During the dot-com boom of the late 1990s, sell-side equity analysts were revered by investors and feared by listed companies. They were highly influential and their opinions could drive the share price of a company. Top analysts were highly sought after by investment banks and some were paid substantial amounts of money.
Today, much of their lustre is gone and there are far fewer of them. New regulations following the burst of the dot-com bubble and then again after the financial crisis in 2008 led to a reduction in headcount. New technologies such as artificial intelligence (AI) that can help write research reports and the growth of passive investing have contributed to the decline, but European regulation following the financial crisis has struck a major blow.
A revised version of the Markets in Financial Instruments Directive legislation, known as MiFID II, was put in place by the European Union in January 2018 and banks in the EU are now required to charge separately for their research rather than bundling it together with the cost of trade execution. This has caused fund managers worldwide to re-evaluate their need for sell-side research with many deciding that the benefit does not outweigh the cost.
Trading Floors Look Radically Different
Trading at investment banks has also seen dramatic change since the turn of the century. After the 2008 crisis, financial regulators around the world increased capital requirements for banks, which reduced the capital available for trading. And the Volcker Rule, which prohibited investment banks from engaging in proprietary trading, went into effect in the U.S. in 2014.
Trading profits at the big banks plummeted. In 2009, bulge bracket investment banksy made almost $100 billion from trading alone, but by 2017 this had fallen to just $71 billion. In response, banks started automating trading to cut costs. In 2000, the U.S. cash equities trading desk at Goldman Sachs’ New York headquarters employed 600 traders but by 2017 there were just two left; they had been replaced with automated trading programs.
Now the automation of bond markets is underway. In November 2019, 34.4% of investment-grade corporate bonds traded electronically and, in 2020, MarketAxess Holdings Inc. and Tradeweb Markets Inc. each reported that their electronic bond trading platforms saw their highest yearly trading volumes on record. At the same time, the use of technology in the bond markets is moving beyond execution. AI is being used for pricing and liquidity scoring and is allowing for the automation of a portion of the responses to requests for quotes.
M&A and IPO Grunt Work Is Being Automated
Automation hasn’t stopped at the trading floor. Goldman Sachs identified 127 steps in the IPO process and automated about half of them by 2017. More recently, Goldman has developed an M&A platform called Gemini that can be used by its bankers and clients to identify sale opportunities and takeover targets. Other banks are offering similar platforms, and some are testing the use of digital ledger technology for M&A functions. “Technology is changing the nature of dealmaking and proving that much of the M&A value chain can be commodified,” writes CB Insights.
Middle-market executives and brokers without the resources to develop proprietary in-house tools now have access to online networks and Software-as-a-Service tools to help them do deals. For example, Axial provides deal-sourcing and deal-marketing tools to middle-market participants in North America, claiming to process more than 6,000 deals per year in the $5 million to $250 million range at fees that are reported to be substantially below those of traditional bankers.
Junior bankers might be either relieved or horrified that “the traditional approach of relying solely on spreadsheets to analyze data is quickly becoming a relic of the past,” according to Deloitte. Firms now have access to advanced AI data analysis tools that can be used in the diligence process to analyze cash flows and operations, which can make negotiation nimbler by more rapidly identifying risks and insights, and that can aid with post-merger integration.
The Relationship Between Bankers and Some Clients Is Changing
With the rise of tech companies in both size and name recognition, their relationship with investment banks is changing. Tech companies used to gain legitimacy and prestige by having their IPOs underwritten by a top investment bank (and IPOs done by Goldman Sachs or Morgan Stanley still outperform). But now “tech companies have gained power because tech IPOs have become the best-performing and highest-returning public offerings. That’s flipping the prestige aspect of investment banks’ value proposition. With new, high-profile tech IPOs, it is often the bank that is willing to accept a smaller percentage of IPO proceeds in order to underwrite the offering,” according to CB Insights.
Other changes are disrupting the traditional IPO and M&A models. For instance, most of the year-over-year growth in the U.S. IPO market in 2020 came from special purpose acquisition companies (SPACs). As of Dec. 28, 2020, a total of $79.87 billion in gross proceeds had been raised from 237 SPACs while traditional IPOs had raised $67 billion.
Some tech firms that have a lot of cash are choosing to stay private longer before doing an IPO. Others, like Spotify, Slack and Palantir, are taking advantage of their name recognition to do direct public offerings by selling existing shares directly to the public without going through the underwriting process. And some large tech firms have undertaken acquisitions without the use of an investment bank.
Bankers Need To Care About the Planet (and Others)
Twenty years ago, bankers didn’t need to worry about environment, social and governance (ESG) issues. In fact, the acronym didn’t exist until it was used in a report by the United Nations Global Compact in 2004. But by 2016, CalPERS had adopted a five-year strategic ESG plan for sustainable investing, and in 2018 BlackRock founder and CEO Laurence D. Fink wrote a letter to the CEOs of the world’s largest companies informing them that BlackRock would be holding them accountable for their contributions to society in addition to their profitability.
A recent Global M&A Industry Trends report in January 2021 states, “… institutional investors and private equity funds have made commitments to reorient their strategic directions and evaluate both existing and future investments through an ESG lens. … The message is clear—ESG is now being built into the core of organisations, through their purposes and missions. It is now a factor in both investment decisions and value.”
And these considerations are showing up in M&A. In 2020, 72% of all respondents to an M&A Trends Survey said that “the diverse makeup of the organization is important or very important to their company’s M&A target selection process.”
While investment banking has seen significant changes over the past several decades, what’s certain is the evolution will continue. Brexit, LIBOR transition, the rise of passive investing, regulations that continue to change (the latest moves in both Europe and the U.S. have been to relax some of them), cryptocurrencies and the lasting effects of COVID-19 are just some of the forces that may drive change in the near and distant future.
Illustration by Christy Lundy