Black investment banks under fire: shrinking markets and dwindling profits have many municipal bond brokers with their backs against the wall.

Shrinking markets and dwindling profits have many municipal bond brokers with their backs against the wall

During the 1980s, the formula for success i the municipal bond market was simple: Relationships plus skill equals prosperity. There was a general commitment to affirmative action, and an increasing number of the publicly elected officials handing out lucrative bond deals were black. For minorities wanting a piece of the action, it was a win-win situation.

And win they did - WR Lazard, Howard Gary, Grigsby Brandford and Pryor, McClendon, Counts & Co. These firms, mainstays on the BE INVESTMENT COMPANIES list, were synonymous with success. The principals were serious players in the high-stakes game of municipal finance, where you paid to play and it paid to know the players, i.e., politicians.

"There was a greater emphasis on blacks playing a major role in public finance, which certainly gave people like me the opportunity to come into the marketplace," recalls Charles A. Bell, CEO of Charles A. Bell Securities Corp. (No. 7 on the BE INVESTMENT COMPANIES list). When Bell opened his firm in 1996, he already had over 20 years of experience working for large companies like Bank of America and Lehman Brothers, and plenty of friends in all the right places. Within two months of opening, he became co-financial advisor to the city of Los Angeles, which meant he could bring a steady source of income into his company. Soon after that, Bell served as a consultant to the underwriter of a $110 million bond issue for Compton, California.

It was deals like these that characterized municipal finances heyday during the '80s. In '89, for example, Bell underwrote more than $1 billion in bond issues and served as financial advisor for another $216 million in issues. Even as municipal finance showed signs of slowing down and many large Wall Street firms began shifting away from munis, Bell's firm pushed forward even more tenaciously. After slumping to $368 million in issues for 1990, Bell's earnings were soaring again three years later. His firm underwrote over $3 billion and was advisor for an additional $2.7 billion. In addition, because business was so good, Bell continued to focus on public finance deals.

"I'd been in this business for a long time and had established credibility," he recalls. "It made sense to start and stay in an area where people knew you and you knew the business."

That was the good old days. Today, Bell is feeling the squeeze, like many who depend on municipal finance to stay in business. "These is no doubt, whether you're a small or major firm, that the business is not there as it was four or five years ago," he reflects. "I'm just as concerned as any other firm about my staying ability, given the lack of product, lack of business in our industry, increasing costs and smaller spreads."

BONDS GO BUST

What went wrong? From 1980-89, municipalities issued $1.06 trillion in debt. According to The Bond Buyer, the industry bible, '92 and '93 were the biggest years ever: bonds were issued in the amounts of $234.6 billion and $291.9 billion, respectively. During this unbridled growth period, government agencies and minorities were part of lucrative bond underwritings. Firms like Bell's capitalized on this trend, but they would pay a price later for leveraging their future too heavily in munis.

Since those record years, the market has receded and, as interest rates rose, issues have declined. From January through September 1996, the total issuance of debt was only $129 billion. "The amount of municipal financing coming on the market in any given year now is definitely finite," says Kim N. Wallace, vice president of equities research at Lehman Brothers in Washington, D.C. In the late '80s, early '90s, competition in the market increased as the larger, more established houses recognized there was still money to be made in municipal finance. "Once the big boys recognized it was worth their while financially," he explains, "they targeted [municipal bonds], squeezing out new entrants and smaller players," which generally meant minority- and women-owned firms.

Minority firms also found themselves vying against large corporations for the attention of newly elected black officials who were throwing business their way. "Large companies deftly targeted both their marketing and sales operations to take advantage of the change [on the political landscape]," says Wallace. More people of color were hired and promoted for the specific purpose of wooing their counterparts in the political arena. And they were given superior resources so they could grab a bigger share of the business for the larger majority firms. "This is very much a relationship business," notes New York State Comptroller H. Carl McCall. "I make decisions based on people with whom I have relationships. I know what they can do, their track record and how they operate."

The rising number of black mayors led to many beneficial relationships for minority firms. Former Atlanta Mayor Maynard Jackson and others were instrumental in channeling bond business to minority firms. Jackson, in fact, crafted the prototype set-aside policy for including minority firms in all city government contracting. But in 1989, these programs came under fire.

In that year, many firms that had used set-aside policies to carve out a foothold in the industry were caught blindsided by the Richmond v. J. A. Croson ruling. The courts now challenged the idea that in the interest of fairness, a proportion of all city government contracts should be distributed to minority firms. The Croson ruling forced a stricter standard to justify set-aside programs, giving many municipalities an excuse for ending the practice altogether.

The Croson decision is just part of a growing backlash against affirmative action. "There's no longer the legal and public support or commitment there once was for affirmative action," says McCall. "People in the majority in Congress have made their opposition clear, so there's no question that it has had an impact."

For McCall, perhaps the final factor completing the squeeze on minority firms was that municipalities began to face debt limits after issuing so many bonds. Elected officials are now being forced to answer to taxpayers who are opposed to paying interest on that debt. McCall, who is issuing far fewer bonds these days, says that ratings agencies are looking at all the debt issued over the last few years and downgrading the credit ratings of many municipalities. Because there are less bond deals to go around, most majority firms have gotten out of the muni bond business entirely while many, minority firms are being pushed to the brink.

Last year, the auditor at WR Lazard expressed doubt about the firm's viability. In fact, the creme de la creme of minority investment firms, like Pryor, McClendon, Counts & Co., Howard Gary, and Grigsby. Brandford, are facing legal and financial problems. Calvin Grigsby, whose firm disintegrated under the weight of rumors of misconduct, has reportedly relocated his firm from San Francisco to Miami under name Grigsby & Associates (see "Meltdown in the Muni Bond Market," December 1996).

"There is an almost racist perception that if minority firms got business in the past, it was only because they were doing something illegal, like paying people off," McCall asserts. "Their actions are being scrutinized much more closely than others." Whether or not the pressure of staying in business forced the principals of these firms to resort to criminal conduct hasn't been proven. But the firms mired in scandal will find it hard to fully recover.

CHANGE FOR SURVIVAL

Given that the industry is changing, the investment banking firms must change, too. But as Bell is learning, change does not always come easily. "We have, to a degree, tried to diversify but that's going to take time," he laments. A year or so ago, he established Charles A. Bell Asset Management Corp. to manage corporate and pension funds. But in addition to not having the capital required for a broad expansion, Bell has faced problems entering the equity market. "I don't have the relationships with corporate people that are necessary to become a major player or a general participant," he explains.

This is exactly the dilemma Nathan A. Chapman Jr. tried to avoid when he started The Chapman Co. (No. 13 on the BE INVESTMENT BANK list) in 1986. When formulating his business strategy, Chapman determined that diversification was key. "Everything has its time, and sooner or later if you're too leveraged in one product, then when that product goes away, your business is in jeopardy." Chapman's firm began on the equity side, adding public finance lacer. Although the municipal bond market was still hot in 1986, he offered products that were cool, such as retail brokerage.

"We continued to develop the business and grow it," says Chapman, "because we knew there would come a time when the ability to deal with clients on a retail level would be successful, and that has proven to be the case." Variety is the spice of retail brokerage, where clients have many needs such as mutual funds, annuities, stocks and bonds of all types.

Chapman also wanted to be a big player on the corporate side. "We knew that's where we wanted to go, so we started carving out that niche and building relationships over time." Building that side of the business required a lot of "hard core going out and calling on folks, asking for an opportunity, and bringing them ideas," Chapman emphasizes. Having the ability to back a deal was only part of the equation.

When Eric Small took over Brooks Securities in 1994 to form the S. B. K. Brooks Investment Co. (No. 10 on the 1996 BE INVESTMENT COMPANIES list), he already had the advantage of having forged relationships on the corporate side, acquired over 15 years as a consultant at Arthur D. Little and as an investment manager for Aetna. At the time, Brooks had minimal brokerage activity, and focused instead on municipal finance, which accounted for 80% of the business. But rising interest rates and the default of municipal bonds in Orange County, California, persuaded Small and his two partners to craft a forward-thinking strategy. They immediately set out to strengthen their institutional trade execution, which at the time represented about 20% of their business. Last year, they also complemented their institutional equity brokerage by hiring one of the most experienced equity analysts in the country to head up their research unit.

Wallace says such moves help smaller firms move toward becoming fully integrated investment houses. "Research is a very big area because even the most sophisticated investors need information and analysis." Offering clients more than a single service gives a firm a better chance of retaining that client, while receiving additional revenue as it meets more of the client's needs.

Ernest G. Green, managing director at Lehman Brothers in Washington, D.C., advises firms to look at emerging markets, such as Africa, the Far East, Mexico, Latin America and other countries that are privatizing state-owned assets. Firms can use skills developing municipal bond deals in the American marketplace in order to win public works deals abroad. And black-owned firms should not limit themselves to African nations. There may be more opportunities for minorities in Singapore or Eastern Europe than in South Africa," Green counsels. He also suggests diversifying into areas such as derivatives and financing for the privatization of government assets.

The conventional wisdom is that the municipal bond market will turn bullish again, but investment firms would be wise to continue to diversify. The market will be dominated by fewer, bigger players, competition will remain intense and profits and margins will not be as large as before.

"Minority firms that find a was, to grow separate streams of revenue will be better positioned to survive," asserts Wallace. "Target your niche in the market and go after it aggressively. Try to be the inventor or the innovator."