Foolish Forum: Are Boutique Banks in Style?

The small investment-banking firms known as "boutiques" don't get as much press as Goldman Sachs (NYSE:GS) or Bear Stearns (NYSE:BSC), but they still offer big return potential. After all, anything to do with investment banking or M&A has been white-hot lately. These boutiques intrigued me, so I invited fool analyst Matt Koppenheffer to tell us more about them. 

JK: Matt, welcome back to the Forum. What exactly is a boutique investment bank? How do they differ from the big boys like Goldman?

MK: The short answer to that is size -- boutique is to some extent a nice way to say that the firm is much smaller than the majors like Goldman and Bear. Aside from that, the boutique banks are often known for a higher level of specialization than the big boys. You'll often find that the boutique banks will be known specifically for their work in a given sector such as tech, financial services, or health care.

JK: We've seen a number of these boutique banks go public in the last few years. What brought about this flurry of IPOs?

MK: The slump earlier in the decade hit the investment banks where it hurts. With a profound slowdown like that, capital markets and M&A activity declines big time and that really whacks the I-Banking industry. Some of these firms, particularly Weisel and Cowen, also had major tech practices, and the fact that the bulk of the slowdown was in that sector hurt even more.

Coming out the other end has been sweet, though. Over the past few years, capital markets activity is markedly up and M&A is booming. What's more is that on both the capital markets and M&A side there seems to be a trend toward getting more banks involved in the deals. And when business is good, you generally see a lot of private companies coming out of the woodwork and taking advantage of the positive momentum by going public -- just ask the oil and gas industry with the sky-high oil prices!

The public listings have not only allowed the partners at these firms the opportunity to gain some liquidity, it has also added equity compensation as a tool for management to retain top bankers.

JK: Investment banks are not the easiest companies to analyze. What's the first step a novice investor could take to learn about these companies?

MK: The first step is to get an understanding of what the firm is actually doing. Investment banking can be a very blanket term these days, and not all of the firms are in the exact same line of business. In the group that you singled out above, for instance, Thomas Weisel Partners spreads itself over a mix of business activities including corporate finance, M&A advisory, brokerage, asset management, and equity research, while Evercore is highly focused on M&A advisory.

Once you've got that down, you can typically boil down the activities to a much easier to understand widget-making process. M&A advisory, for example, is all about transaction size and volume. An investment bank will generally charge a fee of 1%-3% of the total transaction size when they act as an advisor. Just like looking at Dell and its market for PC sales, you can evaluate an M&A advisor based on the market's demand for advisory services and the strength of the firm versus its competitors.

JK: Scanning Motley Fool CAPS, I see that the investing community thinks highly of KBW and Greenhill. Do any of these companies stand out in your mind as stellar performers?

MK: To be honest, with this group a lot of it boils down to price -- I don't have many bad things to say about any of these firms. On the M&A side, Evercore is a highly respected shop and for a small firm they get themselves involved in some big time transactions. Lazard is another very highly respected firm and has a very long history. In recent history, Lazard is perhaps best known for its CEO, Bruce Wasserstein, who's a rock star of Mick Jagger proportions in the banking world.

I should also point out that in a former life I worked for Thomas Weisel Partners on the investment-banking side. Though Weisel was hit hard by the tech downturn, it navigated the choppy waters and seems to have come out the other side. It has been particularly strong in the areas of semiconductors, media, and health care.

JK: Any final thoughts on the investment banks in general? How long will these good times last?

MK: Investment banks in general are highly leveraged to the general economy and business sentiment in particular. When times are good, everyone wants to go public, issue secondary offerings, and buy out other companies. The opposite is true when times turn sour. Trying to predict when this will happen, though, is tricky -- as in all predictions.

I tend to take a long-term view of my investments, and this works well with banking stocks. The key is to first find high-quality banks to invest in and get in at a reasonable price. Then, over time, as the market goes through its usual gyrations you can typically find multiple opportunities to both add to and pare back on your investments.

Also, versus their larger brethren, these boutique banks remain relatively "pure" and have not taken on highly leveraged and potentially risky trading operations. This fact could make one of the boutique banks more attractive to somebody who wants to take part in the M&A boom without getting exposed to the black box trading operations at some of the bulge bracket banks.

JK: That's a wrap, Fools. Join us next week in the Foolish Forum for more discussion on hot investing topics.

For more Foolish insight:

• Foolish Forum: Private Equity Fever
• KBW: An Investment Banking Mint
• Thomas Weisel Loaded on Tech
• Cowen Doesn't Wow 'Em
• How Much Is Goldman Sachs Really Worth?

Fool financial services editor Joey Khattab does not own any of the shares mentioned. Tell him what you think about the Foolish Forum. Fool contributor Matt Koppenheffer owns shares of Goldman Sachs and Dell, which is a recommendation of two Foolish newsletter services -- Stock Advisor and Inside Value. The Fool has a disclosure policy.