it might have been.
The timing worked well too. The post-crisis climate meant that a lot of talented capital markets professionals were on the market as the bulge-brackets shed staff. They arrived through other routes too. Until recently Fifth Third’s M&A department was run by Mike Burr, once of JPMorgan but who joined Fifth Third in 2014 when the M&A advisory team he ran at Challenger Capital Group was acquired. Burr left Fifth Third earlier this year, but another JPMorgan alumnus is still there, Mike Ryan, the current head of equity capital markets.
The bank doesn’t break out investment banking and capital markets revenues from its corporate banking income, but corporate banking was up 19% in the first half of this year to $208 million compared with the same period in 2017. The bank said it had seen a record three months for capital markets revenue in the second quarter, driven in particular by corporate bond fees and loan syndications.
The lending side has been the entry point for relationships, but debt capital markets was the obvious business to build on: the bank worked on more than 200 bond deals in 2017. Five years earlier that was about 130. It now has a growing equity capital markets business and its acquisition this year of healthcare specialist Coker Capital Advisors added to its M&A franchise. The much bigger acquisition this year of Chicago-based bank MB Financial was not aimed at capital markets, but it also brings more loan syndication and debt expertise.
One of the areas of greatest potential is private equity. It doesn’t break out its revenues by client segment, but only a small percentage of its capital markets revenues come from private equity. At some competitors that figure can be closer to half, depending on the period, so there is clearly more to be captured.
Marcus knows the firm’s limits. “We don’t have the sales or trading platform that the big firms do,” he says. “Having been there before I know the kind of investment that needs and we are going to be smart with our investment dollars.” But while some public market areas are a challenge, he reckons the firm is on a par when it comes to advising on private market options, such as private placements, M&A, lending and hedging through interest rate swaps.
It all adds up. “Our approach is to be focused on defending our relationships. And if we can go head to head, we can win,” says Marcus. “There is a company in Tennessee for whom we executed a term loan B to take out a high-yield bond. The competition was a money center bank, but we were hired to do it on our own.”
Regions Financial Corporation
Regions Financial Corporation, based in Alabama and with $125 billion of assets, is another of those firms that has developed a capital markets business far beyond the constrained scope of its origins. When Terry Katon joined as chief executive of Regions Securities in 2009, the group’s in-house capital markets division did not extend much further than interest rate derivatives.
The bank also owned a regional brokerage called Morgan Keegan, which had capabilities in ECM, fixed income, public finance and M&A. But as with Fifth Third’s approach to The Ohio Company, Morgan Keegan was mostly left alone and not integrated.
So much so, in fact, that in 2011 it was fairly straightforward for Regions to make the decision to sell Morgan Keegan. Regions still wanted many of the capital markets activities housed within it, but it preferred to build them than attempt to force-fit an existing brokerage into its operations.
And so it was that Regions’ bankers found themselves in the slightly unusual position of starting to think about creating a new broker-dealer even as the firm was selling the existing one.
In fact, the situation was not as peculiar as that suggests. Morgan Keegan was also a retail broker-dealer, something that Regions wasn’t interested in keeping. And it had a larger fixed income sales and trading operation than Regions would have chosen to build. Disposing of it in this way avoided the upheaval – and value destruction – of dismantling the asset before selling it.
It also worked because Regions wanted to focus on origination and then build out the sales and trading piece over time. “In early 2013 we started putting in place the capabilities we thought would be important to have to serve clients,” Katon tells Euromoney. “That meant M&A, fixed income and private placements, as well as building on our existing loan syndication and real estate capital markets business.”
Equity capital markets is missing from that list and it is no accident.
“Most investment banks do M&A and equity capital markets, but when we look at the landscape, M&A advisory is really important for us to be able to give clients and it is a low capital intensity business,” says Katon. “ECM has fewer clients and can be very sector specific, but you have to have a research team embedded, there are compliance issues and the economics of investing in all that are not compelling when we don’t have a retail brokerage in place.”
The other problem for a small investment bank is that the payoff on ECM takes time. Katon, who this year took on an additional role as head of the group’s Charlotte-based operations, reckons that even if Regions did want to start a fully-fledged ECM platform, it would take three years just to get to a $5 million to $10 million revenue business.
A lot of getting more M&A out of the franchise is asking the right questions and speaking to the right decision-makers in the C-suite - Terry Katon, Regions
In short, there are better opportunities elsewhere. The build-out has been carefully structured to fit around the bank’s client base. “We go to where we can find the most applicability, working with the commercial bank, the corporate bank, the real estate business, as well as wealth,” says Katon. The M&A business is largely designed for corporate and commercial banking clients, but he notes that there is also relevance for wealth clients who are business owners and might want to sell in the future.
As at some of the other banks Euromoney spoke to for this article, 2018 is looking good for capital markets at Regions. The second quarter was a record one for capital markets revenue and chief financial officer David Turner name-checked M&A advisory and customer derivative activity as the drivers in the bank’s second quarter results call.
Capital markets income in the first half of 2018 was $107 million, up more than 50% on the same period in 2017.
The bank makes no secret of the fact that it leads with lending. But M&A is a curious exception to that, given that most of the work the bank does there is as a result of relationships between the capital markets teams and private equity sponsors.
Over time, the objective is for that to change. “We have about 350 bankers who call on corporations sized from $20 million to several billion,” says Katon. “They have historically spent most of their time around the debt products, and so are skilled at lending money and finding capital structure solutions for the client.
“A lot of getting more M&A out of the franchise is asking the right questions and speaking to the right decision-makers in the C-suite.”
At the same time, more can be done to plug those private equity clients into the rest of the capital markets offering – and financing. Regions might not be able to run an IPO for them, but that doesn’t mean it cannot play an advisory role and pick up fees. One managing director earning a few million in ECM fees is, for the moment, a much better investment than trying to build an entire business.
Securitization is also a target area. The bank already has a capability there but is adding more, built around its specific client groups. It has a restaurant group, for example, where three securitization structures – whole business, asset receivable and franchise receivable – are obviously relevant.
“What our customers have need for is what our capabilities are set up to serve,” says Katon.
With $138 billion of assets, Cleveland-based KeyCorp is another regional bank that originally got into the capital markets business through an acquisition – broker-dealer McDonald Investments in 1998. But the original strategic impetus of that move was not to build what has ended up as KeyBanc Capital Markets. Rather, it was to build on connections that could be forged between the brokerage business at McDonald and the private bank that was already at Key.
That changed over time, however, as the firm realized the scope of the synergies that could be achieved between Key’s corporate lending franchise and the capital markets capabilities of McDonald.
It means that primary origination is now a firm priority. “Our focus is on providing our clients with the advice and access to capital to move their businesses forward by leveraging our industry expertise, unique ideas, collaborative approach and integrated corporate and investment banking platform,” says Randy Paine, president of KeyBanc Capital Markets and co-head of Key Corporate Bank.
The business has grown well, posting six consecutive years of record results. Investment banking and debt placement fees totalled about $300 million in the first half of 2018, up 15% from the same period last year. In 2017 the firm helped raise over $250 billion for clients across leveraged and high grade debt capital markets, syndicated finance and asset-backed securities. And it still has its secondary sales and trading organization designed to work with investor clients as well as to help place securities.
ECM and M&A are also robust. Key covers about 700 companies through equity research, the bank worked on some 52 ECM deals last year and its M&A platform clocks up more than 100 transactions a year. KeyCorp chief executive Beth Mooney told analysts during the firm’s second quarter results call that strength in advisory fees had helped drive record investment banking results in the period.
“Capital markets is a very strategic business for KeyCorp and one that aligns with Key’s relationship focus,” adds Paine. “This isn’t something we just started doing in the last five or six years.”
Key’s value proposition is very simple – delivering unique relationships and products to customers with superior execution. “Most firms would tell you the same thing, but to provide those unique ideas with flawless execution to emerging growth and middle market companies, you have to be deep in those pools,” says Paine. “We have been doing this for more than 20 years.”
Paine joined the firm through the McDonald acquisition, but there have been plenty more additions to the franchise since those days. In 2017 Key bought Cain Brothers, a leading healthcare-focused boutique. Acquiring a healthcare boutique is a recurring theme at regional banks; the very diverse nature of that sector in the US and the high-growth mid-cap status of many of its constituents make it an excellent fit with regional investment banking franchises.
Growth is still at the forefront of Key’s strategy. “The great thing about the marketplace as we see it is that there is no important product or industry that we don’t have at this point, but we still have plenty of headroom to grow across the majority of our industry groups and product areas,” says Paine. “We are constantly looking for professionals that have deep client relationships and fit with our firm culturally. There is plenty of runway for KeyBanc Capital Markets to expand.”
Citizens Financial Group
Capital markets and investment banking at Citizens Financial Group had a different genesis to that of most regional banks. The group traces its history back to 1828 in Rhode Island. It was bought by RBS in 1988, after which it also acquired some 25 other banks to give it a platform across New England and the Midwest. It has $155 billion of assets.
In the aftermath of the global financial crisis, Citizens identified an opportunity to build a mid-market investment banking operation – and quickly realized how its parent group might both help and hinder it in doing so. First, RBS had been hit badly by the crisis. Second, while it allowed the Citizens brand access to a sizeable platform for debt capital markets financing and trading, the natural hunting ground for Citizens was in the $100 million to $200 million range. Even a firm as battered by crisis as RBS would struggle to justify chasing deals in that part of the food chain.
Dealing with that difference meant effectively setting up a dedicated group within Citizens to pursue deals for the kinds of companies it felt it could serve well – firms in the $25 million to $150 million ebitda range. It could lean on the RBS platform when needed for execution but would originate its own relationships and deals.
Building that business fell to Ted Swimmer, hired from Wachovia as head of capital markets in 2010, presiding over a small team of just a handful of people. In the period until 2013 the business mostly looked like a traditional mid-market syndication franchise – and one that was surprisingly insulated from the turmoil at its parent.
Then came the decision by RBS to spin Citizens off. The IPO took place in 2014 and the firm became independent the following year. Now the strategy could be dictated wholly by Citizens, but there were also downsides. It had lost the investment grade and high-yield bond platform that RBS brought, for example.
Swimmer, who would also become head of corporate finance in 2017, set about building step by step, often tapping staff that were leaving the bulge bracket firms and gradually assuming responsibility for sponsor coverage and corporate finance more broadly.
“We were growing in places like Boston and Charlotte, and we found a very active pool of people looking to get away from the big Wall Street shops,” says Swimmer. “Many of them felt frustrated because those firms simply wanted to move into bigger and bigger markets. We started with five people in May 2010, but we are north of 100 now – and have to turn people away who want to work for us.”
In 2016 Citizens launched Citizens Capital Markets, adding broker-dealer capabilities, and now reckons it is a consistent top 10 bookrunner for middle-market clients. The next phase for the franchise came in 2017, when the bank acquired the Cleveland-based Western Reserve Partners, a deal which brought with it a middle market financial advisory and M&A business to bolt onto Citizens’ corporate finance operation. Coverage now spans 11 industries.
To judge by the results of Citizens’ annual middle-market outlook survey for 2018, the timing for that move could not have been better. The bank surveyed more than 400 C-suite executives at companies with revenues of between $25 million and $3 billion. Almost 60% of potential sellers said they were either involved in or considering a sale or merger in the next 12 months – just two years earlier that figure was 33%. The response was even stronger for buy-side demand, with 76% saying they are either doing or planning an acquisition.
Crucially, an acquisition like that of Western Reserve brings advisory knowhow. “In today’s market everyone has an abundance of capital,” says Swimmer. “If you are not bringing something different, you will not succeed. You are not going to get anywhere without ideas.”
Swimmer’s objective is to get to a point where everything can join up seamlessly. “We want to bring an idea to a customer, do the M&A, finance the buyer, hedge the rates and the currency – all that would be the dream transaction for us, particularly when it then gives us the opportunity to capture annuity business like cash management.”
As at Regions, there is one obvious hole – equity capital markets. The bank is happy to take passive fees at the moment and does so. It has acted in some form on 33 US ECM trades since 2016. But building the research and other capabilities that would be needed for a full-scale ECM franchise is not on the agenda.
Recent results suggest the firm is on the right trajectory. It is clocking up more mandates and second quarter capital markets revenues of $48 million were close to second quarter 2017’s record of $53 million. Loan syndication fees doubled from the first quarter and the bank reiterated its determination to build up debt capital markets underwriting. Foreign exchange and interest rate product fees of $34 million were up 30% year on year to a record.
Western Reserve might not be the final piece of the M&A jigsaw either. Citizens chief executive Bruce Van Saun told analysts on his second quarter results call that he would consider a bolt-on acquisition of another M&A boutique if he could find one that added usefully to the firm’s industry coverage.
Wherever future growth comes from, it is clear that the bank is putting capital markets at the heart of its strategy – in August Swimmer was appointed to the firm’s executive committee.