Carter Glass and Henry Steagall must be rolling in their graves. Those two worthies, then a senator and a congressman respectively, strove to build a solid foundation for American capitalism amid the devastation of the Great Depression. They had seen the savings of working Americans disappear amid the crash of banking houses that had, in part, speculated in stock offerings and then compounded their exposure by lending to the same companies in which they owned stock. The Glass-Steagall Act of 1933 decreed that henceforth there would be two separate banking systems: one for the hard-earned deposits and carefully secured loans of solid American citizens, the other for the frenzied, madcap world of stock underwriting and trading.
Last year, the solid-citizen banks and the frenzied-stock banks began leaping into official partnerships again, like lovers long separated by cruel fate. At least half a dozen such relationships had been consummated by mid-November, and by yearend, rumors were thick about other deals.
Looking at the big picture, the combinations represent another facet of the convergence of financial industries and the mounting pressure on big banks to grow until they can provide all financial services.
“We believe,” as bank analyst Mike Mayo of CS First Boston put it, “we’re on the cusp of a once-in-a-lifetime consolidation in the banking industry.”
More immediately, however, the sudden gold rush was set off by the Federal Reserve’s decision to allow banks to greatly expand activity in corporate equities. Suddenly banks that had been dabbling in that investment side, being careful to limit their subsidiaries’ revenues to no more than 10% from activities like underwriting, were free to think in bigger terms (see sidebar). And once the acquisitions started, says Isaac Lustgarten, a banking and securities regulatory lawyer with Schulte Roth & Zabel in New York, “there was a certain sort of panic in the street, the same way people accuse the average investor of panicking about being left out of the stock market rise. These guys are no different. They are not immune to envy.”
Analysts generally agree that such mergers make sense. Felice Gelman, senior analyst for Keefe Managers, Inc., points out that the proliferation of financial instruments now provides companies a wide variety of ways to get capital. If banks cannot offer some of these sophisticated tools, they lose business to the investment banks that can.
But the real key to why most banks want investment bank expertise appears to be the ability to do equity underwritingu00e2u20ac”put together a stock offering for a company and sell it to the public. Diane Glossman, bank analyst for Salomon Brothers, says, “Most want to be able to do initial public offerings for their existing customers, instead of sending them off to a brokerage firm because they can’t do the distribution themselves. That’s a highly profitable business, though it occurs seldom in the life of a client company. In addition, some want merger and acquisition advisory work. Both activities provide very senior level discussions with your client and put you squarely in a key role with that client long term.”
Another advantage of such deals is that a bank and the investment bank it acquires should be able to profit from each other’s client lists, each offering new services to existing clients.
A bank’s big balance sheet also provides some advantages to an investment house. For one, the investment bank’s credit rating will go up, so it can borrow money more cheaply. That, in turn, may encourage more investment in technology. Also, backed by the bank’s equity, the investment house is freer to buy and sell on its own account on the trading floor. (The SEC requires a specific amount of equity to do certain amounts of trading.)
Fleet Financial Group’s acquisition of the Quick & Reilly Group beautifully exemplifies this point says Katrina Blecher, financial services analyst and vice president of Gruntal & Co.
“What I like best about Q&R is their clearing and specialist operations,” she explains. “A specialist hangs out on the floor of the New York Stock Exchange and has a book of business. One guy might be a specialist in IBM, for example. The bigger balance sheet from Fleet lets them do more business, and the more business they have, the more comes to the clearing operationu00e2u20ac”the back-office operation. Clearing is a third of Q&R’s revenue and so are the specialists. That’s the real key to the deal.”
Some argue that such mergers raise a bank’s reputation in the marketplace. The reason being it now has a more sophisticated knowledge of capital markets because of the investment house’s expertise. Does the same argument suggest that the investment house will lose luster by virtue of being owned by a bank? Aside from the fact that many bankers bristle at the idea they lack financial sophistication, Lustgarten argues, “None of those acquired, though excellent institutions, had the cache of being a Goldman Sachs or Lazard Freres. That question is a common notion, but it will be easier to answer when we see a bank acquiring an investment bank with the highest cache level, and that hasn’t happened yet.”
There are some flat-out disadvantages to marrying the traditional business of banks to investment banking. For one, the investment banking business is acknowledged to be cyclicalu00e2u20ac”and earnings volatile. As analyst Blecher says, “Investors in bank stocks like consistency of earnings… Earnings will be more volatile 10 to 20 years down the road, but then things will be totally different, and investors will be used to the volatility.”
In addition, these transactions are expensive now, as deals and profits at investment houses have boomed along with the historic bull market. And along with the investment banks come high fixed costs, such as salaries and incentives to retain key, specialized people.
Even the presumed advantages may be oversold.
“There is a lot of hype about one-stop shopping,” says Salomon Brothers’ Glossman. “A lot of customers will want that. But there will be others, particularly the sophisticated, investment-grade institutions, that will say, ‘I want to cherrypick it myself. I’ll go to the very best place for the kind of funding I need. Nobody can be world class in all areas.’ ”
The investment house will also presumably lose any business it gets from other banks. Attorney Lustgarten says every bank looking into such a purchase, as part of its due diligence, should ask the investment bank how much business it does with other banks. Although, Lustgarten says, he’s not sure how much of that business there was to begin with. “How much of Alex. Brown’s business was other banks? Probably not much.”
The art of the deal
Given those potential drawbacks, analysts are happy that most of the deals they have seen so far are relatively small in terms of the institution’s total business. Even a bad year at the investment house should not dilute earnings much. One exception was Bankers Trust’s acquisition of Alex. Brown, which will represent about 20% of the combined company, according to Glossman. But that deal won general praise as a complementary match. Blecher referred to it as “one brokerage firm buying another.” Another analyst said Alex. Brown was doing so well this year, its acquisition would not dilute Bankers Trust’s earnings even for 1997.
Blecher pointed out that Swiss Bank Corp.’s purchase of Dillon Read & Co. was also a combination of two “comparable mindsets,” since Swiss Bank has a broker-dealer operation in Europe. Gelman noted that First Union had started building a capital markets group from within before it acquired Wheat First Butcher Singer. “They had a capital-markets approach to their existing customer base, so acquiring a brokerage firm was not venturing into an entirely new business, [it was] simply adding some capabilities. It makes a lot of sense to me.”
One particularly complex area of the deals involves structuring the purchase and incentives. In general, the owners of the company being acquired want all their money up front, while the acquiring bank wants the key producers locked into contracts that will keep them aroundu00e2u20ac”and still hungry enough to work at peak productivity. Some deals are paid for entirely up front, but many are paid for at least in part by “earnouts.” In this way, the profits of the subsidiary pay for its purchase, and the target’s partners or shareholders may be paid on the basis of how the subsidiary performs over the next few years. (Acquiring a publicly held company means three-way negotiations: the acquiring bank, the shareholders of the acquired company, and the key producers of the acquired company.) Earnouts are not only tough to negotiate, they are tough to manage going forward, as the acquired company fights to make its goals.
Part of that continuing struggle is the issue of autonomy. The investment bankers do not want new systems and controls put on them that may make it more difficult for them to achieve their bonuses. The bank, however, wants to make sure those producers are harnessed to the bank’s overall goals. Vague memories of headlines about rogue traders who lost billions of dollars help goad the urge to control. Sometimes, says Lustgarten, a bank actually makes the operation it acquires less profitable by imposing infrastructure costsu00e2u20ac”new computers, new offices, a percentage of the bank’s overhead, etc. Such moves may make sense for the bank as a whole, but individuals who lose a bonus may not stick around.
And though acquiring banks may promise autonomy, says Gelman, “it’s a wonderful world if you can sell your company and ignore the new owners. That doesn’t happen too often. If a company is well run, autonomy won’t be an issue, because everybody will share in the same objectives. That’s the real issue. But if maintaining autonomy is the investment bankers’ key issue, they shouldn’t sell.”
The issue is exacerbated by what many observers believe are fundamentally different cultures. As Blecher points out, “If the bank has a trading desk, you could conceivably wind up having someone making $80,000 next to someone making maybe a million dollars for doing basically the same job.” Approaches may also differ on what advice to give clients, who should control the relationship, and so on. Lustgarten notes that merchant banks and clearing banks in England have largely remained separate despite the fact they can merge, and he argues that is evidence that cultural differences run deep. But, scoffs Glossman, “Commercial banks have already changed. Tell me the difference between Jimmy Lee’s operation at Chase and a pure investment bank. It’s slim to none. Culture may have been an issue in the early to mid-’80s, but it’s not nearly as big an issue today.”
Of course, none of this debate answers the question of whether banks today are making the right move in buying investment houses.
Connie McCullough, senior vice president of Norwest Investments and Insurance, Inc., which does not currently do equity underwriting, says their institution has declined to jump in the fray. “We continue to evaluate brokerage firm opportunities, but we feel prices are at a premium. The real assets are the people, and they can walk right after closing. So we’ve made the decision as a company to focus on growing our investments internally.”
She acknowledges concern about the fact that there are only a limited number of potential partners, and they could all be gone when Norwest is ready to buy. But, McCullough says, “you have got to get value for the price you pay. You play your card today and hope you made the right move…. The culture differences are the real issue. We’ll have to see the model first of what’s going to work and wait for things to settle down.”
That was what First Union planned to do, according to Jerry Schmitt, executive vice president and co-managing director of the bank’s Capital Markets Group. The bank underwent some talks with brokers, but decided in early May to simply build in-house.
“Then the landscape started changing,” Schmitt says. “People were buying left and right. All those we would want to have competitive capability against were doing those kinds of deals. Plus, I had been in New York trying to find a person or two who would come in and head our building effort, and I had seen enough people’s eyes glaze over.” He says those he talked to perceived the effort of trying to recruit a whole group and build the bank’s critical mass as “a really, really difficult job.”
“That was new information we brought to the table when we talked with Wheat again. Now we are two years further down the road than we would have been.”
In a sense, most banks that have bought investment houses so far are buying as well as buildingu00e2u20ac”buying a small operation and planning to build it internally. And the market’s reaction? Analysts generally are bullish on this option (the biggest investment houses are too expensive to buy now anyway). But they are equally satisfied with banks that are not buying now. In short, analysts we talked to are resolutely clear about the fact that they are not sure what will happen next. And as for commenting on which parties might be involved in the next marriage, no one ventured to guess, nor would they predict whether the pace of deals in 1997 would continue into 1998. And no one yet was certain whether the banks that acquired investment banks in 1997 paid too much or whether they should have waited.
“Some will not work,” says Keefe Managers’ Gelman, “and they will have to be coughed up and will be acquired at bargain prices. Does that mean it’s a mistake to establish yourself as a scale player early on? I don’t think so, necessarily. Was it a mistake for Travelers to buy Salomon? They get a huge global network, and the chances of them being able to acquire that out of the wreckage of a failed acquisition in some downturn isn’t too high…. We’ll have to give it time and see how it works out. Good acquisitions are made at all phases in the cycle. It’s not only the price you pay, but what you do with what you acquire.”
The converging global marketplace has had its effect on the spate of investment business acquisitions. It is generally agreed that European banks are hungry to acquire American investment expertise, in part because of looming pension problems in Europe. It is also clear that there are only 20 or so investment houses that are both small enough to be affordable and big enough to make a difference. Gelman predicts that 15 or 20 large institutions will try to offer a complete range of investment services, while others will develop boutique services later, perhaps along geographic or product lines.
But bankers should not let their eye stray off the bottom line. Glossman argues: “If buying an investment bank doesn’t add to returns and doesn’t add to your earnings growth rate, then why do it? The answer that you’re ‘doing it because of the competition’ is not a good answer.”
And for bankers worried whether history will show they made the right move in these changing times, attorney Lustgarten offers a sort of solace.
“You’ll never know [whether buying now was a mistake]. These companies will become absorbed into the bank infrastructure, 10 people will leave and 15 will be hired, new costs and compliance procedures and infrastructure will be imposed on one part of the organization or another, you will spend money for technology, you will hire people because some did not have the expertise they claimed to have, and deals will be referred back and forth. So when you ask later whether it was a good investment, the answer will end up being, ‘What do you mean by a good investment?’”
So while boards considering such action may be unsure of the right strategy today, they can take comfort in the thought that, in the future, no one will be sure whether they did the right thing anyway.
Think of that as the upside of uncertainty.