Joe Manton

2022 was a bad year to be an M&A investment banker, and it's been a rough start to 2023. Through January, the total value of global M&A was on pace to drop about 25% in the first quarter compared to the fourth quarter of 2022. We have seen a couple of unsolicited large offers in recent days, but we had no $10 billion-plus deals announced during the first month of the year.

What will it take to get M&A going and improve the outlook for the investment banking businesses? We'll talk about that with RBC Bank analyst, Gerard Cassidy on this episode of The Pipeline, an S&P Global Market Intelligence podcast. I'm Joe Manton, an editor with S&P Global Market Intelligence, and your host to The Pipeline podcast, where we provide insights into M&A, IPOs and all things deal-making.

I've covered investment banks for years and listened to many, many earnings conference calls of large banks. On those calls, equity research analysts ask questions of management teams. And one of my favorite big bank analyst is Gerard Cassidy. I like Gerard because, not only is he a great bank analyst who created the Texas Ratio, which is an indicator that helps regulators and banks management team determine the likelihood of a bank failure.

But I also like Gerard because he is one of the few analysts who regularly ask executives at the large banks about their investment banking businesses. I caught up with Gerard in January, soon after the big banks reported year-end 2022 earnings. The fourth quarter ended a woeful year for the investment banking businesses at Citi, JPM, Goldman Sachs, BofA and Morgan Stanley. Combined, those companies reported a nearly 50% drop in revenue from their equity capital markets.

Debt capital markets and M&A advisory revenue in 2022 compared to 2021. Any of those in and around the investment banking businesses have noted that they think the second half of 2023 will be better than the first half of the year when it comes to deal-making. That's where we pick up the conversation with RBC Capital Markets Analyst, Gerard Cassidy, with me asking Gerard, about why the second half of the year may be better than the first half of the year.

Gerard Cassidy

It's making the assumption that the markets will be more stabilized because the federal reserves to be finished with its monetary tightening strategy or tool by raising short-term interest rates. So by taking interest rates out of the picture, meaning rising rates, that hopefully will offer some clarity to the outlook for companies that may want to do acquisitions or go public.

Now certainly, quantitative tightening is still underway, which is another tool they use for monetary policy. But the increases in Fed funds rates, the forward curve is suggesting by the middle of this year, it should be over. And if it is over, again, there should be more stability in the marketplace.

Joe Manton

Okay. Yes. So that was one of the questions I wanted to ask you, what has to change in order for deal-making to pick up. I mean you just touched on the Fed. Any other indicators? Are you looking at the VIX?

Gerard Cassidy

I would say, the economic indicators, what the yield curve is telling us, should the economy not go into a recession, it's a soft landing, and that would be very positive for the capital markets businesses, particularly investment banking. So many of the economic indicators, whether it's initial unemployment claims number that comes out weekly every Thursday morning, or the monthly jobs report or the PMI numbers, everything is looked at carefully.

And as people get more confident that the economy is stabilizing or improving, it's still the economy in the fourth quarter of 2022. According to the Atlanta Federal Reserve, which does the real GDP now forecast, they're still calling for about a 4% real GDP growth number. So to go from 4% to a negative number may take time, meaning into the second half of 2023. Should it not appear, meaning it doesn't turn negative, again, could be another real positive sign for the investment banks.

Joe Manton

Sure. Okay. And what businesses do you expect to bounce back first? Or the ECM, DCM or...

Gerard Cassidy

I would say it's probably going to be DCM. That would be one, followed by the ECM and IPOs, and then the advisory after that.

Joe Manton

Yes. I'm a little surprised to hear you say DCM. I was just kind of thinking, with the higher rates, companies would be less likely to be issuing debt.

Gerard Cassidy

I think what you'll see is that the debt markets are always open. Because if an issuer is willing to pay the rate, generally speaking, there are buyers out there for the debt. You can't really say that about the ECM market. Because if investors are going to shun the IPOs because they have been losing money owning stocks, it's tougher sometimes to open up that market. So in DCM, to us, if the borrowers are willing to pay the higher rate, there certainly able to issue debt and they just may not like the cost of it.

Joe Manton

Got you. That makes sense. And then on M&A, I mean, M&A, it always seems like the longest to come back. Why does M&A take longer to come back?

Gerard Cassidy

I would say because you have to find willing sellers, of course, that's one. Number two, the buyers themselves have to be confident enough that the outlook for the economy is improving. And they want to be certain of that before maybe they jump in and do a deal that could prove to be distracting as they're trying to close a deal, but at the same time, running their own business. In a more challenging economy, it might just be too risky to do that.

Joe Manton

Makes sense. And I've heard a lot of executives, the big banks and the more advisory-focused investment banks talk about how conversations on M&A deals with clients have been ongoing all throughout 2022 and the level of dialogue has remained robust. Did you put any stock into that? I mean they kind of say that as an indication that M&A will bounce back once it gets going. Do you think it's sort of a valid point?

Gerard Cassidy

Yes, I think when it comes to M&A, there, of course, are hostile deals that happened. But generally speaking, the majority of mergers and acquisitions are done on a friendly basis. And in doing so, there's a courtship and the courtship between companies can take months or years. And so as a result, you're going to see that even during challenging times, companies are talking to one another.

It doesn't necessarily mean they'll do a deal. But it's not an on/off switch where people turn it off because the economy is more challenged. They keep it on throughout the cycle, and they continue to keep the dialogue going. There's no surprise that when you hear the investment banks talk today, they are indicating that those dialogues are continuing.

Joe Manton

And then David Solomon on the Goldman Sachs call, their CEO, he had mentioned that it typically takes 4 to 6 quarters before M&A picks back up after a downturn. Is that -- from your experience, is that something that -- that timeframe, does that sound about right to you?

Gerard Cassidy

Yes, it does. The players in that market want to be certain that they're not maybe taking on added leverage to complete a deal, and then unfortunately, run into a problem with the economy. So the deal activity does lag cycles, so it -- that sounds about right.

Joe Manton

You mentioned leverage, it seems there's been some real cooling in the leveraged loan market. Do you think that the large banks have an appetite to fund leverage loans at this point of the cycle?

Gerard Cassidy

I would say there's always an opportunity for banks to make leverage loans and underwrite leverage situations. But in this kind of environment, they're more conservative. So is there an appetite? Yes, there's always an appetite. But it's not a very big appetite today in our view.

And once again, it has a lot to do with the expectation that we're likely to see, an economic slowdown or a recession. And when that happens, the leverage loan defaults, moved up meaningfully from the period we're in today. So I can understand why people wouldn't want to have less exposure here than possibly 3 or 4 years ago.

Joe Manton

Right, right. And the private equity firms are often the players involved in those leverage buyouts. And you were asking -- on the JPM call, you were asking about their lending to private equity firms. Was that kind of what you were getting at? Were you kind of asking about the leverage -- the loan market there?

Gerard Cassidy

I would say that when I was discussing the leverage loan market with JPMorgan, our focus is the private equity area. Because, as you have seen, a number of companies that were valued at extremely high valuations in the fall of 2021 have come down materially in value.

And if banks are lending into these private equity firms and they're using the funds to maybe acquire somebody or to fund one of their portfolio companies, and they're using -- with borrowings from the bank, we'd like to know about that because the implication in value has been material, and that could affect the loan.

So it's an area that's very opaque, and it's an area that's grown very fast over the last 5 years for these large universal banks and investment banks. And whenever we see rapid growth in a riskier lending area heading into an economic slowdown or a recession, it often spells an increasing credit problems, which is the reason we've been asking this question of banks.

Joe Manton

And have you been satisfied with the answers that you've been getting?

Gerard Cassidy

No, we're not. I mean, it's still too opaque. We would -- I think many investors would like to see the size of these portfolios and then broken out by not necessarily individual company names, but how much is exposed to the communications sector or the software sector or biotech, just so that investors have a better understanding of what they're getting into.

Joe Manton

Right. And then so you would like to see the loans made to private equity firms and what sectors those PE firms are focused on. Is that kind of like...

Gerard Cassidy

That, and also just if -- let's say it's KKR or Carlyle takes down a $100 million loan from JPMorgan, what are they using it for? Is it to then lend it to one of their portfolio companies to help them grow their business? Is the loan going to be used to buy another company to put it into the portfolio? So it's all of those types of questions that investors need to get their arms around.

Joe Manton

Which banks do you think are the biggest players in that market there?

Gerard Cassidy

Generally speaking, it's the investment banks, so Morgan Stanley and Goldman Sachs. Also the larger banks such as JPMorgan Chase, Bank of America, Wells Fargo are all players in this space.

Joe Manton

Interesting. Okay, was there any comment you heard around the conference calls that make you any more optimistic about the advisory capital markets outlook or is you're feeling sort of the same?

Gerard Cassidy

We would say that our expectations were generally met about the business, and it really has not changed those expectations. But we're keeping an eye on, again, different indices to try to see when the pivoting point should come. We think it's a little early right now, but we're trying to keep an eye out for it so we don't miss it.

Joe Manton

And then we've heard about -- there's been some reports out there about some banks that are making some headcount reductions in the investment banking units. Do you think we'll see more of that? Or has it kind of played out by now?

Gerard Cassidy

In terms of the headcount reductions, we have to remember that 2020 and 2021 were record years for the investment banking industry, particularly 2021. Because of that activity and because of the strength of revenues, many of these banks went out and hired thousands of people in 2020 and 2021.

Now with business coming back to normal levels in 2022, you can argue, was below normal levels, we anticipate to see the rightsizing of the personnel departments of these companies. And it started -- Goldman let over 3,200 people go or about 3,200. And Morgan Stanley, it was, I believe, over 1,000. So we are expecting these companies similar to years past or cycles past to align their expenses now with a lower revenue environment. The real question is going to be in the first half of 2023.

What if business doesn't come back, and it's a dreadful as it was in 2022, then there probably is going to be another round of downsizing to bring the expenses in line with the depressed revenues -- and when revenues do come back, and they will, it just -- it takes time. Again, they won't be at that 2020 or 2021 level. It will be more, we think, similar to the numbers that were achieved for the industry in 2017, '18, that time period.

Joe Manton

What types of personnel are being affected? Is it some more of the junior staff or senior bankers?

Gerard Cassidy

We see it affecting all levels of personnel. Do you really need today SPAC investment bankers? So managing directors that were in the SPAC space that was red hot in the first quarter of 2021, is there really a need for -- or is there a need for as many of them today? The answer is no. So it's not just the junior-level employees, but it could go quite high if the business has not really recovered.

Joe Manton

And then just thinking about the 5 large banks, JPM, Citi, BofA, Goldman and Morgan Stanley, are any of them better positioned to sort of take market share in the current environment?

Gerard Cassidy

I would say that those -- the 5 dominant banks continue to see their market share increase. Within the five Goldman, Morgan Stanley and JPMorgan seem to be setting themselves apart. But then this quarter, Merrill Lynch had a really strong quarter.

So I think as a percentage of the industry wallet, as it's referred to, the amount of business that is in the investment banking business, the Big 5, I think, will continue to garner slightly higher market shares going forward because they tend to attract some very strong people and have great brand recognition that is needed in the advisory business.

Joe Manton

Yes, it was funny because the BofA seemed to be the only company of the 5 that spoke positively about their investment banking business.

Gerard Cassidy

Correct. Correct.

Joe Manton

They're talking about getting more relationship to their commercial bankers, right?

Gerard Cassidy

That's part of it. Bank of America went on a very focused expansion of their investment banking business probably 5 or 6 years ago now to bring it down to the middle market commercial customer. They weren't always hunting for elephants. And I think that's playing out to their benefit in these types of markets that we're experiencing today.

Joe Manton

That will do it for this episode of The Pipeline podcast. We thank Gerard for taking the time to discuss the investment banking businesses with us, and we thank you for listening.