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. But those plans are now on hold following the August belly flop on the world's bourses. "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. They have been anticipating a financial-services boom in Europe rivaling the bonanza they have reaped in the U.S. in recent years. Such American firms as Merrill Lynch & Co. and Morgan Stanley Dean Witter, as well as European rivals such as Deutsche Bank, which is advising MorphoSys, have poured money into European investment banking. With the American securities industry looking increasingly saturated, the Old World was to play a key role in future growth.

TRADING LOSSES. But if rocky markets halt the development of Europe's financial system, the banks could be stuck with hefty costs instead of fat profits. "The big question for the industry once things have stabilized is whether we go back to the robust atmosphere of before or whether there has been long-term damage to confidence that cuts revenues," says John D. Leonard, banking analyst at Salomon Smith Barney in London.

At the least, profits will take a solid hit this year. 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, who expects the squeeze on profits to continue into next year.

Any disappointments in Europe could pose serious problems for the 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. The big investments are just beginning to bring in the fat returns expected. 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.

LIKELY LAYOFFS. All of Goldman's major American 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. That means more tough times for European firms such as Deutsche Bank Securities Inc. and Dresdner Kleinwort Benson, which could fall even further behind their American rivals in a tougher environment. On Sept. 7, Salomon hired a team of banking analysts from Dresdner.

Even strong U.S. firms, however, are being tested by the current rocky bond market. The European junk-bond market, pioneered by American firms over the past 18 months, has stalled. The Americans were making progress in enticing European pension funds and money managers into taking pieces of riskier debt issues. Now, with prices down 10% to 12%, their appetite for risk has dwindled. Nearly a dozen deals worth about $3 billion are on hold, according to Frank Knowles, an analyst at Merrill Lynch & Co. in London.

Bankers hope that investors will get over their squeamishness and recognize a buying opportunity. But until they do, the whole 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 and Lehman Brothers, which focus largely on bonds. If the shunning of all but the safest debt continues, it could hurt the mergers-and-acquisitions business, as riskier grades of debt are often key to financing takeovers.

But so far, M&A remains 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. True, a few deals have been postponed. But many others are moving ahead, and new ones keep popping up. The latest eye-catcher is Rupert Murdoch's $1.03 billion takeover of Britain's popular soccer club, Manchester United.

DAMAGED CONFIDENCE? There are powerful forces in Europe that should continue to generate more deals and fees. Large European companies are in the midst of sweeping restructuring programs that are seeing them shed noncore divisions. Families that own companies increasingly want to cash out. Leveraged buyout firms with some $20 billion in their coffers are stalking European targets. And although the current market turbulence may lead to deals that are less pricey, those lower prices may eventually stimulate the merger business and result in more activity. "Values are emerging in some sectors that haven't been there for some time," says Lazard Bros. & Co. Vice-Chairman John Nelson. "Those with cash will move into the market."

An even more important question is how much long-term damage has been done to investors' confidence. Until recently, Europeans were pouring their money into equities. Their holdings in equity funds have risen by $215 billion since the end of 1997, says Gary Dugan, European equities strategist at J.P. Morgan. Europeans appear to be continuing to pump money into stock funds despite the recent turbulence--but the flows may be slowing.

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 seeing a shift from equities to bonds among its European clients, but inflows into equities 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.

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