Investment banks did a good job over the summer months of managing down expectations for their third quarter earnings, as trading slowed, risk aversion spread and deals dried up.
Investors searching actual earnings announcements for a sign of hope might catch the glimmer of one from the relative strength of the banks’ corporate clients. The slow return of M&A activity helped boost investment banking revenue in the third quarter. Earnings reports from the largest Wall Street firms saw advisory fees rival and, in some case, exceed those fees generated in equity capital markets.
For JPMorgan and Citi, fees generated by M&A advisory topped those from ECM in the third quarter. While a far cry from the heights of 2007, fees generated from global M&A activity this year are expected to exceed 2010, and increase further in 2012. As of October 17, global M&A advisory fees totalled $15.4 billion for investment banks year-to-date, according to Dealogic – up 9% on the same period last year.
| "The collective balance sheets of S&P500 companies are holding in excess of $1 trillion in cash. Looking to invest in high-growth opportunities is one way of putting that cash to work" |
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Jack MacDonald, co-head of Americas M&A at Bank of America Merrill Lynch, says: "There is a significant amount of cash sat on the balance sheets of large corporations earning very little return. The collective balance sheets of S&P500 companies are holding in excess of $1 trillion in cash. Looking to invest in high-growth opportunities is one way of putting that cash to work; we expect this in part to drive M&A activity for the next 18 to 24 months."
Mega deals are the largest generators of fees for the investment banks. Freeman Consulting Services says Kinder Morgan Energy Partners’ $38 billion acquisition of El Paso Corporation, which was announced last month, will generate around $145 million in fees to be split among four banks and three law firms on the acquiring side.
But mega deals remain few this year, with corporates unnerved by equity market volatility and the uncertain macro-economic outlook. There have been just 20 deals of more than $10 billion this year globally, up only four on last year, and way off the peak of 48 in 2007.
US banks dominate the first three positions in market share in global M&A – Goldman Sachs, JPMorgan and Morgan Stanley. More than half of global M&A volumes this year have been out of the Americas.
But one investment banker says he expects competition to increase in the M&A sector among banks. "There is downward pressure across investment banking on revenues with equity capital markets so quiet, and advisory is seen as a way of boosting all revenues," he says, adding that, while it is not guaranteed, advising a corporate on its balance sheet and subsequent merger or acquisition deal results in more business from the client in other areas of investment banking. Large investment banks with broader business lines can be expected to fight hard to protect their position against the advisory boutiques.
The good news is that as corporates feel forced to redouble efforts to produce better returns for shareholders, the number of spin-offs and break-ups has been increasing. MacDonald says there has been a lot of interest from corporates in asset separation or subsidiary redeployment. "We’re now seeing that type of activity exceed 2008 levels," he explains. "CEOs and boards are focusing on ways to create value for shareholders through spins and splits.
"Many management teams and boards are looking at their portfolio to assess if there is a disconnect in their sum-of-the-parts valuation. To the extent a significant disconnect exists, they are then seeking to separate assets, whether it is high-growth assets from low-growth assets and letting them trade on their own, or assets with disparate capital requirements, for example."
As of October 17, 59 spin-offs globally had been completed this year. Last month, Abbott Laboratories announced plans to separate its pharmacy business from its consumer products businesses. Earlier this year, Sara Lee separated its food service and retail business from its international food business. In August, Kraft, under pressure from shareholders, separated its global snacks business from its grocery unit.
Shareholder activism also led McGraw-Hill to split in August, but Rob Kindler, vice-chairman and global head of M&A at Morgan Stanley, says: "Some of these spin-offs are the result of shareholder activism, but most are occurring because institutional shareholders are looking for companies to focus their business mix. The era of the huge conglomerate with different businesses has passed."
As well as pleasing shareholders, MacDonald says spin-offs have other benefits. "Spin-offs have the added benefit of creating a separate acquisition currency and can also boost employee morale, as employees in the spun-off entity see their performance reflected in their share price," he says.
The spin-off trend has played into the hands of the investment banks with experience in leveraged finance, equity capital markets and advisory.
Kindler says: "Boards want to work with full-service firms because the company needs advice on the capital structure, leverage levels, how the market will receive the spin-offs and how they will trade."
Kindler says spin-offs are not new, but have become very complex. "Instead of taking stock and spinning it off to shareholders, you see the stock to buy back shares and split it off," he explains. "That’s a difference in this current momentum of spin-offs."
| Revenues boost |
| Third quarter investment banking revenues |
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| Source: Company supplements to Q3 results |
The spin-off trend has benefited Credit Suisse, which has the largest share of fees from US spin-off advisory deals this year, followed by JPMorgan and Morgan Stanley. Spin-offs, however, account for only a small amount of overall M&A fees. In global advisory up to October 17, $354 million had been generated for banks from spin-offs. That is only 2.3% of all M&A revenues. One banker, however, says the value of advising a spin-off or break-up goes beyond what is reflected in the advisory revenues. "Spin-offs lead to loans and ECM fees, so boost all investment banking revenue," he says.
In the case of Kinder Morgan’s acquisition of El Paso, for example, Freeman Consulting Services estimates $45 million to $65 million in fees on the acquisition side to advisory, and as much as $100 million in fees on the financing side.
One consultant says he expects competition in advisory to heat up among the investment banks. "There are few rays of light in investment banking, but advisory seems to be an area that looks like it is going to grow, not shrink. I would not be surprised to see the top five players focus in on this area."
Kindler says that only continued volatility in the equity markets will hamper M&A activity. "The wide swings in equity markets make it difficult to ascertain values," he concludes. "If stability returns, then 2012 will be extremely active in M&A."
