From CB Insights, October 26:
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.....
....MUCH, MUCH MORE
