After wheeling and dealing throughout 2021, investment banks face an uphill battle this year. The S&P 500 and the Nasdaq are in bear markets, and volatility across financial markets has weighed on dealmaking activity this year.
Jefferies Financial Group (JEF 2.60%) was the first major investment bank to deliver its second-quarter results -- and its report could be flashing warning signs about what we'll see when its peers post their numbers in July.
A significant drop in IPO activity was a drag on earnings
Jefferies Financial Group advises clients on mergers and acquisitions and helps companies raise money through initial public offerings (IPOs) or by issuing debt. The financial services company's fiscal second quarter ended May 31. Net revenue in the quarter dropped 30% year over year to $1.4 billion, with much of the decline due to lackluster results from its equity and debt underwriting units. Net income for the firm dropped 68%.
"Our second-quarter results are reasonable in the face of an extremely challenging capital markets environment, with some markets being all but shut to new issues," said Chief Executive Officer Richard Handler in the press release accompanying the Q2 report.
Why investment banking is down
That report offers investors a glimpse of what could come when investment banks like Goldman Sachs and Morgan Stanley report earnings next month. 2021 was a record year for investment banks, as 2,850 businesses raised $600 billion globally by going public. While experts early this year were expecting a slight slowdown, no one expected IPO activity to come to a screeching halt.
Major banks saw their investment banking revenue plummet in the first quarter, citing less company interest in going public during a period of high market volatility. That volatility has persisted as inflation remains high, and Russia's war in Ukraine only adds uncertainty to the macroeconomic situation.
The Federal Reserve is committed to aggressively increasing interest rates to bring inflation back in check. Since March, the Fed has raised the benchmark federal funds rate from near-zero to an upper range of 1.75%. Raising interest rates can push equity prices down as it decreases the value of companies' future earnings, and this effect can be particularly intense for companies with lofty valuations and little or no profits. But it impacts the valuations of all companies, public and private.
As such, it could be that many private companies are holding off on going public because they don't want to see their values slashed in a market that has soured on young, cash-burning companies. After all, recent IPO stocks like Robinhood, Coinbase, and Marqeta have lost 70% or more in market cap since going public.
According to data from the Securities Industry and Financial Markets Association (SIFMA), total equity issuance through May 2022 was down 80% year over year, while IPO issuance was down a whopping 93%.
The second-quarter report of companies with significant investment banking businesses could be unpleasant reading; I expect the profits of Goldman Sachs, Morgan Stanley, and JPMorgan Chase will be down from the same quarter last year.
Jefferies CEO Handler did offer some encouraging words, saying that "our backlog is consistent with last quarter's strong levels." That was similar to Goldman Sachs Chief Financial Officer Denis Coleman's comment last quarter that its "investment banking backlog remains robust."
Companies may be itching to go public, but given the current market backdrop, they're being cautious, and you can't blame them. Investment banks will continue to face near-term headwinds, but their robust backlogs of deals could help them bounce back later -- assuming conditions regarding inflation and rising interest rates improve.