Tough times for the real masters of the universe

Investment bankers used to be known as masters of the universe, but while they span from deal to deal, and client to client, other hands were shaping the cosmos. Secretive strategic investing teams sank the banks' money into companies such as AcadiaSoft, Markit, SwapClear and Tradeweb, enabling them to influence the speed and direction of change in the markets where they made a fat slice of their revenues.

No longer. Innovation is now driven by a fast-expanding galaxy of fintech firms, and banks have less ability to influence it – new capital rules make it costly to hold a big portfolio of equity stakes, and it has also become harder to build like-minded investing consortia as bank strategies have diverged.

One bank's London-based head of strategic investing says 75% of his portfolio would have been considered fintech before the term was coined – the difference now is the "proliferation of hundreds of smaller companies. That creates challenges keeping tabs on them in each region. You can't monitor everything."

This is a cruel twist. Many fintech firms have sprung up to help banks cope with their straitened conditions, by cutting capital and costs, aiding compliance, and generally boosting the spread available on client business. But they are fighting for support at a time when banks' traditional investing model is being shaken up, which is bad news for start-ups and banks alike.

"Banks that don't engage with this are out of business. They would be facing an existential competitive disadvantage," says Mark Beeston, founder of London-based venture capital firm, Illuminate Financial Management. He claims his firm has run the rule over more than 700 start-ups during the past three years.

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As a result, the industry is experimenting with innovation units and incubators – cooking up their own ideas, or giving a leg-up to companies hoping to become the next big thing. But in many cases, banks now expect to be humble customers of these firms, rather than all-powerful owners.

Adapting to this new reality can be painful. Multiple sources say Morgan Stanley last year sought to reduce the capital consumed by its investment portfolio by getting some assets off its balance sheet. Because these stakes are not publicly traded, they are subject to banking book capital rules, where the standardised risk weight would be 400% - a treatment that has remained the same since the Basel II rules were finalised in 2004, but which has become increasingly painful as minimum equity requirements have increased.

Options on the table included selling assets to enable fresh investments, or housing parts of the portfolio in a fund, achieving capital savings in the process. Credit Suisse had taken the latter route in 2013.

As Credit Suisse did, Morgan Stanley's move would have required it to slash its ownership stake and bring in a substantial sum from external investors in order to comply with the Volcker Rule in the US; among other restrictions, banking entities may not own more than 3% of the total value of a covered fund, and a banking entity's aggregate investments in covered funds may not exceed 3% of Tier 1 capital.

"One idea was to move it into asset management, sell down the balance sheet and then raise some outside capital and turn it into a fund. But I don't think they were able to get the bids for the portfolio they wanted, so they put it into unwind," says one US-based former strategic investor.

Two other former investors also claim the bank did not agree with the valuations placed on the assets, and decided not to sell. One says parts of Morgan Stanley's portfolio being offered for sale included broker-dealer Bids Trading, investor communications platform Symphony and analytics firm Visible Alpha.

The bank's strategic investing team – which had separate groups for equities and for fixed income - has since shrunk. In January, following the attempted asset sale, Morgan Stanley combined the two groups into a single, cross-asset unit, under the leadership of New York-based Zheng Wang. The seven-strong New York-based equities strategic investing team was trimmed, with its head Gary Offner, among those to leave.

Previously four-strong, the fixed-income strategic investing team saw the exit of Wall Street veteran Dexter Senft – credited with inventing the collateralised mortgage obligation – and in July the unit suffered another departure, according to further principal investing sources. London-based Angel Rodriguez Issa, last reported in charge of the fixed-income component, did not respond to a request for comment.

The details of this story were confirmed by two former members of Morgan Stanley's strategic investing team.

Morgan Stanley declined to comment, but a source close to the firm says as part of the normal course of business the bank may look to exit investments and redeploy capital.

Shake-up in strategy

Alan Freudenstein, managing partner of Credit Suisse Next Investors – the fund built on the bank's former principal investments – believes a combination of factors have caused a shake-up in strategic investments, with capital one of the key drivers: "There are the capital requirements of it – these investments are very long-dated, mark-to-market, so it has impact on the business."

Freudenstein used to lead the bank's principal investing team. Today, the Next fund sits within Credit Suisse Asset Management, containing investments originally made by the bank in companies such as exchange operator Bats Global Markets, electronic communication network FastMatch and software firm Palantir. Other strategic investments were retained by the bank, including one in Tradeweb, where the stake was tied to a requirement for Credit Suisse to provide the trading platform with liquidity.

A London-based head of strategic investing agrees capital requirements have cut the size of the investments banks are willing to make, relative to the pre-crisis era. "When everyone seeded Bats back in 2007, there were some relatively big tickets written. Given the changing priorities of the Street, would you see Morgan Stanley, Royal Bank of Scotland and UBS writing eight-figure cheques today? Probably not."

The number of deals is also said to be static or shrinking, with banks not seeking to grow portfolios estimated to contain between 30 and 80 stakes in most cases. In part, this is because there are fewer areas in which banks want to co-operate.

"There was an alignment of interests across strategic investing departments in the 1990s, particularly when it came to electronification and e-commerce, but every bank now has its own core strategy," says a head of strategic investing at a large US bank. "They are not all aiming to be a top three or top four player in every asset class. Instead, they are focusing on one or two areas that will make or break the firm – and that plays out in the strategic investment programme."

Does a bank need to invest in a software company that provides it with services? Not necessarily. You may not invest in a chip company just because they are in all computers, even if you are a big consumer of the product
Alan Freudenstein, managing partner of Credit Suisse Next Investors

Others say regulatory fines have played a part in restricting strategic investments. According to analytics firm Corlytics, the world's top 12 investment banks have paid out $144 billion in penalties since 2012, which has a double impact: capital is being tied up in reserves and – with regulators on the warpath – banks are also wary of getting into a consortium that may later be cast as anti-competitive. Ten major banks that owned stakes in data provider Markit agreed a $1.9 billion settlement in September 2015 over claims they had colluded to keep new players from entering the market.

But perhaps the biggest structural change in the way banks approach strategic investments has occurred since the the turn of this decade, as the direction and speed of innovation has started to be driven by the growing ranks of start-ups, rather than an orderly circle of bank-backed projects.

According to consultant Accenture, the value of global fintech investment in 2015 grew by 75% to $22.3 billion, and more than $50 billion has been invested in almost 2,500 companies since 2010.

This is a lot of activity for principal investing teams of one or two dozen people to get their arms around. Illuminate's Beeston is one of those who argues they should not try – instead of being investors, or trying to invent their own technology, banks should just be consumers of these solutions.

Credit Suisse's Freudenstein sees it the same way: "That's the best strategy going forward. Banks devising a trading system can give it a competitive edge, but commoditised back-office processing, post-trade, cloud architecture – why would a bank want to invent all those things itself? Does a bank need to invest in a software company that provides it with services? Not necessarily. You may not invest in a chip company just because they are in all computers, even if you are a big consumer of the product."

The London-based head of strategic investing agrees this is a key question: "I ask myself, why am I investing? Is it a control and governance play? Is it something I want to deploy over my own network? Why do I not just want them as a vendor?"

How banks are organised

None of this means principal investing is dead – it just has less power to influence the market's destiny. As a result, there is much less tolerance for getting bets wrong, and far more emphasis on ensuring buy-in from the business lines. Questions about how to allocate the portfolio's profit and loss (P&L) can be crucial. Banks approach these issues differently, but many have sought to break with the past (see box: Principal investing at three banks).

In the old days, some banks allowed deals to be struck not just by the seasoned strategists in the principal investing unit, but by a wide range of senior people within the business. A former US strategic investor says his previous employer, a bulge-bracket bank, realised "balance sheet was getting tied up in investments without the requisite returns. Tonnes of investments were being done in places like asset management, credit cards and payment processing. They realised there were all these little orphan deals and the people negotiating these deals were not investors, they were just sales people, so these things were being done in weird ways and weren't being structured, governed or reported on properly."

Many banks previously gave their teams a broad mandate to invest in anything of interest, says Jenny Knott, chief executive of the post-trade risk and information division at broker Icap, but now they are much more "geared and tethered" to making sure there is a business sponsor within the bank for particular investments: "To ensure it is kept relevant, on-track and can be leveraged for synergistic benefits."

JP Morgan, which has a strategic investing team of 16 spread across Hong Kong, London and New York, restructured its efforts in 2013 with the aim of ensuring a coherent approach to fintech. The bank's portfolio of 150 investments was consolidated under US-based Rick Smith, head of private investments. Beforehand, business lines had managed their own deals and focused primarily on corporate and investment banking; today, all investing is overseen by Smith, who has a bank-wide mandate and reports to chief operating officer Matt Zames.

Smith says: "Sourcing fintech opportunities is driven by lots of different parts of the bank, which funnel them into a new opportunity co-ordinator for each of the business lines. The business lines sponsor strategic investments, where the P&L ultimately sits. So, we don't have to talk business lines into making investments."

Strategic investment teams may not be equipped to scale to the challenge
Mark Beeston, Illuminate

After sifting through the various opportunities, Smith says the best are pursued by the business and by JP Morgan's centre of investment excellence. Investment decisions are made by an investment committee that includes heads of the business, other senior bank executives and Smith's team. The bank also has a technology strategy and partnerships group that Smith says interfaces with all aspects of the fintech community, with the strategic investing group, and with the four lines of business of the bank."

He adds JP Morgan is taking its strategic investing activity to an "aggressive, take-advantage" stage. "Some people are focused on sprinkling money around and seeing if they can get exposed to these young, interesting companies. Our strategy is not that," he says. "We want a specific partnership with each company and clarity on what that partnership is before we make the investment. Then we continue to work actively with the company after investment to drive value."

Venture capital and accelerators

Leaving all of this work to the old-style strategic investing teams would be risky, says Illuminate's Beeston. He argues these units are not best placed to invest in very early stage fintechs, which by their nature require more nurturing compared to the mature industry utilities the teams managed up until recently: "Strategic investment teams may not be equipped to scale to the challenge. It's a lot of ground to cover, predominantly at an earlier stage than they've previously chosen to invest at."

So, banks are also opening up new channels to connect with fintechs, in theory complementing the work of the principal investing teams.

A number have created corporate venture capital (VC) funds, which have a mandate to roam - unlike principal investing units, opportunities can include companies that have little or no connection to the bank's own business. Australia-based Ian Pollari, global co-lead in consultant KPMG's fintech practice, says one in four deals in fintech companies is currently sourced from corporate VCs, although that number includes non-financial institutions as well as financial institutions.

Most use the bank's own capital. Citi Ventures, led by Debby Hopkins, identifies and invests in fintech start-ups strategic to Citi, although opportunities in the markets and securities services areas are kicked over to the strategic investments team led by Bill Hartnett.

The backing is not insignificant. HSBC has allocated $200 million to its fintech fund. Santander Innoventures is set to deploy $200 million to minority stakes in financial technology start-ups. CommerzVentures is Commerzbank's corporate VC fund, which it declined to comment on prior to the fourth quarter when it will unveil a new strategy. BBVA has spun out its venture arm into Propel, a $250 million fintech fund. UniCredit, meanwhile, has launched a $200 million joint fund with Anthemis.

With such moves, corporate VC objectives are shifting – the idea is not just to bet on the banking industry's equivalent of Google, but also to bring expertise back into the organisation.

But the London-based head of strategic investing is downbeat on what corporate VCs can contribute, arguing they often miss a fintech's barriers to success: these include having a great idea but not yet building the technology; having great technology but lacking a business behind it; or possessing a good business model without a client network. Citing as an example the proliferation of swap execution facility platforms funded without sufficient clients to connect to them, he says: "VCs underestimate the barriers to implementation in capital markets."

Accelerators and incubators

The creation of incubators, or accelerators, is another popular method for banks to engage with start-ups. JP Morgan Chase, for example, is adopting start-ups for six months in a program called In-Residence, offering them access to facilities, systems and expertise. Others, including Barclays, Deutsche Bank and HSBC have similar initiatives (see box: The greenhouse effect).

But the downside of accelerators and incubators, according to the US-based former strategic investor now running a fintech VC fund, is that they are "for the most part fairly toothless. They're definitely not as connected with the business as the strategic investment arms are."

Another downside, for US banks at least, is that under the Volcker Rule setting up incubation units is challenging because they could be deemed covered funds. Two heads of strategic investing at US banks said this had deterred them from setting up incubators. One said: "We considered an incubator but haven't pulled the trigger because we haven't sorted out what the Volcker implications are, as to whether it constitutes a covered fund."

In the US, Bank Holding Company Act (BHCA) rules are another consideration, say strategic investors, complicating their ability to finance start-ups. The framework discourages banks controlling more than 5% of an outside company. With minimum investment sizes from institutional investors large in comparison to early stage company valuations, this could rule out some deals.

The Federal Reserve will take into account other factors in addition to percentage of equity, says a US head of strategic investing, such as number of board seats held and percentage of the start-up's revenues that come from the bank: "You may not pass the equity threshold with just 4.9%, but if you hold one out of four board seats and contribute 25% of revenues, then the Fed could deem you in control. They will also look at your liquidation stake based on paid-in capital – 30–40% trips the trigger from a BHCA perspective. It's a game of Twister."

A fintech source complains the 5% bank equity limit also makes it tricky from a start-up's perspective as the smallest companies do not have the time and resources to manage a syndicate of several bank investors.

It feels like today you need to have a chief innovation officer, a VC fund, a chief digital officer, a chief of fintech, and once you have all of that you can relax
Huy Nguyen Trieu, The Disruptive Group

All these changes to banks' investing model are likely to spell the end of an era – no longer will innovation be driven at an approved pace by a small circle of consortia-run businesses.

That may ultimately be a good thing, fostering greater diversity and competition. But for individual banks, it is also likely to result in increased strategic risk: they will stand or fall on the choices each makes alone, rather than collectively.

Observers offer two broad criticisms of the approaches now emerging. Huy Nguyen Trieu, chief executive of The Disruptive Group, an advisory firm and business builder in innovation and finance, says earmarking $200 million is not sufficient to future-proof an organisation: "It's what you can make or lose on a trading floor in a single day. The risk is it's a tick-box exercise. It feels like today you need to have a chief innovation officer, a VC fund, a chief digital officer, a chief of fintech, and once you have all of that you can relax. Large organisations wanting digital transformation need to have their board convinced and digital central to their overall strategy, not housed in a separate unit."

The other threat is that banks' proliferating outreach and ownership efforts will be difficult to direct. "Because fintech has become so pervasive, you've got different parts of the institution actually engaging in this space and possibly making overlapping investment strategies. Those different parts of the institution are probably not talking to each other as much as they should be," says Steve Davies, fintech leader for Europe, the Middle East and Africa at PwC in London.