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The financial services industry is betting that mergers will lure corporate customers.
Ian Springsteel, CFO Magazine
November 1, 1997
Just two years ago, many finance executives were still dismissing the notion of a union of commercial and investment banks as fantasy. But with the financial services industry gripped by merger fever, companies like Speedway Motorsports Inc., a Concord, North Carolinabased racetrack operator, are adjusting to a new reality.
Announcements two months apart jolted Speedway's key banking partners. Last June, the company's commercial bank of 20 years' standing, NationsBank Corp., announced it would pay $1.2 billion for Montgomery Securities, the San Franciscobased investment bank that Speedway had included in a recent $125 million high-yield private debt offering. Then August brought news that First Union Corp., long a contender for Speedway's banking business, was to pay $471 million for Wheat First Butcher Singer Inc., the Richmond, Virginia-based investment bank that managed Speedway's initial public offering in 1995.
Although the Glass-Steagall Act--the 1933 law that officially separated investment banking from commercial banking--remains on the books, it hasn't hampered the pace of recent merger activity between banks and investment banks. Indeed, when the Federal Reserve Board raised the amount of investment banking income a bank can earn from a capital markets subsidiary to 25 percent from 10 percent last December, it essentially received a wink and a nod from Congress, long deadlocked over the fate of the banking separation law.
As a result of that loophole-widening maneuver, deals were reached fast and furiously this spring and summer. First into the ring, Bankers Trust New York Corp.-- already viewed widely as a formidable investment bank, albeit one without equity powers--purchased Baltimore's Alex. Brown & Sons for $1.7 billion, filling that gap. Across the continent, San Franciscobased BankAmerica Corp. snapped up Robertson, Stephens & Co. (conveniently based in BankAmerica's headquarters building) for $540 million. Over a half dozen more followed by the end of September.
The case for spending large quantities of their shareholders' equity, bankers say, rests heavily on cross-selling corporate customers with one-stop investment banking. This familiar refrain has acquired new resonance as today's bankers contemplate a tough choice: either scramble in the race to gather up customers who need access to capital, or else cede a competitive edge to companies that can underwrite equity deals and arrange corporate mergers in addition to being able to handle all banking needs. Lacking a full slate of investment banking tools, commercial bankers increasingly fear, means opening the door to predators.
Some CFOs see near-term gains from the combinations. "It's great," says Speedway CFO William Brooks. "We look forward to the increased competition and to the service and execution improvements these deals will likely bring," he declares. "We'll be doing more deals, and we'll continue to spread our business around to whomever is most competitive. After all, we're getting to the size where we could go to the New York banks if we had to."
With the combined NationsBank and Montgomery Securities gunning for Speedway's business, those trips to New York might not be necessary. James Hance, vice chairman and CFO of NationsBank, is hungry for all the business that companies like Speedway can offer. "We used to not even have a shot at capturing the equity relationships of our customers. Now we do, and we intend to," he says.
Although the aggressive deal makers are convinced that they've changed the world for the better, their customers have yet to see expected advantages materialize. In fact, customers' credit and relationship risks have visibly increased as potential capital providers shrink in number. After all, in leaner times than these, is it really an advantage to seek fresh capital through an investment bank whose parent company is threatening to foreclose?
Evidence that corporate customers stand to benefit at all from these mergers has to come from other examples. Trends in the hotly competitive corporate bond underwriting market, for instance, seem instructive. From 1995 to 1996, average underwriting fees for a high-yield debt issue declined from 2.37 percent of proceeds to 2.31 percent, and asset- backed securities fees declined from 0.33 percent to 0.31 percent, both continuations of earlier reductions, according to Moody's Investors Service. This was driven primarily by the superregional commercial banks, as they ramped up their corporate bond departments and competed for larger deals in the market.
"Fees are going to be based on an overall relationship," says Ken Thompson, comanaging director of First Union Corp.'s Capital Markets Group, in Charlotte, North Carolina. "We've seen it in other areas, and we'll continue to see pressure on investment banking fees, including equity underwriting fees."
NationsBank's Hance agrees. "The more aspects of a relationship we can capture, the better the economics become for us. That means 'total service pricing' on every transaction," he says. So will there be fee competition in equity underwriting? "I think it's inevitable in the long term," he contends. "After all, the [large Wall Street] bulge-bracket firms are trying to pry away traditional loan deals from us based on price. This whole marketplace is only going to get more competitive."
THE ONE-STOP MYTH
Nevertheless, finance executives' opinions on the advantages of one-stop shopping are, at best, divided. "A complete solution is welcome, especially if the bank comes to you with an idea for an acquisition or a refinancing. That's also when our bank has the advantage, because they know us and know our needs," says Catherine Hnatin, treasurer of Exide Corp., the $2.5 billion (in sales) battery manufacturer in Bloomfield Hills, Michigan. And now that her lead bank, Bankers Trust, has Alex. Brown's capacities at hand, those solutions will be even more complete, she thinks. "But I'll still shop around," she says. "You can't tie yourself too closely to any one institution."
In other situations, one-stop shopping seems almost irresponsible to shareholders. "For a small private company looking to establish a new banking relationship with a group that could eventually take them public, one-stop shopping might be desirable. But given where we are, I can't see any real benefit. Simplicity is not a real selling point," says William Gilmour, CFO of Mapics Inc., a recent reverse spin-off from Marcam Corp. (now Marcam Solutions Inc.), in Atlanta. Mapics chose Donaldson, Lufkin & Jenrette Inc. (DJL) to underwrite and orchestrate the spin-out rather than Alex. Brown and Hambrecht & Quist, the two bankers used by the parent company for its IPO in 1990. "We're a software company, but we're very stable and make a lot of money, so we didn't fit the profile of companies like H&Q, which represent very fast-growing companies that are often losing money. DLJ, on the other hand, could see the value we had and knew how to get our stock in front of the right investors," says Gilmour.
So for all the brouhaha about one-stop shopping, it seems more a rationale to divert attention from the core driver of these mergers: the imperative commercial bankers feel to enlarge their fiefdoms and put their copious capital levels to work in higher- margin businesses than commercial lending and cash management. In fact, corporate customers don't seem to care much about either one-stop shopping or a cut in fees, were they to materialize. What does matter, say CFOs who are veterans of the equity issuance process, is excellence of research, market advice, distribution, and aftermarket support. There is no compelling reason for all of this to come from one source, even with the benefit of discounted fees. In fact, it might be sounder to rely on sources that are independent of one another.
That was true for Omtool Ltd., a Salem, New Hampshirebased software maker that went public last August 8 with the help of Robertson, Stephens as lead manager and Montgomery and First Albany Inc. as co-managers. "Fees were never really an issue, and the 7 percent was untouchable," says Omtool CFO Darioush Mardan. "To select a banker," he says, "first we asked ourselves, Did we get along with the analyst, and were they excited about our story- -would they go out and sell it on the Street for us? Robbie Stephens had that, and First Albany's research is fantastic. Second, we wanted good market-making support, and we knew that both Robbie and Montgomery have very good aftermarket trading operations. With several other banks, we felt we'd be lost in the shuffle or that the bank would just disappear and not support us once the deal was done."
When David Southwell, CFO and executive vice president of specialty pharmaceuticals upstart Sepracor Inc., in Marlborough, Massachusetts, had to choose an investment bank to lead the merge-and-spin-out IPO of two subsidiaries as ChiRex Inc., he opted to use C.S. First Boston instead of Sepracor's usual lead investment bank, Smith Barney. "This was a complex deal with a lot of risk for us and the investment bank because it had to be explained very well to the institutional investment community," says Southwell. "First Boston had the leading chemicals analyst on the Street at the time, Kimberly Ritrievi, and we knew they could get the story across and price the deal correctly to be successful." Of course, Southwell, himself a former investment banker for Lehman Bros., does have some loyalty; he turned back to Smith Barney to lead the divestment of affiliate shares of ChiRex early in 1997.
Would it have mattered much if his lead commercial bank--which happens to be Fleet Financial Group Inc.--had bought one of the other banks with not-quite-as-good research, such as Montgomery, Alex. Brown, or Cowen & Co.? "Not at all," says Southwell. "You're always better off choosing a bank for the needs of the deal at hand and the expertise it offers. What's important is getting the highest and best price for your shares."
A BIT EDGY
The apparent mismatch between bank marketing hype and corporate customer desires makes some bank stock analysts edgy about prospects for successful cross-selling of equity underwriting to commercial bank customers. "No one in these kinds of integrations has ever cross-sold as much as they thought they would, and this will be no exception," says Nancy Bush, a bank analyst for Brown Brothers Harriman & Co. Although Bush is more sanguine about some of the regional and fee-based deals, such as those struck by First Union and Fleet, she thinks there's plenty more to worry about in the larger deals, enough so that she downgraded NationsBank shortly after the Montgomery deal was announced.
For one thing, there's little to suggest that commercial bankers will be adroit judges of equity-driven investment bankers, who assess companies and risks very differently from credit-quality-driven bond departments. Plus, the new owners must learn to manage and maintain their purchases--primarily the individual investment bankers, research analysts, and star brokers that drive those organizations--and integrate them with core bank operations. "Even if banks manage to keep the best investment bankers in place and supply them with incentives, I think there will be huge customer-ownership and pay issues among employees on both sides of these mergers," says Bush. "The risk for banks is not credit risk this time around, but acquisition and operational risk."
Also, commercial banks without large capital markets operations don't seem to be paying a huge price--at least from their customers--for the omission. "So far, commercial banks without debt underwriting haven't been penalized by customers," says Allan Munro, a partner with Greenwich Associates, a Greenwich, Connecticut-based financial services consulting and research firm. "That may be different now that true one-source financing operations have been created. Middle- market companies will always be a little nervous about having their financing relationships concentrated with just one institution. But they haven't had the choice to do everything under one roof until now, so it's hard to tell what will happen."
Bank industry leaders believe they are right to seize this chance to create a new corporate finance model. "What analysts like Nancy [Bush] are overlooking is the changing marketplace," says NationsBank's Hance. "If we didn't do this, it would make our corporate banking profits vulnerable. We need equity underwriting in order to protect what we have and maintain our growth."
In addition, the wagers being made on these businesses "are not bet-the-hacienda kind of deals for the commercial banks, because they're so heavily capitalized and so much larger than the investment banks," says James McDermott, president of Keefe, Bruyette & Woods Inc., an investment bank in New York. "Plus, I think commercial banks have changed their own cultures to be more flexible and entrepreneurial."
So which party will come out the biggest winner when all these deals are signed and done? Customers? Commercial bankers? Bank shareholders? Most likely, as one might expect late in a bull market, it will be the investment bankers, especially the ones selling out their interests and garnering large retention bonuses from the commercial bank buyers in the process. "I really hope commercial bankers are asking themselves just why these people are selling now. After all, they are among the most successful, savvy players in the stock market," says Bush. "It looks to me like a judgment on the market and the investment banking business--and not a very positive one."