Death, Decay, and Rebirth on Wall Street — pt. ii
Changes in the financing market for early stage companies and the emerging power of even more traditional b2b brands is causing sweeping changes to the capital markets landscape
Preface
As we sit here in the middle of the COVID-19 pandemic, it is clear that we have entered some type of portal and, while perhaps not yet having emerged on the other side, are certainly in transit. Many mega trends which have been apparent for years are now accelerating past escape velocity. It is my belief that we are already in the New Regime and while things don’t change overnight, many of our cultural touchstones and generalized assumptions of the past 12 years will simply no longer hold.
One of the areas that I am both most familiar with and is ripe for this accelerated change is Wall Street. I had been working on a white paper for some time examining the relationship between Wall Street, Silicon Valley, tech, the asset management industry, and changing consumer behaviors. I present it here, slightly adapted, and in several parts. This is part ii, which looks at the changes in capital markets since the Great Recession. part i, with relevant background, can be found here. Part iii will cover research and regulation.
Capital Markets
The capital markets business within a typical bulge bracket or boutique investment bank is responsible for the origination, underwriting, marketing, and distribution of primary and secondary market transactions in equity and debt markets. This generally breaks down along the lines of Equity Capital Markets, Debt Capital Markets, and Leveraged Finance. A capital markets banking relationship can begin early or midway into a company’s lifespan, and ideally for the IB concludes with an IPO or M&A transaction — further leading to a lifetime relationship of advisory fees and use of the suite of services available from other parts of the bank. While not directly comparable to a lending relationship handled on the commercial side of the bank, the rise in regulatory capital requirements and consolidation of money center and commercial banks post-2008 lead to a permanent change in the funding mechanism for small businesses. According to analysis by Rebel Cole of the U.S. Small Business Administration from January 2018[i], small business loan originations were still 40% below pre-crisis levels, with the decline most pronounced at larger banks. They note that “it appears that there has been little in the way of a recovery in the small business loan market, but a somewhat more robust recovery in the market for total business loans.”
An HBS study by Kathy Gordon Mills and Brayden McCarthy from September 2016 underlines the structural issues in the system, noting that “A decades-long trend toward consolidation of banking assets in fewer institutions is eliminating a key source of capital for small firms.”[ii]
The gap in the market noted by Mills and McCarthy has been filled by three different services targeting different segments. First has been the proliferation of online lenders such as Lending Club, Kabbage, and On Deck. This tends to target riskier consumers and businesses and isn’t in direct competition with the investment banking capital markets business. Secondly, there has been an expansion of direct lending businesses, through a mix of special purpose hedge funds and merchant financing firms, as well as lending specific funds raised as part of the overall strategy of more traditional asset managers.[iii]
Lastly, as lending to small businesses became less profitable, capital became cheaper and more abundant on the back of persistently low interest rates. This led to an explosion in VC which is still ongoing, as investor fundraising doubled again just in 2019 to $983bn from $544bn in 2018.[iv] The change in funding patterns is only one side of the story, as technology investments are leading to more automated processes at the banks themselves. The FT notes that “The next frontier is the “primary side of the banks’ capital markets businesses, which helps companies issue debt and equity.
Bank of America Merrill Lynch, for example, has spent time collecting and cleaning up internal information on initial public offerings it has managed, and fed the 50-gigabyte data set into a machine-learning tool it calls “Predictive Intelligence Analytics Machine”, or Priam.”[v] Similar efforts have also been underway at Goldman Sachs, among others.[vi]
The popularity and success of the direct-listing IPOs by Spotify and Slack show an additional changing vector of the capital markets business. As certain large-scale consumer tech platform brands have gained massive popularity, they have been able to leverage their tech savvy and impactful footprint to head their own transactions, saving millions in fees. Slack’s success further proves that this can be expanded from just consumer facing brands even to services primarily targeting businesses. [vii]
Conclusion
The trends in the capital markets business are clear. As funding for businesses at earlier and riskier parts of their lifespan is replaced by a host of other segment specific services, improved communication and financial technology is de-emphasizing the role of the investment bank in many early-stage financing transactions. Meanwhile, banks are adapting internally to these changes with more automation, even in processes that have traditionally been highly relationship dependent. This has led to a larger portion of the relationship value from funding companies earlier in their lifespan that was captured at IPO coming later and at less profit to the investment banks. These developments will continue to drive a competitive environment with fee pressure and ongoing disruption to traditional channels.
[i] How Did Bank Lending to Small Business In The United States Fare After The Financial Crisis?, U.S. SBA, January 1st, 2018
[ii] The State of Small Business Lending: Innovation and Technology and the Implications for Regulation, Mills & McCarthy, 2016
[iii] Why Direct Lending Is a Booming Part of Private Debt, Bloomberg, March 6th, 2019
[iv] PWC/CB MoneyTree Report Q4 2019, pg. 105
[v] Wall Street grafts new technology on to old-school fundraisings, FT, April 23rd, 2019
[vi] Goldman Set Out to Automate IPOs and It Has Come Far, Really Fast, Bloomberg, June 13, 2017
[vii] Evolving Perspectives on Direct Listings After Spotify and Slack, Rodgers, Jaffem Cohen, Latham & Watkins LLP, December 17th, 2019
