The heyday of investment banking was in 2006, when the global industry leaders such as Goldman Sachs, Lehman Brothers and others made high ROI and awarded their employees generous bonuses. But that golden age crumbled as soon as in 2008. The market players spent the next 12 years reviewing their investment banking models or leaving the market being unable to adapt to new conditions. The main problems they struggled with were IT penetration into the IPO sphere, pressure from the capital market and dwindling returns from IPO and M&A deals.
The development of information technologies in the banking industry has brought investment platforms any company can use to find an investor on most favorable terms – a good alternative to a bank’s service. Furthermore, many startups began to postpone their IPOs, while some even decided against going public and continued to develop using venture funds – that was another blow to investment banks’ income. According to an Ernst & Young study, the number of public companies in the United States in 2014 was about 290, up from 112 in 2016. According to Seeking Alpha, investment banking profits from organizing IPOs dropped from 25% to 15% over the same period.
Investment banks can be of help in a public offering due to their special relationships with institutional investors and the ability to pitch the company they organize the OPI for. But if a company has a well-selling name, there is no need for such services. For example, companies such as Slack or Spotify sold shares to the public without using an investment bank and were fine with that.
As investment platforms continue to improve, searching for an investor will become increasingly more open and cheaper than the services of major investment banks.
In addition to IPO, M&A management accounts for a significant share of profit for investment banks. Profit from this type of activity has gone down from 43% in 2015 to 34% in 2018, according to KPMG. This is partly due to the fact that the industry is thriving with boutique companies specializing in M&A in SMEs (up to $100 mio in business worth) where the average deal value is between $30 mio and $50 mio.
Some small and medium-sized companies do not involve any boutique companies or banks in the acquisition of their target companies and prefer to negotiate directly with owners and hire lawyers for a specific deal. Companies thus significantly reduce expenses on consulting services and negotiations. As the number of direct lending funds is growing every year, it is much easier now to get extra funding for an M&A deal, which also does not favor investment banks.
Notable examples of direct deals at the high end of the market include acquisition of WhatsApp by Facebook and acquisition of Beats by Apple. Considering that banks would charge 3% to 4% commission, the cost-cutting was substantial.
On October 1, 2019, Russia introduced limitations on the bank funding of M&A deals. Bank must immediately classify such funding as a category 3 risk and build reserves of 21% to 50% in case of potential losses. Generally, this new rule makes third party financing more expensive and less appealing.
Wealth management is another key source of revenue for an investment bank. Their competition is hedge funds and private companies that specialize in asset management and offer their clients better terms. The situation is also tense because of the difference in the yields of the US Treasury’s 10-year and 2-year bonds: the short-term bonds bring more profits than the long-term ones, which is a signal of the impending recession. The current situation in general reduces the companies’ interest in taking risks, makes them postpone investments for an indefinite period and switch to safe assets.
What should banks do under the conditions of decreasing revenues and growing competition? They need to adapt and transform, or else leave the market. The introduction of automated trading platforms allows for surviving competition and lowering brokerage fees, which attracts investors with a large number of trading operations.
Banks can also automate the job of low-level IPO analysts, or abandon unprofitable activities like IPO or M&A and focus on wealth management. Some banks, such as Citi or Deutsche Bank, remain full-service banks, no matter the odds.
By Elena Gertsberg, CEO and founder of ADAR ADVISORS financial services company