One of the panels at the recent student-sponsored Wharton Finance Conference was subtitled: “In Search of the Optimal Business Model for Investment Banking.” Given the current pall on Wall Street, that search has taken on new urgency in the midst of a continuing debate over how investment banking should be structured when the markets recover, what the role of large universal banks and boutiques should be, and how the industry should better define the relationship between Wall Street research and investment banking.
Tom Flanagan, managing director in the financial sponsors group at Lehman Brothers and one of the conference panelists, laid out the current woes: very few IPOs, deals postponed, mergers and acquisition business down 40% last year which was already down from 2000, defaults on bridge and high-yield loans, accounting fraud, and layoffs. “And I’m usually an optimistic, peppy kind of guy,” he said.
The gloom has heightened discussion about the merits of a big, one-stop bank versus a specialized boutique, a subject of increasing importance ever since structural changes in the industry, including deregulation, led to a new generation of global banking behemoths in the 1990s.
“Historically the commercial bank controlled the financial capital and the investment bank controlled the intellectual capital,” said Andrea Katter, managing director in the mergers and acquisition group at Bank of America Securities. “Those lines have blurred over the years as commercial banks have acquired, or through lateral recruiting have recruited, that intellectual capital. This has been one of the biggest changes in the last 10 years.”
Simon Canning, managing director of UBS Warburg, said he believes in the European model of universal banking, though he also sees a role for specialists. “There is absolutely a role for boutiques and for large firms. But you need to distinguish between a brain surgeon and a general practitioner.”
A brain surgeon, he suggested, is like a boutique banker, with skills in a certain industry or in a specialized type of transaction. For the brain surgeon to work effectively he needs access to the brain – the company’s top executives. A universal bank is more like a major hospital with the ability to write loans, underwrite securities or give advice. If a company chooses to go this route, its banker may be more like a general practitioner, who has a broad set of skills and can put all of the big bank’s resources to work for the client.
David Hartzell, co-head of CIBC’s Business Services Investment Banking practice, was working at Alex Brown when it was acquired by Bankers Trust in 1997. He was still there when Deutsche Bank bought the firm in 1999. “At Alex Brown it was helpful to all of a sudden be able to provide leveraged financing to our clients. We were losing business. We would take clients public, then [they would move] to DLJ or someone with broader financial capabilities,” said Hartzell.
According to Parker A. Weil, managing director at Merrill Lynch, the current retrenchment on Wall Street has left many companies desperate for financing, particularly in the telecom sector where he specializes. “The companies I cover have insatiable needs for capital. Liquidity in today’s market is so important.”
Coby J. Stilp, director in the financial entrepreneurs group of Salomon Smith Barney’s investment banking division, agreed. He said that when investors were pumping capital into Wall Street in the last 1990s, companies had to think carefully about whether to use a small, specialty banker or a large, full-service bank. “In times like today, I think the business goes to people who can provide capital.” He predicted the world’s largest banking institutions will continue to grow. “I’m of the mind that there will be two or three or four universal banks and then a larger number of small boutiques that specialize.”
Meanwhile, the rise of the big banks and their ability to write loans for customers that do other business with the bank has led to a vast mispricing of loans, panelists suggested. “Banks are not properly pricing the loan product,” said Bank of America Securities’ Katter, noting that return on equity for the average corporate loan is 10% to 12%, but bank shareholders demand 20%. To stabilize loan pricing, “a lot of universal banks are demanding that large corporate clients buy other services from them.” If clients balk, she added, the large banks refuse to supply credit.
According to UBS Warburg’s Canning, “For all the intellectual capital available on Wall Street, it’s very good at mispricing the cost of capital.” Banks need to learn how to say no to their clients. “That is very painful, but if you feel in the long run that is the right advice, you should not extend the capital mispriced … I, for one, have always felt there must come a time as with any rational market where pricing should go up in loan product. I think if pricing went up in loan product you would see slightly different behavior.” Banks, he added, ultimately are judged on the quality of the deals they finance: “The truth is, a lot of bad deals have been brought to market.”
With investment banking’s emphasis on size, opportunities exist to work with mid-sized deals, panelists said. “There is a role for people who are able to structure and distribute difficult deals particularly for the middle market,” Canning noted. “Loans under $100 million are hard to get done today.”
Hartzell, who works on middle-market deals at CIBC, said big banks, which traditionally have focused on large capital companies, are reaching into the middle market. “In the [current] environment, everybody is pitching everything because of the overcapacity on Wall Street. Everything is out of whack with deal flow. When the market recovers, we’ll see some stratification with companies going after large caps and an opening for middle-market institutions that can provide good strategic advice, that know the industry, and can give the attention the clients feel they deserve.”
In today’s market, panelists suggested, private equity firms are able to make deals that are not possible for large banks with obligations to their public investors in a climate marked by concern over potential default.
Weil, of Merrill Lynch, said the slump in investor sentiment has created some “outsized opportunities” in good companies that have been lost in the wreckage on Wall Street. Private equity firms, he added, are lining up to get in on those opportunities, because they have the flexibility to take on the risk even in today’s climate. “Public companies are restricted from playing that game because of our shareholders’ concerns.”
He said he could not imagine his firm, for example, writing a bridge loan for Tyco. “A private entity could do that more seamlessly … You’re seeing a lot of private money looking to invest which is going to do very well in today’s market.”
Big or small, investment-banking firms are also wrestling with the question of separating research from their fee-driven advice and finance business. “This is a huge issue,” said Lehman Brothers’ Flanagan, noting that conflicts between investment banking and research arose from the deregulation of securities commissions on May 1, 1975, known as May Day. Before that, the cost of providing sell-side analysts was covered by trading fees. But when fees dropped after deregulation, analysts grew dependent on investment banking fees for their keep. Abuse was inevitable, he said.
Research has a place on Wall Street, Flanagan added: It remains important to investors – not necessarily investors who react to buy or sell recommendations, but those who take the time to read the analysts’ report and decide for themselves if a company’s model will work.
Research analysts are also important for small and mid-sized companies as a way to get information to investors, Flanagan noted. “If you get rid of research and make it a backwater, you will have poor communication between companies and investors.” In addition, when an analyst or a banker leaves a firm that took a company public, the company gets lost. “Those companies become corporate orphans on Wall Street and don’t get valued properly.”
In May, Merrill Lynch agreed to pay $100 million to settle conflict-of-interest complaints by New York Attorney General Elliot Spitzer who alleged Merrill’s in-house research staff was used to promote the firms’ investment banking business. Merrill agreed to separate research from its investment banking business as part of the settlement. Spitzer’s office has also subpoenaed clients of Salomon Smith Barney’s former star telecom analyst Jack Grubman in another conflict-of-interest investigation.
Stilp said the last six months have been a “watershed” at Salomon Smith Barney: “We’re not even sharing the same elevators as the research analysts. It is as different as night and day compared to six months ago.” He pointed to two models for research: one in which retail investors underwrite the service, or the late 1990s version in which fees earned in the investment banking business went to finance research operations. But Spitzer and others allege that researchers were overly positive about their firms’ clients to drum up investment banking business.
According to Stilp, his firm used a mix of both models. “There are firms, like ourselves, that try to dip into all the pools,” he said. But the ties between research and investment banking were already beginning to fray before the Attorney General began to investigate. “It works really great in bull markets, but when they turn down you’re the first to get hit.”
Stilp predicted that research will become an independent group with no revenue-generating business. But over time, he said, that model won’t work. “I don’t see how people will be able to hire [high-salaried] research analysts and not get paid for it.”