By Charlie Perer, Co-Founder and Head of Originations, SG Credit Partners
Will regional commercial banks stay committed to their investment banking divisions once the lucrative M&A advisory fees dry up in the next downturn?
Large Wall Street banks and investment banks merging is nothing new, but one overlooked story of the last economic cycle is investment banking consolidation in the middle-market led by regional banks. Super regional banks looking to better compete with the nation’s largest banks followed this trend and entered the investment banking business en masse. While it’s one thing for truly global banks to maintain a large investment banking presence, it calls into question whether regional banks need to do it and whether it’s a cyclical or secular trend.
The partial repeal of the Glass-Steagall Act in 1999 allowed for universal banking, which combines commercial and investment banking services under one roof. Within a few years, the repeal completely undid what almost 70 years of regulation upheld: keeping banks and investment banks separate from each other. The repeal changed Wall Street overnight and it was only a matter of time until this trend trickled down to the middle market.
The early 2000s created the true banking financial supermarket for large corporates. Said simply, banks had more products and services to offer large corporate clients. This paved the way for large banks to create and roll out the platform approach to their middle-market regional offices spread around the country. Today, if you are a bank with assets greater than $100 billion, it just makes sense to offer a wide range of products with the ability to cross-sell traditional banking, private wealth management, capital markets and investment banking to better serve middle-market clients and the C-suite executives behind them. The United States’ largest banks rolled out their platform approach in the first part of the century and then started expanding into the middle market. The super regionals took note and have spent the past decade expanding their own platforms, culminating in forming or acquiring investment banks to complete their platforms and generate high-margin fee income.
To name just a few, Citizens Bank acquired Western Reserve in Cleveland, Trinity in Los Angeles and Bowstring in Atlanta; CIBC acquired Clearly Gull; Union Bank acquired Intrepid; Huntington Bank acquired Capstone; Regions Bank acquired BlackArch; TD Bank acquired Cowen; BMO acquired Greene Holcomb Fisher; and Keybanc Capital acquired several investment banks. This list is illustrative and far from comprehensive, with others like Fifth Third being acquisitive as well. There seem to be few, if any, $100 billion regional banks yet to join the M&A advisory trend. The aforementioned acquisitions (and the others alluded to) are a combination of full investment banking platforms and industry vertical expertise, and with the expansion of industry verticals in banking comes the need for vertical investment banking. This is one reason why many believe this trend to be secular.
Regional banks clearly saw the growing trend of increased loan activity during the market run-up, so it made sense to evaluate entering the high-margin M&A business to both serve clients and generate non-balance sheet revenue. However, it remains to be seen whether the top-of-market prices paid to acquire many of these investment banking platforms will ultimately be worth it when M&A activity slows or comes to a screeching halt. Investment banks are great to own when there is a hot deal market, as the margins they create are not even comparable to the low margins of lending. The flip side is also true when deal activity is low and you own a very high fixed cost business. It’s not a given many of the commercial banks who acquired investment banking platforms will want to keep them when they have to fund the operating burn and continue to pay bonuses to keep talented deal professionals.
What has yet to be tested in relation to this trend are the management challenges of retaining and integrating entrepreneurial deal professionals (who have just been paid) once they are in a larger, more corporate structure during a downturn. Many of the aforementioned deals took place in a red-hot economy and the deal professionals were most likely locked-up for several years. What’s left unsaid is how many regional banks will continue to offer these services after the next downturn, which many believe is impending. To their credit, investment bankers are experts at selling at peak valuations, so selling at the top of the market is a great hedge for when deal volume slows down. According to published deal activity, private equity investors announced a total of $436.3 billion in deals during the three-month period ended in June. That’s 15% higher than the previous quarter but a staggering 29% lower than Q2/21. Deal volume also declined 28% year on year. The slowdown in the middle market will most likely be persistent, and as inflation, interest rate hikes and a lack of liquidity potentially persist, dealmaking activity across the global economy could further diminish.
The larger banks will probably chalk up any current or future slowdown in deal activity as the cost of business to compete with the major U.S. banks who have significant capital markets and M&A advisory teams. What’s not certain, however, is whether some of the smaller regional banks will jettison their investment banking initiatives because they will either find them non-strategic or not worth the cost of the overhead in a recession when deal activity slows. The key question is whether these regional banks are prepared to carry high-cost M&A teams when M&A volume is off for more than just one year? Senior executive compensation can be in the millions if an M&A team outperforms expectations, but when M&A activity dries up, compensation expectedly moves down. Ironically, most investment bankers understand this, but compensation is often different once investment banks get acquired by commercial banks.
Digging a bit deeper into the compensation factor, commercial banks have large workforces compared with small boutiques and don’t always pay employees solely on production. This means banks are famous for underpaying for outstanding years, but then likely overpaying during down years. Another key question worth asking is what happens when investment bankers don’t get paid big bonuses for two years straight? There is a lot of past precedent for founders of many of these acquired investment banking groups to simply re-constitute their platforms once their employment agreements burn off. The thinking goes that if they are going to work for salaries only, they might as well go back to working for themselves.
One thing is for certain, when the tide goes out in the next much anticipated recession, we are going to see how many regional banks are committed to their investment banks.