Pressure Continues to Mount at M&A Advisory Firms Post Brexit

Investors seemed to have breathed a sigh of relief this week, though merger advisors still face huge hurdles.
By Bob O'Brien ,

The handful of publicly traded boutique advisory firms that make their money off the M&A market have had a pretty good bounce in the past week. Lazard (LAZ) - Get Report , which suffered its stiffest share price drop ever in a two-day trading period late last month, has managed to bounce 17% off its lows.

Evercore Partners (EVR) - Get Report has regained 14%. Moelis & Co. (MC) - Get Report , which ground along its lows following Great Britain's decision to leave the European Union and didn't bottom out until July 6 -- Lazard and Evercore touched lows June 27 -- has recouped 7%.

Investors seem to be treating the M&A advisory firms the same way they're treating the broad market. Sure, the S&P 500 lost 5% in two days because, honestly, the Brexit outcome defied widely shared expectations. But we came to our senses, and seemed to have concluded that Britain's exit from the common union wasn't a game changer for the capital markets, economies or even global politics. The S&P is nearly all the way back to where it was pre-Brexit vote.

While the global banks that likewise participate in M&A advisory work hiccuped following the Brexit, because these banks aren't pure plays on advisory businesses, their declines weren't as dramatic --- and their recoveries stronger - than those of the boutique advisory enterprises. Goldman Sachs (GS) - Get Report , for instance, lost 8% in the two days following the Brexit vote -- versus the 22% plunge Lazard endured -- and its shares have come back to within 3% of its pre-Brexit trading price.

For boutique advisory firms, though, the new landscape is suddenly much more treacherous. And investors are wrong to presume that some otherwise undetectable "all clear" has sounded for the M&A market.

Europe, including Britain, accounted for 30% of global M&A value last year. Lazard collected 34% of its revenue from Europe. Evercore 23% from Europe.

What happens if, over the next 12 months, the M&A market there evaporates? Oppenheimer, in a recent note, predicted effectively just that, saying that M&A announcements in Europe will come "to a grinding halt." And the effects aren't going to be contained on that side of the Atlantic.

More than anything, the Brexit creates uncertainty. Just what form is Britain's attempt to untangle itself from the common union going to take? How long will it take Britain to restore trade relations with the partners it's divorcing?

What it certainly means is that global buyers with an appetite for mergers will be much warier of paying a premium for assets that participate in a vastly different market. If I'm a U.S. acquirer, am I paying the same price for a British company that doesn't afford me access to a downsized EU? And vice versa?

Uncertainty hits liquid assets hard. Witness the flight from equities into U.S. Treasurys following the vote. But uncertainty takes illiquid assets into dark alleys and bludgeons them. Illiquid assets like M&A transactions or private equity investments.

Analysts lately have even said that there was a higher chance that already announced transactions wouldn't be executed.

It's not like the M&A market was all that vibrant here in 2016. On the conference call to discuss first-quarter results, Moelis management spoke of "an air pocket in M&A activity" in the period. Lazard revenues fell 19% year-over-year for the first quarter, and earnings missed forecasts. The Brexit wasn't something that kicked M&A off its Olympus. It just accelerates the decline that was already in place.

Granted, the effects of the Brexit won't show up in second-quarter results for boutique advisory firms. The vote took place with a week remaining in the quarter.

It's unlikely to evidence itself in the results for this year's third or fourth quarter, either. Advisory firms aren't paid on the deal's announcement. They're paid on the close. Boutique firms can live off the fat of 2015 for the balance of this year. Lazard participated in six of the 10 top M&A deals announced last year, and the resulting revenue is fattening its balance sheet this year.

But what about next year's results? If Moelis thought it hit an "air pocket" in the first quarter of 2016, where's its revenue stream coming from in the first quarter of 2017? Stocks are, of course, a discounting mechanism. You're buying next year's earnings. If deals aren't getting done, or the ones that are get done at discounts, what impact does that have on future earnings for advisory firms?

The economic fallout from the Brexit has far from fully evidenced itself. But analysts have suggested several likely outcomes: the uncertainty removes any confidence that the Fed can raise rates this year. Investors will continue to favor the most liquid assets, even though the yield on the 10-year Treasury has declined to a record low. And with no hope for a rate hike and a tight interest-rate curve, banks' interest margins will remain tight, curbing their income.

If there's one thing that boards and shareholders hate, it's uncertainty. The Brexit is practically a machine that manufactures uncertainty. Heck, the financial community -- practically everybody who opined on the likely outcome of the vote -- said, "Don't worry, it's not going to happen." Until it happened. And now we're all convinced that it's no big deal?

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