(Corrects spelling in paragraph 9)
(The author is a Reuters Breakingviews columnist. The opinions expressed are his own)
By Dominic Elliott
LONDON, June 4 (Reuters Breakingviews) - Goldman Sachs’s (GS.N) initial public offering in 1999 seemed to hammer a nail in the coffin for the partnership model in investment banking. Now activist investment firm Knight Vinke is suggesting that UBS UBSN.VX might adopt something like a partnership structure as part of its plan to split wealth management from investment banking. The breakup idea is overambitious today. Only with time, luck and possibly more capital, could an employee-owned UBS investment bank be made to work.
Knight Vinke wants UBS to sell or demerge its investment bank and accelerate the disposal of non-core assets. The idea is that the remaining wealth management business would enjoy a higher rating, unencumbered by the risk of the investment bank. Each obstacle to this plan has a difficult solution.
Capital and funding
The first challenge would be to check the capital position of the standalone investment bank and legacy trading assets. UBS has 30 billion Swiss francs ($31.8 billion) in equity against 645 billion francs in assets for both its core and non-core divisions. On that basis, the leverage for UBS's investment banking-related businesses is 22 times. That's well below the maximum 33 times mandated by Basel III and should provide sufficient comfort to investors in spite of UBS' recent history of trading mishaps. UBS also has plentiful equity to meet Basel III requirements to cover its risk weighted assets in both its good and bad investment banks. Its latest results show its corporate centre has an extra 7.8 billion Swiss francs of common equity in reserve above its 10 percent core Tier 1 ratio. That could be used to top up the capital of an independent investment bank.
However, funding requirements for the remaining investment bank would be an issue. Jefferies' reversal into conglomerate Leucadia last year means there are no standalone investment banks with large trading arms. Even Morgan Stanley (MS.N) and Goldman Sachs have large asset gathering operations. Before the Leucadia merger, the annual cost of insuring Jefferies' five-year bonds against default with credit default swaps – one of the best indicators of bank risk – was 130 basis points. That implies a big hike in funding costs: UBS's five-year CDS currently trades at around 90 basis points. And UBS's trading operation is many times larger than Jefferies. Even a standalone investment bank with relatively high level of equity would face higher funding costs. It might therefore need even more capital before it could fund itself without the benefit of an implicit state guarantee.
For sale: refurbished investment bank, valid MOT
Then there's the time it would take to transform the investment bank into a partnership. An average of five analysts' estimates puts its sum-of-the-parts value at about 10 billion Swiss francs, or 813,000 francs per employee. It would probably take the unit's 12,500 employees eight years to earn that value through bonuses alone, given about a quarter of total compensation is typically handed out in bonuses annually after base salaries and deferred awards are paid.
For their part, UBS's investment bankers would suffer more from a split than their wealth counterparts. Having a captive investor audience helps investment banks to sell their expertise to institutional and corporate clients. Without those cross-selling benefits, the standalone investment bank's value might fall. But even if the unit was worth 15 percent less – the 8.5 billion francs at which Knight Vinke values it – it would take more than six years to transform the business into a partnership.
True, UBS could lend its investment bankers the money to buy the division. Future bonuses could then be used to pay back the loan, assuming interest payments were non-existent or extremely low. But the risk of staff defaulting on the loan would remain with UBS in the event of another trading fiasco.
What’s the upside?
The wealth management division is worth about 35 billion Swiss francs, according to analyst estimates. If it traded on the same 1.7 price to book value multiple as pure-play private bank Julius Baer (BAER.VX), that would imply an additional 14 billion francs in market capitalisation (UBS group trades on 1.3 times book today).
The snag is that axing the investment bank would probably cost UBS valuable wealth management business. UBS's ultra-high net worth clients – defined as those with at least 50 million Swiss francs to invest - accounted for 45 percent of its total 870 billion Swiss francs in invested assets as of the end of March. Ultra-wealthy clients like to have ready access to structured products created by an investment bank, or easy access to fast-growing equity investments, such as UBS's placing of Formula 1 stock ahead of its initial public offering last year. Juerg Zeltner, UBS's private-banking head, is an ardent believer in having an in-house investment bank and says it reduces client costs.
If a substantial portion of UBS's ultra-rich clients pulled their deposits from a group shorn of an investment bank, the wealth manager’s value would be more like 30 billion francs, even on a 1.7 price-to-book multiple. To be sure, UBS might replace some of those clients with more moderately wealthy customers happy to invest in a safer institution.
It may be that UBS’s investment bankers and wealth managers would love to see the back of each other, and the former would relish becoming partners in the firm. And it may be that shareholders would benefit too. But with so many ifs and buts, many of the current generation may have retired before such a plan materialises.
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- Activist investor Knight Vinke published a letter on May 2 that called for UBS to split its investment banking operations from wealth management on the basis that the former division nearly destroyed the group between 2007 and 2009.
- Knight Vinke believes that the best owners of the investment bank could be its management and employees, who have received 115 billion Swiss francs in salaries and bonuses since 1998 while contributing a negative 25 billion Swiss francs to its parent and shareholders.
- UBS's private banking head Juerg Zeltner said he uses more services than ever from the streamlined investment bank, Reuters reported on June 3. "I gave up macro research, I gave up single stock research and I source everything from the investment bank," Zeltner told the Reuters Global Wealth Management Summit. "We have absolutely no incentive to pay the Street if we can pay ourselves." - For previous columns by the author, Reuters customers can click on [ELLIOTT/]
(Editing by Chris Hughes and David Evans)
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