Four Horsemen Model Going Way of Gipper?

Investment Dealers' Digest
October 2005

Boutique investment banks Thomas Weisel Partners and S.G. Cowen recently unveiled plans to go public, but lurking in the background are constant calls that their model-the small, full-service investment bank-is no longer viable. Inspired by the Four Horsemen of Hambrecht & Quist, Alex. Brown, Robertson Stephens and Montgomery Securities, they focus on providing emerging growth companies with underwriting services, research and sales and trading. But today, M&A is king and equity trading and underwriting are struggling.

Boutiques such as the above, along with the likes of Think Equity and C.E.
Unterberg, Towbin, which sprouted up to serve growth companies after the Four Horsemen were swallowed up by larger institutions, are seeing their profits eroded by high research costs, shrinking trading commissions and a dearth of equity offerings. Since the classic full-service boutique puts less emphasis on M&A than underwriting, a number of these firms are missing out on the one market that has remained hot. As a result, many are looking for the exit, considering consolidation maneuvers or trying somehow to reinvent themselves. For example, Think Equity is said to be looking for a cash infusion or a buyer, while Unterberg is said to be having a difficult time with its current structure.

"The Four Horsemen model cannot work in the 21st century," said Ben Howe, CEO of America's Growth Capital, a Boston-based boutique. "That model was dominated by underwriting, but for the first five years of the 21st century, there has been very little underwriting in the emerging growth sector, and commission trading has declined dramatically."

According to its Securities and Exchange filing, Weisel, which plans to raise $65 million in an IPO, lost $12.3 million on revenue of $119 million in the first six months of this year. At the height of the tech boom of 2000, the bank posted net income on $118 million on revenue of $486 million.
It lost money in 2002 but was profitable last year, when it earned $22.7 million on revenue of $283.4 million. According to the filing, the bank lost money this year because of less activity in the investment banking and brokerage businesses, fewer IPOs and less favorable equity markets.

Boston-based Adams Harkness Financial Group, a full-service boutique serving tech, healthcare and other emerging growth companies, survived since 1937 but lost $9 million amid the tough market of 2004 and was bought out last month by Canada's Canaccord Capital for $20 million.

"Small firms are not making any money on core cash and trading businesses right now," said Michael Butler, CEO of boutique investment bank Cascadia Capital, which focuses on advisory work. "To be profitable in that business, you have to have real scale, have capital to put down as principal and take some risk. It looks like a lot of these companies are going to be faced with business-model decisions or are going to have to consolidate."

Think Equity, an emerging growth boutique in San Francisco, is said to be struggling amid high research costs and a trickle of revenue from reduced deal flow. Bankers said Think is looking for a cash infusion and has considered an IPO (see IDD, "Lazard, Greenhill Spark IPO Chatter," April 25, 2005).

Unterberg, meanwhile, completed 34 deals this year, but only three were M&A advisory assignments, and one was a fairness opinion. Officials there did not return a call requesting comment.

M&A is King

These struggling firms stand in contrast to the likes of Greenhill, the advisory firm that went public last year with revenues of close to $1 million per banker. The full-service boutiques, meanwhile, tend to generate roughly $250,000-350,000 of revenue per banker, said bankers familiar with them.

And the M&A market is booming. Announced M&A volume rose 37% to $788 billion in the first nine months of the year from last year's levels, while US IPO volume slightly declined to $30.7 billion from $33 billion, according to Thomson Financial. Follow-on offerings had a similar pattern as IPOs, dipping to $74 billion from $75 billion, according to Thomson. So it is no wonder that banks with strong advisory businesses are doing well. Indeed, potential buyers are courting many pure M&A players. For example, PNC Financial acquired middle-market M&A firm Harris Williams in June. While PNC declined to say what it paid for Harris, bankers at the boutique "are ecstatic; they are high-fiving all over the place," said a banker familiar with the matter. Other M&A boutiques also have been approached, including Houlihan, Lokey, Howard & Zukin, which is discussing a deal with Japan's Orix Group (see IDD, "Houlihan Said To Be In Acquisition Talks," Oct. 24, 2005).

Howe at America's Growth Capital, which has a capital markets business as well as a strong M&A practice, said that his firm is putting more emphasis on M&A. To that end, founding partner Maria Lewis Kussmaul switched to the banking side from her former role as head of research. Howe said he is careful to preserve and develop trading and research, as he believes IPOs and other equity deals will return in significant volume in the coming years. The traditional Four Horsemen model had a strong equity capital markets practice and a small M&A business. Today, one needs the reverse, Howe said, although he believes that a more balanced mix of underwriting and M&A will prevail.

"It is a matter of strategy," Howe said. These days, "about 90% of the revenue is from M&A, while the number of new issues is small and trading revenue across Wall Street is shrinking." America's Growth closed 32 deals since its founding two years ago. Among its deals, it advised on a $1 billion LBO last month for SS&C Technologies, one of 15 M&A deals it completed so far this year.

Other boutiques remain focused purely on advisory work. These include Boston-based Revolution Partners, which has a lean crew of 17 bankers and 20 employees altogether and has closed 10 deals in 2005, according to CEO Peter Falvey. "You need to do one thing extremely well," he said. "Either specialize or be very large."

However, bankers list a handful of narrowly focused boutiques that have been successful offering research, sales and trading. These include Boston-based Leerink Swan, a biotech-focused firm, as well as JMP Securities, a San Francisco-based full-service boutique that focuses on financial services.
Despite JMP's large head count of 150 employees, it manages to draw enough business due to its specialization, bankers said.

But these are the exception rather than the rule. "The two businesses you really want to be in are advisory and proprietary trading," said Falvey.
"All the other businesses are nice, but this is where you are really making money."