What Happened To Europe's Deal Boom?

U.S. investment banks bulked up on the Continent. Now there may not be such a bonanza

September was to be a grand month for MorphoSys, a Munich-based startup that clones human antibodies. Its founders planned to list 25% to 30% of the company on Germany's small-company stock exchange, the Neuer Markt. No longer. "There is too much turbulence in the markets right now," says CEO Simon E. Moroney.

That's not what Europe's investment bankers want to hear. Anticipating a financial-services boom in Europe, U.S. firms such as Merrill Lynch & Co. and Morgan Stanley Dean Witter, and European rivals such as Deutsche Bank, which advises MorphoSys, have poured money into investment banking. With the American securities industry looking increasingly saturated, the Old World was to play a key role in future growth.

But if rocky markets halt the development of Europe's financial system, the banks could be stuck with hefty costs instead of fat profits. Billions of dollars in trading losses resulting from the collapse of Russia and the ripple effects of that debacle will put a dent in most banks' earnings. "There has been a significant slowdown in the sale of risky instruments, from emerging markets to lower-rated corporate bonds to structured assets," says Bill Winters, head of European fixed income at J.P. Morgan & Co. in London.

Any disappointments in Europe could pose serious problems for American firms. Goldman, Sachs & Co., for instance, has beefed up from just 73 people in Europe in 1980 to its present level of around 2,500. Goldman, which is on the verge of a historic initial public offering of its own, pulled in $694 million in pretax earnings in Europe in the first half of 1998, one-third of its total. All of Goldman's major U.S. rivals also have expanded aggressively in Europe and are vulnerable to a slump. Merrill Lynch, for instance, has been on a multibillion-dollar buying spree and now has about 8,000 employees in Europe. If market volumes drop, that much overhead could become a heavy burden.

Industry layoffs are undoubtedly in the works. Aside from emerging markets, fixed-income departments, where business has fallen off sharply, could be the hardest hit. But the stronger American firms are convinced that Europe can't turn back on its path of market building, and they are ready to absorb some short-term earnings hits to reap the benefits.

Even strong U.S. firms, however, are being tested by the current bond-market instability. The European junk-bond market, pioneered by U.S. firms over the past 18 months, has stalled. The Americans were making progress in enticing European institutional investors into taking pieces of riskier debt issues. Now, with prices down 10% to 12%, their appetite for risk has dwindled.

Bankers hope that investors will get over their squeamishness and recognize a buying opportunity. But until they do, the entire fixed-income area--from emerging markets to high-quality corporates that have been a major source of profits for banks--will be hurting. That could put pressure on firms such as Salomon Smith Barney and Lehman Brothers, which focus largely on bonds.

BRIGHT SPOT. So far, mergers and acquisitions remain one of the bright spots in the City of London, Frankfurt, and Paris. August was a strong month for takeovers, with some $21.5 billion in deals involving European companies--about the same as the previous August, according to IFR Securities Data in London. Although the current market turbulence may bring less pricey deals, those lower prices may later lead to increased M&A activity. "Values are emerging in some sectors that haven't been there for some time," says Lazard Bros. Vice-Chairman John Nelson. "Those with cash will move into the market."

Yet an even more important question is whether or not individual investors will do the same. So far, Europeans are continuing to pump money into stock funds, but the flows may be slower. In August, for example, Italian investments in equity funds declined to $290 million, compared with about $3.2 billion the month before. Fidelity Investments is noticing some shifting from equities into bonds among its European clients, but inflows into stocks remain positive. So far, investors and bankers are continuing to bet on Europe's financial and corporate restructuring. But the new volatility is beginning to test everyone's tolerance for trouble.

Before it's here, it's on the Bloomberg Terminal.