As late as December 2007, many hoped that the mid-market banking sector would avoid the worst of the financial market turmoil. With a primary focus on equity markets, their books were not loaded with toxic debt, their clients looked in pretty good shape and deals were still being done. Although London’s Alternative Investment Market (AIM), the world’s biggest growth market, could not compare with the stellar performance of 2006 when it listed a record 278 companies, it still attracted almost 200 new listings and raised £16.1bn in 2007. In the US, mid-market mergers and acquisitions (M&A) volumes looked healthy. Figures from PricewaterhouseCoopers’ (PwC) transaction services group revealed that at the beginning of December 2007, mid-market M&A accounted for 23% (or $355bn) of total US volumes.
But it is now clear that mid-market banks are also suffering. The credit woes that initially hurt large banks and put the brakes on big deals have spilled over into the mid-market sector. Activity across the board, in equity and debt capital markets and in mergers and acquisitions, has taken a turn for the worse.
At US-based Jefferies Group, which in the past seven years has delivered phenomenal growth and profitability, this year’s Q1 figures showed a second straight quarterly loss, and net revenues were down 52% on the same period last year. Management said that this was primarily because of losses in its high-yield trading and asset management operations, and thin investment banking revenues. CEO Rich Handler called market conditions in the firm’s growth sector “brutal”.
Collapsing volumes
It is a similar picture in the UK. In the first five months of this year, AIM volumes have collapsed: the amount of funds raised through initial public offerings (IPOs) fell by 75% versus the same time period last year. In 2007, investment bank Collins Stewart managed 18 IPOs and 27 rights issues on AIM. So far this year, it has brought one IPO to the London market. This drop in volume was reflected in the firm’s interim statement in May: unaudited revenues were down by more than one-fifth on the same period last year and management made it clear that shareholders should not expect too much from the rest of the year.
It is common for bulge brackets to laud the importance of a diversified business model but in tough markets this is likely to be the deciding factor for success, or even survival, in the small and mid-sized sectors, too. For firms that are reliant on a particular market or a particular sector, the immediate future looks uncomfortable.
“Some mid-market firms can be seriously affected because they lack the access to funding and don’t have the broader business models that help to see larger banks through difficult periods. Larger firms are more likely to have other operations – such as cash management or securities services – that perform fairly consistently through economic cycles. [Equally] big banks generally have larger balance sheets that are enormously beneficial in such periods,” says Andrew Gray, partner in the banking practice at PwC.
Tough for AIM dependents
Dru Edmonstone, a director and head of corporate broking at Dowgate Capital, a small London-based firm that is a nominated adviser (Nomad) on both AIM and the PLUS market, a competitor to AIM, says that if a firm is dependent on AIM business, then it is a very tough market out there. “The downturn in the market means that investors are less confident, so companies are not raising money. Corporate clients are scared of doing a rights issue in case they don’t get the deal away,” he says.
The sector is unlikely to be able to sustain recent growth in headcount and those with weaker balance sheets and lacking scale will be vulnerable, says Mr Edmonstone. “A lot of new players came into this market during very strong market conditions, and many have developed very bloated cost structures during AIM’s bull market; as the market deteriorates, they will be increasingly difficult to maintain,” he says. Mr Edmonstone’s firm is a Nomad to 96 clients.
The tougher climate has already begun to force consolidation. Earlier this year, UK investment bank and stockbroker Blue Oar acquired fellow broker Astaire & Partners, and Ambrian Capital acquired Nabarro Wells. Insiders say that many other deals are on the cards.
At Collins Stewart, the largest broker on AIM, chief executive Joel Plasco says that the firm recognised several years ago that a UK-focused business made it vulnerable. He says that since he was appointed CEO two years ago, his main aim has been to diversify as well as grow the business.
One of his first forays was to add M&A advisory with the acquisition of Hawkpoint (which had been spun out of NatWest in 2000) at the end of 2006. The rationale behind the deal was to stem the exit of corporate broking clients – from 5% to 10% a year – who left because Collins Stewart could not give them advice. For an investment bank to be able to retain today’s mid-market clients, says Mr Plasco, it must be able to offer a broader range of services.
Mr Plasco admits that if Collins Stewart was relying on AIM volumes, it would be in trouble. “We have worked very hard to move Collins Stewart away from its reliance on UK capital raising. From the start, diversification from a product and geographical perspective was our major priority. If our business was the same shape it was a few years ago, we would probably now be looking over the edge of a cliff.”
Slim pickings
Mr Plasco admits that pickings are still very slim, however, even if he is keen to point out that Collins Stewart is growing its market share in a diminishing market. “In the US, there are signs of life in terms of deal flow for the second half of the year, but it is very much subject to sentiment. There’s no shortage of companies that want to raise money via the capital markets; the question is when the institutions out there will have the appetite to start getting back into the mid-market,” he says.
One of characteristics that helped to insulate smaller deals as credit dried up elsewhere was their relative lack of dependence on debt markets, whether high yield or collateralised debt obligations (CLOs). First quarter data from investment banking boutique Robert W Baird & Co and Thomson Reuters showed that almost three-quarters of the 4134 US mid-market M&A deals in 2007 were valued at less than $100m. Such transactions are largely the kind of strategic bolt-on acquisitions that are made in good and bad markets.
Problem deals
The moment that deals rely on debt raised in the capital markets, matters become more problematic. Hedge funds, which financed a large proportion of such deals before the crunch, are being squeezed by the banks, and although mid-market CLOs have avoided the downgrades of their larger counterparts, their outlook is clouded by trends in the broader market. Data from Lehman Brothers revealed that in the first three months of 2008, mid-market CLO volume had fallen by half compared to the same period in 2007.
| “There is enough capital to fund strategic transactions and ongoing business activities for mid-caps, but traditional debt financing in the mid-market has become more difficult to close and more expensive. The high-yield market continues to be closed in Europe. So the volume of transactions is therefore down but not nearly as sharply as in large-cap land,” says David Weaver, president of Jefferies International. |
Investors burnt
| It is the same story in equity finance, where the liquidity of issuing companies is key, says Patrick Meier, head of global investment banking, EMEA, at RBC Capital. “There is plenty of money out there but the institutional investor community has been burnt, particularly in companies where underlying liquidity is low. Hedge funds may need to be able to divest quickly and small, illiquid companies just don’t offer that potential,” he says. |
That trend has been more noticeable in some sectors than in others. Counter-intuitively, commodities are not always the easiest sell. Metals and mining is a cyclical success story but it includes a lot of small, illiquid companies so, despite high commodity prices, many such companies are discovering that financing is now harder to come by.
At Jefferies (which, in addition to its metals and mining team in the US, formed a strategic alliance in November with advisory firm Hatch Corporate Finance) Mr Weaver says that a lot of hot money went in to that sector and a lot of hot money has now flown out. “People start to remember the importance of liquidity in difficult markets,” he says.
Moreover, many commodity plays incorporate a great deal of political risk, and this is just a bit too rich for some investors at the moment, says RBC Capital’s Mr Meier. “There is a heightened awareness that governments can change the rules. For example, in Ecuador and Venezuela, mining activity has more or less been shut down as governments move towards nationalisation. In Zambia, a large copper producer, the government has just completely rewritten the fiscal regime, increasing corporate taxes and applying windfall taxes based on revenue not profits. While some investors have the appetite for such risks, they are becoming much more selective about what deals they do.”
Some sectors are strong
In many other areas, there are still healthy volumes. Mr Weaver says that the media sector is pretty strong, and the technology M&A market is particularly active where an industrialisation process that has underpinned the market for several years is still driving consolidation. “If you are a strategic buyer, it is a great time to be active,” he says. “Deals are taking longer to come together because clients are taking their time and choosing their targets carefully. But deals are still being done.”
There are always winners in a downturn and scarcity of funding is giving mid-market banks with cash the upper hand. Lending is no longer a commodity and lenders are able to pick and choose between deals. RBC, for example, whose business model – aside from its natural resources heartland – is largely focused on the mid-market, is building out its leveraged lending business as others wind down operations. In May, it hired an 11-man team from CIBC’s defunct leveraged business, which shut down in December 2007.
“Our balance sheet is in good shape and we don’t have massive leveraged portfolios already, therefore we have capacity. Spreads are now much higher and business is more economical, so general profitability is better. But we are not in a rush to do deals. We will pick and choose the right deals and price them properly,” says Mr Meier.
RBC is not alone in building out the businesses where revenues are expected to grow. In December, Jefferies formed a new unit for structured equity products, including so-called blank-cheque company IPOs, which hit record volumes in the US last year. In April, it retooled its restructuring business, which was depleted a few months ago when advisory boutique Moelis & Co poached several senior staff. Jefferies says that it is advising on more than 20 active restructuring deals with an aggregate value of $25bn. It says it is also exploiting market dislocations and that it hired extensively in April to expand its mortgage-backed securities business, where it thinks gaps are opening up and opportunities remain.
Still growing business
The stock market may have given Collins Stewart shares a battering in recent months (dropping from 180.5 to 76.5 a share since December 2007) but Mr Plasco has also been busy building out existing operations and adding new ones. In February, the bank acquired troubled debt financing business ISTC as a first step into DCM, and in May, Robert Stein was appointed to develop its sovereign wealth fund business. It has also been steadily building its US platform; last July it acquired investment bank CE Unterberg Towbin, with particular strength in the technology, life science and defence sectors, and now has 170 people in the US, about 60% of whom are focused on sales and trading.
In Asia, the firm has a small but growing presence in Singapore. In February last year, it partnered with Vijay Choraria in a joint-venture corporate advisory boutique, Collins Stewart Inga. In February this year, it announced its first IPO in India for Cords Cable Industries. Mr Plasco says the partnership is working well, even if it is not quite how it was envisaged. When the deal was struck, AIM was at its height and the expectation was that it would facilitate Indian companies wanting to tap the London market; it turns out that there is more capital raising taking place in India and further afield in Asia, and Inga gives Collins Stewart access to that flow.
Business model, product mix and global footprint play as big a role in the fortunes of today’s mid-market investment banks as they do for larger competitors. No longer can firms rely on a narrowly-focused, domestic business, especially during difficult times. And, clearly, if the long-term story is a good one, falling revenues are no barrier to continued investment in the business. “Our shareholders and our board have been through cycles before,” says Mr Plasco. “They are aware that this is the best time to build a business and create significant value.”
