Innovators drove the markets – what drives them now?
Capital markets bankers have spent much of the last five decades dreaming up products to help clients and themselves make money, but is process, which has largely taken a back seat, now becoming the battleground?
Ask capital markets professionals if they consider their industry to be innovative and few will disagree. It is taken for granted that a business that began to take shape in its modern form in the late 1960s has been a hotbed of invention: always problem-solving, sometimes problem-causing.
In every asset class, bankers can reel off a list of product inventions that show the importance of efficient financing techniques and the growth in resources that have been committed to their development.
All of which makes it striking that those same bankers often struggle to think of radical ways in which the actual method of executing much of capital markets activity has changed, certainly in recent decades. Yes, there has been tinkering around the edges as banks look to make processes a little more efficient, but at heart, the execution of a deal in many asset classes is essentially unchanged from the early days.
Even Eric Dobkin, the Goldman Sachs veteran known as ‘the father of the IPO’, agrees that the way in which equity offerings are done today is much as it became after he and his generation had set about transforming equity capital markets execution in the 1980s.
Innovation in capital markets looks like it has been mostly a story of product rather than process. This is not surprising. While there has been constant change in the size and scope of the situations that corporations and others have sought to finance – and in the way in which the providers of that finance have looked to generate returns – the relationships between many of the actors have stayed largely the same.
The intermediary-based system of firms that bring the buy and sell side together has endured – and, despite regular predictions of its demise, shows little sign of being abandoned.
What is also striking is that among the bankers and traders wrapped up in the excitement of the birth of a new market, there were also those who saw developments through a different, longer-term lens.
Hans-Joerg Rudloff, a former chairman of Credit Suisse First Boston and one of the architects of the Eurobond market, told Euromoney on the occasion of our 25th anniversary edition in 1994 that: “From 1960 through to the 1980s, we were doing nothing more than trying to restore the markets as they were before 1914”.
As Euromoney pointed out then, at the end of the 19th century there already existed, in some form, multi-currency bonds, derivatives, asset-backed securities and railway income bonds.
Matthew Westerman, the former co-head of global banking at HSBC and now at investment firm ML&W Partners, says that the biggest change in the capital markets over his career starting in the mid 1980s has been what he calls “the death of distance” – the collapsing of the world into a smaller place, largely driven by communications technology.
Jim Esposito, global co-head of securities at Goldman Sachs, who worked on some of the most complex emerging markets debt transactions in the 1990s with the exchanges of Brady bonds, notes that markets have simplified since the global financial crisis.
“This may come across as counterintuitive, but today’s capital markets deals are not necessarily more complex structures than in the past,” he says. “Deals today are larger and happen faster, but not more complex.”
The crisis, he notes, brought a new craving for transparency, liquidity and simplicity.
Pierre Palmieri, head of global finance at Société Générale, thinks about the subject a little differently to some. He traces innovation in finance and capital markets through four distinct phases.
It starts, he argues, with the emergence of a new product, in the manner seen in the early days of the Eurobond market or through the 1980s to mid 1990s, when most of the existing businesses in investment banking were created.
“The second stage is the application of existing products to new markets or clients,” he says. Securitization was created in the 1980s, he notes, but the first application of the technique to a trading company, like Glencore in 1997, would be an example of the second phase.
The third phase is where the industry sits today, he says, in a world where innovation is focused on process and driven by information technology. And a fourth, future phase will be the meaningful application of finance to a multitude of environmental and social issues, where he thinks the industry is only scratching the surface now.
“Of course, innovation is very different in nature in each phase, because the people driving it are different, whether they are front-office product and coverage staff, or those running the business and technology operations, and probably a much broader combination of partners in the future,” adds Palmieri.
He doesn’t dismiss the importance of some of the technological innovation that is seen now, such as the use of blockchain in trade finance.
“But it is painful when people only think about IT when they talk about innovation in finance now,” he says. “That should be a means, but not the end. Business innovation remains key.”
Some 25 years before Palmieri was starting out in derivatives, bond bankers were already arguing with each other – a habit that they would find it hard to shake over the next half century. While it became commonly accepted among the Anglo-Saxon banking community that the very first Eurobond deal was the SG Warburg-led $15 million issue for Autostrade in July 1963, in continental European banking circles the beginning was traced to an EUA5 million issue for Sacor of Portugal in 1961 – the deal that was the launch vehicle for the European Unit of Account.
It was an argument that was still playing out in the earliest pages of Euromoney in 1969, although by that time the market was already changing fast.
Some 20 years before the formal concept of a bought deal would cause controversy in the bond markets, senior figures at the firms managing these embryonic early 1960s issues would sit and decide on the precise terms they would offer a borrower, underwrite the issue on that basis and then invite a few others to take part.
Until the Sacor deal, New York had been the only real functional financial centre in the world, but the return of currency convertibility in 1958 meant that others could finally emerge. It wasn’t London at first, however: the Sacor issue was launched in Luxembourg and, with no clearing system in existence, settlement of transactions between the participating banks was carried out by driving the bonds between firms in a van.
The crisis turned the focus squarely onto conduct and discipline – it’s everything that we live and breathe now
By the time Euromoney arrived on the scene in 1969, clearing and settlement systems were beginning to emerge, albeit with fitful success. Morgan Guaranty’s Euroclear had just got under way based on the revolutionary notion of fungibility. The New York brokerage, Weeden & Co, had just started dealing in convertible Eurobonds again, after a six-month absence that had been caused by it getting so far behind in the delivery of bonds.
But every other month the whole market seemed to be about to die, whether through a complete evaporation of liquidity, a halt of bond delivery or some other failure.
Product innovation came thick and fast nonetheless. Convertible bonds had featured since the very early days, but the first sterling-dollar issue appeared in 1968, issued by the UK subsidiary of the National Cash Register Company but convertible into the dollar stock of the parent. At the time, the dollar premium was over 20%, such was the demand for dollars, so a cross-currency convertible bond gave investors the ability to invest in their local currency until the time of conversion.
The first floating rate Eurodollar issue was probably a $14.7 million issue for Dreyfus Offshore Trust in May 1969, although a 1970 deal for Enel tends to get the credit more often. Syndicated Euroloans also got under way. Eurocommercial paper came in 1970.
“It is only to be expected that the Deutsche Bank should head the list [of top Eurobond managers],” we wrote in January 1970 when publishing our first league table. “This institution has got most aspects of the German capital market firmly under its control.”
And the rest of the list gave an insight into the way in which the early Eurobond market was still a wealthy retail territory. Names like White, Weld did well because they serviced the bigger retail names. But First Boston or Merrill Lynch did not feature in the top 10, hampered by their institutional focus. That dynamic would change fairly swiftly.
By the time that Chris O’Malley started working in the gilts business at stockbroker Phillips & Drew in 1974, the Eurobond market was still not the focus for many firms.
“I remember the day we went into Eurobonds because it was 7/7/77,” says O’Malley. “The firm had become aware that gilts were only part of a growing international bond business and that there were these new things called Eurobonds, but the principal driver was to preserve our franchise in gilts.”
In those days the Eurobond market was a strange place, says O’Malley. New issue houses were the merchant banks and, increasingly, the new US investment banks, but the dealing community was made up of the old stockbrokers. To be an exchange member you had to be a partnership and could not carry over profits, so it was impossible to act as a principal.
“The result was that the secondary market was completely undercapitalized,” says O’Malley. “Trades almost always had to be matched.”
In 1980, there was one of the more startling innovations in process that the bond market had seen: the bought deal. The precise meaning of the term depends on who you ask; there had always been fixed-price deals that contrasted with the traditional Eurobond method of only fixing terms after a 10-day selling period.
But what happened in April 1980 was different. Michael von Clemm, chairman and chief executive of CSFB, called Thomas Patton, an executive vice-president at General Motors Acceptance Corporation (GMAC), offering to buy outright $100 million of five year GMAC bonds at 13⅜%. Patton thought about it for 30 minutes and then agreed.
Von Clemm said that he had wanted to blow open a window in the Eurobond market, which had been practically shuttered by rising rates. In that climate, issuers didn’t want to wait the 48 hours it would typically take to get a management group together. The difference was that von Clemm’s offer involved no discussion with GMAC and GMAC would have no say in what happened after it had taken the money. On the flipside, von Clemm didn’t have to worry about co-managers dumping bonds in the grey market – another controversy that was raging around that time.
Suddenly New York bankers were worried that Eurobond houses would eat their lunch. And none more so than First Boston, which would soon be one of the firms outmanoeuvred again by von Clemm and Rudloff at its own affiliate CSFB in London when they bought a $100 million issue by the European Investment Bank, snatching it away from a New York deal being discussed but which could not match CSFB’s terms.
The technique would emerge time and again, but the initial flurry of deals was brief, because it had depended on a number of large institutions having cash that they needed to put to work in a market where issuance was scarce. Pretty soon that source dried up and issuers knew that they would once again need to tap smaller investors and that that meant having syndicates.
From the standpoint of technology, not a lot had changed by the time that Guy Hands, now the chairman and chief investment officer of private equity firm Terra Firma, started life as a Goldman Sachs bond trader in 1982. At least he had an HP-12C calculator, launched in 1981, and which everyone would use to calculate bond yields.
But when it came to the essentials of the market, nearly 20 years after its birth, most people were still guessing.
“You had a Reuters screen that would give you an indication of where long bonds were and where three-month bonds were, but you had to guess at where Eurobonds should be,” he says. “We dealt over the phone, and it was almost a game of bluff. You were trying to guess whether the other guy was a buyer or a seller.”
Hands found himself running a desk by 1987, when he was just 27. One early technological innovation was an HP desktop computer – “it looked like a Dalek” – that enabled traders to calculate spreads more easily. And the better information meant deals could get bigger and liquidity could grow.
Martin Egan, now global co-head of primary and credit markets at BNP Paribas, also started out in 1982, at JPMorgan. His first job was as a position clerk.
“Everything was manual,” he remembers. “Traders would have trading blotters recording their positions, a position clerk would tally up all the positions using copies of traders’ buy or sell tickets, the head trader might have their positions up for all to see on a blackboard.”
The dealer boards and screen services that began to emerge in the 1980s would take out much of this, but despite the efficiency that they brought, there were many in the market unhappy with what such innovations also took away.
Hands was one of those at first. He remembers one trader telling him that it was possible to smell a seller or a buyer at 50 feet.
“This was lost when we went to screens,” he says. “The view was that Bloomberg was the ultimate evil and that it would wipe out investment banks. We were paranoid that we would never make money again.”
It didn’t turn out like that. “In fact, as information became ubiquitous, it gave you the ability to hedge,” says Hands.
Paul Tregidgo, who started at CSFB in 1985 and stayed at the firm or its affiliates until 2017, argues that the thinking behind bought deals like those that von Clemm had pioneered had its origins in the attitude that already existed to committing risk to a client.
“It was unthinkable not to do a deal on the terms you had agreed to take to market,” he says. “It was obviously articulated in different ways, but there was a real conviction around originators in the ability to commit risk very rapidly and deliver on that. As a way to win deals it was simply the nature of things.”
Like so many long-serving bankers, it is the period from the mid 1980s to the mid 1990s that Tregidgo identifies as the most packed with innovation and energy. He would go on to set up and run the bank’s emerging market debt capital markets business. One highlight for him was liability management work for Latin American countries like Brazil and Mexico in the mid 1990s, transforming 1989-era Brady bonds into regular bond issues.
“There was a ton of creativity and innovation behind the scenes on these deals, which transformed the benchmarks of the asset class, not just in transaction design but in customized processes created laboriously and manually to clear and settle very large and complex trades,” he says.
Tregidgo’s Latin America work might have featured sovereign borrowers heavily, but in the broader markets another change was afoot.
Egan remembers: “Corporate issuers coming into the Eurodollar market in a big way was really an evolution through the 1990s. But it was different to earlier. In the Eurodollar market in the 1980s, you would see corporates coming 50 or 60 basis through Treasuries.”
Hands also remembers that. “You might have the US government at 14% to 16%, the French government at 19% to 20% and then you could have Disney at 9%,” he says.
By the late 1980s, corporate issues were starting to be priced more attractively, and a growing investor base keen for a spread over risk-free debt fuelled a rapid growth in the sector. The dominance of corporate issuers was on the cards, and not just in high grade.
In the late 1970s nobody knew what a leveraged buyout was,” Theodore Forstmann, partner at Forstmann Little, told Euromoney in 1986. There were buyout deals in the 1970s, but it was the preserve of a few wealthy individuals buying companies. It wasn’t an industry.
But by 1986 every US bank knew what an LBO was. The sector had been on a tear. In 1985, deals totalled more than $31 billion, double what they had been in 1984 and three times the figure for 1983. An attack on the business by Federal Reserve chairman Paul Volcker in 1984 had paused it but not for long.
Bank lenders were piling into the senior debt while insurance companies drove the mezzanine. All were chasing returns: Kohlberg Kravis Roberts (KKR), which specialized in the equity, had posted a compound return of 60% over 17 years, something that made other market players take notice.
The lenders were enablers of this new market in a way rarely seen in other asset classes. As Robert E Koe, president of lender Heller Financial, told Euromoney in 1986: “The flow of LBOs is created by lenders. They don’t just support the market; they make it happen.”
Over time the insurance companies started to find it hard to compete with more nimble specialist lenders and so began to partner with Wall Street securities firms who wanted to raise funds to grab a piece of the action in a market they could not lend to. First Boston created a $250 million mezzanine pool with Metropolitan Life. Cigna teamed up with Morgan Stanley.
But if KKR was the dominant force in the equity – its fiercely contested $25 billion buyout of RJR Nabisco in 1988 became the LBO deal that epitomized the excess of the era – it was securities firm Drexel Burnham Lambert that was untouchable in the new structure that would help fuel that excess: the junk bond. Drexel’s market share was regularly above 60%.
And it was Drexel that pioneered the pursuit of greater and greater rights to the holders of the paper it peddled, setting up lengthy battles with senior lenders. The most stretched deals were propped up with zero-coupon bonds – the paper that provides the difference between what the cash flow will support and the price being asked, in the words of one investor in the 1980s.
Drexel's star was to fall as fast as it had risen. When Jean-François Astier, now head of capital markets at Barclays, started in banking at the start of the 1990s, Drexel had just collapsed. The firm had finally been shuttered after a junk bond sell-off in 1989 and settlements with the US government and the SEC over charges of insider dealing and manipulation, much of which involved the junk bond department that had been presided over by Michael Milken.
Some Drexel employees would be snapped up by investment bank Donaldson, Lufkin & Jenrette, making it the high-yield market leader by 1997 and attractive enough for Credit Suisse to acquire in 2000. But amid the savings and loan crisis, the US market was no longer exuberant at the start of the 1990s. Astier spent his first couple of years working on restructurings, the usual situation for leveraged finance bankers during down cycles – and, in Astier’s words, “the best training anyone could ever get”.
Within a few years, however, the stage would be set for leveraged finance to move into a new direction – across the Atlantic. Astier remembers first becoming aware of the potential for a European market in the mid 1990s, when he was an associate at Lehman Brothers, and in particular with the 1997 issue backing the LBO of Swiss company Geberit International. In a moment of serendipity, a maker of lavatories had become the first European junk bond.
“I went to see my boss and said: ‘Things are happening in Europe,’” Astier says now. “He completely ignored me, but nine months later I went back in and said that other banks were beginning to staff up in leveraged finance in Europe. ‘So,’ he said, ‘why don’t you go?’”
He began building Lehman’s high-yield business in Europe in 1997 and the firm had a decent run. The market was developing slowly, primarily on the back of buyouts but also with infrastructure financing in the telecoms sector. The Russian crisis in 1998 was an early challenge, but the embryonic market recovered fast. Astier reopened the market in November of that year, leading a $150 million bond for Versatel.
By the end of the 1990s, the market was still small but would be sparked by one new development: the introduction of the single currency into financial markets in January 1999. High yield, already a small constituency of issuers and investors in Europe, had been hampered still further by its domestic currency nature across the continent. The advent of a common currency could finally defragment the market.
Jim Amine, who is now chief executive of investment banking and capital markets at Credit Suisse, was one of the early pioneers to make their way from the US to set up a fully fledged European high-yield operation for the bank in anticipation of the growth that he was sure was on the way.
“At the time the market in Europe was essentially dollar denominated debt for relatively high growth companies who did not have access to the bank market.”
With the creation of the euro, the issuer and investor base was unlocked, allowing high yield to shift over time to a dual-tranche market: although euro tranches could be done, the European market still needed the dollar pricing benchmark. But by about 2004 the euro asset class was a well-functioning self-standing market.
The establishment of the new market saw a repetition of all the old arguments about the competing rights of bank lenders and bondholders that had played out in the US in the 1980s, but in Europe the opposing sides were even further apart.
“The interesting thing in terms of structure was that unlike in the US, the loan market and the bond market were completely independent – there was no overlap of investors,” says Amine. “The loan market was not a B loan market, and buy-and-hold banks were very suspicious of high-yield bonds. It meant that initially we were having to structure bonds at a holding company level so that they were structurally subordinated and the traditional bank investors could consider them more like equity.”
That could only go on for so long, however, and would inevitably come to a head. And it did so in a single transaction, the $277 million dual-tranche bond led by Credit Suisse and JPMorgan in 2003 backing the buyout of Brake Bros by private equity firm Clayton Dubilier & Rice the previous year.
“What happened was that a group of bondholders put their foot down and said that they wanted instruments that were subordinated debt and not like preferred stock,” says Amine. “So we created a new structure, with upstream guarantees and subordinated claims for the bondholders vis-à-vis the bank lenders.”
In the Euromarkets, if a well-known company decided on a Monday morning that it needed $200 million of new debt, it could call someone and by that afternoon have completed the deal
The challenge to be overcome was that European leveraged finance was still dominated by senior bank lenders, not subordinated high-yield bond investors. To make matters worse, the deal had started out with bondholders structurally subordinated, with the change requested later. But eventually enough concessions were made to the syndicate to secure approval for the guarantees and the deal was hailed as ground-breaking.
Innovation had allowed the market to get back on track, then, but there would be a longer and more fundamental challenge in some borrowers’ perception of the new high-yield credit market: why should they pay 10% or 11% for debt if they could get a bilateral loan for Libor plus 300 basis points?
“The point that people missed was that the creation of the credit market was not to replace loans, but to add leverage via a distinct investor base,” says Amine. “The reality was that during the late 1980s and the 1990s, what became some of the most valuable companies in the US were high-yield bond issuers because they could get growth capital, and it was a great option if your other choice for growth capital was equity.”
For all the bells and whistles that were to come over the years in high yield – covenant-lite deals, second lien loans, private mezzanine, PIK [payment in kind] toggles – Amine doesn’t think of the debt markets as having produced sudden great leaps of innovation.
“A lot of the changes on the debt side have been very incremental,” he notes.
This is largely thanks to the curtailing effect of regulation, particularly since the global financial crisis. Leveraged lending guidelines that restricted leverage multiples prevailed in the US market for a while, although they were recently eased when their status was questioned, meaning that they would need to be voted on to remain in force.
But for many bankers the guidelines have long been an indication of the flawed nature of regulatory approaches to innovation in financial markets: that they frequently seek to address a problem that does not exist, while allowing others to flourish.
In the case of post-crisis leveraged loans, for example, the market has moved decidedly from an A to a B market. The buy side is specialist and dedicated, and therefore arguably not systemic – bridge finance on banks’ balance sheets is about $80 billion now, compared with over $400 billion before the 2008 crisis, noted JPMorgan chief executive Jamie Dimon in a recent analyst call.
In addition, the leveraged lending guidelines did not apply to unregulated firms, leaving some market actors able to fuel a ballooning of leverage while the banks could only watch as their business was eroded.
Others point to the way in which specific moves such as efforts by the administration of president Barack Obama to restrain the emergence of high-growth energy companies fuelled by leveraged loans caused a number of them to go bankrupt. More than one banker asks the question: is that a good use of regulation? Those flying the flag for structural innovation in primary markets are certainly sensitive to the pre-crisis charge of over-complexity and illiquidity, but often feel the pendulum has moved too far the other way.
Much of Palmieri’s experience of product innovation came from the world of derivatives and structured finance – he has been at Société Générale since 1987. In those early years, his work revolved around adapting the emerging derivative structures of swaps and options to new situations.
He says that he and colleagues realized that they were on the cusp of a momentous change.
“We were doing it from the perspective of solving problems for clients, but also while expecting it to be big,” he says. “It was definitely an adventure.”
Success in that world of financial product innovation is something of a percentages game.
“You launch 10 ideas and, if you are good, then there is one that is successful; if you are lucky there are maybe three,” Palmieri says.
One that was successful was work he did on the financing of non-French exports. At the time a French bank would typically only finance deals involving Coface, the French export credit insurer; a German bank would finance those supported by Hermes, the German equivalent, and so on. The revolution was to seek to help not just the clients in the home market but also to be able as a French bank to finance Italian or British exports, for example.
“Domestic clients could complain that this meant we were going to finance their competitors, but we would say to them: ‘Are you at some time going to move your production entities, are you going to export from various other countries? If so, wouldn’t you be interested in having a bank that was able to finance all those things?’”
Palmieri’s point about how the realization that the tools he was working with had the potential for great growth also illustrates how the perception of an innovation is a function of the time when it emerges. So it was with the growth of credit markets in general and securitization in particular.
Egan remembers, for example, the $17.5 billion seven-tranche bond issue for France Télécom that he did in 2001 after joining Paribas.
“The credit markets really began to take off at the start of that decade – the whole dynamic changed completely,” he says.
Guy Hands eventually moved from being head of Eurobond trading at Goldman to be head of its global asset structuring group, becoming one of the key figures in the development of securitization techniques. In 1994, he set up the Principal Finance Group at Nomura, where he led the way in radical deals in a host of sectors.
“When it started, securitization was focusing on assets that were undervalued,” he says. “It freed up capital to be invested. It was very much about a way to get management teams capital that they could use.”
What changed, he argues, is that increasingly participants entered the market who were further and further removed from the assets that were at its heart.
That the overlaying of ever more thinly sliced or synthetic structures onto what had been a fairly uncontroversial technique went on to shake the foundations of the financial system is now well recognized. It is a salutary lesson in the danger of unchecked innovation.
Egan says: “We know that securitization products were at the core of the challenges around the financial crisis, but I think that the decade running up to it was characterized by a dramatic search for return and yield driven by innovation, which came together in a perfect storm to produce all sorts of products that ended up being challenged.”
Innovation doesn’t get much more striking than what Eric Dobkin can look back on over his extraordinary career in equity capital markets.
Much of the equity capital markets business as we know it now originated in the work that Dobkin and his colleagues were doing in the mid 1980s. Much of this emerged from a strategic planning initiative at Goldman intended to address the fact that while it was the leading trader of equity blocks, top three in research, had an outstanding salesforce and was the principal equity firm in the US at the time, it was only number 10 at best in the primary equity league tables in its home market.
Dobkin’s breakthrough in the 1980s was twofold. One, targeting the institutional investor base that Goldman was already working with on the secondary side; and two, trying to sell new equity offerings more broadly than to existing investors only.
At the time, individuals were the primary owners of stocks and it was the wirehouses that were selling small lots of equities. Over time, as institutional investors looked to move more into equities, it was those firms with institutional relationships like Goldman that would benefit.
“What we did was to create an equity capital markets team to bring the same discipline and marketing approach that we used when we had a large block to sell for an investor,” he says. “It was about creating a partnership between issuers and investors.
“We talked to potential issuers and told them that they shouldn’t be selling 200 and 300-share lots. They could be tapping into the burgeoning wealth at institutions like Fidelity and Putnam by selling bigger blocks in a much more efficient manner.”
Issuers thought this new way of looking at equity capital raising sounded pretty interesting. The next step was to talk to investors and engage them with a sense of partnership too.
“Our pitch was that if we did our job right, then investors would be long-term shareholders in the company as both parties would have a common goal of there being a stable shareholder base,” says Dobkin.
To do that meant investing time with the buy side, giving them direct access to the issuer so that they could understand its strategy and develop confidence in the story. It is difficult now to grasp how radical this was in the mid 1980s, but until that point the market had been dominated by a retail mentality. Thinking about it in terms of institutions was unusual.
Dobkin and his generation of pioneers had a couple of macro trends in their favour – stemming, ironically, from a period of poor equity market performance. Making money from US equities in the 1970s was tough. The Dow Jones started the decade at about 800 and ended it at about 800. It meant that as the 1980s began, there was a growing belief that finding value in equities might require expertise beyond what the amateur might have.
“You wanted a smart guy running your money, so perhaps you started to give it to Warburgs, who ran Mercury Asset Management,” says Dobkin.
At the same time, there was another constituency of investors who were preparing to throw themselves into the equity market with much more force than before. Pension funds, in part driven by the requirements of the Employee Retirement Income Security Act (Erisa) of 1974, were finding that they would need to take more risk than in the past to generate the returns they needed. And they couldn’t do that with their traditional 80% allocation to fixed income.
The result was an institutionalization of the equity markets – exactly what Dobkin sought to capture. It didn’t hurt that issuers were also under pressure to raise equity. Economic downturns in Europe and the US had left corporations struggling with heavy debt burdens and needing to delever their balance sheets.
It wasn’t just new thinking that was needed, however. There was more innovation to be rustled up on the regulatory side if the markets were to be unlocked. Rules laid down by the SEC required companies issuing debt or equity to adhere to waiting periods before they could offer the securities after having announced their intention to do so. The Euromarkets, meanwhile, had proved themselves to be attractively quick for issuers for years, as Dobkin notes.
“In the Euromarkets, if a well-known company like a Nestlé decided on a Monday morning that it needed $100 million or $200 million of new debt, it could call someone and by that afternoon or the next day, it could have completed the deal,” he says.
The discrepancy meant that the US capital markets were at a big disadvantage compared with the Euromarkets.
Dobkin and others spent a lot of time at the SEC lobbying for change. The upshot was the concept of shelf registrations, whereby a company would file a single prospectus covering the sale of a certain volume of securities over a certain period of time, without needing cumbersome documentation before each sale.
“It meant that as long as a company continued to file quarterly statements, you didn’t have to reinvent the wheel just because you were issuing new equity,” he says. “After all, investors were buying and selling your stock every day.”
It is a change that certainly resonates now. The ability of private equity sellers to fire a quick block trade into the market today started with the work done back in the 1970s on shelf registrations.
John St John, an ECM veteran who now runs his own advisory firm, STJ Advisors, entered the market in 1985 at Barings, at about the time that Dobkin was knee-deep in his transformational work.
Although he just missed it, he puts the 1984 British Telecom IPO firmly in the bracket of single greatest innovation in ECM, being the first time that there had been a big multi-jurisdictional equity offering and the first time a widespread retail base had been targeted.
Over the next 15 years, privatizations across Europe would bring shares to the masses, driven not by economic expediency but by political ideology. But it is not a record that has been sustained.
“Europe has done rather badly with retail since then and that is mostly because of the dominance of the institutional-only banks,” says St John. “As time has gone on, the banks that own the allocation own less retail distribution and have less desire to allocate to retail investors.”
In Japan, by contrast, retail allocations can take most of a deal, driven by the network of a firm such as Nomura. In European deals no one is even advocating a retail tranche of 15% these days.
For Conor Killeen, who founded Irish corporate finance firm Key Capital in 2001 and had previously worked in equity capital markets since the early 1980s, the biggest change in ECM was the move away from offerings being conducted on a fixed price.
“Whether it was a rights issue or a flotation, the rules that operated in a lot of European markets always imagined the use of a fixed price, which was probably not the most efficient,” he says.
Black Monday was the beginning of the end for the big hard-underwritten marketed deals. The follow-on privatization offer of BP saw the syndicate on the hook for the offer price for a two-week period that straddled October 19, 1987, the day of the crash. By the time the deal closed on October 27, BP shares were at 262p, compared with an offer price of 330p.
What smarted the most was not in fact the UK placement – the hundreds of institutional shareholders that were sub-underwriting the deal were doing so because they wanted the stock – but that the roughly 20% North American placement was not sub-underwritten, leaving US and Canadian banks on the hook.
Killeen reckons that while deals like BP certainly gave mileage to US lobbying for the technique of bookbuilding without a fixed price, there were nonetheless benefits to issuers of the old ways of doing things.
“After that, it suited the Americans to run around and say [underwriting] didn’t work, but if you look at it from the point of view of a seller you get certainty,” he says. “Of course, it also meant that once in a while the underwriting had to be earned. What happened in 1987 was that there was a big dislocation in the market.”
Those who often did well out of the fixed price arrangement, he argues, were the underwriting institutions and the brokers, who were having to price the risk for a two-week period but often did so very attractively, at a deep discount.
“That moved out of favour as we began to adopt the North American model of demand-led, marketing-led pricing,” says Killeen. “But the problem was that this now meant that the underwriters were really taking zero underwriting risk but still being paid for it. The only real risk for the banks was counterparty risk, but in the US they were still being paid 5% to 7%.”
Even so, he reckons that issuers have benefited from the change overall. Taking into account costs and fees, issuers are typically effectively raising capital at a discount of perhaps 10%, but this might have been 20% in the days of hard underwriting.
For Killeen, the shift also illustrates one of the subtle differences between the European and the US approaches to the relationship between issuer and bank: that in the US there is a culture of generous payment of commission for success in sales, whether for a house sale or a flotation.
Sam Dean, former EMEA head of corporate finance at Barclays and for many years an equity syndicate head at Deutsche Bank, started his career 26 years after Dobkin. He reckons that he saw almost no technical innovation in equity capital markets deals for the whole of his career.
The most substantial technical change, he argues, was the abandonment of spreadsheets for recording the order book, a development that he was introduced to on his very first day at work at Kleinwort Benson (where St John was running ECM), straight out of school, after a stint as a fruit-picker.
“It was December 13, 1993, and I knew nothing about anything. Michael Lavelle, who I would be reporting to on the syndicate desk, came to pick me up from downstairs and told me we were going straight into a meeting with a company called Computasoft.”
That meeting was to assess a deal management product called Bookbuilder that Computasoft – which is now called Dealogic – had been touting to the capital markets banks since launching its first iteration in 1986.
“Until then you were using Excel spreadsheets for everything,” recalls Dean. “It was incredibly laborious with all the different exchange rates. When you swapped books with another bank on the deal, you sent your sheet to them and it got added to all the others.”
A few months later, Kleinworts took the plunge and switched to the new system.
“Things changed dramatically from an execution point of view,” says Dean. “You could provide much quicker updates to the client. Rather than eventually sending a spreadsheet at 4am, you could update them live.”
Innovation is at the core of capital markets, and sometimes it looks like products are leading and sometimes processes
Bookbuilder and its related platform SynDesk are still at the heart of deals today – although Dealogic has now merged them into a single platform called DealManager – and part of its appeal is that it enables banks to push faster and more granular information to issuer clients, as well as helping syndicate members work together more efficiently.
The importance of both of those functions was recognized quickly. When Dean was working on the UK electricity generation company privatizations in the UK in 1990, Kleinworts built a booth on the trading floor that bankers dubbed ‘The war room’. Its dramatic name belied the fact that it was simply slicing and dicing the Bookbuilder data in attractive ways to display to the UK government when they visited the floor to be updated on the progress of deals.
Did anything else have as much of an impact?
Not according to Dean: “Other than that, which happened 25 years ago, I don’t think anything else comparable has happened from a tech perspective in ECM.”
There hasn’t been much change in process either. Short-lived trends like the sponsor-driven competitive IPOs of the mid 2000s did not last long, squashed by banks and regulators alike. The Google IPO, conducted as a pure auction directly to investors in 2004, didn’t inspire copycats.
“That was 15 years ago – I think we can say by now that the innovation hasn’t caught on,” says Craig Coben, vice-chairman of global capital markets at Bank of America.
Coben sees little difference in the way that deals are being executed in 2019 to how they functioned 20 years before, although he notes that the fully marketed secondary offering has been pretty much phased out.
“Fundamentally, the ECM industry still executes business in an artisanal and arguably analogue way,” he adds.
When it comes to one innovation – the move to the pot system for order gathering and payment of fees – Dean believes firmly that things have moved against the interests of equity issuers.
“When I started, you were paid through the selling commission – incentive fees didn’t exist, so the only way you earned more than the other banks was by outselling them,” he says. “There was no pot system at this stage so everything was up for grabs. It was all about distribution.”
One result was that the buy side got a lot of calls as banks raced to outdo each other to get order designations from institutional clients – the so-called jump-ball method, as distinct from strictly pre-agreed economics. Typically deals might be part pre-agreed, part jump-ball.
“The salesforce would be on red alert during a deal because if they didn’t get an order it meant they didn’t have the relationship they had claimed to have with a client or they weren’t working hard enough, or both,” says Dean.
The advisory side was different. “Banks fought tooth and nail for the mandate, but once you were on the deal you locked arms and worked together,” adds Dean.
This all changed with the introduction of a new way of paying the banks on a deal, which gradually found its way to Europe from the US. The pot system – whereby orders would no longer be attributable to a specific syndicate bank – fundamentally changed how firms thought about the way in which they compete on deals, argues Dean. Specifically, it has moved competition from where it should be, in distribution, to where it shouldn’t be, in advice.
“I don’t think you should be competing on advice during a deal,” he says. “If you have to deliver a difficult message to an issuer, you have to deliver it. If you are constantly worried about your incentive fee, that becomes more difficult.”
By this logic, the result is that issuers get worse advice – and in part because of their preference for incentive fees.
The other impact of the change in fee structure was that the distribution effort got worse. Bankers often say that investors were relieved not to be pestered once the entire syndicate were not incentivized to compete for their order, although the reality is that no investor was helpless. Sales calls were – and still are – far more likely to result in the banker leaving a message than the investor answering the phone.
Sometimes even that didn’t happen. Dean remembers a deal in difficult market conditions where he was one of four bookrunners. A fund manager rang him on the last day of the deal to say that he was thinking of putting in an order but that no one from any of the leads had contacted him.
“It seems ridiculous, but if you are in tough markets, your last three deals traded down and you’re not going to be individually given credit for that order anyway, then the salesperson in that situation might just not make that call,” he says.
Have outcomes got better? There is little evidence of that. After about 40 years of international equity offerings, deals still get pulled at the last minute or else trade appallingly after being mispriced. Practice has not made perfect, which suggests that either it is impossible to improve outcomes or it is possible but the answer has not yet been found or the incentives for bankers to do so are entirely missing.
“The facts are embarrassing,” says Dean. “Markets are always going to throw you wobblies and there will always be tricky things to deal with, but a deal’s ability to get done and done well should improve over time. But it requires incentives to be better.”
One firm trying to fix at least some of these issues with a rare example of process innovation in equity capital markets is STJ Advisors, which celebrated its 10th anniversary in 2018.
STJ argues that it is uniquely positioned as a non-competitor to the banks that manage equity offerings and that it is able to collect data from those banks that usually would not be prepared to share it with others. By collating that data and then mapping and analyzing it in multiple ways, the firm can divide the target account base between the banks in the syndicate with precision, with the aim of making the marketing effort considerably more widely spread and efficient than might be the case if banks were left to their own devices.
This is partly because of external factors.
“Commissions are down 95% in 20 years, so there has been a huge contraction in the number of accounts that banks cover,” St John says.
There also came to be a greater reliance on the participation of hedge funds as they emerged in the 1990s, although the performance of deals once more than about 25% has been allocated to hedge funds suffers rather predictably.
The concentration effect, whereby deals are now controlled by a small number of firms that focus almost exclusively on a small number of accounts, is what St John thinks hurts deal performance.
His aim – bringing the effort back into distribution so that every firm working on a deal is motivated to sell to a select group of accounts where it claims to have its best relationships – echoes Dean’s complaint about how the market has shifted.
And, after doing about 120 IPOs at his firm, St John reckons he has the statistics to back up his claim. He defines an IPO failure as being it not pricing when scheduled after the announcement of an intention to float – unless the Vix [the Cboe’s volatility index] is above 28. Curiously, no European IPO has ever priced when the Vix is above 28. On that basis, he says failure rates on IPOs in Europe are getting worse, rising from about 20% of deals about five years ago to 40% in the last quarter of 2018.
Pricing performance on STJ offerings looks more controlled, which St John puts down to the more stable foundation provided by the broader account base of long-term investors who understand the equity story. The first-day performance of his deals in the last five years has ranged from plus 10% to minus 10%. The market as a whole ranges from approximately plus 50% to minus 50%.
ECM bankers still like to complain about St John’s methods, even 10 years on, given the workload that it involves and the control that it removes from them. Off the record, however, some give him more recognition than they are prepared to do in public.
“What he is doing is unique – he’s well ahead of the mob,” says one. “His database is unparalleled in terms of what accounts are doing, what they have participated in in the past and where the relationships between individuals are.”
Back to SocGen's Palmieri and his assertion that earlier attitudes to innovation allowed for the fact that only one in 10 projects might be successful. That might work for a fintech startup that is busy moving fast and breaking things. But in the post-crisis climate where banks have to be ever leaner on costs and ever fatter on capital, could that kind of luxury ever be supported at the big firms again?
“During the early period of my career, although you had senior managers who were probably less technical than they are today, they had this instinct that they needed to invest,” says Palmieri. “They were forward looking and not so constrained by short-term profits and regulation – a business head could have 10 or 20 front-office people to work on something and know that they would not deliver revenue for perhaps two years.”
Two things are stifling that investment in creativity, he argues. Since the global financial crisis, the focus of senior management is taken up with topics other than the creation of new products and businesses. At the same time, the global revenue pool is also shrinking.
Clients and their needs have also changed, he says. In the late 1980s and the 1990s, when capital markets were being deregulated and economies were becoming more global, the key clients were those riding those trends who required new products to help them do it.
“Today it’s a bit different: since the crisis, clients also need reliable banks who can manage their risks well, with transparency, and who can protect the interests of their clients. It doesn’t mean they don’t need innovation any more, but it’s a different kind.”
Egan at BNP Paribas agrees that the 2008 crisis changed everything in terms of where banks had to place their efforts.
“The crisis turned the focus squarely onto conduct and discipline – it’s everything that we live and breathe now,” he says.
Has it stifled product in favour of process?
“At this juncture, yes,” says Egan. “Issuance markets are in the long journey to a new evolution. If you compare 2019 with 2008, the issuance market is not hugely different: it is big and open 24/7, it is global in nature. But there is much more discipline around areas such as fairness and appropriateness.”
Allied to that is a focus on what Egan calls the management of the customer journey: “That has always been there, but now there is more emphasis on the concepts of customer service, openness, transparency and conduct.”
Westerman spent much of his career working on ECM transactions that, even if they weren’t constantly evolving in terms of execution process, did have to adapt over and again to the needs of specific issuers or sellers. But even post-crisis he doesn’t think that capital markets have suddenly turned vanilla.
“I don’t see it like that,” he says. “One of the remarkable things about the capital markets is the ability to be mercury-like, finding ways around things. It is one of the greatest single contributions.”
He agrees, however, that technology does not have the same obvious applications to M&A or primary capital markets work as it does in some other areas. A big trade-finance operation, for instance, might take perhaps one million incoming calls every year and is the kind of business that might lend itself to applications of artificial intelligence.
Paul Tregidgo is one of those who, despite having seen so much innovation in the field of product, agrees that primary market process has remained quite static.
“It is true that telexes are thankfully industrial relics,” he says. “There are fewer scraps of paper and long nights at the printer. But in a fundamental sense the processes remain very similar to the way they were when I started.”
Is he surprised by that?
“It is astounding on many fronts, not least the cost of this legacy of inefficiency and the operational risk that goes along with it,” he says. “When you begin to consider what technology could do for the cost of capital formation and for transparency, you wonder why dynamic capital markets are in many ways still operating on old-school processes.”
On top of that, the industry also faces very different challenges when embarking on new products to those faced in some other industries, where the stakes may be lower.
“If you are building a taxi-hailing firm or an e-retailer, it doesn’t matter so much if the latest gadget does not arrive on your doorstep or you have to hail your own taxi,” says Tregidgo. “But if your payment system fails and your money doesn’t arrive in your bank account, the consequences are severe and immediate for individuals and catastrophic at scale in an interconnected global system. There is no margin for error.”
You launch 10 ideas and, if you are good, then there is one that is successful; if you are lucky there are maybe three
What is also clear is that, aside from occasional experiments with auctions or direct issuance – Google’s IPO in 2004 was going to change ECM for ever but did nothing of the sort – the removal of the intermediary from the process has not taken off.
“What is unique about the primary capital markets business is that it is a team sport,” says Tyler Dickson, co-head of banking, capital markets and advisory at Citi. “The syndicate exists because of the banks’ relationships with the issuer and investors, and the fact that they are not all the same. So innovation in the primary capital markets business will come about through collaboration between intermediaries.”
So far, that is pretty much how things have played out. But slicker ways of transacting, perhaps by using blockchain technology, seem to be where the interest is pooling, even if it is still at an early stage.
The World Bank brought its landmark blockchain-driven bond-i deal in 2018. Marex Solutions has issued a blockchain-based structured note using a platform from Nivaura.
Platforms such as VC Trade, backed by German banks, are providing an online marketplace for issuers to sell Schuldschein – Lufthansa is the most recent. Red Eléctrica of Spain signed the first syndicated loan on a blockchain last year.
More progress is being made on methods of giving an edge in certain specific situations. Banks have been building artificial intelligence tools that will help them sell equity block trades more efficiently, for example, and to predict activist behaviour before a company has even realized it might be a target.
These are all intriguing developments, but many are still in the realm of curiosities, designed to test the appetite for further work or to provide real-world experimentation. For the moment, bankers think it is in the secondary market or in business lines that are themselves more built on repetitive processes where there is the most potential for radical change.
“No one has come to the conclusion that just because you can do something it will necessarily be better,” says Dickson at Citi. He sees applications of the blockchain being of much more use in areas like commercial and retail banking than in primary capital markets issuance.
He also does not subscribe to the idea that there has been some dramatic shift from product to process innovation over the history of capital markets. He prefers to see the two as forever intertwined.
“I would say innovation is at the core of capital markets, and sometimes it looks like products are leading and sometimes processes,” he says. “For instance, when credit was expanding rapidly in the decades before the crisis, you saw a lot of product innovation, which you have always seen in high-growth periods. In lower-growth periods, you see more process innovation.”
The pace of this innovation is only set to increase, Dickson reckons.
“You might perhaps see a unique period when products and processes are both evolving at the same time – it could be a golden age for capital markets.”