Friday, October 07, 2005

Wheeler on WallStreet

by Heidi Moore :: 3 October 2005 - TheDeal.com
Copyright 2005, The Deal, LLC. All Rights Reserved

The securities industry is starting at last to wake from a five-year dealmaking slumber. And one of the people prodding it to get a move on is Jane Wheeler. A senior managing director at Evercore Partners Inc. in New York, Wheeler, 36, specializes in advising on deals involving financial technology companies — think E*Trade Financial Corp., Instinet Group Inc. and Ameritrade Holdings Corp. as well as major exchanges like Nasdaq Stock Market Inc. — an interest she picked up in 1997 while a vice president in Morgan Stanley's financial institutions group.

In July, Wheeler jumped to Evercore to expand her work to include advising Wall Street investment banks, which she says would rather have a boutique than a large rival bank poking around their books and helping them do deals. Not that that has been a problem for Wheeler before. In 2004, while still at Morgan Stanley, she helped sell ABN Amro NV's U.S. equities and options execution and clearing unit to Merrill Lynch & Co.

Wheeler is now betting that there are a lot more deals where that came from, as much of the financial services industry stops to reconsider the long-held precept that diversification is king; acquisitions, divestitures and joint ventures are sure to follow. Wheeler recently talked to The Deal about the outlook for the securities industry, the future of the financial supermarket and how hedge funds continue to encroach on Wall Street's turf.

The Deal: What is your view of the securities industry right now?

Jane Wheeler: These are fascinating times for the industry. One of the trends we're seeing is the focus has diminished somewhat on the idea that whoever has the most capital wins. So now you see some of the highest-multiple stocks in the financial services industry have more fit and focus and are less capital-intensive. Having spent years building $100 billion to $250 billion market cap companies, we now see companies like Citigroup [Inc.] and J.P. Morgan [Chase & Co.] trading at 10 or 11 times '06 earnings, and the highest-multiple stocks in the financial services industry being companies like American Express [Co.], Greenhill [& Co.], BlackRock [Inc.], Sallie Mae.

Another interesting trend is continued empowerment of shareholders globally. The hedge fund trend is now asserting itself globally. I think it is notable to see a company like Deutsche Börse [AG] have their chairman and CEO ousted by hedge funds. It's emblematic of two trends being played out over several years. It's driven by the institutionalization of the capital markets: Hedge funds are getting more powerful, and they're exerting more of their weight. Before hedge funds, there were corporate raiders in the U.S., but now Europe and Asia are seeing the effect of hedge fund activism.

Companies need to be aware of how shareholders react to actions they take and ones they don't take. It's a well-known fact that arbitrageurs can take significant stakes and change shareholder votes. Don't wait for them to knock on your door, saying they don't like the actions you're taking. And by the way, if they do come knocking, listen hard and don't be dismissive of what you might otherwise regard as short-termist or irrelevant shareholders. Even one or two shareholders can sometimes marshal significant numbers of shares behind their desired outcomes.

Another trend I think is very relevant to the securities industry in particular is that hedge funds are becoming the new market makers and market makers the new hedge funds. So you see the value-at-risk of Goldman, Sachs [& Co.] and Morgan Stanley continuing to increase, and at the same time you see hedge funds being the ultimate price setters in many capital raisings and in the secondary market. There are some interesting transactions that have transpired recently. For instance, I found the Manchester United [plc] transaction financed by [hedge fund] Citadel [Investment Group LLC] very interesting in this respect. Citadel bought it directly from the company, instead of having a traditional investment bank finance it and then resell it to Citadel.

So what would that mean for the investment banks? Is this is a potential loss of fees for them?

Yes, and I think that's why you see the VAR [value-at-risk] increasing for firms like Goldman and Morgan Stanley. Banks are being forced to know how and when to commit their capital if they want to make money. They're not going to be able to simply serve an agency function. They have to know when to allocate capital — when that's a good trade and when that's a bad trade. And that includes doing so across a variety of instruments and a variety of geographies, and doing so with very short timelines to make those decisions and very big capital commitments to be made.

That, in its simplest form, can take the form of bought deals. And if you were to chart the capital-raising sector and compare the percentage of secondary offerings that were bought deals a decade ago to the percentage today, you would see a dramatic increase. You would see that now more than half the financings that companies do are bought deals.

What is the future of the financial supermarket?

Supermarket has different meanings to different people. I talked earlier about the disconnect in the multiples ascribed to the different conglomerates and some of the more single-focus companies. And that, I think, could drive at the margin some rethinking of the supermarket. At the same time, being able to offer multiple products to customers is going to be essential in being competitive in financial services. You only have to look at the success Merrill and E*Trade have had in sweeping customer cash into bank accounts, and how important a source of revenue that's been to those companies, to see that it will be a critical component to the competitiveness of retail brokers. So in that sense, it will be important to have a full spectrum of products to offer your customers.

People also use "supermarket" to mean one financial institution that covers the financial services landscape. Traditionally, financial services organizations have been appallingly unsuccessful at cross-selling. Where cross-selling is not being successful, companies will rethink their diversification, and fit and focus will be more acceptable.

Are we moving toward a landscape full of more specialized financial services?

We could, and I think it will be a compelling dialogue for boards to have, given the valuation differential. By and large, the more diversified companies are getting lower multiples, and the more focused companies are getting higher multiples. That will give more imperative to the debate, as well as the strategic question around why have multiple business lines if the cross-selling isn't actually working.

What about selling proprietary products? There's been a lot of talk about open architecture — selling all kinds of funds, not just the proprietary funds created by individual firms — and its importance in the asset management industry. What is the future there?

I think the Citigroup-Legg Mason [Inc.] transaction is a fascinating indication of what could happen. I think companies will continue to have proprietary products, but they'll have to be very careful about favoring those products, that's for sure. And as they do that, those asset management businesses will have to stand on their own merit. They'll have to be attractive businesses in their own right, not just because you can push them down your distribution.

As companies look at their asset management businesses in that light, some may choose to exit. Others won't. Others will successfully manage having distribution and asset management, but again, those will be arm's length business relationships between those two units.

What about the struggle in the retail brokerage industry between attracting high-end customers and low-end?

This is a really important trend. The initial response to what is effectively a very unprofitable customer base, certainly below the $250,000 level and arguably below the million-dollar level, has been to move those customers to lower-cost distribution. So Merrill has moved many of those customers to call centers. I think that's only step 1. I think that ultimately many of what you might traditionally call the wire houses will not be able to effectively service people with below $250,000 of assets. And that market will be ripe for the retail banking sector and online brokers.

It's fascinating that somebody like Ameritrade has an operating margin in excess of 50% pro forma for this transaction they're about to close [acquiring TD Waterhouse USA], serving just those customers that Smith Barney and Merrill Lynch and Dean Witter can't make money on. And, of course, that's a customer base that is the bread and butter of the Bank of Americas and Wachovias of this world. And both of those companies have come out with interesting brokerage offerings recently. In June of this year, Wells Fargo [& Co.] also introduced low- and no-cost online brokerage commissions.

Wachovia Corp. and Bank of America Corp. both have retail brokerages, yet they are often shunted aside when the subject is discussed. What will be the future of commercial banks in the brokerage business?

The banks are in a very interesting position, in that they have always been lower-cost processors than the brokers. It's interesting that BofA used to own [Charles] Schwab [Corp.], and would still own Schwab if Chuck Schwab hadn't bought the company back. So I think that retail banks have some innate competencies in serving that lower-cost demographic that the big Wall Street firms don't have — namely, that they're not good at being low-cost producers and processing lots of transactions in an efficient, low-cost way.

Will Wall Street get better at doing that, or will they leave it to the banks?

Today, they're trying to get better at doing that. Merrill's really on the vanguard of this — they were the first to move customers to call centers, and others are copying that. They're trying. They're not ready to abdicate completely that customer base — and there are questions about their cost structure if they do. In theory, you could cut the 20% of your customers that represent 80% of your costs, but in practice those 80% of your costs don't always go away. So I don't think the Wall Street firms are ready to abdicate now, although I think they will at some point. Maybe not all of them will elect to do so. It could come in an exit, in a divestiture, in joint ventures.

There's a lot going on with the exchanges as well, as we saw in the New York Stock Exchange Inc. deal with Archipelago Holdings Inc. and the deal between Nasdaq and Instinet. What's the landscape for that subsector?

Exchange consolidation is bound to continue. Exchange deals are among the most complex and the slowest to accomplish, partly because of the regulatory complexity of these mergers, but also because they carry with them what I call "flag issues." These exchanges can be important for nationalistic reasons. The chief example of that is the hotly contested London Stock Exchange [plc] situation, where Deutsche Börse and Euronext [NV] have both made motions to show interest in the London Stock Exchange, and there were lots of nationalistic issues raised with respect to what happens to the U.K.'s important exchange.

Setting that aside, there are enormous expense savings to be had from combining exchanges. There are also savings to the end user. And those savings, where a clearinghouse is involved, can come in the form of huge savings on the money that customers are supposed to post to the clearinghouse. Where clearinghouses are not involved, it can come in the form of savings if lower fees are passed on to the users. And it can come, as we're seeing in the broader securities industry, from being able to transact across different markets on one platform.

And that's a broader trend in the securities industry as well: We're seeing convergence in the securities industry. The most developed convergence is the one between the equity markets and the fixed-income markets. You've seen many of the big banks — Morgan Stanley and Goldman Sachs are good examples — make moves to merge their equity and fixed-income departments. And it makes a lot of sense for those firms to do so. It makes sense for users to be able to transact on one platform, longer term. That's just one example. But you can see where other industries, other parts, other products will converge. The trading of other products will converge, and as that happens people will want to trade in one place.

Will other exchanges start consolidating?

There are lots of exchanges still in the United States. People can forget with all this talk of New York and Nasdaq that there are lots of other exchanges. There's the Chicago Mercantile Exchange [Inc.], which has one of the largest market caps in the world, for any exchange. There's the Chicago Board of Trade, which filed to go public. There are all the regional exchanges. Then there are a host of options exchanges, the most notable of which is the International Securities Exchange [Inc.], which is public. And that's just the traditional exchanges. There are also alternative trading systems, which effectively compete with the exchanges. There are some very sizable ones, like Liquidnet [Holdings Inc.] and ITG [Investment Technology Group Inc.].

Do you think that any of the large banks will merge with each other anytime soon?

I do think that will happen over the next three to five years. We may see one or two significant mergers among major financial institutions.

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