How Brokerages May Fare as Era of Takeovers Ends

The worst didn’t happen. The demons of Friday the 13th didn’t consume Wall Street. As the market further stabilized Tuesday, many traders concluded, along with New York Stock Exchange Chairman John J. Phelan, that last week’s plunge in stock prices was no more than a market “squall.”

But if the investment world has avoided calamity, last week’s drop and the turmoil in the takeover game that brought it on have left Wall Street facing a far different--and probably more difficult--situation.

The fast-money takeover game that uncapped a gusher of fees and other earnings for Wall Street this decade seems to be on the wane. The shock of a 190-point drop in the Dow Jones industrial index dealt a new blow to the confidence of the average American investor. And not a few market gurus have forecast that the plunge will bring an end, at long last, to the seven-year bull market.

The upshot: Wall Street’s big investment banks and retail brokerages, which have already shrunk their staffs by 12% since the crash of 1987, may face new rounds of job cutbacks and consolidations in the months ahead. And the investment world is likely to face a change in tone as a decade dominated by the colorful personalities of the highly leveraged takeover game gives way to a new era.

“The great and glorious days of the ‘80s may not be over,” says Robert Kavesh, finance and economics professor at New York University. “But we seem close to a turning point.”

James Grant, editor of Grant’s Interest Rate Observer and a critic of heavy borrowing, put it more forcefully. “An era is ending; another is beginning,” he said. “Those in the highest esteem will be toppled, and the most humble will rise again.”

The development of the highly leveraged takeovers reshaped Wall Street in the ‘80s. With heavy borrowing, deal makers could arrange takeovers that in earlier years wouldn’t have been viable, and that created jobs for scores of investment bankers, stock speculators, takeover lawyers, proxy solicitors, public relations firms and more.

The recent turmoil in the junk bond market, however, is expected to mean fewer takeovers overall and more deals of the kind that are less profitable for the investment banks. The deals will be done as swaps of both companies’ stock, or with more cash and less debt.

This change would cut into the profits of the big investment banks in several ways. The firms receive fees for the deals they arrange and for underwriting the junk bonds that are key to financing them.

In the past four years, too, the investment banks have profited handsomely by putting up their own money for the deals. And the firms have arbitrage departments that speculate in the takeover stocks that have been so important in driving the market.

Many of the largest investment banks derive about 50% of their profits from merger-related activities; several derive 20% of their pretax profits from the takeovers called leveraged buyouts alone.

“Anything that jeopardizes that business would have a very material impact on their bottom line,” says Samuel L. Hayes III, a Harvard University professor of investment banking.

Some of the investment banks may also be at risk in some of the takeover deals they have already financed with “bridge” loans. These are short-term loans made to clients until they can arrange longer-term financing by, for example, issuing junk bonds.

But questions about the wisdom of some of these loans have emerged since September, when Campeau Corp. ran into trouble paying off bridge loans for its purchase of Federated Department Stores. Investment banks including First Boston, Paine Webber and Dillon, Read & Co. have $400 million invested in the Campeau bridge loan.

James E. Cayne, president of the Bear, Stearns & Co. investment bank, predicts that “an awful lot of firms are going to see reduced revenues” from the investment of their own money in takeover deals and are going to pull back from such deals in the future.

As for the possibility of losses, “the jury’s still out,” says Cayne, whose firm has avoided such deals as too risky. “They could be substantial.”

A managing director of one Wall Street firm predicted that investment banks will be forced to make painful cuts in their mergers and acquisitions staff because of the expected slowdown in takeover activity. The last big contraction for merger professionals came in the early 1970s, he said, when a typical investment bank had about 2,000 employees, including several dozen in the mergers and acquisition department.

Now, he said, the big firms employ 8,000 to 10,000, including merger teams that run to 400 professionals. “Nobody’s had any experience in how you shrink these operations,” he said, adding that it would be a “shock” for many employees to see how sharply compensation will be reduced if the takeover market doesn’t revive.

Fewer takeover deals would likely also sharpen competition among investment banks for the deals that remain. In turn, that is expected to cut many fees.

Dwindling takeover activity would most affect the dozen or so largest investment firms and would have much less of an effect on the smaller and regional stock brokerages that make up the rest of the investment industry.

But all firms that make money from selling stock to individuals are likely to feel the impact on confidence of last Friday’s market spill. Though the worst did not take place, the recurrence of such huge drops has persuaded many lay investors that there is no logic or safety in the crap shoot of the stock market.

“More individual investors will come to believe that direct participation is something they should avoid, and that if they’re going to buy stock they should do it through mutual funds,” says Perrin Long, who analyzes Wall Street firms for Lipper Analytical Services.

One signal of tough times facing Wall Street is in the continuing fall of the prices of seats on the New York Stock Exchange. On Tuesday a seat sold for $436,000, the lowest price since one sold for $425,000 in 1985. Because of generally low trading volume and scarcer commission dollars, exchange seats have lost more than half their value after peaking at $1.15 million on Sept. 21, 1987.

The investment industry, as represented by members of the NYSE, have cut their employment by 31,700 since the strike, or about 12%. Some analysts believe that cuts of another 10% to 15% could be ahead if a bear stock market combines with a sharp reduction in takeover activity.

Even the gloomiest observers expect to see new financial trends soon supplant the fading fads of the ‘80s on Wall Street. But the leaders of the new age are not likely to be the leveraged buyout specialists, takeover lawyers and corporate raiders who have shone so brightly in the popular imagination in this decade.

“Soon people won’t even remember those guys’ names,” says Sharon J. Kalin, president of the Athene-Coronado Management arbitrage firm. “The fact is, they’ve already been deposed.”