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Archive for November 2011

What constitutes a “full-service” Equities business?

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[Part 4 of Equities Context and Content]

Mature Equities businesses offer a complete array of products and services under the umbrella of Equities. The full-service Equities model incorporates five diversified business lines, each of which has a set of products and services that capture revenue in various forms:

  1. NEW ISSUE
    Origination business based on corporate relationships, resulting in direct underwriting and placement fees and indirect revenues from investor clients seeking to participate in their allocation. Examples include: common and preferred equity, convertible bonds, and private placements.
  2. FLOW
    Agency risk transfer business resulting in commissions and the potential for reduced expenses due to internalization. Examples include: “high-touch” and/or electronic order handling in cash equities and listed derivatives.
  3. BALANCE SHEET
    Financing businesses resulting in accrual of spreads in excess of cost of funding. Examples include: prime brokerage, securities lending, repo, and OTC derivatives.
  4. CAPITAL
    Principal trading businesses, including market-making and client facilitation, resulting in revenues from bid/offer spreads and directional risk-taking. Examples include: underwriting, block trading, aspects of program trading, listed options market-making, and certain proprietary trading strategies.
  5. SERVICES
    Low-risk, operationally-intensive agency business resulting in fee income tied to balances or transactions. Examples include: custody, administration, cash and collateral management.

 

A comprehensive offering allows such firms to compete globally for all client segments and to address the entire available revenue pool. As shown in Table 2, McKinsey estimates the global revenues that may be directly linked to Equities at over $120 billion in 2010.

Figure 2 illustrates the five Equities business lines in a way that circumscribes the revenue pool:

Table 2

Table 2: Equities-related revenue pools / Figure 2: Equities revenue map

Diversification can reduce earnings volatility and reliance on new issue activity. Of the five dimensions, flow commissions in cash and derivatives account for 39% of the pool, a fact that leads all competing firms to focus on execution capability. With more than twice as much revenue at stake overall, diversified firms not only access the related pools, but may also have an advantage competing for flow.

The capabilities or limitations of a larger firm directly impacts the ability of its Equities business to compete in each of the five dimensions. For example, the firm’s ability to allocate balance sheet and capital to its Equities business allows Equities to offer financing products or to carry inventory in convertible bonds. Similarly, Corporate Banking could drive new issue supply through the Equities business via its capital markets efforts.

Written by highlineadvisors

November 9, 2011 at 12:41 pm

Why does the firm context matter?

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[Part 3 of Equities Context and Content]

There are five bank or broker-dealer businesses that can significantly enhance a firm’s Equities business. The capabilities and resources “owned” by these other business units can provide a competitive advantage in attracting equity investors:

  • CORPORATE BANKING
    Direct lending and corporate finance can produce two of the resources most valued by investors: new issues and access to corporate management. The Equities business can in turn provide market color on previously-issued equities and related derivatives to bankers and their corporate clients, earning mandates for share repurchases and block trades. The two business units can also share the cost of Research within applicable regulatory limitations.
  • PRIVATE WEALTH MANAGEMENT
    Retail can be a powerful contributor to an Equities business through the direction of order flow and stock loan balances. A captive source of liquidity and commissions provides a boost to the sales and trading unit, and a unique supply of hard-to-borrow securities can differentiate the prime brokerage unit. A retail distribution network may be viewed favorably by both corporate clients awarding new issues and block trades, and asset managers seeking capital.
  • TRADING IN OTHER GLOBAL MARKETS ASSET CLASSES
    Trading capabilities in complimentary asset classes can provide research, market color, and occasional trade facilitation for equity investors. Single-name credit products such as corporate bonds and credit default swaps can provide investors with deeper insight into corporate capital structures. Index, currency, and rate products offer investors a means to hedge macro exposures in their portfolios. Commodities trading expertise can also provide macro insights as well as deeper understanding of companies in the energy, agriculture, and metals sectors. Broader trading capabilities can provide solutions for cash and liquidity management in repo, government securities, and corporate commercial paper.
  • CUSTODIAL/TRANSACTION BANKING
    Custodial Banking can strengthen relationships with both corporate and investor clients. On the corporate side, credit lines, treasury services, cash management, and payments processing can lead to increased access to management and participation in new issues. On the investor side, clearing, collateral management, custody, securities services, and fund administration can result in operational dependencies between the firm and its investor clients. Banks with a deposit base may enjoy a higher credit rating, thereby enhancing the ability of an Equity business to compete in prime brokerage and over-the-counter derivatives.
  • ASSET MANAGEMENT
    There are a number of regulatory constraints and perceived conflicts that weigh on the synergies between an Equities trading business and a related Asset Management subsidiary; however, a percentage of agency order flow from the Asset Management arm may be directed to the Equities business, and access to stock loan supply can support its prime brokerage and derivatives trading efforts. Partnership in the creation of equity-linked ETFs and structured notes can generate product supply for retail and wholesale investors. Apart from trading, Asset Management provides a means to monetize Research, in some cases alongside of investor clients.

Figure 1 illustrates some of the contributions of these five business units to the traditional business of Equities and its clients:

Figure 1

Figure 1: How Firm Context for Equities Enhances Investor Value

Clients care about what a bank or broker-dealer can do for them overall, without concerning themselves with a firm’s internal product boundaries or management organization. When broader capabilities are called for, collaboration with other internal business units becomes critical to the success of the Equities franchise.

What do investor clients really want?

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[Part 2 of Equities Context and Content]

The needs of investor clients are complex and involve much more than the execution of orders. By convention, clients rely on their execution commissions (and, in some cases, financing balances) to obtain additional resources from their brokers. As clients ascribe less value to pure execution, they are directing the bulk of their commissions toward more valuable services and scarce resources.

Table 1 shows the capabilities of a bank or broker-dealer, some or all of which may be meaningful to an institutional investor:

Table 1

Table 1: Components of an Investor Client Value Proposition

The table also illustrates two challenging aspects of Equities businesses: First, that there is no direct revenue associated with many of these resources and services. Second, that these resources and services can lie beyond the traditional purview of Equities management. A successful Equities business must deploy the full capabilities of its firm and direct them at investor clients to access all potential sources of revenue, direct and indirect.

Equities Content and Context

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We are launching a series and associated white paper entitled “Equities Content and Context: Comparative Business Models Among Banks and Broker-Dealers.”

“Don’t get involved in partial problems, but always take flight to where there is a free view over the whole single great problem, even if this view is still not a clear one.”  —  Ludwig Wittgenstein
“What you see is what you get.” — Flip Wilson

Article at a Glance

Declining revenues and pending regulation are forcing firms to review their Equities businesses. Competing Equities businesses differ greatly from firm to firm in the breadth of capabilities. As a result, some firms may be unable to access revenue pools that make competitors appear more successful in comparison. A closer look at how a firm’s strengths appeal to specific client segments can reveal why an Equities business is underperforming relative to the market or its peers. An understanding of “boutique” models can provide insight for large banks and smaller broker-dealers alike, whether they are contemplating further investment or a pull-back.

The value of an Equities business to investors is largely dependent on the capabilities of the firm in which it operates. Despite an advantage in breadth of capabilities, large firms that fail to deliver a wide range of products may end up with boutique-like results. Small firms forced to compete on a limited product set can still distinguish themselves in specific market segments.

This article explores the following questions as they relate to managing an Equities business:

  • What do investor clients really want?
    What are the products, resources, and services that are most valuable to their business?
  • Why does the firm context matter?
    How can other business lines contribute to the success of an Equities franchise?
  • What constitutes a “full-service” Equities business?
    What do the largest, mature Equities businesses offer to clients? What additional revenues do they capture?
  • How is client value converted into revenue?
    How are products positioned as client solutions?
  • How do Equities businesses align with investors?
    Which clients is the firm most likely to attract?
  • What are the partial or “boutique” Equities business models?
    How do firms successfully differentiate? How can a regional or sector-based strategy succeed?
The article and its diagrams will be provided here in subsequent posts. If you can’t wait for the serialization, download the full article here.
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