How boutique investment firms will gain from Wall Street reform.

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July 30 2010 6:10 PM

The Little Financial Engine That Could

How boutique investment firms will gain from Wall Street reform.

In the summer of 2007, Ken Moelis, then president of UBS' investment bank, started his own M&A firm. That year, he orchestrated the sale of Hilton to the Blackstone Group for $26.5 billion. This month, the firm was named Best Global Independent Investment Bank by EuroMoney and is arguably outgrowing its boutique status. It is also stealing talent from the so-called bulge brackets, the nine largest and most profitable investment banks.

The M&A space is saturated with boutique firms—their market share has doubled to 20 percent since 2008 and has tripled in the past decade, according to Thomson Reuters. But the quick rise of Moelis & Company demonstrates how young firms in this rickety climate can trample their competitors. While some observers are adamant that financial reform will not affect boutiques, the industry is on the verge of a regulatory shakedown, so it is bound to witness more Ken Moelises—large and small.

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Boutiques like Moelis & Company are hardly little guys in the traditional sense, but they still are small players in a big pond. As the private-equity space becomes more crowded, they will continue to make their mark. And while no one can predict exactly how reform will impact the financial landscape, it's hard to imagine how smaller, younger firms won't benefit from a more level playing field.

The megabanks, after all, are in trouble. The Volker rule prohibits banks from owning more than 3 percent of a fund's capital. As a result, returns on equity will decrease, as will profits and valuations. Meanwhile, deals are constricting, which benedits boutiques that handle transactions under $250 million. The average deal size in the first half of 2010 was about $45 million, compared to $120 million and $166 million in the first two quarters of 2006 and 2007, respectively. "This trend to smaller deal sizes, primarily spurred by increased activity across the interactive, marketing services and technology marketplace, bodes well for boutiques," said Wilma Jordan, founder and CEO of the Jordan, Edmiston Group.

Debt restructuring is now booming, and many large corporations who face or fear cash flow problems have been turning to boutiques—partly because they are impartial parties who don't take positions on, invest or hold risk in deals. The investment banks were conflicted out of this line of work when they got into lending after the repeal of the Glass-Steagall Act of 1933. Rather than Goldman Sachs (GS) and Morgan Stanley (MS), the top restructuring advisors are Lazard, Rothschild, Moelis and Evercore, and Greenhill.

Every day, new firms and funds are created, and bank veterans migrate to or launch boutiques. When compensation packages are regulated more stringently, bankers will act like drug dealers who vacate corners to outsmart law enforcement, finding refuge in areas where there is less government oversight. Scott Bok, CEO of Greenhill, said new entities such as advisory firms, hedge funds, and proprietary trading desks at big firms, "will be created as life gets more complicated and difficult for the large firms."

While these younger firms don't have balance sheets to finance large deals through debt or equity, they might even find themselves partnering with megabanks that have capital to risk and are looking for opportunities to make money. That will result in more deals. In a strange twist, the megabanks—plagued with conflict-of-interest woes—might be forced to partner with boutiques that offer independent and impartial advice.

Financing is the area that will create the most activity for small- and medium-sized firms. Reliance on banks is decreasing. Corporations are turning to the bond market. So might boutiques. Big banks are reluctant to take on additional risks because of the uncertain regulatory environment, which presents an opportunity for boutiques to step in. The banking sector is tight, and credit isn't being extended as much. "On all these dimensions—doing the deal, taking trading positions and financing these transactions—the stronghold of banks will come down," said Viral Acharya, professor of finance at New York University's Stern School of Business.

Meanwhile, with banks busy checking through regulations for the near future, there will be a boon to firms offering creative underwriting and secured lending, such as venture facturing and venture leasing. It's not so hard to imagine a scenario in which these outfits begin to corner markets in the same way boutiques moved into debt restructuring when the big banks were conflicted out. "These obscure areas are the ones with the greatest opportunity," said Josh Lerner, professor of investment banking at Harvard Business School and author of Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship Have Failed—and What To Do About It.

Of course, the little-guy economy is fraught with tales of little access to credit, cash, and clients. Last fall, a financial-services-data upstart seeking to provide hedge funds with real-time, automated trading data was touting its low burn-rate, cheap cloud-computer power and bootstrap mindset. But it is kaput.

About a year and less than $30,000 into the project, the founder determined that his company's sentiments data in various markets was unreliable and could not compete with the giants, or even small firms that already had gotten into the space. "No fund will go with a cheap option if they can go with Thomson Reuters," said the founder, who requested anonymity.

Even though the project failed in its current state, the research team is still trying to get it off the ground. Like the failed Social Bomb app, the best solution is to find one client that, in this case, would help foot the bill for research and development. "It's a better model than putting together a business plan and hitting up every single fund there is," he said.

Boutiques that grow, however, either increase their balance sheets and outgrow their boutique status, or go public or get bought by a bigger institution. They can't tread water. Or can they? Conventional wisdom says that you can't be a global bank, operate with about 300 people, and only a handful of offices abroad. But with so much in flux in this economy, what's around the corner is anyone's guess.

Jill Priluck is a writer living in New York City.

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