Investment bank corporate finance advisers and underwriters face a continued squeeze on fee income this year because, according to most estimates, corporate bond issuance is set to plummet by around 50%. Companies entered last year’s sharp downturn with a high degree of leverage after an unprecedented and prolonged investment boom and a raft of M&A activity.
Now “bust” rather than “boom” is on the lips of most corporate treasurers, who find themselves under pressure to reduce financial leverage, while M&A activity is going into free fall.
“The invest-or-die mentality has given way to de-leverage-or-die,” says John Butler, head of debt strategy at Dresdner Kleinwort Wasserstein. “Corporates leveraged up through the second half of the 1990s in an effort to grow and acquire their rivals before they themselves were acquired.
They also repurchased record amounts of shares in an effort to increase their returns on equity.” But Butler warns that the next one to three years will see a dramatic decrease in financial leverage. He estimates that investment spending in the US, the benchmark for corporate issuance, plummeted from a 12% year-on-year increase in 2000 to minus-2% in 2001.
This rapid decline in corporate spending, combined with the associated drop in M&A activity, was predicted to result in a 50% to 70% drop in new bond issuance in the year from July 2001.
Global investment banks have been refocusing their strategy – coming down from their perches might be a more accurate way of putting it – to pick up business from corporates that in the past they would have considered too small. “Until this year we would rarely touch a company valued at less than £1bn,” says a corporate finance director at Goldman Sachs. “Now the threshold has been lowered to £300m or £400m and this is not a bad development. For one thing it has proven to be a training ground for young people to cut their teeth on. If they make a mistake and IPO a company’s subsidiary at £100m when it should have been valued at £110m, then it’s not the end of the world.”
Corporates scale back M&A activity during periods of investment retrenchment, according to Dresdner’s Butler. He points out that the M&A cycle normally tracks the investment cycle, which in turn is related to the balance sheet cycle. Hence, M&A transactions result in more rather than less leverage on the balance sheet and are associated with more, rather than less corporate bond issuance.
The outlook may not be very positive for corporate issuance and investment banks casting about for M&A mandates, but it is not completely gloomy.
Dominic Franklin, global head of Investment Grade Primary Markets at ABN Amro agrees that the funding needs of corporates have been reduced due to the economic slowdown and the threat of recession, as well as the lack of M&A activity. However, he argues that the lack of demand has to some extent been offset by the fact that a lot of companies have been diversifying away from bank loans. “Although companies’ needs are reduced, we saw a lot of paper in the euro market in 2001 by companies refinancing bank lines in order to diversify their sources of funding. At a time when bank lines are becoming more expensive it does make sense to look at the bond markets, which also provide the added advantage of longer term funding,” he says.
In fact, the bond market may suffer less in Europe than in the US. The decline in euro market issuance is likely to be smaller because of the counter-effect of the ongoing structural shift away from bank financing and towards debt market financing. Banks are also re-structuring their loan portfolios, in large part through the securitisation of low-yielding assets, including loans to investment grade corporates in the form of collateralised loan obligations (CLO). Thus the overall decline on euro corporate debt supply will probably be less in euros than in dollars.
The 11 September attacks on New York and Washington are another factor likely to depress the corporate bond market, in Europe as well as the US. “In the aftermath of the terrorist attack on the US the credit markets are currently nervous and it will be difficult to issue paper without paying a significant premium,” says Franklin. “This could steer companies back in the direction of banks, which always tend to be there in difficult times when the bond markets tend to be nervous. However, I think that once the dust settles over this crisis and the uncertainties reduce, the bond market will continue to develop at a fairly strong pace.” But in the short term he believes investment banks will continue to suffer as their corporate finance work stagnates.