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Burned by complex deals, investment banks show a new appreciation for simplicity.
Avital Louria Hahn, CFO Magazine
October 1, 2008
Talk about a harbinger: When FairPoint Communications finally received long-awaited regulatory approval to acquire Verizon Communications's New England landline assets in March, the banks financing the deal panicked. The Lehman Brothers–led group began blitzing the Charlotte, North Carolina–based company with calls, using state regulators' newly revised capital requirements as an apparent excuse to hike the borrowing rate on the $2.5 billion financing package they had agreed to a year earlier.
In the period since terms were first set in 2007, spreads for double-B credits like FairPoint doubled. On the banks' side, they were facing $200 million to $300 million in losses unless they somehow squeezed concessions out of FairPoint. At the prevailing market rate, though, the $2.5 billion deal would have been prohibitively expensive for the midsize telecom carrier.
"You could feel the tension," says John Crowley, FairPoint's CFO at the time. "You could tell they were calling to do something they weren't comfortable doing but had to do anyway."
Six months later, of course, Lehman filed for bankruptcy protection. But FairPoint's experience exemplifies some of the risky bets that many investment banks routinely made with their balance sheets during the credit glut — and then regretted. The lessons still fresh, investment banks are now entering a period of conservatism. They are restricting balance-sheet use, retreating from highly complex products like collateralized debt obligations (CDOs), and renewing emphasis on the basics — advisory work, equity research, trading and underwriting, asset management, and basic forms of securitization.
"The Street's risk appetite is shrinking," says Brad Hintz, banking analyst at Alliance Bernstein. "It is shrinking because the regulators have learned a lesson, the rating agencies have learned a lesson, and the Street itself has learned a lesson."
Hintz made those comments prior to last month's stunning developments on Wall Street; there may, in fact, be more lessons to learn. This Wall Street realignment calls for CFOs to more closely scrutinize investment-banking relationships to determine if the partnership still suits them. Has a Wall Street bank changed its business mix? Can it deliver on a financing commitment? Does it still possess expertise in a client's sector? Can it be relied upon as a counterparty?
Wall Street's Retreat
To survive and compete, banks are retooling. Universal banks such as UBS and Wachovia tried to be one-stop shops by jumping into investment banking. Investment banks tried to compete by stepping up lending. But some of these diversified firms are seeking to exit certain businesses and specialize again.
When it doesn't involve balance-sheet risks, investment banking can be a lucrative and low-risk business. But in recent years, as commercial banks have entered the securities business, heated competition has driven dealmakers to package advice with financing (thus taking on substantially more risk) to win clients.
Analysts expect that the surviving brokerages, which have to borrow in order to finance deals and compete with commercial banks, will retreat from waving their balance sheets at potential advisory clients. "You are going to see the Street cede market share from its lending business to commercial banks," Hintz says. "The Street found that when they have a commitment to somebody that they cannot finance themselves, they can end up with a hung bridge loan."
As Lehman's financial condition deteriorated, the bank peddled a majority stake in its asset-management division and considered unloading its fixed-income business to become an advisory boutique. Wachovia, whose new CEO is overhauling the bank after an ill-timed acquisition of mortgage giant Golden West, wrote down $6 billion in the second quarter and plans on asset sales, which may include its insurance and brokerage businesses, according to RBC Capital markets and Alliance Bernstein analysts.
"Some banks are not convinced that investment banking needs to be a core strategy," says Eduardo Mestre, vice chairman of Evercore Partners. "The notion of being a 'supermarket' or a multiple-product provider with cross-selling synergies has proven to be less of a boon than people anticipated." Banks, he adds, are therefore asking, "Do you really have to be all things to all people? Is that a competitive advantage?"
Take My Advice
While investment banks won't rush to fund M&A deals, they will push advisory services. M&A advisory is one of the most profitable areas in investment banking. Fees are based on deal size and range anywhere from 2 percent on the high side to half a percent for multi-billion-dollar deals. The problem, though, is competition. A pure investment bank offering mostly advice and no financing has to differentiate itself in other ways, either by an excellent reputation for certain kinds of deals or with expertise in a given vertical market. Goldman Sachs has a reputation for defending companies from hostile bids, for example, while Lazard is well known for its restructuring prowess.
Another notable change in investment banking will be a migration away from a heavy reliance on revenue from fixed income businesses. Fixed-income revenue has declined 36 percent in the first half of 2008. In particular, CDO-related fees, which contributed $3.5 billion in revenue to the top five issuers in the first half of 2007, tumbled 90 percent in the first half of 2008, to $374 million, according to Freeman & Co., a financial services advisory firm.
Securitization, a dirty word since the collapse of the mortgage-backed securities market, will make a comeback, analysts say — but not in the complex, opaque form of CDOs. Simpler, more-transparent securitization that complies with tighter credit-rating standards and is backed by strong assets will draw investors — maybe even more than previously, now that more-exotic products are off the market.
Even as the credit crisis deepened, companies with strong credit ratings, such as Textainer Group Holdings Ltd., managed to structure receivables securitization deals. Bermuda-based Textainer, a large-container lessor, buys and leases containers and securitizes the receivables in a special-purpose vehicle. Last July, the company increased the size of its securitization facility with Wachovia to $475 million (from $300 million) at a favorable rate of 1.25 percent over LIBOR. The deal "will help to ensure that we have access to the financing necessary to position Textainer for future growth," says John Maccarone, Textainer's president and CEO.
CFOs will also benefit from investment banks' renewed interest in equity research. Why? After years of erosion, equity-trading margins stabilized earlier this year, says Lionel Conacher, president and chief operating officer of Thomas Weisel Partners. More revenue devoted to equity-research groups will likely result in more companies getting more coverage. Some mutual-fund companies have been showing renewed interest in research, while hedge funds, which have always been willing to pay for research, manage a growing pool of assets, and therefore have more impact on trading, Conacher says. "The pendulum has probably swung too far and now people are realizing the need to pay for good ideas."
Even in the midst of the credit crunch, several banks beefed up research departments, although much of the action focused on non-U.S. companies, a major growth area. For example, Citigroup, a top player in Asian investment-banking, hired a dozen new analysts last August even as it trimmed other areas.
One product line that will continue to enrich investment bank revenue streams is derivatives. Derivatives have been one of the fastest-growing areas for Wall Street banks, which will still be able to write them and buy credit default swaps to hedge lending exposure. That's assuming that movements to reform the over-the-counter market's practices — such as a standard auction settlement mechanism and guidance on collateral management — won't dissolve margins.
The continued existence of the derivatives market is important to companies as well, because it provides a way to hedge interest rates and limit foreign-currency exposure. But given the current instability in investment banking, finance chiefs will have to exercise extra caution when choosing a counterparty for derivatives contracts, says Alliance Bernstein's Hintz.
A CFO looking to enter interest-rate swaps, for example, would be wise to choose a bank with superior credit ratings for the longer-term trades and relegate short-term swaps to those with less-than-stellar credentials. "The weakening of the ratings of the brokerage firms means that many corporate counterparties are going to be passing on the brokerage names in the future and will do only short-dated derivatives," says Hintz. "The longer-dated trades will go to the commercial banks because of their ratings."
Betting long on investment banks in any area of financing is inadvisable, at least for now. Crowley recalls that he "sweated bullets" as the Lehman deal went through a revise even as Bear Stearns collapsed. Many CFOs may find themselves in similar straits as the number of investment banks shrinks and large commercial banks further expand their already sizable range of offerings. These days, everyone would welcome a return to simpler times.
Avital Louria Hahn is a senior editor at CFO.