Investment banking is seeing its historical profit centers eroded by technology and regulations. Core processes are being automated or commoditized. From IPOs, to M&A, to research and trading, investment banks are getting smaller, leaner, and scrambling to keep up with innovation while capitalizing on the opportunities presented by the Covid-19 pandemic.
In 2006, investment banks were at the top of the finance world. With torrential growth and return on investment (ROI) driven largely by the trading of complex financial instruments, Lehman Brothers, Bear Stearns, Goldman Sachs and others achieved record profits and awarded unprecedented bonuses.
Over the next 2 years, everything fell apart.
After the collapse of Lehman and Bear Stearns and the global financial crisis that ensued, the business models of the world’s biggest investment banks needed to change.
In the US, legislation emerged to forbid investment banks from prop trading, or trading with their own capital, and forcing them to keep more capital on hand. This regulation reduced trading profits and created a need to cut costs, spurring investment banks to spin off unprofitable divisions or eliminate them entirely. While the rules against prop trading have more recently been loosened, the restriction has still changed how investment banks operate.
Moreover, as more and more companies raise large equity rounds, they’re also choosing to delay public offerings. And even when major tech companies do decide to go public, some, like Spotify and Slack, are doing so mostly without the help of banks. As a result, banks are facing dropping IPO profits. Even so, September 2020 was one of the strongest months for IPOs since Uber went public in May 2019.
At the same time, financial upstarts have built technologies that could eventually cut into the relationship-driven work that investment banks are used to doing.
The other functions of investment banks haven’t performed much better. Investment banking revenues hit a 13-year-low in 2019. In the world of asset management, the biggest players are now dedicated firms like Vanguard. Total assets under management (AUM) at the top asset managers now dwarfs total AUM at the top banks. And across equity research and sales & trading, poor performances and new regulations have led to widespread layoffs as banks have figured out they can do more with less.
It has been a tumultuous decade for the world’s biggest investment banks. Some banks have collapsed. Some have adapted and gone on to post record profits. But there’s no question that the way these institutions function has shifted, pushed along especially by the financial crisis and technology trends. Even as the regulation pendulum swings back toward more limited oversight, how investment banks operate is fundamentally changing.
Table of contents
1. The disruption of the IPO
Underwriting an initial public offering (IPO) is a highly profitable business for an investment bank.
A company decides it wants to raise money by going public, and an investment bank helps by connecting them with willing investors, promoting the company’s stock, navigating complex legal frameworks, helping determine a price for the stock, and purchasing an agreed-upon number of shares and reselling them, thus taking on risk for how the stock will perform. For this work, the underwriting bank can make tens of millions from an IPO — whether or not the stock performs well.
But today, the powerful tech companies fueling the world’s biggest IPOs are exerting their influence, using their size and name recognition to extract lower fees from the investment banks. Some are also exploring alternatives to the IPO, like the direct public offering (DPO) and alternative exchanges. And perhaps the trend that’s had the biggest impact — some big companies are electing not to go public at all.
Thanks in part to an abundance of cash being offered by venture capitalists and sovereign wealth funds, many startups are opting to stay private indefinitely. As a result, investment banks are having to chase more deals and reaping lower revenues for doing so.
IPOs once accounted for around 25% of investment bank revenues, but in recent years that figure has decreased to about 15%, according to Seeking Alpha. The lingering effects from the Covid-19 pandemic have pushed expected underwriting IPO revenue to just 7.5% of investment banking revenues in 2020, per IBIS World.
As revenue generated from underwriting IPOs has gone down, investment banks have turned to technology to lower costs and automate parts of the process. This is helping banks maintain profit margins — for now. But it also signals the susceptibility of the investment banks to commodification down the road by technology disruptors. For now, though, it is the contraction in IPOs that is having the biggest impact on this investment banking function.
One of the main things investment banks offer the companies whose IPOs they underwrite is legitimacy — they confer their prestige on them. Having a prominent investment bank co-signing and underwriting their IPOs is one way to gain the confidence of public investors.
And before the dot com crash, Goldman Sachs’ IPOs did tend to jump an average of 293% from their starting price through their first Friday on the market — compared to 26% for the bank Donaldson, Lufkin & Jenrette and 78% for Merrill Lynch.
Major investment banks still have a big impact on IPOs. Of 2018’s 7 best performing tech IPOs, according to Motley Fool, 6 used either Goldman Sachs or Morgan Stanley, or both, as underwriters. Facebook, eBay, General Motors, Twitter, and Dropbox are just a few examples of major IPOs that were underwritten by one or both of these firms in years past. Both Goldman and Morgan Stanley have been closely involved in many of the most anticipated IPOs in recent memory. Both firms were among the 23 banks underwriting Snowflake’s IPO, which was the biggest software IPO in history — more than triple the size of VMware’s offering in 2007 — as well as the IPOs of real estate investment firm Broadstone Net Lease, telehealth company Amwell, and investment group StepStone.
Once a company finds a bank or group of banks that want to underwrite their IPO, the bank(s) lines up a “road show.” During the company’s road show, company and/or bank executives give presentations to mutual fund managers, hedge fund managers, and others across the country who may want to buy large blocks of shares.
While they drum up interest in the company, known as “book building,” underwriters also work to price the IPO, or determine how the stock should be priced when it first hits the market. To do this, they look at examples of comparable companies that have gone public, projecting how the company may perform in the future, and assessing how much funds may be willing to pay to invest.
Going public is a significant liquidity event for a company, but is also a complex legal event. Most companies need help navigating the process, and investment banks participate in this service along with lawyers.
In return for all of this, investment banks charge an underwriting fee that traditionally comes in at around 3-7% of the gross proceeds of the IPO. The exact size of the fee depends on the type of deal. Standard, sub-$500M raises and more complex IPOs are more likely to result in a fee around 7%, while larger or simpler IPOs may end up closer to 3%.
Taking a hefty fee mitigates the investment bank’s risk by insulating it from the stock’s actual performance in the market.
When Facebook went public in 2012, the stock fell 15% in its first few days on the market. Despite this, the Wall Street Journal reported that Morgan Stanley, Goldman Sachs, and the company’s other underwriters made $175M in fees.
Some have even accused investment banks of mispricing stocks, alleging that the banks deliberately underprice new stocks in order to engineer a “pop” on their first day of trading — benefiting the bank but also the institutional investors that the bank brought into the stock.
For example, the dotcom company eToys filed suit against Goldman Sachs claiming exactly that in 2002. When eToys went public, Goldman Sachs (its underwriter) convinced it to open up its listing at $20. The stock price jumped in the first day of trading more than 4x, but months later the company collapsed. According to eToys, Goldman intentionally mispriced the stock to benefit its many institutional clients. After more than 10 years in court, Goldman Sachs settled with eToys’ creditors for $7.5M.
Today, this system is showing signs of breaking down — or at least shifting in favor of the massive tech companies that have given investment banks their biggest IPOs in recent years. Biotech firms saw most of the best IPO performances in 2019, but conditions appear to be favoring large software platforms and tech companies once again in 2020.
The top sectors for global IPOs in 2019 and 2020 — technology companies have led both years. Source: Wall Street Journal and Dealogic
Tech companies have gained power because tech IPOs have become the best-performing and highest-returning public offerings. That’s flipping the prestige aspect of investment banks’ value proposition. With new, high-profile tech IPOs, it is often the bank that is willing to accept a smaller percentage of IPO proceeds in order to underwrite the offering.
When Facebook wanted to go public, it convinced Morgan Stanley, Goldman Sachs, and others to accept a reported fee of just 1.1%. Further, the banks underwriting the IPO of SoftBank’s mobile business lowered their fee to about 1.5%.
Big, prestigious tech companies like Facebook can get their fees down to approximately 1% because they’re already known quantities. They don’t need a bank to co-sign them. All they need is access to the investors who already know these tech companies’ names.
“These Valley types think this whole process could be automated and they don’t have to pay 7 percent to these flashy, French-cufflink-wearing Wall Street types” — Eric Jackson, founder of Ironfire Capital
Eager to maintain their margins and protect their competitive advantage, much of the logistical machinery underlying the IPO process has been automated and commodified by the banks already.
Goldman Sachs began working to automate its own IPO process after it found that around half of the 127 IPO steps it identified could be done by computers — for example, making calls to compliance, making calls to legal, delivering price updates to clients, preparing the company’s audited financials, and so on. By 2017, it had much of this codified in its own internal software.
For now, automating the IPO process helps Goldman hire fewer junior bankers, do more IPOs in less time, and hold onto its high profit margins. In the long run, however, this more commoditized IPO process may not help Goldman compete in a world where high-flying tech companies are happy to stay private, take themselves public, or even raise capital with new forms of money itself.
Today, the biggest threat to investment banks’ IPO function may be the trend towards not going public at all.
Flush with cash, more startups than ever before are choosing to forgo the public market and stay private for far longer than in years past.
Funds like the $100B SoftBank Vision Fund have been pouring hundreds of millions into companies that may have otherwise looked to raise cash in the public markets. The result has been the normalization of the once-rare $100M+ “mega-round.”
While staying private has its disadvantages, the approach does offer startups far less scrutiny from regulators and freedom from the pressure on quarterly results that public companies are subject to. This is a significant factor for startups that need a long runway before they can show consistent growth and profitability. For their investors, staying private can give companies more time to grow into their valuation.
The upward trend in late stage funding is squeezing investment banking margins. However, a recent rebound in tech IPOs may help in part to stem the losses. Since a 2016 low, the number of US-based, VC-backed tech companies has steadily increased. As of mid-October 2020, 36 US-based, VC-backed tech companies have gone public.
EXPLORING CHANGES TO THE IPO
The opaque nature of traditional IPOs has long been a sore spot for would-be investors seeking greater transparency into the process. In addition, the often-considerable fees charged by investment banks in the traditional IPO process has been powerfully dissuasive to many companies seeking to go public.
These costs and the lack of transparency has prompted some companies to explore alternatives to the traditional IPO that could present opportunities as well as challenges to investment banks.
Unity Software, a software platform aimed at video-game developers, pursued a bidding-based approach to its IPO in September 2020, similar to the process used by Google when the search giant went public in 2004.
Unity relied upon a bidding system managed by Goldman Sachs, in which prospective investors were asked to bid on shares in Unity. Investors could specify the number of shares they wished to buy and the price they were willing to pay. Investors could also make multiple bids on Unity shares at varying prices. Once investors’ bids were placed in the system, Unity could choose how the offering would be divided among those investors.
This approach not only gave Unity greater control over the process itself but also provided a more transparent way for the company to gauge interest in its offering. It also afforded Unity more direct influence over its share price and its investor base itself. This approach also eliminates banks’ ability to offer lower share prices to appease their preferred investors. Given the strength of Unity’s offering, which exceeded analyst expectations, it’s possible other companies will explore similar models for their own offerings.
DIRECT PUBLIC OFFERINGS
With all the name recognition many tech companies have already earned themselves, some startups have decided that they can just list themselves on the stock market directly.
In April 2018, Spotify did just that and demonstrated how the emergence of tech as a major driver of the economy’s returns could one day reshape the way all companies go public.
Instead of an IPO, Spotify filed for a direct public offering, or DPO — it began selling its existing shares directly to the investing public without going through the underwriting process.
Spotify’s DPO was seen as largely a success. On its first day of trading, Spotify’s stock price experienced a volatility of 12.3% — lower than most other large-scale tech IPOs — indicating an underlying confidence in the company. The company was able to achieve its primary goal for going public in the first place: providing liquidity to its shareholders.
The move garnered Spotify a lot of attention at the time. Now, it’s beginning to get some high-profile imitators, including Slack in April 2019 and Palantir in September 2020.
“The US initial public offering market is broken. Try a direct listing, like we did at Spotify.” — Spotify CFO Barry McCarthy
The DPO model is intriguing to private companies because it could save them much of the sizable fee they might otherwise pay to an investment bank. However, the model doesn’t currently allow companies to issue new shares, meaning that DPOs do not raise any capital for the company.
While Spotify still worked with a few investment banks to help organize the logistics behind the unconventional deal, those advisors made a small fraction of what they would have on an IPO — only reaching about $30M among the 3 banks, according to The Wall Street Journal.
Spotify’s choice to go public without an underwriter diminished the value of the banks’ special relationships with institutional investors.
Even if DPOs don’t become common routes for typical companies looking to go public, given the lack of new funding raised, they will still likely remain an attractive option for large tech companies that are already flush with cash. The most successful startups today have better access to late-stage capital and also tend to have high levels of social capital. When companies plotting to go public already have the prestige that comes with growth and success, along with strong consumer sentiment, it becomes much harder to convince them of the added value from hiring an investment bank to help them go public.
“If a company can raise the majority of its growth equity capital privately and float their shares in a broker-free offering, it would be scary for the underwriting business,” said Michael Sobel, co-founder of Scenic Advisement, an investment bank serving private tech companies.
Palantir, the controversial data analytics company backed by Peter Thiel, is another tech company that opted for a DPO over a typical IPO when it went public in September 2020.
Palantir did not raise any proceeds as part of its listing. As such, rather than traditional underwriters, several investment banks, including Morgan Stanley, served as advisers to Palantir as part of the process.
Several other technology companies have pursued or considered similar listings. Task management platform Asana went public via DPO in September 2020.
Other technology companies are looking to cut the cost of going public and simplify the listing process by creating alternative exchanges. This includes the Investor’s Exchange (IEX) and the Long Term Stock Exchange (LTSE), which take aim at market data and exchange access fees charged by major exchanges like Nasdaq and the New York Stock Exchange (NYSE).
IEX received approval as a registered stock exchange in 2017 and is now looking to attract trading volume away from exchanges by letting companies list for free. In October 2018, IEX listed its first public company, Interactive Brokers. IEX will let companies list for free for the first five years, before charging a flat annual rate of $50,000.
Today, IEX has a market share of 2.5% of trading volume, compared to incumbent exchanges like the Nasdaq and the New York Stock Exchange which have about 20% each. Though small, IEX’s position relative to the market has been steadily on the rise and the 5-year free listing period could be attractive for companies looking for alternative ways to go public.
In September 2020, Members Exchange (MEMX), another alternative exchange, began trading. MEMX was founded by 9 financial services institutions including Bank of America Merrill Lynch, Charles Schwab, and Citadel Securities with the goal of simplifying equity trading. The exchange is the first that is founded by its members. It aims to address Wall Street concerns that the larger players in the market — including the NYSE, CBOE, and NASDAQ — use their size to unfairly charge investors for trading and for access to real-time market data. MEMX recently announced it would not charge for access to market data.
Skeptics have pointed to the fact that new exchanges typically fail due to traders’ reluctance to trade in markets where there are few participants. To overcome this problem, MEMX intends to spend its $135M in capital raised to undercut the larger exchanges on price, even if it means losing money.
Speaking with The Wall Street Journal, MEMX CEO Jonathan Kellner said the exchange is “prepared to be aggressive and lose money on every transaction to get people to participate.”
Exchanges may be a hostile market to new entrants, but that hasn’t deterred other new exchanges from eyeing their slice of the pie. Miami International Holdings launched its own exchange, Miax Pearl Exchange, in February. Dream Exchange, which describes itself as the first minority-owned exchange in the world, intends to launch in 2021 and aims to create a more inclusive trading environment for smaller companies and empower minority communities.
INITIAL COIN OFFERINGS
In an initial coin offering (ICO), instead of going public on an exchange or raising equity financing, companies instead issue their own cryptocurrency, avoiding the need for bankers at all.
In 2017, startups raised $5.6B from ICOs worldwide, and the growth continued into the early months of 2018. However, interest in ICOs cooled after a number of fraud allegations and a crackdown by the SEC.
While ICOs ultimately failed to have a lasting impact on the IPO market, they represented one of the many alternatives to the expensive IPO process private companies explored. With many of the most-hyped ICOs of recent years turning out to be scams, many investors have turned their backs on ICOs as an investment vehicle.
But one tried-and-true investment vehicle that may see even greater interest in the coming years has long been a major source of revenue for investment banks: mergers and acquisitions.
2. The disruption of M&A
Mergers & acquisitions (M&A) is a traditionally relationship-driven industry built on big transactions and big fees. For investment banks, M&A has historically been one of the most reliable revenue streams.
However, M&A fees are expected to account for just 14% of investment bank revenues in 2020, a significant decline driven in large part by uncertainty caused by the Covid-19 pandemic.
Top banks are still struggling to achieve pre-pandemic levels of advisory fees for M&A activity as their clients continue to wrestle with the ongoing economic fallout.
Technology is changing the nature of dealmaking and proving that much of the M&A value chain can be commodified. In the middle market (deals worth between $10M to $1B in value), private, online networks and SaaS tools are giving smaller company executives and brokers the ability to conduct M&A transactions on their own more quickly and far more affordably.
Even some big companies are opting to go it alone when it comes to mergers & acquisitions. Apple’s acquisition of Beats, Comcast’s acquisition of DreamWorks, Facebook’s acquisition of WhatsApp, and Oracle’s acquisition of Micros Systems were all done without an investment bank’s involvement — and those 4 deals were altogether worth more than $31B.
Of course, M&A is still a lucrative function for investment banks today. SoftBank’s 2016 acquisition of the UK’s Arm Holdings for $30B, a deal which reportedly took just 2 weeks to complete, was expected to generate $120M in fees for the investment banks involved.
M&A is a complex logistical and financial affair, and may best exemplify the prestigious, high-touch, and relationship-driven work investment banks are known for.
In a merger or acquisition, the companies involved must agree on price, on how existing shares and stockholders will be affected, how control of the company will be distributed, how assets and capital will be distributed, and much more.
Investment banks help in the M&A process by, among other things, valuing a company, sourcing a buyer or seller, negotiating agreements, and arranging financing.
In early 2020, as governments and financial institutions began to grasp the true extent of the Covid-19 pandemic, some analysts believed that M&A activity would see a sharp upswing. Investment banks and large, wealthy corporations were ideally positioned to use their considerable assets to snap up smaller companies heavily affected by the necessity of remote work and the financial pressures to cut real estate expenses and other costly overhead.
But the opposite was true. As the scale of the crisis became evident, M&A activity contracted sharply. US-based M&As in Q2’20 were down nearly 40% from Q1’20, though levels rebounded in Q3, per CB Insights data.
While overall US-based M&A is tracking down in 2020 with full year run-rates projecting about a 20% decline compared to 2019, some investment banks believe there are still opportunities for institutions willing to utilize their capital in a volatile market. In its Global M&A Outlook report published in June 2020, Goldman Sachs said that while COVID-19 had delayed many M&A deals, shrewd investors would soon resume those deals to strengthen their position as the broader economy recovers.
A flurry of M&A activity in September 2020 was seen as the beginning of what some institutions saw as an inevitable recovery following the initial financial shockwave. But while many privately held companies, especially those in the technology sector, may take advantage of their significant cash reserves to solidify their positions in an uncertain market, investment banks are unlikely to see in the near future a return to the kind of returns they enjoyed in previous years.
Another significant development across the M&A landscape has been that of “portability,” or how a company’s debt obligations are handled when that company is acquired. Traditionally, when a company is acquired by another, creditors that have loaned money to the company being acquired could still expect for those debts to be repaid. Now, however, thanks largely to plummeting interest rates, it has become a buyer’s market and portability clauses are becoming increasingly common in M&A deals.
Not every type of merger or acquisition needs an investment bank to shepherd it through, however, and more and more companies have been electing to run the M&A process on their own, without the assistance of an external advisor like an investment bank.
Since the financial crisis, the large investment bank has become the source of some suspicion when it comes to handling large scale M&A. Since banks like Goldman advise on M&A deals and trade, some executives view them with distrust. Smaller banks that don’t trade, such as Qatalyst, may be seen to have fewer potential conflicts of interest when it comes to their advisory work.
Qatalyst, which focuses on technology, handled the sales of OpenTable (to Priceline) and LinkedIn (to Microsoft), while Centerview Partners, which focuses more on consumer products and pharma, handled the sales of Kraft Foods (to Heinz) and Lorillard (to Reynolds American).
Qatalyst, in particular, became famous for generating higher-than-average premiums for its specific type of client — and of course, as a result, the firm likely is able to further attract some of the most high-profile clients, creating a self-reinforcing cycle.
That performance comes from the firm’s focus and expertise. Frank Quattrone, the firm’s founder, cultivated close relationships with founders and VCs in Silicon Valley throughout his years at Morgan Stanley’s tech investing group. While there, he helped bring Amazon, Netscape, and Cisco public. He also helped Google in an advisory capacity when Microsoft was considering bidding on Yahoo. When he left Morgan Stanley to start Qatalyst, those relationships helped establish the firm’s expertise in high tech M&A, with high-profile names like Google CEO Eric Schmidt vouching for his abilities and pledging to work with the banker.
“What Steve Jobs is to technology products, Frank Quattrone is to tech banking. The best there ever was — period,” said VC Roger McNamee.
Qatalyst isn’t just competing for traditional investment banks’ clients — it’s competing for their talent, too. In March 2020, Goldman Sachs’ former head of activism and shareholder advisory, Peter Michelsen, left Goldman to assume a similar role at Qatalyst.
Thanks to their expertise, these specialized banks can in some cases charge even higher rates for fees than Goldman or Stanley. In 2017, Qatalyst’s fees were 50+ basis points above the median rate for $1B to $5B transactions, according to the Financial Times. While this isn’t classical disruption, in that typically a disruptor charges less than incumbents and goes after a specific piece of the value chain, nonetheless Qatalyst’s growing reputation for focusing narrowly on M&A and facilitating high-value deals is a threat to the major investment banks that would otherwise compete for high-profile tech M&A deals.
SPECIAL PURPOSE ACQUISITION COMPANIES (SPACs)
One of the most significant developments in M&As in recent years has been the increasing popularity and prevalence of special purpose acquisition companies (SPACs).
Also known as “blank-check companies,” SPACs aren’t true corporate entities. Rather, they are shell companies whose sole purpose is to merge with another business that would ordinarily be acquired in a traditional M&A deal. The biggest benefit of SPACs, and one of the major reasons for the recent resurgence in their popularity, is in how these shell companies raise funds and merge with other companies.
SPACs file IPOs in much the same way as any company would. The SPAC offers to sell shares to investors, and the proceeds from the sale of those shares are typically held in a trust until a merger target can be identified. While SPACs are typically run by experienced investors with deep experience in specific sectors, a SPAC does not have a target in mind at the time it files its IPO. This is what gives blank check companies their name.
The primary advantage of this approach is that it’s often a lot faster and simpler to file an IPO for a shell company with no actual operations than it is for a company with tangible assets and liabilities. For investment banks, SPACs represent a disruption of the traditional M&A or IPO processes, but provide a significant revenue stream that many of the largest underwriters have been keen to embrace. As of July 2020, Citigroup Inc., Credit Suisse Group AG, and Goldman Sachs handled roughly half of all SPAC underwriting revenue, representing approximately $400M in fees from SPACs in 2020 for these banks alone.
In 2020, SPACs represented approximately 40% of the IPO market. In addition, SPACs had raised more than $41B between January and September 2020 — more than they had in the previous decade combined.
But SPACs aren’t just becoming more popular — they’re getting bigger and bigger, along with the fees investment banks are collecting.
Social Capital founder Chamath Palihapitiya has taken advantage of the SPAC mania. Palihapitiya’s first SPAC, Social Capital Hedosophia, merged with Virgin Galatic in 2019, and his second, Hedosophia II, merged with real-estate startup Opendoor just days before Palihapitiya registered Hedosophia IV, V, and VI with the SEC. The 3 new blank-check companies have combined headline values of more than $2B, but Palihapitiya has remained quiet about his intentions for the new companies.
Other major players have emerged in SPACs during the past 12 months, each of which has been bigger than the last. Hedge-fund manager Bill Ackman’s SPAC, Pershing Square Tontine Holdings, went public with a valuation of approximately $4B in July 2020, the largest SPAC to date, with Citigroup and UBS among the investment banks underwriting the SPAC’s IPO. Former Goldman Sachs head Gary Cohn, who left Goldman to become President Donald Trump’s financial adviser, launched his own SPAC earlier in 2020 and joined activist investor Cliff Robbins’ SPAC in August.
However, for all the promise and excitement surrounding SPACs in 2020, the honeymoon period may not last as regulators eye blank-check companies with increasing scrutiny, particularly their responsibilities regarding disclosures.
Speaking with CNBC’s Squawk Box in September 2020, SEC Chairman Jay Clayton said he would like SPACs to face additional disclosure requirements so that investors “can understand all those motivations” behind SPACs’ prospective investments. While such speculations aren’t necessarily indicative of forthcoming policy changes, they may reveal the SEC’s longer-term intentions for what has become 2020’s hottest investment vehicle.
The “traditional M&A” was often driven by a desire to boost EPS (earnings per share), with companies seeking to combine assets with a similar business, merging with a business in a lower-tax jurisdiction, or looking to gain desirable assets owned by other businesses.
Investment banks were ideal partners for these kinds of deals, which fueled the merger mania on Wall Street in the 1980s, because they had spent decades executing M&A from the perspective of increasing earnings per share (EPS), understanding the impacts of a deal on a company’s balance sheet, and identifying synergies, such as expanded production capacities or creating economies of scale.
Today, executives are more focused on strategic M&A, rather than a quick EPS fix. While strategic M&A isn’t new, tech companies today are especially focused on building more competitive long-term businesses by buying into new product spaces and expanding their portfolios.
When Facebook bought WhatsApp and Instagram, they were not buying them for their handful of coders or tiny offices. It was buying them as part of a long-term strategy. When Spotify bought the podcasting company Gimlet Media, it was placing a bet on the future of podcasting — not scooping up a high-earnings company to improve their own financials. Making these kinds of deals go forward requires less financial management and more product vision.
With the motivations behind M&A shifting, boutique banks reshaping M&A in tech and other verticals, technology creating more options within middle market M&A, and a rising number of executives tackling the process alone, the space is poised for a further shift in how this crucial function of the world’s biggest investment banks works — presenting yet another threat to the business model of investment banks.
While M&A has held up relatively well given these problems, the same cannot be said for another line of business that has fundamentally changed since the financial crisis — asset management.
3. The disruption of asset management
Asset management for institutions, high-net-worth individuals, and other private clients is one of the most profitable financial services today.
Since the financial crisis, however, new regulations making it harder for investment banks to trade with client money and new types of financial products have made dedicated asset managers the most popular place for investors broadly to put their money.
Today, most asset management revenue goes to BlackRock, Vanguard, Fidelity, and State Street. Notably, these firms are not burdened by the same kinds of regulations as investment banks.
The investment banks have been racing to catch up — asset management represented 24% of Goldman’s firm-wide revenue in 2019, compared to about 13% a decade ago — but the pure-play asset managers have been even more successful and may have used their significant head-start to build an unassailable lead in the passive investing business.
Moreover, the main reason that banks are deriving an increasing percentage of their revenues from asset management is because their share of revenues from other activities, like trading, have dropped so dramatically. Over the last decade, trading went from 65% to 37% of Goldman’s revenue.
The dedicated money management firms have, however, clearly become the growth vehicle of choice for private investors and mutual funds.
Before the financial crisis, investment banks had an advantage based on their massive scale and balance sheets, which allowed them to get better deals on trades than other types of financial institutions.
But new regulations passed after the financial crisis, such as “stress tests” designed to check investment banks aren’t carrying too much risk, led to the biggest investment banks being required to carry more capital and trade less — including with client money.
During the same time period, a new generation of asset management firms was ascendant. For about 7 years following the crisis in 2008, short-term interest rates in the US stayed at just above zero, encouraging investors to look for other places to put their money. Many of those investors opted into low-cost index funds from companies such as Fidelity and Vanguard that offered a cheap way to get exposed to the rebounding US economy.
Assets are shifting from investment banks to dedicated money management firms because they have been better able to drive returns at lower fees.
The biggest asset manager today, BlackRock, began its ascent when it bought iShares, Barclays’ exchange-traded fund (ETF) platform. ETFs are investment funds that consist of different securities, usually pegged to some index — giving potential investors the ability to easily diversify their investments. Because trading with ETFs is passive, they involve lower costs — in the case of iShares, about one-tenth that of an equivalent mutual fund.
Between 2008 and 2013, investors increased the amount of money under management in ETFs by more than 3x, with nearly half of that going into ETFs issued by BlackRock.
BlackRock has the most market share of any ETF issuer, with Vanguard and State Street coming in at #2 and #3 respectively. Source: ETF.com
BlackRock’s expertise in ETFs was a major boon for the asset manager in March 2020, when the US federal government hired the firm to assist with its plan to support the American economy as the Covid-19 pandemic tightened its grip. With no direct experience in purchasing corporate bonds, the Federal Reserve relied on BlackRock to buy bonds on its behalf, though the final decision on such purchases was retained by the Fed.
During the first half of 2020, more than $48B was invested in funds purchased by the Federal Reserve via BlackRock, almost double the amount invested during the same period in 2019. BlackRock itself made out handsomely as part of the deal, with the firm seeing a YoY increase of about 160% in investment in BlackRock funds — approximately $34B — over the first half of 2020.
Overall, 99% of the Federal Reserve’s new ETF portfolio was comprised of BlackRock, State Street, and Vanguard funds.
As of June 2020, BlackRock had approximately $7.32T in assets under management, adding $100B during Q2’20 alone. Vanguard has experienced similarly strong growth in recent years, managing approximately $6T in assets.
A worrying fact for investment banks is that they have so far only been able to achieve a small percentage of market share in a service that is so lucrative and which makes up such a significant portion of their revenue.
This is likely why the big banks are focusing on the wealth management side of asset management. As of 2020, Morgan Stanley’s wealth management division had approximately $904B in assets under management. At Goldman, wealth management among ultra-high-net-worth individuals is highly lucrative. As of July 2020, Goldman’s wealth management division experienced YoY revenue growth of 7% to $1.1B, and its assets under management grew by $49B to a total of $558B.
But high-net-worth wealth management by Goldman and Morgan Stanley hasn’t driven the same kind of returns as dedicated asset managers, which is why it appears that the reign of BlackRock, Vanguard, and their ilk will continue.
And now dedicated asset managers have their own disruptors, making asset management an even more competitive area for investment banks. A slew of startups have emerged over the last few years that are especially popular among millennials, and designed to serve as a cheap investment manager and an introduction to the basics of wealth management.
Robo-advisor startups have a younger and lower-income client base than the investment banks and are not yet a significant concern for these institutions. But they do pose a long-term disruptive threat to both investment banks and dedicated asset managers.
The conventional financial industry thesis is that personal finance apps serve as a bridge to more traditional asset management products: once young people “grow out” of their savings app, they’ll open a mutual fund account.
But without their own compelling similar offering, investment firms could eventually miss out on a generation with rising incomes and more comfortable with apps than banks.
Personal finance apps already offer investing in stocks, investing in ETFs, and investing in different curated buckets of securities differentiated by market and risk-tolerance.
Stash offers its users the ability to invest in various themed ETFs. Source: Stash
Some apps, like Wealthfront, have already positioned themselves as the upmarket “upgrade” for users with more than several thousand dollars needing to be managed.
With less than $100,000 under management, the line between what a dedicated asset manager can do and what a personal finance app can do is increasingly thin. And as millennials trained on financial literacy in the App Store enter their prime for earnings, it’s plausible that their apps will continue to increase in sophistication to accommodate them.
Unsurprisingly, the big banks are responding to this trend. Goldman Sachs is reportedly preparing to launch a digital wealth product, potentially in the form of a robo-advisor, under the Marcus brand, which has previously focused on high interest savings accounts and personal loans.
With their prestige and brand value, building a robo-advisor and going after the millennial market may be one of the most effective ways for banks like Goldman to compete with the new dominant firms in the asset management industry.
Building an app that helps users understand the market and invest their money could also be a powerful way for investment banks to leverage their research expertise towards attracting a new audience — especially now that the traditional value of equity research, which was once a pillar of the investment banking business model, has been brought into question by changes to the way that banks bill their clients.
4. The disruption of equities research
Equity research — reports on companies, securities, and markets for investment banking clients — is an industry that has been in decline for the last decade.
But more recently, the European Commission’s Markets in Financial Instruments Directive II (MiFID II), which went into effect in 2018, has nearly made this traditional function of the big investment banks obsolete.
MiFID II banned the “bundling” of research with trade execution, compelling investment banks to price and sell their research as a separate product. This triggered a re-evaluation of the value of that research among the clients of the world’s investment banks, with many deciding that they could go without.
In addition, new technologies like natural language processing, which helps computers to analyze human communication, are offering more efficient means to automate the writing of research reports. While some of these technologies have actually been developed or white-labeled by incumbents, they are also being deployed by smaller companies eyeing another opportunity to further cut into investment banks’ historic functions.
While sell-side analysts still offer corporate access on behalf of buy-side investors, such as hedge funds, the research side of the job has been fundamentally disrupted.
The result has been layoffs among equity research staff at investment banks around the world and cutbacks in the level of investment in research. At the same time, smaller, independent research firms with the capability to specialize have found their fortunes on the rise, while buy-side shops such as dedicated mutual funds, pension funds, and hedge funds, have been building up their own internal research capabilities.
The traditional job of the equity research team inside an investment bank is to analyze securities and produce advice for the rest of the firm, as an added benefit for the investment bank’s clients, and sometimes for the wider public. They use quantitative and qualitative models to work out the fundamentals of a company, assess its future earnings potential, determine whether it is a “buy” or a “sell,” then collect that information into a report. Those reports are then sent to the pension fund managers and retail investors who are clients of the bank, and they can decide if they want to buy or sell the stock based on that research.
The problem, historically, has been that most of these reports go unread. The top 15 global investment banks produced about 40,000 research reports every week in 2017, but less than 1% of those reports were read by investors, according to Quinlan & Associates. Investment banks were able to justify creating these mountains of unread research without charging for them because the cost of doing so was subsidized by trading, and it provided a value-add for their institutional clients.
That all changed when MiFID II, which went into effect in January 2018, forced banks in the EU to start charging separately for their research rather than bundling it together with the cost of trade execution.
MiFID II’s purpose was to update the rules set forth in the original MiFID, passed in 2007. The core principle of MiFID II was transparency — better reporting of trades, more precise timestamping of transactions, and reassurances that customers were getting the best price possible on a particular trade.
One of the biggest targets of MiFID II’s rules was equity research. The regulators behind MiFID II saw research as a perk that brokers used to persuade buyers to trade with them (and potentially trade more often) rather than another broker (who could potentially offer a better price). Regulators feared these “soft commissions” could lead to fund and asset managers trading with the broker that gave them the best research perks, rather than the broker that would get their investors the best price.
MiFID’s “unbundling” triggered a re-examination from fund managers around the world of the cost-benefit of equity research. The result has been a wave of layoffs, shake-ups, and cutbacks across the research space.
“Sell-side research is completely inefficient,” as one senior portfolio manager told Institutional Investor, “There’s too much of it, and most of it is no good… [before MiFID II] we didn’t really care about research — we didn’t track it, we didn’t know whether it was useful. It was just there. Now that fund managers have to pay for it themselves, they’re saying, ‘Actually, no, f— it — it’s not worth it.’”
In 2019, regulators in the UK estimated that equities research spending fell between 20-30%. Regulators in the U.S. have been extraordinarily reluctant to embrace MiFID II restrictions, which led to American asset managers significantly outspending their European counterparts on equities research — spending that was overshadowed by the strong performance of the funds under their management.
In turn, investment banks (some of which had already begun to price their research separately just before the onset of MiFID II) have begun looking for more ways to cut costs in their research departments.
Macquarie’s European division announced a round of analyst layoffs in May of 2018. In July 2018, it was reported that 24 analysts had left Bank of America’s 130-person UK research team since the regulations kicked in. And in November, Germany’s Berenberg laid off around 50 staff, mostly in equity research. Citigroup, Deutsche Bank, and Nomura all announced similar reductions in their analyst workforces in 2019.
Most banks have offered an unbundled, reports-only version of their research team’s output for years. After MiFID II, however, investment banks — even top banks like JPMorgan — dramatically slashed their prices.
In the run up to MiFID II, EuroIRP found that the general price for research reports from investment banks had decreased from around £200,000 to £50,000 (roughly $250,000 to $60,000 at the time) in the 6 months leading up to September 2017.
Asset managers, freed of the obligation to bundle payment for trading and research, have started looking for more cost-effective sources for their research needs.
In some cases, they’ve invested more in their own teams, hiring subject matter experts to help them trade in specific industries.
ARK Invest, for example, an investment manager focused on disruptive technologies, hired James Wang — a former product manager at Nvidia — to “cover artificial intelligence and the next wave of the internet.”
The internationally-oriented Ariel Investments LLC, on the other hand, has specifically sought out analysts with experience living in countries like Greece, Russia, and China.
Asset managers are looking to independent, specialized research agencies and building out their own internal research teams because doing so allows them to pay only for the research they value, while also providing more control over quality.
“We felt the need to build up our own capacity because of a diminution of the quality of the sellside research. It’s been a big shift. We’ve taken on a lot of costs, but net-net it’s good. The quality of our information has gone up” — David Hunt, chief executive at Prudential
This emphasis on human capital reflects the types of research that many big institutional clients were actually using and deriving value from before MiFID II was passed: by and large, one on one meetings with experts.
Before MiFID II, 46% of fund managers reported “one-to-one meetings” as the most valuable part of equity research interactions received from investment banks. Source: Bloomberg
As more and more institutional clients move their spending in these directions, investment banks will likely cut down even more on their investment in research — an expenditure that was already declining prior to MiFID II.
Some firms are exploring technologies that can help them more efficiently produce research internally.
Germany’s Commerzbank, for instance, is working on an artificial intelligence project with the end goal of automating the writing of analyst reports. The bank’s R&D head, Michael Spitz, has argued that the project is feasible because “equity research reports reviewing quarterly earnings are structured in similar ways” and the source data is publicly available and formatted, making it easier for a script to extract the relevant information.
The French research firm AlphaValue SA is also capitalizing on this shift — in its case by bringing the crowdsourcing business model to equity research. Instead of producing research and attempting to sell it to asset managers, AlphaValue SA “names a stock, lists how much it will charge to provide research and invites a number of investors to co-finance the cost,” according to Bloomberg. The result is a system that only generates research on companies that fund managers want to read about — rather than producing thousands of reports covering thousands of publicly listed companies.
Investment banks themselves are responding to these threats in various ways.
As some investment banks with highly ranked research departments like JPMorgan are lowering prices on written research, they are also driving profit by bringing in additional revenue from offering fund managers individual calls with analysts. Prices for calls reportedly range from $1,000 to $5,000 per hour.
Others are differentiating with technology. Global Head of Research at UBS Juan-Luis Perez spearheaded the reinvention of his firm’s research division, hiring data scientists, software engineers, and social scientists to collaborate on solutions to client questions.
Many of these reports use complex statistical analysis, deep learning, and natural language processing technologies — a much different end product from the typical research team’s “buy” or “sell” recommendation. As of November 2018, the UBS “Evidence Lab” began offering its services to non-UBS clients via a subscription model, bringing it into competition with independent research firms.
In research, those firms that are sufficiently large and prestigious like JPMorgan will find ways to drive revenue, even if those revenues now have a lower ceiling. Other firms will differentiate by using technology, and others will differentiate by finding a niche where they can extract a higher margin through their expertise. In this, the situation in the equity research world bears a striking resemblance to the kind of disruption happening in investment banks’ sales & trading divisions.
5. The disruption of sales & trading
Perhaps nowhere has the combination of post-financial crisis regulations and technological disruption had more effect on investment banks than in their sales & trading departments.
Today, banks only make money from trading by charging their clients a commission on each executed trade. Before the financial crisis, however, investment banks could execute on their own trading strategies using their own money and keep the profits. In 2009, JPMorgan, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley made almost $100B from trading alone.
But a massive sea change for the banks began with the Volcker Rule, which came into effect in 2014 and was passed as part of Dodd-Frank, which banned investment banks from prop trading, or making bets with their own capital.
The thesis behind the Volcker Rule was that when banks were empowered to use leverage in trading and make riskier bets, it increased the chances of those trades going poorly and putting the whole bank, along with client’s money, at risk.
Coinciding with the Volcker Rule’s passage, various financial regulators around the world increased capital requirements, forcing investment banks to keep a higher ratio of their capital on hand rather than in trades.
Largely as a result of these two changes, trading profits at investment banks plummeted. At Goldman Sachs, trading has gone from 65% of overall revenues to just 37%. In 2017, the revenue on trading for the five banks mentioned above was just $71B, down almost 30% from nearly a decade prior. And during the third quarter of 2017, Goldman Sachs’ trading division produced only $1B in revenue — the equivalent amount they would have produced in just ten days in 2009, according to the Wall Street Journal.
But this trend wouldn’t last long. As of April 2020, Goldman’s trading revenues had increased by 28% to $5.16B, driven in large part by trades made in the wake of the Covid-19 pandemic. Citigroup reported similar gains, achieving $5.6B in fixed income trading revenue in Q2’20 — a YoY increase of 68%.
A newer challenge is that while the big banks have been looking for ways to trade more competitively, new quantitative trading firms like Jane Street and Citadel have stepped into the trading vacuum, bringing technology to trading to help themselves and their clients generate bigger profits faster than anyone else.
The result has been a commodification and re-centering of the trading world from the biggest investment banks to quantitatively-driven funds and other firms, where traders can take more risks, enjoy a less encumbered regulatory environment, and generate higher returns. The investment banks have responded in kind, investing in technology themselves to automate parts of the trading function and retain their profit margins as much as possible.
2018 was one of the best trading years for the investment banks since the financial crisis, but the industry’s performance as a whole is still far off pre-recession levels.
Trading became the lifeblood of the biggest investment banks early on, largely due to the fact that they had an advantage in the market due to their scale.
They helped institutional investors buy and sell securities, but more importantly, they traded them themselves. Because of their size and immense holdings, they had the leverage to get better prices than other kinds of financial institution — and they could use their large capital holdings to make bigger bets with their own balance sheets.
A few years into the Volcker ruling, however, the investment banking divisions of the world’s biggest banks were suddenly less profitable than retail and other divisions.
We understand the advantage of the independent market makers over the big investment banks.— Michael Bumkeun Cho, portfolio manager at Samsung Asset Management
UBS closed its fixed income trading division in 2012 — a division UBS would ultimately reopen several years later — with Credit Suisse following and scaling back its interest rates trading division soon after. At the same time, many of the investment banking world’s best proprietary traders, among them partners, “40 under 40” commodities traders, and hundred-million-dollar rainmakers, left their investment banking jobs to join hedge funds or start their own:
In 2013, Morgan Stanley itself admitted in an analysis of the investment banking sector that demand for equities trading was falling with the emergence of electronic trading and from lower cost options.
Today, the big investment banks operate more like “utilities,” as former Pimco portfolio manager Harley Bassman termed them.
Rather than trading with their own balance sheets, banks like Goldman Sachs are generating most of their trading revenues from helping their clients — like big hedge funds and asset managers — complete their trades.
The first problem with this strategy is the focus, by Goldman and other big investment banks, on providing trading services to hedge funds, which tend to be a more unpredictable business, rather than other large institutions like asset managers and corporations, which have more predictable trading needs.
The second problem is the emergence of quantitatively-driven and tech-first firms like Bridgewater, Jane Street Capital, and Citadel that seek to offer a cheaper, faster, and more lucrative way to execute trades.
Jane Street, which has acquired a reputation as one of the toughest places on Wall Street to get a job, was born in 1999 as a quant-trading firm focused on ETF arbitrage. The firm traded over $10T across bonds, equities, and ETFs in 2019 alone. With that large volume has come an increase in capacity, leading top asset managers and others to start looking to firms like Jane Street to help with their trading needs.
“We understand the advantage of the independent market makers over the big investment banks,” said Michael Bumkeun Cho, who is a portfolio manager at the $200B firm Samsung Asset Management. He began using Jane Street, according to the New York Times, “when he learned that Jane Street responded more quickly to his trading orders and charged lower fees.”
The investment banks have tried to fight back by making their own investments in technology.
In mid-2016, JPMorgan had only 123 positions open on its hiring website in sales and trading, but over 2,000 different job postings in tech, including blockchain research. As of October 2020, JPMorgan had more than 4,000 open technology positions.
And Goldman Sachs has built its own automated trading platform, named Marquee, which it rolled out in the UK in 2018. The platform is designed to replace the work of some of Goldman’s technology and operations staff by automating more conventional trading functions. It is not Goldman’s first technology investment to boost trading efficiency. There were 600 traders at the US cash equities trading desk at Goldman Sachs’s New York headquarters in 2000. By 2017, there were just two — due in part, to automating aspects of the trading pipeline and an increased focus on technology-driven retail banking.
While trading has changed since the days of the financial crisis, the top investment banks by revenue — Goldman Sachs, Morgan Stanley, and JPMorgan — have been largely able to weather the storm. As of 2020, the situation is largely the same. JPMorgan remains on top by a considerable margin with revenues of $6.4T, followed by Goldman Sachs with revenues of $5.7T, and Bank of America Securities with revenues of $4.8T.
The biggest investment banks have the size and the ability to offer prime brokerage services to the hedge funds where the majority of trading takes place.
They can also afford the kind of investments in technology that could allow them to make deep cuts to their payroll.
The top investment banks are so-called “flow monsters” — banks with balance sheets big enough to offer the kind of trading capacity necessary to meet the cost of capital.
Boston Consulting Group predicts, however, that only a few investment banks will ever again be able to grow to that kind of size.
The rest may need to scale down, diversify into corporate and regional banking, or find a niche where they can use their expertise to increase their margins.
6. The outlook for investment banking
The big investment banks are all responding to the changes wrought in their industry in different ways.
Some banks, like Morgan Stanley, are heading off decline in the future by selling off failing operations and focusing on units, like asset management, that are still recording good profits.
Others, like Goldman Sachs, are investing in technology and new digital products. Meanwhile, it’s cutting costs and hiring new workers in places like Malaysia and Utah, where the expense of operating is lower. JPMorgan, in a trendier approach, has recently embraced blockchain technology.
With virtually every core function of traditional investment banking under siege, banks are rushing to launch products, restructure, and sell off unprofitable units. The Covid-19 pandemic has created opportunities for many investment banks across equities and fixed-income trading, debt-capital markets, and M&As – opportunities that resulted in dramatic increases in revenue at many of the major firms.
For many banks, downsizing or otherwise modifying their original growth ambitions will be the natural culmination of a decade of change and turbulence.
For others, change will be slower. As the prestige in the finance world continues to flow from investment banking incumbents towards firms like BlackRock, Jane Street, and Citadel, investment banks will only be able to reverse a slow decline by radically changing the way they do business.
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