The co-president of global markets and investment banking at Merrill Lynch assures Geraldine Lambe that a spate of diversified acquisitions is all part of a disciplined strategy to reshape the company.
In the past 36 months or thereabouts, Merrill Lynch has made 33 acquisitions or new partnerships. It may be more by the time The Banker hits the news stands. Merrill has moved to or bolstered its presence in places such as Turkey, India and South Korea, continues to build its commodities and energy platforms, and to bulk up its debt capital markets capabilities.
In Merrill’s global markets division, for example, the firm has added about 2600 people in the past two years (not counting the thousands added in the rebuild following the firm’s brutal staff cull in the early 2000s: by mid-2005 almost 3000 people had been added to the depleted investment bank’s ranks).
However, Dow Kim, co-president of global markets and investment banking at Merrill Lynch, responsible for the bank’s global equity and debt businesses, insists that this is no acquisition binge. And it is most certainly not a return to a boom-and-bust strategy.
“For the past several years we [with Greg Fleming, Mr Kim’s co-president responsible for origination and investment banking] have had a mission to build a more diversified portfolio via organic and inorganic means, but we have not over-invested in one particular business. In fact, you could probably argue that we are still under-invested in some areas.”
Building platforms
This is a disciplined build-up, says Mr Kim; one that is progressively reshaping the bank to meet client demands and changes in the marketplace. For example, Merrill’s most recent purchases in September and October 2006 – First Franklin, a leading US non-prime mortgage originator, and Petrie Parkman, an investment bank specialising in the North American oil and gas industry – both illustrate the firm’s strategy to continue buttressing existing platforms as well as building new ones.
“There are no longer any holes in our platform, but some areas are not yet working to full capacity,” he says, citing other examples such as oil trading, metals, coal trading, mortgages and the Pacific rim area. But this is no bad thing, he adds. “It means we still have more upside relative to our peers.”
Merrill’s expansion reflects positively in the firm’s quarterly and annual results. Fourth quarter earnings of $2.3bn, and earnings per share of $2.41, were up a staggering 71% on Q4 2005. They may have been down 24% from Q3, but that included a one-off gain from the Blackrock transaction. Excluding that, earnings were up 21% on the third quarter.
All in all, 2006 was Merrill’s most successful year ever, with solid growth pretty much across the board. Annual net earnings were up by an impressive 49% on 2005, to $7.5bn, or earnings per share of $7.59.
Richard Bove, bank and broker analyst at Punk Ziegel in the US, says: “Everything that could possibly go right for this company is going right.”
When Merrill seriously began playing catch-up in the commodity and energy sectors a few years ago, some pundits feared that the firm was paying top price for acquisitions, too late in the game. Mr Kim says there was a similar debate within the bank: “But, ultimately, we knew we could leverage any acquisitions within the investment banking franchise as well as with our retail distribution network.”
Defying the forecasters
Gloomy critics have thus far been proved wrong. Although figures are not broken out, analysts at CreditSights say that in the third quarter results briefings, Merrill highlighted that the still nascent commodities franchise delivered record quarterly revenues (which also doubled its previous record) and helped to push the overall fixed income, currencies and commodities business to another quarterly record. In Q4, revenues were up by 70% on the same quarter in 2005, driven by every major business line. Equity markets, too, increased by 49% on the previous year, with particularly strong performances from private equity, propriety trading and the cash trading business.
Mr Kim says there is plenty more potential to grow revenues as the early-stage commodities business launches, such as oil, coal and metals, begin to gain traction. “You cannot leverage business capabilities or business lines if the fundamental capability is not there. We have been carefully ‘connecting the dots’ across our platform. This is a big part of how we will be able to generate incremental revenue growth. It will enable us to consolidate our approach to ‘bundled origination’,” he says.
He gives as an example the bank’s business with private equity firms. Merrill has been steadily developing its capability to offer advisory services, financing, interest rate hedging and investment – what Mr Kim refers to as bundled origination. “Today we are capable of doing many more of these transactions because we have spent time and money scaling up our business,” he says.
This ramping-up is not just about securing this quarter’s or even this year’s profits, he adds, this capability will define the winners and losers in the industry. “Capital markets’ business will eventually be dominated by only a handful of firms with deep expertise and global reach. If you want to be one of them, you need to have critical mass,” says Mr Kim.
It is no secret that clients are demanding ever greater capital commitment from their financial services providers; the number of equity block trades, for example, though not a great business for investment banks, has nonetheless risen rapidly on the back of client demand.
It therefore comes as no surprise that investment banks are ramping up their risk appetite, and Merrill is no exception. Its value-at-risk (VaR), which roughly shows the potential loss from adverse market movements on a one-day time horizon, rose by more than 20% between the first and third quarters of 2006. Much of that VaR is concentrated in interest rate and credit spread products (which increased by 54%) and equities (up by 30%). Commodities, too, had risen by 11%. At the end of the third quarter, CreditSights estimated that Merrill could lose as much as 25% of that year’s estimated earnings-per-share in a so-called fat-tailed event.
Risk appetite
“Investment banks have had no choice but to build their risk-taking capabilities. Clients want more liquidity and capital from their sell-side providers and that trend will continue,” says Mr Kim, who acknowledges that Merrill has built-up its client and proprietary trading, principal investment, and private equity capabilities.
One analyst suggests that Merrill was beefing up its risk-taking efforts to boost return-on-equity (RoE) – which at around 22% lags behind Goldman Sachs’ spectacular 40% in some quarters. Mr Kim denies that RoE-envy is driving Merrill towards more risky business, although he agrees that the increasing risk appetite industry-wide is at least partly a matter of having to perform in line with competitors.
Mr Kim, who has a fearsome reputation as a trader with an impressive understanding of risk, stresses that, as with Merrill’s expansion strategy, its risk commitment has been strictly planned and executed. “We have been very disciplined and have ramped-up only in line with our overall growth. We are responding to the new business environment, but we have picked our spots – and a lot of our risk emanates directly from our client business, not our proprietary business.”
Risk management
Mr Kim also stresses that the bank has been careful to acquire the right skill sets that enable it to manage greater risk. Merrill’s energy trading business certainly seems likely to have benefited when hedge fund Amaranth Advisors lost $6.6bn (or 70% of the fund’s assets) in one week in September last year through speculation in natural gas. “If you look at difficult quarters, in 2006 and 2005, Merrill outperformed its competitors,” he says.
Risk issues notwithstanding, Mr Kim says that Merrill has a renewed focus on RoE and is working with capital management and balance sheet management committees to increase revenues on assets and improve the firm’s after-tax margin. And leverage remains relatively low, he adds.
“Year end, our share price was up 37.5% [$63.73 versus $93.10], which is not shabby. Our price-to-book ratio is 2.3x and is trending upwards, so we are narrowing the gap on our competitors; and because we have plugged some holes, we have more upside relative to our peers,” says Mr Kim. “There are still a lot of businesses that will really kick in in 2007, including our investment in mortgages in the US and the UK, further growth in our commodities platform, and the build-out in our global derivatives business.”
CAREER HISTORY
2003 Appointed executive vice-president, president of global markets and investment banking, responsible for the global sales and trading businesses
2001 Promoted to head of global debt markets
2000 Appointed head of global enterprise risk management, an integrated global derivatives and foreign exchange group within global debt markets
2000 Moved to New York
1997 Managed the integrated fixed income business in Japan for three years. Appointed as a member of the executive management committee in Japan
1996 Appointed managing director and head of debt and equity derivatives in Tokyo
1994 Joined Merrill Lynch to manage the debt derivatives trading desk in Tokyo
1991 Moved to Chemical Bank in Tokyo as vice-president and head of yen options trading. During nine years with Manufacturers Hanover/Chemical Bank, took part in the Wharton Executive MBA Program and received an MBA degree (1990). Also completed the Advanced Management Program at the Harvard Business School
1985 Joined Manufacturers Hanover Bank in New York as a credit analyst. Also had roles in commercial banking. Eventually became a derivatives trader
1984 Received a Bachelor of Science and Economics from the Wharton School
