Investment Bank Extinction?

A recent PE conference held in Munich caused a stir, as Guy Hands, the head of British buy-out shop Terra Firma Capital announced the redundancy of investment bankers. Hands proposes the economic conditions are right for private equity groups and similar buy-out firms to manage purchases without the advice and underwriting investment banks have to offer.

Warren Buffet, the Oracle of Omaha, famously dislikes investment bankers. His firm, Berkshire Hathaway, recently made their largest cash purchase in their company's long history of acquisitions, while employing no advisors (read: investment bankers).

As a little refresher, while investment banks partake in various value-creating activities, their primary function has always been to act as middle men, lining up buyers and sellers of all sorts of financial instruments, like bonds or stocks. This includes actions like taking a firm public (an IPO) and advising on a merger, acquisition, or divestiture.

For example, in an LBO, an investment bank will usually underwrite the debt used by a PE group to purchase a company, then sell the debt off to investors. I-banks have been necessary, because underwriting is difficult and complicated, and also demands an unbiased third party to guarantee that the debt is good.

But what credibility do these banks have after so seriously flubbing these CDOs and CMOs last year? And the fact that the fatty premiums I-banks charge for their services is upwards in the tens of billions of dollars might make their services a hard sell. It is no wonder that PE groups are building their own debt raising branches. And with the cash-rich sovereign wealth funds on the rise, financing is no doubt easier than ever to mitigate for PE groups.

OK, but is this change actually feasible? Are investment banks on the out and out for M&A work? Doubtful. Investment banks have incredible infrastructure set in place, in order to sell all over the world. Furthermore, PE groups can't both reach out for buyers of debt AND try to keep their purchase a secret (obviously a necessary move when acquiring a public company). Some of these issues can be addressed as IT improves, but all that probably means is prices will go down as ibanks lose bargaining power. Anyway, investment banks make plenty of money elsewhere, and the investment bankers will simply take their skills elsewhere (e.g. private equity).

Interestingly enough, the deal structuring for PE groups is nothing to be proud of, either. A PE firm interested in purchasing a company has to deal with information asymmetry - what financial skeletons-in-the-closet are the management hiding from them? A popular way to overcome this is by binding he remaining management to the purchase through heavy investment. Normally, execs who are staying on are required to invest all of their own assets into the success of the firm, purchasing common stock, and pile on personal debt as well. So if the company goes under, they are out of house and home. Sounds like a gamble? Well, at least the rewards are huge.