UK: GREAT PAST ... SMALL FUTURE.

UK: GREAT PAST ... SMALL FUTURE. - Basking in the glory of their past, London's merchant banks have failed to face the truth: they no longer have anything special to offer; several of their number have already fallen into foreign ownership, and it's only

by Chris Blackhurst.
Last Updated: 31 Aug 2010

Basking in the glory of their past, London's merchant banks have failed to face the truth: they no longer have anything special to offer; several of their number have already fallen into foreign ownership, and it's only a matter of time before others follow.

They still hang oil paintings of the founders on the walls of Morgan Grenfell's City of London headquarters. Plenty of highly polished wood, antique furniture and a hushed, respectful silence complete the sense of a place that has changed little over the years. If those founders journeyed down Great Winchester Street today, past the old City Universities Club, and avoided gazing skywards at the National Westminster Tower, to their old stamping ground tucked away in the corner, they could be forgiven for thinking it was business as usual.

They would be wrong. Not only do those solid walls hide a welter of modern micro-chip technology, they also create an illusion. For things are not what they were at Morgan Grenfell, now part of the giant Deutsche Bank, and the same is true, or soon will be, for most of its rivals. Soon, nearly all merchant banks will be built in this way: retaining their historic name and image but no longer independent and no longer British.

From being a famous name that acquired a reputation for ultra-aggression in the 1980s, only to come a cropper on Guinness and heading nowhere fast - 'if we had stayed on our own we would have become more inward-looking and circumspect,' says Justin Dowley, the bank's corporate finance director - Morgan Grenfell is number one in project finance deals worldwide, top in privatisations globally and, unthinkably before, leader in German domestic and cross-border takeovers.

Profits since 1990 and the Deutsche takeover have soared, setting new records. Last year they were £150 million. A delighted Deutsche is pushing ahead with ambitious plans to create a huge international investment bank - along the lines of the US powerhouses Morgan Stanley and Goldman Sachs. 'We are going to build a securities distribution business,' says Dowley. 'Deutsche Bank gives us the opportunity to offer a wider product range to our clients.' His rivals, he says,'may think they can carry on making a very good living out of pure advisory business - they may - but there is a danger of getting caught in the middle ground, between the boutique and the investment bank'.

Merchant banks pride themselves on their history and immovability. They devote hours of time and money to crafting an air of confidence, to exuding a feeling of supreme well-being. Brash Americans may try to take them on, waving seemingly blank cheque books and making bold assertions they cannot match; new, smaller houses may nibble away at their business, claiming to be more personal than their larger cousins; accountants may set up new departments to steal their business. All to no avail: the true merchant bank is untouchable and will be there long after they have gone. That at least is the way they like to present themselves. They are mistaken.

Two words delivered to a merchant banker these days will shake them to the core. Say it quickly and watch the smug smile disappear: Barings and Warburg. Then, in an instant, come the excuses. The tragedy of Barings, they will tell you, was unique to Barings. A horrendous episode, they say, that could never happen to us. 'Someone should have known what was happening; obviously there was something wrong with the controls,' says a merchant bank director, of Barings. Likewise, Warburg. A less clear-cut case than Barings, all sorts of theories are advanced for its stunning absorption by Swiss Bank Corporation for less than net asset value. 'A collective loss of nerve at the top,' says one senior banking analyst. 'Morale was totally shot to pieces.' Management, battered by a series of high-profile departures, he says, 'had lost its fire, it no longer wished to stay independent'. Warburg, says Dowley, 'didn't get a handle on its cost-base'. Good years meant whacking great pay rises, which, unfortunately led to crippling overheads when profits dipped. Unlike some of its tightly-held rivals, Warburg was a quoted company, with demanding, non-family shareholders. 'Because they have such volatile earnings, merchant banks are not businesses which sit happily with being quoted, with outside shareholders. If public shareholders see profits fall, all of a sudden they get windy,' says the Morgan Grenfell man.

Some time ago, says a senior international banker who has an intimate knowledge of Warburg and its purchaser, SBC, 'David Scholey (Warburg's chief) decided that the only way forward was to increase the capital base. Warburg was just not big enough to go it alone.' He continues: 'A merchant bank should either be a well-capitalised institution capable of delivering underwriting and underwriting risk so it can advise on acquisitions and contribute to their funding or it should exist to 26e provide advice in the boutique manner. Their future is one or the other - the Warburg dilemma has shown that.' SBC's new purchase, said the international banker, 'looked across at Goldman and Morgan and worried that, as they were offering global advice and Warburg's clients were becoming more global, its franchise would be threatened. So it aspired to be a full service-provider like them but didn't have their muscle.' As for those that are left, he says: 'They are all going to go one way or the other.' While great emphasis is placed on the uniqueness of the debacles, bankers are curiously reluctant to confront one glaringly obvious truth: after glorious pasts, a high proportion of the greatest names in London merchant banking have fallen into foreign hands. Warburg wanted to compete with Goldman Sachs but was not big enough; Barings was not sufficiently strong to weather its crisis; Kleinwort Benson read the writing on the wall and accepted Dresdner Bank's advances last month; and Morgan Grenfell was in trouble after Guinness. Different route, same result, same underlying weaknesses.

More will follow: it is only a matter of time, argue analysts, before N M Rothschild, Hambros and Robert Fleming follow Warburg, Barings, Kleinwort Benson and Morgan Grenfell into foreign ownership. Schroders, arguably the most successful in recent years, is at the 'large end of the boutique category', and could survive in its present form, says a Swiss banker, but such are the forces gripping them and their rivals, he adds, 'that I'm sure they debate it constantly'.

When the going gets tough, the traditional merchant bankers' response is to maintain a stiff upper lip and hope the trouble will pass. So it was with Hambros Bank recently. A 58% plunge in annual profits to £37 million, a slashed dividend and a slump in shares of 28p, still could not shake the resolve of Hambros's deputy chairman, Christopher Sporborg. 'A lot of people are questioning the role of the smaller banks. I think there is a real place for people with energy and innovation and those who can create new products.' For 'a lot of people', choose almost anyone you care to mention. Moody's, the international credit rating agency, believes London merchant banks are ripe for consolidation and acquisition. The agency pinpoints two areas of weakness: rising costs and volatility. Overall, it concludes, the capital bases of Britain's merchant banks 'may not be adequate for a modern, global investment bank'.

'British merchant banks?' responds Robin Monro-Davis, head of IBCA, the specialist banking analysts, 'there will not be many left in a few years.' These once dominant institutions, he adds, are being made to learn that there 'is no such thing as monopoly providers any more'. And 'what', he asks, 'do British merchant banks provide that is special? Answer, nothing.' Client loyalty, once their bedrock, he maintains,'is no longer axiomatic'.

The reasons for using merchant banks are fast diminishing. Once, they employed only the best of the best. Not any more. These days, the first port of call for the brightest graduates heading for the City is the glamorous international blockbuster: Nomura, Merrill Lynch, Goldman, Morgan Stanley, Salomon.

The merchant banks that once prided themselves on their intellectual rigour coupled with commercial pragmatism are becoming a refuge for lawyers and accountants seeking something slicker than their former firms. Ask any merchant bank for technical advice on the listing requirements for the London Stock Exchange and you will be swamped. Ask for an introduction to the main players in a country like Malaysia, for example, and they may struggle.

Tradition decrees that if a company wants to raise cash its bankers will step to the fore. Otherwise astute businessmen have been only too happy to call in merchant banks at the earliest opportunity. This, though, with the advent of new technology and better communications, is no longer the case. A director of a large, quoted British company declares that his company could accomplish a debt issue entirely on its own. He could place the paper with 20 institutions, all of whom he knows personally, not all of them in this country. He believes it would be possible to cut out the middleman completely. The only difficulty would be persuading market makers to quote prices in the stock. Tell that to bankers and they wince. First, they say it cannot be done. Then, begrudgingly, they admit, yes, it makes sense.

Slowly, clients are waking up to the practices of their bankers. In November last year, the Office of Fair Trading issued a research paper, Underwriting of Rights Issues - a Study of the Returns Earned by Sub-underwriters from UK Rights Issues, by Paul Marsh of the London Business School. The slim, academic, 41-page report caused panic in the City. On page after page, Marsh lays bare what many people had long suspected: that the merchant banks make a fortune from underwriting rights issues, traditionally one of the planks of their business, and the risk of getting a bloody nose is minimal.

The figures would shame many other industries. In a sample of the 691 issues by UK companies between 1986 and 1993, Marsh found that they raised a total of £39.1 billion. Of this, a standard 0.5% went to the lead underwriter - the merchant banks - for sponsoring the issue, providing advice and carrying the risk of failure from the signing of the underwriting and securing of the sub-underwriters. On the face of it, not too bad. But what we are talking about here are fixed fees for something the banks can do in their sleep. As for the 'risk', it is normally only a matter of a few hours until the sub-underwriters are found.

For any industrial company - even the very biggest - any rights issue is special, a one-off event. Negotiating the pricing is unfamiliar to them. 'They will thus naturally look to their financial advisers for assistance, but since their advisers also normally act as the lead underwriter, this raises an obvious potential conflict of interest,' says Marsh.

Whatever clients lose from paying a fixed fee, argue the underwriters, is more than matched by the gains made from negotiating the best discount for the issue. Baloney, implies Marsh. Evidence suggests that 'lead underwriters provide companies with strong advice against setting "too tight" an issue discount, on the grounds that this increases the danger of a "failed issue".' In other words, the bank tells the company, do not price it too aggressively because that increases the likelihood of not all the rights being taken up. This leaves a blot on your copybook, is bad for market relations and can cause problems as you find yourself with a group of new, unwilling shareholders - the sub-underwriters. What the bank does not tell the client is that, by the way, those sub-underwriters are friends of ours, good clients, and we would hate to see them lose.

If underwriting costs are excessive, says Marsh, 'then the direct costs of raising equity capital are higher than they need be. This has an important bearing on the competitiveness not only of the issuing firms, but also of the financial services industry.' Prices will come down - 'companies know it, everybody knows it, the law of economics says they will come down', says a director of a foreign bank in London - and when they do, leading the charge will be Morgan Grenfell and Warburg under their foreign owners. When charges fall, merchant bank profits will be hit - just at the moment when they least need it. 'If profits start to be taken out of their business, their difficulties can only increase,' says the international banker. Already volatile earnings will come under even greater pressure.

Eventually, something will give. The only solution for the banks, say those closest to the doomsday scenario currently being played out, is to swallow their pride and link up with large, ambitious foreigners. Otherwise they run the risk of obliteration from those snapping at their heels: the accountants who have yet to make an impact on major deals but whose prowess is growing all the time; lawyers who are also straying into areas of traditional banking advice; and the specialist boutiques which provide a more personal service are springing up almost daily.

Unlike their older, bigger counterparts, the boutiques come without the baggage of massive overheads, large staff and salaries. So far, their impact has been slight. Only Hambro Magan - ironically the adviser to SBC on the Warburg purchase - has made a substantial impression. 'There will be a role for pure advisory houses,' says a senior banker. 'They won't make headline revenues but they won't have headline cost-bases either.' To succeed, the newcomers will have to overcome tradition and prejudice. 'If we put Warburg's name on a document, most investing institutions will take it as read,' says Nick Ritblat a director at British Land and former merchant banker. 'If we used Hambro Magan, people would say "why are you not using your relationship bank? There must be something funny about it".' What the banks can offer, and what the foreigners want, is their network of contacts. 'Culturally, it is very difficult for a foreign bank to break into the UK for UK equity raising,' says the international banker. 'There are elements of the system, such as the rights-issue structure which acts like a cartel, that are very hard for others to break down.' SBC, he adds, was 'buying a brand name - which is nothing to be ashamed about'. Sadly, all the banks have left are their names. There is little they can teach their new foreign owners, few new ideas they can bring to the table, and certainly not any financial clout. All they have are each other, their clients and the past.

Chris Blackhurst is on the staff of the Independent.

TEN YEARS THAT CHANGED THE FACE OF THE MERCHANT BANKING WORLD

Rank** Bank Ownership Rank** Ownership

1985 1985 1994 1995

1 Morgan Grenfell UK independent 6 Deutsche Bank

(German)

2 S G Warburg UK independent 1 SBC(Swiss)

3 Kleinwort Benson UK independent 9 Dresdner Bank

(German)

4 Schroders UK independent 2 UK independent

5 County Bank* NatWest (UK) 17 NatWest (UK)

6 N M Rothschild UK independent 7 UK independent

7 Baring Brothers UK independent 10 ING (Dutch)

8 Robert Fleming UK independent 3 UK independent

9 Hill Samuel UK independent 16 TSB (UK)

10 Hambros Bank UK independent 14 UK independent

* Denotes name change to NatWest Markets

**Source: Acquisitions Monthly - Leading financial advisers on UK public

takeovers.

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