The surge in interest rates has had ripple effects across capital markets and the economy. Investors saw this last month when regulators shut down SVB Financial's Silicon Valley Bank, which faced massive losses on its bond portfolio due to higher rates, poor risk management, and mass withdrawals by depositors.
Another industry feeling pressure from higher interest rates is investment banking. Activity has plummeted, and very few companies have been going public through initial public offerings (IPOs). Mergers and acquisitions (M&A) deals are down significantly, too.
Jefferies Group (JEF 0.85%) is one major investment bank that recently announced earnings. Because its fiscal first quarter ended on Feb. 28, investors got a sneak preview of what to expect when other investment banks, like Goldman Sachs and JPMorgan Chase, announce later this month. Here's how Jefferies did this quarter and management's expectations in the near future.
Jefferies' first-quarter earnings show the challenging backdrop for investment banks
Jefferies Group, the sixth-largest investment banking concern, globally, relies heavily on this revenue, which makes up 44% of its total net revenue. The latest quarter for Jefferies was a struggle, as net revenue fell 24% to $1.28 billion and net income fell by a whopping 61%.
Jefferies' equity underwriting revenue (from IPOs) fell 20% from the same quarter last year and is down 75% from 2021. Other investment-banking revenue, such as advisory (M&A deals) and debt underwriting (where it helps companies raise money in debt markets), fell 45% and 67%, respectively, from last year.
Here's why investment banking activity is down
Jefferies management was pleased to see it gain market share in the quarter, but the market backdrop made things extremely difficult.
Investment banks have had a rough go of it over the past year as market volatility and rising interest rates wreaked havoc on the business. Companies hesitated to go public for fear of tepid demand and a stock market that has been harsh to recent public companies. For example, since the start of 2022, the Renaissance IPO ETF, which tracks companies that recently went public through IPOs, is down more than 52%.
Image source: Getty Images.
Management also discussed the significant decline in M&A activity and leveraged finance markets that weighed on it in the quarter. One thing that has challenged M&A markets is a tough regulatory environment, which has brought big-ticket deals to a halt. In the U.S., the Biden Administration has taken a more critical view of large deals and has scrutinized those deals based on antitrust rules.
While regulators aren't blocking all deals, the extensive review process is delaying them and making them more costly. According to S&P Global Market Intelligence data, no deals exceeded $10 billion in January. Last year, 29 deals were $10 billion or more.
What investors should expect
Conditions will likely remain challenging for investment banks in the near future. Jefferies Chief Executive Officer Richard Handler and President Brian Friedman said, "[W]e don't know when capital markets will return to some form of normalcy." Instead, the company is positioning itself to ride out near-term headwinds and grab market share in a challenging environment.
Image source: Jefferies Group.
The uncertainty from Jefferies' management shows just how difficult it has been to forecast what will happen in capital markets. Investment banks have faced challenges from all sides during the past year. Slow IPO markets have drastically reduced equity underwriting revenue, while regulatory scrutiny has resulted in fewer and smaller M&A deals.
Investment banks will continue to face headwinds in the near future. A positive sign would be more companies going public and a pick-up in M&A activity. However, until capital markets improve, I'll be avoiding companies that rely heavily on investment banking.
