Greater Risk, Lesser Reward Becomes The New Reality For Underwriters

The Age

Saturday September 11, 2004

STEPHEN BARTHOLOMEUSZ

Something remarkable occurred this week. An investment bank underwrote a $1 billion risk without any guarantee it would be paid for taking it. Given the reputation of investment banks, and US investment banks in particular, Citigroup's decision to underwrite the $1.1 billion sell-down of British Airways' 18.25 per cent shareholding in Qantas without asking for an explicit underwriting fee is something of a watershed.

It is even more noteworthy when it is considered there was no guaranteed implicit fee. Citigroup guaranteed BA a floor price of $3.24 a share, only 9 ? or 2.7 per cent below the price of Qantas shares ahead of the sale.

As it happened, the shares were placed at $3.28 each and the bank shared in the 4 ? a share premium above the floor, although it appears to have received less than half the up-lift. That means it took a $1 billion risk for a fee of less than half a percentage point, with no certainty at the outset that it wouldn't lose money on the deal.

The sale of BA's stake is the latest in a series of innovative capital raisings and secondary placements in this market in which the traditionally lucrative fee streams to investment banks and brokers have been slashed. The most notable were last year's $1.2 billion AMP rights issue and the $3.5 billion deeply discounted ANZ issue to fund the acquisition of National Bank of New Zealand.

The BA sell-down borrowed some state-of-the-art bells and whistles from European market practices but fundamentally represents a continuation of a theme that has been developing in this market ever since UBS introduced the book-build tender with the float of GIO in the early 1990s.

Before then, floats and placements were generally underwritten for large fees, with the underwritten price set at significant discounts to either the pre-existing market or where the shares were expected to trade post-raising.

The investment bank/broker got two "cuts" from that approach. It received the fees, which it shared with sub-underwriters to whom it sold down the risk, and it was able to keep its other clients - institutional and retail - happy by offering them near-certain profits.

The book-build, now the established mechanism for capital raising in this market, appeals because it effectively auctions the available stock off on the basis of bids involving both price and volume - it creates price tension.

It also truncates the risk for the bidders. Where once institutions subscribing to a capital raising might have had an eight-week window of exposure to market conditions, today that exposure is for a day or two at most.

Since the introduction of book-builds underwriting/management fees for raisings have been reducing and the discounts to market at which secondary issues have been made have been compressed.

In the past year, the pressure has intensified on the fee income streams to the investment banks who dominate capital raising.

It is notable that in two of the three more innovative deals - AMP and the Qantas sale - a "boutique" advisory firm, Caliburn Partnership, was an adviser to the company.

The emergence of pure advisory firms - a response to global consolidation of the sector - with an understanding of markets and risk and without the conflicts of the full-service banks will inevitably lead to more focus and pressure on the fees integrated firms charge.

It is probably also the case that both institutional investors and company boards are more sensitive to the scale of the fee leakage that can occur in large raisings.

It is in neither's long-term interest for the levels of value traditionally transferred to third parties in raisings to be maintained, nor for the investment banks to be able to confer privileged access and near-certain profits to particular investors.

Our market is relatively sophisticated and efficient. It was curious to see the fuss in the US when internet search giant Google "pioneered" a Dutch auction mechanism for its $US2 billion ($A2.9 billion) initial public offering. The controversial offer structure was a book-build by another name.

The reason the Google offering was controversial, apart from its novelty in that market, is that it was seen as an assault on the "bulge bracket" Wall Street firms and an attempt to democratise the process of raising capital.

Wall Street, which traditionally has collected massive fee income streams by pursuing underwriting practices that effectively carried no, or at most minimal risk, was understandably cool on the Google float and largely unco-operative with it. Despite some hiccups, it was reasonably successful.

What we've seen in this market - and what occurred to a degree in the US - has been a far closer alignment of fees and risk and the development of structures which, because they reduce risk, will lead to reduced fees.

That isn't a popular or pleasant phenomenon for the big global investment banks that dominate capital markets. Not only are the days of massive fees for minimal risk ending but the ability to confer profit on key clients - an opportunity that was exploited aggressively by the US investment banks during the dotcom era but a practice that caused them considerable financial pain and embarrassment in the aftermath of the bubble - is also disappearing.

As if that weren't enough to make Wall Street heavyweights worry about the size of their bonuses, there are structural pressures emerging across their businesses as the traditional oligopoly within capital markets breaks down.

The source of those pressures is coming from the new hybrid banks, like Citigroup, created through the acquisition or development by traditional commercial banks of specialist investment banks.

Citigroup, JPMorgan Chase and their peers are as interested in volume and broader relationships with corporates as they are in the magnitude of one-off transaction/underwriting fees.

Whether it is equity raising, merger and acquisition activity or debt funding, the cost of using investment banks is falling as the commercial banks start to flex their very considerable muscle and the investment banks' traditional services are commoditised.

That doesn't mean there will eventually be no place for the traditional investment bank nor that the next generation of Masters of the Universe will have to settle for banker's salaries. One would never underestimate the capacity of an investment bank to devise ways to generate lucrative fees.

What it may mean, however, is that the banks will genuinely have to accept more risk on their balance sheets than a traditional commercial bank would tolerate if they want to be rewarded as handsomely as they have become accustomed to.

The new concept taking root in capital markets is "appropriate reward for risk". Citigroup showed this week that "appropriate" may sometimes mean not much at all.

-- bartho@theage.com.au

© 2004 The Age

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