The Pipeline: M&A and IPO Insights | S.3 Ep. 5 - Discussing the key drivers behind a big deal quarter for the large banks

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Joe Mantone   00:00:00

Welcome to another episode of the pipeline, an S&P Global Market Intelligence podcast that dives deep into the world of M&A and IPOs. I'm your host, Joe Mantone. And today, I will speak with Gerard Cassidy, an analyst with RBC Capital Markets. Gerard is a long-time bank equity research analyst and covers the large-cap bank stocks. Gerard, thanks for joining us today.

Gerard Cassidy   00:00:27

Joe, thank you for having me. I really appreciate it.

Joe Mantone   00:00:30

And I just learned that Gerard attended a St. John's University. like myself, he's a big fan of St. John's basketball. So thanks for looking up this year for the Johnny Art, Gerard.

Gerard Cassidy   00:00:39

Are, and we're looking forward to an exciting season.

Joe Mantone   00:00:42

Yes. Hopefully, that is the case. So Gerard is a returning guest on the pipeline, and I always like speaking with him because he's an analyst who pays close attention to the M&A advisory businesses and the capital markets businesses of the big banks, and that's what we're going to cover. The deal-making downturn that started in 2022 has weighed on investment banking revenue. But the third quarter earnings reports from the large banks showed some strong totals for the advisory and capital raising arms of the large banks. And when I say the large banks, I'm referring to BofA, Citi, JPMorgan and also Goldman and Morgan Stanley. So Gerard, we've seen a lot of headlines about how this was a big deal-making quarter for the investment banking business. What's been the biggest driver to the activity?

Gerard Cassidy   00:01:37

Joe, I would say the biggest driver of the activity has been the fall in interest rates since late last year. That would be one of the factors -- the other factor, too, is the change in administrations. The Biden administration wasn't as supportive of mergers and acquisitions in all different types of industries. And the new administration, the Trump administration has clearly set out a tone that they are going to allow more mergers and acquisitions. So this is giving companies more confidence that if they announce a transaction, it will get approved. That wasn't the case in the prior administration. So those 2 factors. And then third, I would say that the outlook, though we have some uncertainty with tariffs, the economic outlook is less volatile going forward and less uncertain. And I think that's giving companies more confidence that they'll get the approval from the regulators, the different approvals that are needed. And at the same time, the economy is healthy, and therefore, there won't be any negative surprises coming from a recession that could have happened a year ago or so?

Joe Mantone   00:02:53

Yes. And under the previous administration, some of the large deals that were announced, they would get approved, but the time line was elongated because of the regulatory reviews and antitrust challenges. But we're not seeing that as much now, right?

Gerard Cassidy   00:03:11

Joe, spot on. And that raises the risk of doing a transaction because you can lose key employees, you can lose potential customers. And so by shortening the time, the approval process, that risk is diminished, which has given again the CEO's confidence that they can announce a deal and going to close in a relatively short period of time.

Joe Mantone   00:03:35

And it's been those bigger deals that have kind of driven the improvement to the M&A market so far?

Gerard Cassidy   00:03:40

That's correct. In fact, it's interesting you bring that up because the number of transactions are down. But to your point, the size of the transactions has grown quite a bit. So the dollar amounts are bigger, but the actual number of transactions are lower.

Joe Mantone   00:03:57

Right. Yes, that's exactly what we're seeing in our data. And for the big banks, those are the ones who work on those large deals, too.

Gerard Cassidy   00:04:03

That's correct. You're seeing that show up in their numbers in the third quarter.

Joe Mantone   00:04:07

And then you mentioned lower interest rates, and I was looking at some of our estimates data from Visible Alpha. And it seems like the biggest upside surprise for the investment banking revenue lines in the third quarter was on the debt side. And the last time you were on this podcast, you noted that debt deals are the first to come back during a deal-making recovery and then equity and then M&A. So does the increase in debt underwriting, is that by itself a positive indicator for the deal-making outlook?

Gerard Cassidy   00:04:40

I think it is. And as you pointed out, as rates have fallen, it gives companies incentives to either issue new debt or refinance existing debt. And the refinancing of either maturing debt or paying off some higher coupon debt has been quite strong this year. And I think that's leading us to believe that assuming the markets don't collapse, we'll see continued strength in the ECM business, meaning the IPO market as well as advisory. One new risk, however, to the ECM business is the shutdown of the government. And obviously, you're going to see the Securities and Exchange Commission not approving new IPOs because they're shut down. So if that extends out into December, the fourth quarter investment banking results could be negatively impacted by the government shutdown. Right now, most of the investment banks are not that worried about it. But again, if the shutdown really lasts into the late November, early December time period, it would certainly impact their revenues. And now you could argue it would delay the revenues and the IPOs could be done in the first quarter of next year, but still that's a new risk we got to look at.

Joe Mantone   00:05:57

Yes. I was a little surprised we didn't really hear much about that on the earnings calls from the banks.

Gerard Cassidy   00:06:04

Joe, spot on. I mean we did not hear it at all, which was surprising. But I think when you think about this government shutdown, we're just not seeing the headlines on this shutdown similar to the headlines we've seen in prior shutdowns. And so it's economy is still functioning well. And so we'll see if it does drag out and it does start to have an impact on the real economy and the capital markets businesses, obviously, we'll hear more of the companies talking about it. But I'm with you. I was surprised that there wasn't much commentary about the shutdown impacting the capital markets businesses at all.

Joe Mantone   00:06:43

But you think we still have a couple more weeks before some of those fourth quarter deals will get pushed out?

Gerard Cassidy   00:06:51

Yes. I would say that we probably have through the end of October and into November. And if it's still shut down, it certainly will slow things down for the fourth quarter, still make it manageable, but certainly slow things down.

Joe Mantone   00:07:06

And then on the Goldman Sachs call, they talked a lot about sponsor activity being up. I think they said it was up 40%. And they also noted that PE firms have $4 trillion in portfolio company assets. So do you think we're at a point now where PE firms are happy enough with valuations where they can exit some of those portfolio investments?

Gerard Cassidy   00:07:31

It's been probably one of the biggest hurdles, Joe, has been that the portfolio companies were not being monetized either through the sale of the companies to other PE companies or to companies in the industry in which the portfolio company operates or taking them public through an IPO. And part of the reason, Joe, this has been the case has been the valuations back in 2021 were so high that after the collapse in the markets in 2022 and into 2023, many of those companies that were valued in the last round of financing in '21, that valuation was not attainable by going public or monetizing it through the sale of the portfolio company. Now that has improved. We're not entirely at the levels that we were at back in the late part of 2021. But what's happened, and I think what the PE companies are seeing is that the companies that have gone public the price performance from the initial price of the public offering year-to-date or from the time that they have gone public, in many cases, has averaged about 50%. So what that means is that though you're not receiving the top dollar on the public offering, but you are seeing it show up in the aftermarket. So that has given, I think, some encouragement to the PE firms that they can take the company public, not sell all of their ownership, of course, and benefit from the follow-on price appreciation that takes place after the company goes public.

Joe Mantone   00:09:09

Yes, that's interesting because usually, private equity firms would rather do a sale and get a clean exit do an IPO, right?

Gerard Cassidy   00:09:17

Correct. Correct. So monetizing it through M&A is certainly one way and the best way or the cleanest way to do it. And we should probably again see some of that as rates have come down and it makes acquisitions more attractive and you very simply can do a cash flow analysis. And when you do that, the net present value in a lower interest rate environment, of course, is higher than in a higher interest rate environment. So that then brings up the value of the portfolio companies should they come up for sale.

Joe Mantone   00:09:50

I was asking about exits just because that's really important to help really get the flywheel spinning, meaning PE firms exiting and then returning some of that capital to investors and then fundraising to start the process over. Morgan Stanley talked about the whole flywheel taking hold on its earnings call. So do you think that flywheel is getting going again?

Gerard Cassidy   00:10:13

I think Ted Pick and Morgan Stanley said it very well about the flywheel and where we are in the capital markets revival. And I do think the flywheel, as they pointed out, has picked up. And to your point, as the private equity companies get to monetize some of their portfolio companies, that money that is returned to their investors is then reinvested into potentially new pools of money and that flywheel does get moving. So I do believe that it was stuck in a lot of sand in the gears, if you will, back in 2022 when rates were going up so rapidly and into 2023. But I think now when you look out over the next 6 to 12 months, assuming there's not any economic surprise on the horizon, that flywheel starts to speed up. And I think you'll see that show up in the numbers over the next 6 to 12 months.

Joe Mantone   00:11:12

And that's a really important business for the investment banks, I should say, clients and financial sponsor.

Gerard Cassidy   00:11:16

Absolutely. The financial sponsor business for the investment banks is extremely important in so many different ways and certainly advising them on monetizing their portfolio companies, taking those companies possibly public as well as lending into the private equity companies themselves. There's many touch points that the investment banks have with those companies, and it is -- and the financial sponsors are very important to the success of the investment banks.

Joe Mantone   00:11:48

Then on the JPMorgan call, I think it was their CFO made the point that he was talking about interest rates. And he said that the cuts and rates are already priced in. And he didn't think it would have that much impact, an additional cut on financial sponsors executing deals just because they have been priced in. A little bit surprised to hear that. Did you -- do you think that's the case? Do you agree with that assessment?

Gerard Cassidy   00:12:13

Yes. So I think what we heard from Jeremy Barnum, the CFO at JPMorgan was that the forward curve is pricing in rate cuts and financial sponsors and all companies look at the forward curve for guidance. It's not always accurate, but they do look at it for guidance. And they do factor in if they have to make a decision today, what that forward curve is calling for. And it's obviously an estimate and the forward curve is as good as anybody's estimate and some people may argue it might be better because it's a collection of the global markets estimating where rates will go. So I do think that is fair, that is already being factored in and priced in. Now the question is, if it isn't realized, meaning maybe rates are cut further or vice versa, rates are not cut at all, that will certainly have an impact on what's going on in the investment banking business.

Joe Mantone   00:13:12

We saw a really big take private deal, the EA deal at the end of the third quarter. Do you think we'll see more transactions of that size? Or is that sort of a one-off?

Gerard Cassidy   00:13:23

I don't think there's a one-off. It really has to do with are the markets conducive to that type of transaction where you're going to have leverage loans involved and initially bridge loans for the investment banks that are involved in the transaction at the outset. And when there's transactions to be had that generate real value to the owners and to the buyers as well, you're going to bring on more transactions. So that expression, transactions be get more transactions, I think, is fair. But the environment has to be conducive to it. And again, with the Fed according to the forward curve, likely to cut rates another 50 basis points over the next 3 to 6 months as well as having an enormous amount of liquidity still in the marketplace. and it's more of a risk-on environment when it comes to making these leveraged loans. I do think the markets are open and more transactions could be had if it makes financial sense to the players that are both the buyers and the sellers of a property.

Joe Mantone   00:14:32

Do you have any thoughts about smaller deals? You made the comment earlier on that the number of transactions is down. I mean, what will it take to get sort of the middle market deals going again?

Gerard Cassidy   00:14:42

That's a good question. Certainly, a more stable outlook on the economy if we can finalize or if this administration, I should say, finalizes the tariffs and the tariff headlines move away from the front page and maybe go to the back page, we discovered that the inflation environment isn't that bad and that the tariffs are not causing permanent increases in inflation. So it's really more of a confidence issue, I think. And as the confidence builds up, the small business optimism index moves higher, I think that brings on more of the middle market deals.

Joe Mantone   00:15:21

Yes. And it makes sense that the smaller middle market companies would be more affected by that uncertainty because they can't absorb the tariffs as much as a large company can.

Gerard Cassidy   00:15:33

I would agree with you.

Joe Mantone   00:15:34

Right. So they put the deals on hold. Yes. I wanted to ask about Wells Fargo. They've landed some pretty big investment banking assignments recently. We don't normally talk about Wells Fargo when we talk about the Banking businesses of the big banks, but they've landed some big deals lately. They've been hiring in investment banking, and they talked about on their call how they want to be a top 5 Bank. Do you think that they can get there to the top 5?

Gerard Cassidy   00:16:03

When you look at the top 5, those are some pretty impressive companies, and it's certainly great to have aspirations. And they are Wells Fargo growing nicely. As you might recall, because of the issues they had with the Federal Reserve and other regulators, there was an asset cap put on that company, which was recently lifted. And because of the asset cap and under the leadership of Charlie Shar, who came in around 2019 to turn the bank around, which he has done successfully in having all of the regulatory orders lifted with the exception of one, which is they're working on now, of course. But the investment banking area, his background is former -- one of his former employers, JPMorgan, he understands the business, has come from that business. And so he built it out while the asset cap was on because they really didn't grow the balance sheet like commercial lending would. And so to your point, they've hired a number of managing directors. As you also pointed out, they are on some very large deals as the adviser, which is really positive for them. But getting to the top 5, it's going to be hard. It's a slug fest. Obviously, the folks in the top 5 slots are not going to roll over. Let's hope they can do it. But boy, it's certainly going to be not a cakewalk to get there. But certainly, they do have those kinds of aspirations and you want goals and you want your people to reach them, and those are incentives that they can achieve. But hiring more folks. And as you know, at the very top of the capital markets structure and investment banking, they've hired some key folks from some of the biggest investment banks on Wall Street. So that's certainly helping them focus in on those top -- one of those top 5 slots.

Joe Mantone   00:17:55

Do you think they would do a deal just to build some more scale quickly?

Gerard Cassidy   00:18:01

That's a really interesting question. And the short answer is yes. Are they going to run out and buy XYZ investment bank or one of the boutiques? It's hard to say because, first of all, you got to find a boutique that's for sale. So that's a real possibility. But what they've been able to do is hire people, key people, rainmakers, if you will, as we sometimes call the big investment bankers that bring in the business. And you got to always be careful of that because if you acquire an investment banker or a boutique, you've got to lock down the people because your assets at an investment bank walk out the door every night. And so that would be something that they would have to contemplate. Are we better off just hiring teams of people or if we go after a boutique investment bank, making sure we lock down the people once the deal is inked. And so they understand that, obviously. So that's certainly something that might be considered, and we'll see how that plays out over the next 12 months.

Joe Mantone   00:19:05

Yes. And I do agree with you being in the top 5 is really impressive and where St. John's is ranked right now is #5 in the preseason poll. So Dennis discussion here, do you think St. Johns will end up in the final 4 this year?

Gerard Cassidy   00:19:20

I would like to see that and they could reminisce and bring back -- I know he passed away Lou Car, but bring back that sweater that has so much coverage that it was not the most attractive looking sweater, but got them to the final 4. So hope sings eternal. So I would say that they've got the momentum on the Pitino, that is for sure. So I think they got a real shot at it.

Joe Mantone   00:19:43

I'm a fan of the Rick Pitino white suits personally.

Gerard Cassidy   00:19:47

We just can't go to Arthur Avenue in white suits and the spaghetti sauce could get all over us.

Joe Mantone   00:19:52

You got the clam sauce.