Strong get stronger: IB in the third quarter shows an uneven recovery
Rupak Ghose
Animal spirits are back. With stock markets hitting record highs and credit spreads tighter than they have been in decades, dealflow is picking up. But this is not an unqualified raging bull market for investment bankers. The recovery has been uneven and differences in business mix will determine who benefits most.
Bank of America and JP Morgan earlier this month said they expect third-quarter investment banking revenues to rise 10%–15% and by low double-digit percentages year on year, respectively. By contrast, Citigroup said it expects mid-single-digit growth.
Quarterly guidance is often a function of the way different management teams set investor expectations – the Citigroup CFO may just be taking a more conservative approach than his competitors. But it got me thinking about the large differences in business mix across banks and how that could influence revenue growth.
At one end of the spectrum is Goldman Sachs, a firm that, according to LSEG statistics, made only one-third of its IB revenue in the first seven months of this year from debt issuance and the rest from equity-related and M&A dealflow. At the other end is a firm like BNP Paribas, highly dependent on debt-related deals.
Debt dependence
In general, US banks have more exposure to equity-related IB activities and European banks have a greater dependence on debt.
Equity raising also varies across different regions. The third quarter has seen the continuation of improving trends in the US in IPOs and convertible issuance – Klarna’s listing in New York helped September become the best IPO market in four years in the US – albeit follow-on activity has been more mixed. In Europe, the recovery in IPOs has been muted, relying more on follow-ons from the likes of Galderma. Trends in Asia are somewhere in between, with an IPO market not as weak as Europe's.
But ECM has shrunk so much in recent years that LSEG statistics show it is only 10%–20% of revenues for most IB franchises while M&A and DCM are much bigger businesses. M&A is almost double the size of ECM and for market leader Goldman it provided almost half its overall IB revenues in the first seven months.
M&A has been strong all year, and the third quarter was the best in years. Once again, the engine of growth has been the US. M&A activity in the rest of the world has also been solid, with EMEA finally coming out of the doldrums. The Middle East was busy with deals ranging from Israeli software companies to Saudi energy firms.
Wait for it
The nature of M&A, with most fees booked on deal completion rather than announcement, means fresh dealflow creates earnings power for coming quarters. LSEG statistics show Bank of America’s fee for the merger announced in July between US railroad operators Union Pacific and Norfolk Southern could be a record US$130m. However, the deal – assuming it gets the necessary regulatory approvals – will not close until the start of 2027, meaning BofA will have to wait to collect the majority of its fees.
But even as equity-related investment banking picks up, debt bankers are not seeing the same upswing, partly because of the higher base levels of activity in prior quarters. Nevertheless, it will be a headwind to those publicly reported IB revenue growth rates.
There is one part of DCM that is seeing issuance levels rise: high-yield. The US risk-on rally has helped issuance levels in the US in particular. Activity levels in the smaller European high-yield markets have also been healthy albeit not to the same degree.
By contrast, the large investment-grade markets have seen lower activity from corporates, financial institutions and sovereigns in the third quarter. The pace of decline is slightly greater in Europe, particularly as the US benefited from the jumbo Oracle refinancing at the end of the quarter.
Despite the increasing dominance of the top US firms in trading and dealmaking in Europe, one of the few remaining fortresses for European banks is investment-grade DCM. In European high-yield, US firms are more competitive. As for US markets, Goldman Sachs and Morgan Stanley are not only more exposed to ECM and M&A but also to high-yield.
When Barclays outlined its three-year plan 18 months ago, it highlighted its ambition to expand in equity-related and US investment banking. So far, both have proved tough. Citi is another firm with a plan to build its M&A business. It will be hoping that the new dream team of ex-JP Morgan rainmakers can close the gap on the likes of their former employer and Goldman.
If the IB recovery continues to skew towards M&A, high-yield and US IPOs, this will have an outsized benefit to a small number of investment banking franchises: those jumbo US banks already at the top of the league tables. The strong, in other words, will once again be getting stronger.
Rupak Ghose is a former financials research analyst