By Eric Siu
Bankers at the world’s top investment banks closely monitor “league tables” with the same dedication as avid Premier League soccer fans. The usual suspects lead the pack. At the top of the mergers and acquisitions (M&A) table are storied franchises such as Morgan Stanley, Goldman Sachs, JP Morgan, and Bank of America. Colloquially known as “bulge brackets,” these public financial institutions offer a full suite of financial services ranging from capital raises and asset management to advisory and market-making.
Closely on their heels, however, are drastically smaller, “boutique” firms. These specialized practices, known to few outside of Wall Street, offer a much more narrow range of services and often specialize in M&A advisory. This new crop of banks with streamlined business models, deep rolodexes, and niche focuses are giving traditional industry players a run for their money.
The Wall Street landscape, as we knew it a few years ago, has changed. In the aftermath of the recent financial crisis, new regulations, overall risk aversion, and operational inefficiencies are reining in once highly profitable practices such as fixed income and proprietary trading. The age-old model of being a financial jack-of-all-trades has proven to be a burden. If prominent banks are to regain their competitiveness, they will have to focus on their core strengths instead of striving to mimic market leaders. Market dynamics will force bulge brackets to shift resources away from low-margin, weak-demand services and product offerings and will ultimately lead to a more diverse industry landscape.
Boutique Banking on the Rise:
Managing directors at leading boutiques such as Evercore, Centerview, Greenhill, and Moelis & Company are overwhelming ex-bulge bracket veterans who have chosen to set up their own shops in pursuit of higher compensation and career independence, among other factors. Given their wealth of experience and industry expertise, heads of elite boutiques have been well-positioned to capitalize on the wild ride in M&A over the past decade. According to the Financial Times, M&A volume tripled between 2003 and 2007, plummeted during the crisis, and has since strongly rebounded. During this volatile period, several boutiques went public and since then have seen sky-rocketing returns on their stock (see index). Wall Street has not been so fortunate. Over the past year, shares of bulge brackets experienced returns that can only be described as anemic, 4% year-over-year versus 17% for the leading boutiques. In the first quarter of 2014, boutiques advised on roughly a third of all announced M&A deals according to Dealogic estimates.
The beauty of these independent advisory firms lies in their simplicity. They typically earn their bread by closing deals and receiving a commission-based advisory fee. About half of the revenue goes towards employee compensation and a quarter towards overhead, leaving a wide operating margin. There’s no need to worry about Basel III, FASB 157, risk-weighted assets, or a long string of expensive lawsuits.
And boutiques will certainly have no problem competing with bulge brackets for the newest crop of young talent. According to Glassdoor figures, the leading boutique investment banks offer analysts compensation that’s on par with bulge brackets, and in certain cases are even higher. Though analysts may give up the opportunity to develop a broad network of industry professionals in a more structured work environment, they often play a more integral role in the actual transaction process than they would at a larger institution. With firms such as Centerview and Evercore directly competing with the likes of Goldman and Morgan Stanley for big name clients, top college graduates are increasingly making the switch to boutique banking.
Wall Street’s Dilemma:
The post-financial crisis economy has not been kind to big banks. On May 19th, Swiss bank Credit Suisse pleaded guilty to tax evasion in the United States and will incur a fine of $2.6 billion, in addition to increased regulatory oversight. These costly criminal charges come only a month after Bank of America reported critical accounting errors that led to a delay in a highly anticipated share buyback program, much to the dismay of shareholders and BoA employees. Around the same time, Barclays, a British bank, saw several of its top rainmakers leave amidst poor compensation. It effectively renounced its ambitions of becoming a top global investment bank, announcing sweeping layoffs in its U.S. investment banking operations. Deutsche Bank, long recognized as an industry leader in fixed-income trading, stubbornly clings on to its foothold in fixed-income and currencies despite a sharp cyclical downturn, cumbersome regulations, and general risk aversion towards exotic, but profitable investments. The recent spate of negative press has not only sent share prices tumbling but has also battered credibility just as banks were beginning to rebuild confidence with clients.
However, the strong recovery in corporate finance has Wall Street excited. M&A volume for 2014 stands at $1.3 trillion, up 43% from the previous year. Several factors are at play here. After years of hoarding cash, large corporations are ready to take advantage of the restabilization in the economy, strong equity markets, and relatively low interests rates to make strategic acquisitions. Private equity firms also have a record amount of “dry powder,” funds they raised but have yet to deploy, and are ready to take on unprecedented levels of leverage in the hunt for attractive acquisition targets. According to proprietary interviews with C-suite executives, banks are readily offering cheap credit lines and a host of amenities to solidify existing relationships with clients. With multiple banks lined up in the hopes of landing the next mega-merger, corporations will have plenty of advisors to choose from.
Despite the optimism, the latest research from strategy consultancy Oliver Wyman and Morgan Stanley suggests big banks will need to work more smartly to win a spot at the table. Bulge brackets are smothering their clients with excessive and ineffective coverage. Corporate executives have noted that most of these outreaches amounted to nothing more than generic pitches and product peddling. This inefficiency can be traced back to the siloed nature of many financial institutions. The research departments, product groups, and deal teams often operate independently with limited communication across the various functions. In order to provide truly effective client coverage, banks will need to internally employ multilateral efforts to gain a deeper understanding of client needs.
A More Level Playing Field:
Banking is ultimately an information-based profession. M&A advisors, therefore, are paid based on who they know, what they know, and how well they negotiate. The emergence of innovative technologies that effectively use the wealth of available online data have begun to chip away at the first two ways investment bankers add value. First, who you know does not really matter anymore. Simple LinkedIn searches and a few minutes on Google can get you the contact information of virtually any influential corporate decision-maker. Second, the infamous “pitch-book,” one of the first sets of presentation materials prepared in a transaction process, has become commoditized as financial analyses have become cheaper and the preparation process easily outsourced. While it does indeed take years of hard work to become an industry expert and a menace at the negotiation table, technology has undoubtedly leveled the playing field for bulge brackets and ambitious up-and-comers.
Where Wall Street still excels and will continue to dominate is actual financing. Regardless of how prestigious or talented the new crop of boutique firms become, they will not have the same level of access to capital markets or have such an enormous balance sheet to leverage. This is Wall Street’s value proposition. Bulge brackets will continue to excel at complex transactions that require access to significant financing or capital markets. However, it is difficult, though not impossible, to demonstrate that complex financial institutions with many moving parts and regulatory obligations can necessarily provide better advice than a lean boutique shop staffed with industry veterans. To borrow a concept frequently used in management consulting, banking incumbents must adopt an 80/20 mentality towards their offerings.
But perhaps we are only scratching the surface of a more fundamental issue with how investment banking is done today, one that is more philosophical than operational. What was once a straight-laced, buttoned-up industry has transformed into a high-flying, glamorous profession. While there are certainly many bankers on the Street who truly have the interests of the client at heart, it appears that the urge to one-up rivals in prestige and earnings has led to poor decision-making, irrational deal-making, and risky trades. This begs the question of who bankers really serve today: shareholders or clients? When J.P. Morgan stood before a U.S. Senate hearing, he spoke these famous words:
I should state that at all times the idea of doing only first-class business, and that in a first-class way, has been before our minds…The banker must be ready and willing at all times to give advice to his clients to the best of his ability. If he feels unable to give this advice without reference to his own interest he must frankly say so. The belief in the integrity of his advice is a great part of the credit of which I have spoken above, as being the best possession of any firm.
Though spoken nearly a century ago, J.P. Morgan’s words get at the heart of why independent advisory firms are beating out bulge brackets. Decades of consolidation, keeping-up-with-the-Joneses, and profit chasing has left many firms bloated and unable to live up to the mandate of “doing first class business in a first class way.” Unless broad structural changes are made, Wall Street will continue to lose market share to smaller, more nimble boutique shops.