The Art and Science of Investment Banking
Published in Upside Magazine in 2000
by John F. Ince
For eons the business of investment banking has been considered equal parts art and science. It is a relationship driven business where the feel for the market at a particular moment can be a key competitive advantage for a firm. And yet all around the new economy, technology is taking much of the art and feel out of business transactions. The question remains: how much longer can investment banking remain a tradition-bound industry where personal relationships and long standing practices are the driving force in most deals?
For the moment investment banking is basking in the afterglow of rapidly increasing revenues and profitability? What’s giving fuel to all that growth? First there has been the astounding increase in the availability of venture capital. The maturation of the venture capital industry has provided a steady flow of IPOs to the industry. According to Thomas Weisel (See Sidebar) of Thomas Weisel Partners,, “80% of venture backed companies get sold and never go public. 20% go public. You’ve gone from roughly 25% of the IPO market being venture backed companies to over 65%. And obviously the result has been a tremendous acceleration of the dollar volume of the IPO market.”
With accelerated consolidation in all sectors of the economy, there has been a dramatic increase in size and flow of M & A activity, and therefore a dramatic increase in fee income. The rise in the stock market has generated an ever increasing trading volume. Last year, according to Weisel, $180 billion of equity was raised in the public area compared to $100 billion the year before.
The net net has been a dramatic growth in the profitability and size of the investment banking industry. According to Weisel, if one include revenues from institutional brokerage, M & A and equity, the industry has been growing at 35% compounded rate for the last decade. Weisel estimates that that marketplace has grown from $17 billion in 1995 to $40 billion in 2000.
All this is taking place against the backdrop of regulatory changes. Last year, Washington opened up the floodgates of change with the partial repeal of Glass Steagell, which since the Depression era has legislated the separation of commercial bank, investment banks and insurance companies. Quickly cam wave after wave of merger and acquisition. Each commercial bank felt they needed a boutique house to fill out their offerings. Fleet picked up Robertson Stephens, which had been was bought in 1997 by BankAmerica. B of A sold it the next year to BankBoston, which dropped BancBoston from its name after its parent merged with the increasing voracious FleetBoston Financial. NationsBank then swallowed up Bank of America, which had previously swallowed Montgomery Securities.
Chase Manhattan, not quite satisfied with their acquisition of Hambrecht and Quist, made the big splash in mid-September with a purchase of the venerable house of Morgan for $35.2 billion or $195 share. That transaction united two to the most venerable banks each with rich legacies, but the synergies remain unclear. Having already acquired Chemical Bank and Manufacturers Hanover, Chase is attempting to position, the newly christened, J.P. Morgan Chase as a one stop shop that can compete in both commercial and investment banking. That deal comes on the heels of two other major acquisitions of investment banks by commercial banks. UBS, the giant Swiss bank paid $12 billion to buy Paine Webber early in 2000, and in August 2000, Credit Suisse ponied up $12.8 billion to buy Donaldson, Lufkin & Jenrette.
Will all these strategic moves pay off? Not everybody thinks so. Says Thom Weisel, “With the JP Morgan – Chase deal and the DLJ deal, there’s a tremendous amount of overlap. It represents a thought process that is, quite frankly, historical–the global footprint, one stop shop, broader product base, bigger balance sheet – compete on the basis of capital. These larger firms have gotten so large that they suck the best quality people into management. Then they Peter Principle them up, so that they’re not really dealing with clients any more, and the people under them are just kids.”
For the better part of the 1990’s, J.P. Morgan had been attempting to transform itself from a blue-chip commercial bank into a investment banking powerhouse. The Chase-Morgan deal underscores the desire of the commercial banks to move into higher margin business. Says Joe Schell (See Sidebar) head of the Global Technology Investment Banking Group at Merrill Lynch, “Commercial banks have wanted to get into high margin businesses like investment banking for years. They hadn’t been successful getting into those businesses on their own so now they’re doing it by acquisition.”
Then there are the pioneer firms like Wit Soundview and WR Hambrecht + Co, who are betting that the changes all around the new economy are so fundamental, that it is simply a matter of time until investment banking is also transformed. The Internet has opened up the possibility of new and potentially revolutionary delivery mechanisms for stock in IPOs. According to Chris Mulligan, Managing Director of Wit, “Our mandate is to revolutionize the capital raising process. What does that mean? It means we facilitate the dissemination of critical information, aggregate all demand, allocate securities in a smarter fashion and insure better price transparency.”
While the pioneer firms have gained a lot of publicity, their volume of offerings and allocations has been small. Although Wit has participated in 130 offering in 1999 and 119 offerings as of September 2000, they have managed only a handful. So far only four companies have used WR Hambrecht’s Dutch Auction (See sidebar). One possible explanation for reluctance of issuing companies to let startups like Wit and WR Hambrecht manage their offerings is due in large part to what Bill Hambrecht calls the “Cathedral Effect”. Says Hambrecht, “Issuing stock is a major event in the history of a company, not unlike a marriage. For economic reasons the father of the bride tries to convince everyone that the Justice of the Peace makes the most sense. The bride however usually wants to be married in the cathedral.”
The Internet has also lowered the barriers to entry in the financial services marketplace. Both financial and nonfinancial firms have been able to role out products and participate in new marketplaces. The net result is that the financial landscapes has becoming much more competitive. According to Adam Holt, analyst with Chase H & Q, “What you have is traditional financial institutions trying to find ways to maintain customer bases, and remain competitive in a rapidly changing environment.” Companies like e-loan, mortgage.com, NextCard are moving into lending spaces that had traditionally been the exclusive empire of the financial institutions. Then you have companies like E-trade and Ameritrade moving into the brokerage industry, distintermediating more traditional financial service firms. At the same time you have new breed of ground up banks like Wingspan or Netbank.
The so called ‘bulge bracket” firms frequently use rhetoric that seems dismissive of potential threats to their hegemony from the upstarts, but their actions suggest that they take the larger threat posed by technological change quite seriously. If technology is the dimension on which investment banks will compete, Goldman Sachs, for one, intends to be well positioned to maintain their leadership position. Goldman has earned it’s stripes over the years taking some of the largest technology companies public including Microsoft and Yahoo. Says, Steven Mnuchin, Co-Head of the Technology Operating Committee and Global Head of e-Commerce at Goldman Sachs, “Technology is having a dramatic impact on all areas of the firm. Not only do we work with technology-focused clients in our banking and investment banking practices, but we have also made a major internal commitment in this area as well.”
Indeed, Goldman now has over 3500 full time professionals dedicated to internal technology in areas like electronic trading, risk management systems, infrastructure, clearance businesses, operations and modeling. In this fiscal year they will be spending $1.5 billion on internal technology. On September 11 2000, Goldman further emphasized their commitment to technological leadership with their acquisition Spear, Leeds & Kellogg L.P. (SLK) for $6.5 billion. This deal positions Goldman firmly at the center of price discovery. It also puts Goldman Sachs at the forefront of advanced technology, specifically in the development and application of sophisticated trading, execution and clearing technology. The SLK deal comes on the heels of their 1999 purchase of Hull, the largest electronic trader of options in the United States, for $500 million. Hull had developed a sophisticated platform to find the best price for options. Goldman has also hedged its bets with 15% stake in Wit Soundview. Stating the obvious, Mnuchin says, “We see technology as critical to our future success.”
None of these strategic moves would have been possible without Goldman’s 1999 IPO with netted them in excess of $5 billion. With investment banking operating on such high margins, can others be far behind with their IPOs? Fleet Boston Financial Corp is rumored to be considering spinning off it’s subsidiary investment banking house, Robertson Stephens, in an IPO. These moves are but one more acknowledgement of the extraordinary values being created by investment banks today.
Merrill Lynch has also made a major commitment to global investment banking bringing in industry heavyweight, Joe Schell, formerly with Montgomery Securities, and Banc of America Securities to shore up their technology capabilities. Schell wasted not time, more than doubling the size of the technology investment banking group, from 80-170 within his first 9 months on the job. He expects to add another 70 people within the next year.
New ideas often take hold slowly, especially in industries as tradition bound as investment banking. It may be a stretch to characterize investment banking today as an industry at the crossroads, but it clearly exhibits many of the symptoms of one entering the nascent stages of transformation. And much of that transformation is due to technology. Given the fundamental nature of the transformation that is sweeping through other sectors of economy, we can soon expect investment banking to undergo a more radical transformation that it has seen in decades?