There is no doubt that 1999 will go down in history as a glorious year for the investment banking community. It was the year in which trillion dollar totals were hit by both Goldman Sachs and JP Morgan. The only pity is that so much of what was once the UK merchant banking industry was present only as the ghost at the feast. Very few survived the early 1990s to see the good times again.
Whether sold off by disappointed parent companies or bought out by voracious US or European players, the sector has dwindled to a handful: Flemings, Close Brothers, Rothschilds … Yesterday’s names, such as Warburg, Morgan Grenfell, Barings, Kleinwort Bensen and BZW have all fallen into European hands, while Schroders, which went to Citigroup, now flies the US flag.
John Maxey, a partner in Arthur Andersen’s M&A practice, points out that even the word “merchant banking” now has an odd, nebulous ring to it.
The US banks are now the strongest in Europe and their term, “investment banking”, is now in vogue. Merchant banking is a phrase that already connotes something as distant and quaint as an Edwardian garden party.
The transformation of investment banking into the US mode, a deal-focused activity with a portfolio of products aimed squarely at the complexities of the mega deal, has rewritten all the value-based league tables. (Barclays heads the league table for best corporate hospitality, but somehow that is not quite the same game …).
As Maxey notes, “Five years ago Schroders or Warburgs would have been top of the league tables for advisory work in Europe. Now it is all Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, JP Morgan and Warburg Dillon Read.” At the top end of this market, as in any other, size really does matter. These players rely on strategic manoeuvres to build and maintain world class critical mass. This impetus feeds down the chain, even into the traditional clearing banks, which is why we are seeing Bank of Scotland and the Royal Bank of Scotland competing to buy NatWest, with Lloyds TSB reputedly lurking to scoop up the loser.
As Michael Joseph, managing director of Lloyds TSB’s venture capital business, points out, the seemingly boundless appetite for mega-deals among the top banks is causing something of a drought at the small end of the market. “The sheer weight of money involved in billion dollar deals means that there is much less interest in the market for deals south of $50m,” he says. For example, by comparison with the fees on the Mannesmann-Vodafone deal, the fee for a $50m acquisition has the status of a rounding error. Yet the due diligence work required for the two can be almost on a par.
This does not mean to say that there is no money to be found for mid-range investments in Europe. In fact, those players which have remained focused on this sector have found themselves with work aplenty. As Simon Gorringe, head of the mid-cap team at Flemings, notes, the absence of competitors is something to be celebrated, not mourned. The gravitational pull that is tugging investment banking out of the mid-cap sector and into the mega deals has left plenty of excellent mid-range opportunities.
Consequently, he is happy to report that Flemings is undismayed by the demise or change of ownership of British merchant banks all around it.
“The big bulge bracket US operations are focused on the Vodafone-type mega-bids, but this is far from being the only game in town,” he says.
“We recognise, of course, that it would be foolhardy to take on the top US players across the board. However, back in 1998 we saw what was coming and we set up a mid-cap team of 25 specialists to focus specifically on technology and specialist industrials on a fast growth track,” he says.
The typical deal for Flemings lies somewhere between £100m and £1bn, and the company has done well in its sector. It advised Centrica on the £1.1bn acquisition of the AA in September last year, for example.
The success of Flemings’ strategy, Gorringe argues, can be seen from the fact that although Flemings has one of the largest exposures to emerging markets of any bank, it was still able to show a profit through 1998, despite the crises that beset the tiger economies. Since the recovery in Asia the bank has enjoyed record volumes of corporate finance business in the region.
After an excellent year Mark Wrightson, the chairman of Close Brothers, is similarly untroubled by having fewer British banks to beat to the corporate doorstep. The bank’s UK and Euro-centric focus means that, unlike Flemings, the Asian markets steep downturn was not a major drain on profits. Instead, the bank benefitted from a very active year. As Wrightson puts it, when the stock markets are buoyant, everyone feels confident and businesses are prepared to get involved in making investments, whether by greenfield or through acquisition.
“Every investment bank has its own league table that it tops. Ours happens to be the UK public quoted company table. We did more public company takeovers than any other investment bank in this sector over the past year,” he says. Close Brothers’ strategy is to look to develop relationships at an earlier stage in the corporate life-cycle than most US investment banks would feel comfortable committing with. Yes, but where’s the deal?
“We set our stall out on the basis that there are a range of companies that are receptive to, and would gain from, someone who is in the business of discussing strategy with them, knowing their industry and knowing the investing institutions – knowing what gets them excited or fearful,” says Wrightson. “What one has to do in this business is to grow with the company.
Over time they (the corporate client) reach a size where the company naturally comes into the investment banking industry’s cross-hairs. Once they are potential players, as a biological matter they need to grow a carapace against the investment banking book. We then change our relationship to being a trusted inner counsel for that company.”
Of course, this is not to suggest that the upper part of the mid-market (a confusing term at best) is vacated ground. As Maxey points out, taken on a global basis, the big US investment banks will sign a very large number of £400m-type deals. In fact, Maxey argues that even in the £50m to £200m category there are more players involved looking for corporate advisory work than ever before – and the top accountancy firms are as eager as anyone to get a share of this pot.
Investment bankers are willing to concede that the big accountancy firms have some very bright and capable people. They also recognise that these firms have been hiring a steady stream of ex-merchant bankers through the mid-to-late 1990s. However, no investment banker worth their salt really feels troubled in their bones by the idea of serious top-end competition for M&A work from the accountancy profession – yet.
The commercial banks are acquiring more of a taste for venturing beyond senior debt, but their fling with the investment banking arena went sour through the last decade. Richard Wetenhall, director for marketing and strategy at the Royal Bank of Scotland says that there is a “graft rejection” between the different styles of banking. Commercial banks are traditionally risk averse and their culture does not sit well with their gung-ho, deal-doing, investment banking brethren. The result, he argues, tends to be animosity, fuelled by misunderstanding.
For its part, the Royal Bank may have succumbed to the point of having its own middle market development capital arm, but it is definitely not in the core equity issuing arena. What it will do, Wetenhall says, is to be venturesome as far as extending its own balance sheet is concerned to help deserving clients meet needs that otherwise could not be met.
Wetenhall cites the case of Richard Branson’s West Coast Rail, where the Royal Bank financed £700m of debt on its own books to buy Branson his set of tilting trains. The money was needed rapidly so the bank acted.
Having done so, it then went at speed to the capital markets with a new bond and got the debt off its balance sheet as fast as possible.
“It would have been a huge risk for West Coast Rail to have issued a bond like that without being sure of getting the funds. The approach we took ensured that it was a success. This is fairly adventurous stuff.
We are not averse to risk, just to mis-priced risk,” Wetenhall comments.
What this means is that the client has to be prepared to stump up a realistic figure for the risk that the bank is prepared to take. “A lot of what we do is to try to structure things so that the risk is appropriate for us and for the customer,” he says. The bank is happy to sit in what Wetenhall terms “the area of overlap” between commercial lending and capital market activity. It is also happy to verge on corporate advisory work in the middle market, where the relationship with the client lends itself to discussions about strategy. But this, he stresses, is a very different activity to that which a Goldman Sachs A-team would deliver. Extended corporate advisory work is pure investment banking terrain, he insists.
Wetenhall is not particularly optimistic about the accountancy profession’s chances of breaking into the higher reaches of the corporate advisory market – after all, he argues, the accountants have spent the past 15 years trying and not made it yet. “These are highly skills-based businesses,” he says. “If the accountants succeed in luring the best graduates and partners away from merchant banks, they might succeed. However, the brand and the people in a JP Morgan or Goldman Sachs work as a very strong virtuous circle that is difficult to break.”
Colin McGill, divisional chief executive of corporate banking at Bank of Scotland, reckons commercial banks in general, and his organisation in particular, now have much more of an appetite for lending beyond the senior debt. Taking chunks of the mezzanine debt is now established, and the banks are looking to take portions of the higher risk, higher margin levels of the debt stack. “We have seen the structures for debt and the appetite for the various structures change significantly in response to the economy, and to the supply and demand of financing,” he says.
The whole point of a debt stack is to try to apportion safe-value versus risk-value and to reward or price different levels of risk appropriately.
McGill argues that as banking moves away from being defined as a product and becomes a service, the trick is to focus on the value being delivered to the customer. With this in mind, and with relationship building as the goal, it becomes possible to accommodate different funding levels.
“This movement into the higher layers of the stack started some years ago in the US. UK banks now realise that it can be quite a profitable direction to go in,” he says.
As a final note, it has to be said that everyone in the sector has at least one eye on the Internet, which lurks unpredictably in the background.
Does the Internet have the capacity to Amazon the investment banks or will they be able to tap it for its distribution potential and its retail-fund-raising capabilities? Will corporates be able to go direct to the Internet for funding, inviting the punters of the world to subscribe to this or that scheme, bond or deal? Or will we find that the Web page concerned bears the JP Morgan/Goldman Sachs logo?
Next month: Anthony Harrington investigates the role of the accountancy firms in corporate finance.