A NEW BATTLE LOOMS ON WALL STREET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

A new battle looms on Wall Street

By William Cohan

Published: August 4 2009 18:47

The traumatic upheaval that has roiled Wall Street during the past two years has produced – surprisingly quickly – a widely acknowledged new pecking order in the world of high finance: Goldman Sachs, in trading, and JPMorgan Chase, in banking, have become the undisputed industry leaders, with a hand in nearly every deal or trade. Clients can try to avoid these two, but only at their own peril.

The likes of Morgan Stanley, Barclays and Bank of America/Merrill Lynch – wounded but not fatally – continue to seek a firm footing on which to operate, while the so-called “zombie banks”, such as Citigroup and Wells Fargo, remain on life support. Boutiques, such as Lazard, Greenhill, Rothschild, Evercore and Jefferies, that primarily provide advice to clients – and little capital – have been hiring broadly and have seen a resurgence of activity in their restructuring businesses, where a wave of recapitalisation and “amend and extend” deals have allowed many overleveraged companies to avoid bankruptcy filings. For the boutiques, the question remains whether, any time soon, there will be enough non-restructuring advisory business – formerly known as M&A – to justify all the new hiring.

But none of this is particularly surprising in the wake of the worst crisis to hit banking since the Great Depression produced the Glass-Steagall Act and the separation of investment banking from commercial banking.

What does seem to be spooking Wall Street these days, though, is the traction that some private equity firms, such as KKR and Apollo Advisors, and hedge funds, such as Citadel Investment Group, appear to be “backward integrating” into investment banking by building up their businesses that compete with Wall Street in the lucrative underwriting of debt and equity securities. KKR has been talking about building this effort for the past few years, ever since it announced its intentions in its own IPO prospectus in July 2007, and has hired a team to do it. “Through our capital markets and distribution function, we are able to capitalise on the current instability in financing markets by sourcing capital from non-traditional sources,” Henry Kravis, KKR’s co-founder, has said of this effort. Recently, Citadel hired Todd Kaplan, a former senior banker at Merrill Lynch, to start a capital markets business at the hedge fund and is likely to hire another group of bankers to work with him. Word on the street is that Leon Black, at Apollo, is exploring a similar strategy. In a world of shrinking fees, to have your clients start to pick your pocket in this – albeit modest – way is an uncomfortable development for investment bankers.

In many ways, this effort makes perfect sense. First, for years firms such as KKR, Apollo and Citadel have been providing billions of dollars in underwriting fees to Wall Street. It is logical for them to try to siphon off a portion for themselves and their limited partners, especially in underwritings involving their own portfolio companies. KKR said as much in its prospectus: underwriting deals allows the firm to “capture certain financing fees otherwise paid to third parties”. To date, KKR has underwritten four deals. Its recent distribution deal with Fidelity Investments, the mutual fund manager, gives its nascent effort another boost.
Second, these firms can take advantage of the low standing in which clients hold their Wall Street bankers. One veteran banker said he believed a “culture of cynicism” had emerged among clients who learnt the harsh reality in this crisis that in dicey situations, bankers would not hesitate to put their own interests first. Or, as another senior Wall Streeter put it, bankers are now “a lower form of life than Somali pirates”.

Thus the news last week that KKR will try to take six of its companies public is the perfect moment to give its capital markets underwriting business a test drive. KKR has reportedly signed on as a lead underwriter – along with Goldman and Citigroup – of the IPO of its portfolio company, Dollar General, the discount retailer that appears to be gearing up to raise hundreds of millions of dollars in an equity offering. If KKR helps to lead underwrite the Dollar General IPO, it would mark the first time it had led one of its own deals and, of course, the first time that it was able to grab a hefty percentage of the IPO underwriting fees – generally 7 per cent of the deal – for itself.

Wall Street has much to worry about, ranging from where business and profits will come from in the future to what stiffer government regulation will mean, to a growing public backlash about how it handled itself during the financial crisis and why it paid out billions of dollars in bonuses despite losing billions of dollars. Congress has just issued subpoenas to both Goldman Sachs and JPMorgan, among others, seeking documentary evidence of fraud in the events that led to the recent financial carnage. Congress is also looking to curb bankers’ pay. The justice department is investigating Markit Group, a data provider owned by Wall Street firms, to see what role having exclusive information about the pricing and trading of exotic derivatives had in exacerbating the financial crisis.

These investigations should worry Wall Street executives in the short term. Longer term, though, it is competition from the likes of KKR and Citadel in their bread-and-butter underwriting businesses that could turn out to be the one significant development with lasting effects to emerge from the financial crisis.

The writer, a former Wall Street banker, is the author most recently of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street

Copyright The Financial Times Limited 2009