Sunday, September 28, 2008
Goldman Sachs & Nomura's Strategy
Finance Asia: As Goldman Sachs exits stand-alone investment banking, Nomura doubles down on the model by buying the Lehman Brothers franchise in Asia and Europe.
Who is taking the right approach?
Some observers argue that the high-leveraged investment banking era is over, and that Goldman Sachs has made a graceful exit from stand-alone investment banking to a bank holding company (BHC) model at just the right time. If they are right about Goldman, it would seem difficult to be bullish on Nomura’s expansion of that same investment banking model in Asia and Europe. The weakness of the investment banking model embodied by Goldman Sachs and Morgan Stanley is nicely summarised in the September 20 issue of The Economist as stemming from: the higher risk of insolvency, due to higher leverage and the reliance on the short-term wholesale markets; the requirement to mark-to-market; and weaker future demand for their services, especially in structured finance.
Reiko Toritani, chief banking analyst at Fitch Ratings in Japan agrees: “investment banking is facing difficulties due to an overall reduction in risk appetite and a reduction in the leverage to stimulate returns. Morgan Stanley and Goldman have had to become more risk averse after being forced to change to bank holding companies (BHCs), and by more difficult markets," she says.
Goldman’s woes seem to reflect those problems. The bank has gone through an expensive capital raising exercise with Warren Buffett of Berkshire Hathaway. Buffett will invest $5 billion in perpetual preference shares with a 10% annual dividend and retain an additional $5 billion worth of warrants. And on Wednesday, the bank raised another $5 billion through an accelerated book-build. BHCs are closely regulated by the Federal Reserve, and leverage levels will be capped closer to commercial bank levels (around 10 times for the sector, compared to 30 times for the non-commercial bank sector pre-crisis). That will make it hard to maintain previous earnings levels.
The exit of Morgan Stanley and Goldman leaves Nomura as the last major stand-alone investment bank in the world. Nomura is fiercely proud of its independence from Japan’s mega-banks, and it is likely that it is hoping its raid on Lehman Brothers will give it the international scale to sustain that independent model. The question is, has Nomura just put off the fateful day when it is wrapped in the arms of a mega-bank, or at least changes its status?
One sceptic of the stand-alone model points out how close even Goldman may have come to disaster, despite its high reputation. “Goldman has a similar business model in many ways to Lehman and Bear Stearns. It’s a tribute to its franchise and mystique that it managed to retain investor confidence,” he says.
One could argue that Goldman played its cards wrong and that it could have avoided its exit from stand-alone investment banking by raising capital much earlier. Indeed, the firm famously made a lot of money shorting the mortgage-backed market in 2007 and early 2008. Goldman must have understood the negative macro-economic implications of the development of these instruments, and should have spent less money on the famously lavish bonuses, and more on plumping its equity cushion. But, says a former Goldman banker “not paying bonuses (almost a year ago) would have resulted in people leaving the firm; raising capital would (even though it would have been cheaper then than now) have sent a danger signal to investors at a time when sentiment was jittery.
Raising money now from Buffett is the right thing to do, as is adopting the BHC model. People are more accepting of the need to do so, and it will help the firm ride out the downturn,” he says. It isn’t clear if there is anything preventing Goldman from reverting to independent status when it finds the right moment.
In the meantime, over in Tokyo, Nomura has taken the opposite tack. It saw some investment banking assets going cheap and couldn’t resist. The $225 million Nomura reportedly spent on the Lehman operations in Asia, and the ‘nominal price’ paid (according to senior Nomura advisor Sadeq Sayeed, as quoted by Bloomberg) for its European operations, is low – and buying cheap is always the best hedge.
In addition, Nomura has bought people and IT platforms, and not assets or liabilities. Yet the Nomura strategy looks paradoxical: it is buying into an investment banking model which has been abandoned by arguably its finest exponents. Can Nomura turn it around? That, says Takeo Sumino, a managing director responsible for private equity at Nomura Securities in Tokyo, is not the right question. “We are not trying to be like Goldman or Morgan Stanley. We are seeking to return to the days of the ‘independent, trusted advisor.’ We are emphasising the traditional investment banking model - before it was transformed by Goldman and others using high leverage and high risk.”
He’s not alone in this view. Says David Marshall, head of Fitch Ratings in Hong Kong: “securities brokerage and related services will still be needed in future, as will arranging sales of corporate debt and equity. Provided they maintain conservative balance sheets and plenty of liquidity - which in practice securities firms in Asia tend to do - they are much less vulnerable to liquidity problems than the highly leveraged US investment banks proved to be.” Nomura’s Sumino reinforces his point by arguing that Goldman was moving its focus away from “the capital markets, advisory, and wealth/asset management business - those traditional investment banking businesses - and was increasingly focusing on the capital-intensive proprietary trading business, similar to the hedge fund and principal investment businesses, and also close to the private equity business. The consequences of that new strategy led to a relatively highly leveraged balance sheet.”
In addition, Sumino says “unlike US I-banks, we will not be trying to compete with hedge funds and the private equity funds and this should reassure our client base.” Sumino says that one of the main advantages of Nomura’s model is that “the role of the trusted advisor becomes all the more important at a time when commercial banks have investment banking operations. They can use their balance sheets to unduly influence their corporate clients. We can provide an alternative service and independent advice. As the last remaining independent investment bank, we can provide a special service to our clients.” A serious issue concerns the 5,000 new staff Nomura has acquired.
The Lehman staff, accustomed to the higher leverage, high-risk model may not take kindly to Nomura’s more conservative approach. Privately, sources at Nomura acknowledge this, but say they hope they can retain as much talent as possible, even if the Lehman staff find their trading capital cut back considerably. It is certainly difficult to see this marriage working easily. Even granted Nomura (the plan is to drop the Lehman name) sticks to the ECM, DCM and M&A businesses, how profitable can it be in today’s environment? Those areas are all suffering in the ongoing credit crunch: indices across the region are falling and business activity is drying up due to a lack of positive news.
For Fitch’s Toritani, however, this is not a sign the Nomura strategy is bad. “It just means the payoff will take time. (It will come) during the next upturn, rather than immediately.” One might argue that Nomura’s financial position is not that strong in the first place either, and it has $6 billion in subordinate debt and loans to service. Nomura lost $67 million last year, and its stock price has dropped by almost half from its 12-month peak. It can’t afford to lose money for too long.
However, Sumino counters by pointing out that Nomura is ‘well capitalised, with relatively low gearing and extensive foreign experience." In addition, he believes synergies can be extracted from the combined business: “We have the best brokerage client base in Japan – and they have an appetite for uridashi bonds (foreign currency bonds held by Japanese investors) as well as foreign equity. We will, of course, explore cross-fertilisation between our domestic platform and our international platform.” Shinichi Tamura, banking analyst at Deutsche Securities in Japan sees other opportunities for Japanese banks in Asia. “The Japanese will likely not be replicating the ultra-high ROE (return on equity) model used by Western banks in Asia. Rather it’s possible they will acquire operations, as in the case of Nomura and Lehman, to service the international operations of their Japanese corporate clients. Japanese firms need to match assets and liabilities in non-Japanese markets and carry out M&A. Such an operation can help them do that.”
If Nomura becomes a successful and genuine ‘trusted adviser’ internationally, it will be ironic for Wall Street banks. Before the go-go culture emerged following the deregulation of the banking industry in the UK and the US in the 1980s, that was their role too. They then moved away from relationship banking to the more profitable (at least in the short term) transactional banking, as described in Jonathan Knee's 2006 The Accidental Investment Banker.
So who is smarter then? The question is tongue in cheek, of course. But at the moment, Nomura looks better placed. They are buying assets rather than trimming their balance sheets, and they are expanding their operations rather than laying people off. They have not made the profits of Goldman, but their long term strategy is clearly articulated. At the moment, that’s not the case with Goldman: Goldman has its reinvention to the next stage of investment banking still before it.
p/s photos: Hannah Tan