Equity Merchant Banks: The Financial Sector's Profit Powerhouse of the Future

If Goldman Sachs Group Inc.'s (NYSE: GS) blowout second-quarter earnings demonstrated one thing, it's that the new "equity-merchant-banking model" - the replacement for the Wall Street investment bank of pre-financial-crisis days gone by - is where financial-sector investors will make their money for years to come.

And there are two clear frontrunners that investors will want to watch - Goldman, and a second equity-merchant-banking firm that every financial-sector investor should take the time to know intimately.

Before we analyze both firms, however, it's important to understand just why this transformation from investment bank to equity-merchant bank is taking place.

In the fall of 2008, succumbing to the raging inferno of the financial crisis, Goldman Sachs Group and Morgan Stanley (NYSE: MS) - the two survivors of what was once a cabal of insanely powerful and profitable investment banks - fell swiftly.

Goldman and Morgan, who had laughed off the failure of rival Bear Stearns Cos. and cheered the bankruptcy of even-more-powerful competitor Lehman Brothers Holdings Inc. (OTC: LEHMQ), weren't so smug when remaining rival Merrill Lynch & Co. Inc. ran into the arms of Bank of America Corp. (NYSE: BAC). Fearing their own spontaneous combustion, the last two remaining full-service investment banks underwent an emergency U.S. Federal Reserve makeover, and emerged as bank holding companies. The objective: to be able to access the federal government's capital and liquidity safety nets.

As risk-taking investment banks imploded, the overly aggressive use of leverage in an easy-credit environment left the private-equity sector reeling from a devastating one-two punch that some feared threatened the very future of that business: Not only are the private equity firms bruised and battered, many of their leveraged buyout target companies have been pummeled into bankruptcy.

While investment banks and private-equity shops were down for the count, they weren't actually knocked out. Given this beating, however, it's clear the two institutions will have to standardize their fighting styles, meaning that one day soon you won't be able to tell investment banks and private-equity players apart.

But that won't matter. Once transformed, this new type of institution will constitute the new "equity-merchant-banking class," and may be the strongest green shoots to emerge from the financial firestorm they both helped ignite.

Some firms, like Goldman Sachs, will not miss a beat. In fact, Goldman is already building on its reputation as one of the greatest-money-making machines the world has ever known. For proof, just look at Goldman's latest earnings, which are nothing short of spectacular.

Goldman's Profit Picture

Goldman Sachs earned $3.44 billion for its fiscal second quarter, an all-time record for the company and a result that actually exceeded what it made all last year. Revenue from stock underwriting and from trading hit record levels, too, less than a year after Goldman accepted $10 billion in U.S. bank-bailout money.

Financial risk was clearly amped up and spreads on all the financial instruments Goldman trades and makes markets in were wide enough to drive a truck through, which means there was plenty of "low-hanging fruit" for the company's traders to benefit from.

As a bit of a back-handed slap at the taxpayers that had lent the company the $10 billion when it needed it - and that gave it another $12 billion from the American International Group Inc. (NYSE: AIG) - Goldman set aside 33% more cash for compensation for its suddenly no-longer-struggling employees.

Land of the Giants?

Though the temple of Goldman Sachs fears no evil, for it finds so many of its former priests in the highest of positions across the fertile valley of American government. The bank spreads its message and money through its proselytizing army of lobbying angels, and there are heretics in the land who have not drunk the "Goldman Kool-Aid" and who are agitating for a reformation.

An upcoming congressional debate on financial regulation will be very telling, since it should allow us to see just how much influence Goldman has on the U.S. legislative process. Any discussion about how to deal with financial firms deemed 'too big to fail" that doesn't highlight Goldman serves as evidence of that final hardening of the mix of money and politics that cements our future.

Even if Goldman sidesteps the big question, other issues are percolating, including:

  • Is Goldman's compensation model the poster child for moral hazard, as it rewards a take-no-prisoners risk-taking approach to trading every instrument under the sun - and those in the shadows, too?
  • Does Goldman enjoy too many "insider" perks, such as unrestricted position trading of energy and other commodity futures, and forward contracts and swaps - even though it is not a producer of any of the commodities it claims to need to hedge?
  • Will it finally come to light that Goldman's recently stolen "proprietary" trading software actually soaks up market liquidity and increases volatility for the rest of the investing public, while Goldman reaps vast rewards?
  • Will Goldman be allowed to become a clearinghouse agent in the multi-trillion-dollar underworld of credit-default-swap trading, and be allowed to keep an eye on all its counter party trades?
  • Will Goldman's moneymaking and money-distributing machine be able to continue to grease its success in controlling American government?

Time to Call the Trustbusters?

With Congress diving into the swirling crosscurrents propelling both sides of the debate on all matters of financial regulation, anything can happen. For instance, there have been calls for a return to the good old days of Glass-Steagall, when commercial banks and investment banks were legally kept separate. One of those calls was made by Paul A. Volcker, the inflation-fighting hero and former Fed chairman who is now the chairman of U.S. President Barack Obama's Economic Recovery Advisory Board.

And while the powers that profit from the status quo - including most of our legislators and politicians - may let their best ride on the bigger-is-better theory, if there is a push to separate commercial banks from their investment-banking counterparts, investors would do well to follow the spin-offs: It will be the investment banks that will once again have greater leverage latitude to rake in profits, while deposit-taking institutions will be heavily guarded from once again causing an explosion whose fallout debilitates both the Federal Deposit Insurance Corp. (FDIC) and the U.S. taxpayers.

The Looming Profit Picture

JPMorgan Chase & Co. (NYSE: JPM) reports its earnings today (Thursday), while Bank of America Corp. (NYSE: BAC) reports tomorrow (Friday). A close look at the two banks' mixed revenue picture may show a rebound - if not underlying strength - in JPMorgan's investment-banking and capital-markets business lines, and in BofA's Merrill Lynch component. Morgan Stanley will be next up, and close scrutiny of its earnings will shed more light on how the old investment-banking model is faring in this post-credit-crunch environment.

The other equity merchant banks - the giant leveraged buyout (LBO) shops that, in the last market dust-up, got good public relations advice and began calling themselves private equity firms - are aggressively plotting their own next set of moves. They are having their troubles, but the largest and most powerful firms will end up seated at the pinnacle of the new financial-services-market pyramid right next to Goldman Sachs.

Investors might do well to watch the stock of one specific LBO shop as it morphs into a full-blooded equity merchant bank.

That player is The Blackstone Group LP (NYSE: BX).

A Player For Investors to Watch

In 1985, with a mere $400,000 in capital, former Lehman Brothers, Kuhn, Loeb Inc. Chairman and Chief Executive Officer Peter G. Peterson - along with Steven A. Schwarzman, Lehman's former head of global mergers and acquisitions business - formed Blackstone. This duo of investment-banking heavyweights understood that in order to build a so-called "legacy" firm with real marketplace staying power they would have to populate the company with pedigreed descendants of other venerable banking, trading and political dynasties. And that's just what the two Blackstone founders did.

Today, Blackstone Group is best known as one of the largest private equity shops in the world. What's less well known is that Blackstone is much more than just your run-of-the-mill private-equity, LBO shop.

Blackstone is the prototype of the new equity-merchant bank.

Blackstone has four very lucrative business segments that are operated separately from a profit-and-loss standpoint, but still serve as an interconnected web of relationships, transactions, spheres of influence and future-profit-generating potential. The four segments consist of:

  • The Corporate Private Equity Segment, in which Blackstone uses pooled money gathered from pension, insurance, endowment and sovereign wealth funds, as well as other institutional sources. This unit had first-quarter revenue of $68.4 million, a major turnabout from negative revenue of $193.6 million for the fourth quarter of 2008.
  • The Real Estate Segment, which invests directly and indirectly in U.S., European and so-called "special-situation" real-estate transactions through a series of funds. The troubled real estate business had negative revenue of $211.9 million for the first quarter of 2009, compared with negative revenue of $477.8 million for the fourth quarter of 2008, and positive revenue of $47.9 million for the first quarter of 2008.
  • The Marketable Alternative Asset Management Segment, also known as MAAM, which utilizes proprietary hedge funds, funds of funds, closed-end mutual funds, mezzanine debt financing, and senior and subordinated debt investment vehicles. MAAM had revenue of $99.5 million in the first quarter, following negative revenue of $55.7 million for the final quarter of last year.
  • The Financial Advisory Services Segment, which consists of three distinct - but overlapping - businesses: Private Placement Advisory, Restructuring and Reorganization Advisory, and Corporate and Mergers and Acquisitions. This unit has demonstrated some substantial potential of late. Revenue was $92 million for the first quarter, up 29% from the first quarter of 2008, but down 13% from the fourth quarter of last year. Net-fee-related earnings from operations were $24.7 million for the first quarter of 2009, an increase of $22.1 million from the first quarter of last year and an advance of $3.9 million from last year's final quarter.

It won't be all roses and champagne for Blackstone in the near future, as even Hamilton E. "Tony" James, Blackstone's president and chief operating officer recently lamented, "the underlying economy continues to decline and the timing of a turnaround is still uncertain."

While it's entirely possible that neither the financial markets nor Blackstone may seen their fortunes soar anytime soon, when the recovery finally does take hold, and capital is flowing more freely again, Blackstone could lead the market in a steep upward ascent.

Near-Term Challenges Abound

In the meantime, however, Blackstone and its private-equity brethren - indeed, the entire private-equity sector - could be facing a host of challenges that essentially amount to another potential reformation movement.

The McKinsey Global Institute and data provider Preqin recently reported that private equity assets under management totaled $1.2 trillion last year, up from $900 billion in 2007.

But there's bad news. In 2009, fundraising is down an estimated 78% to a projected annualized total of only $89 billion, the McKinsey and Preqin report states. Nearly 43% of assets under management, or some $535 billion, has not been committed to deals. The good news about all that "dry powder" is that it can be put to work to buy distressed and already-discounted assets at their cheapest point. But the bad news is that without easy credit and the ability to leverage debt, all that capital will have a hard time generating the types of returns that private-equity investors signed up for.

 Institutions that commit capital to private equity funds typically allocate a set proportion of their total capital pool to the leveraged-buyout alternative asset category. As their own investment portfolios have shrunk due to the financial collapse, their allocation to private equity now exceeds their intended allocation limits.

In an exquisite irony, however, private equity firms are now beginning to mark down their portfolio companies so deeply that the value of the holdings of their institutional investors is once again below their allocation limits to private equity. That means it's going to be hard for investors to beg off when private equity firms come calling on their institutional investors to ask for additional capital infusions.

But this irony is creating a backlash from some institutional investors that may ultimately change the way investors commit capital to private equity.

Another issue facing Blackstone is a push by the Obama administration to end the practice of "carried interest," which allows general partners to not have to "mark-to-market" and have their unrealized profits taxed as ordinary income, but lets them carry their profits until portfolio holdings are sold so that they can then be taxed at the 15% capital gains rate. Even so, as we've seen with the reformist attempts aimed at Goldman Sachs, many of the attempts to crimp Blackstone and its big private equity brethren will be pushed back by the powerful machinery of these mega-wealthy financial juggernauts.

With all the potential new regulatory propositions, tougher capital requirements and compensation restrictions hanging over commercial banks, equity-merchant banks like Goldman and Blackstone will have more room to move, more institutional participation through their separate fund vehicles and far greater growth potential in such areas as:

  • Mergers-and-acquisitions dealmaking.
  • Corporate reorganization businesses.
  • Investments in distressed assets.
  • Fee-based investment-banking services.
  • Capital markets trading.
  • Leveraged buyouts.
  • Direct investments in public companies.
  • And private placements.

If they are not sliced and diced as a result of the upcoming congressional regulatory battles, both of these equity merchant giants will be investor favorites for years to come.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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