A deep dive from CB Insights, Apr. 2:
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 innovations.
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 two 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: they generated just
$7.3B in revenue in 2017 from equity capital markets, which includes
IPOs, down an inflation-adjusted 43% since 2000’s peak, according to the
Wall Street Journal.
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.
Instead of working with a bank to make an acquisition, you can use Axial
— the so-called “Tinder of M&A,”
for its algorithm-based approach to matching companies with potential
buyers. In 2015, 26% of $1B+ mergers and acquisitions took place without
the help of external financial advisors, up 13% from the year before,
according to Dealogic.
The other functions of investment
banks haven’t performed much better. 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
- The disruption of the IPO
- The disruption of M&A
- The disruption of asset management
- The disruption of equities research
- The disruption of sales & trading
- The outlook for investment banking
1. The disruption of the IPOUnderwriting 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 even in
some limited cases, initial coin offerings (ICO). 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.
In 2017, investment banks generated
$7.3B in revenue from underwriting IPOs: a 43% reduction since 2000,
adjusted for inflation. 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.
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 high 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.
Private companies are untested.
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....
...MUCH MORE
