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Pick-and-Shovel Plays for Rising Mergers and Acquisitions

Investment banks are a good way to play the new M&A cycle.

Michael Wong, Stock Analyst, 05/17/2011

The papers have been abuzz with merger and acquisition news. There's been the drama of the financial exchanges, with NYSE Euronext NYX announcing a merger agreement with Deutsche Boerse DB1 and subsequently twice rejecting NASDAQ OMX Group NDAQ and IntercontinentalExchange's ICE unsolicited higher bid for the company. Berkshire Hathaway BRK.A BRK.B was put in the spotlight after its acquisition of Lubrizol and related resignation of Berkshire CEO heir apparent David Sokol due to a conflict of interest issue. Megamergers have also resurfaced, with AT&T's T $39 billion bid for Deutsche Telekom DTEGY's T-Mobile USA unit.

The string of high-profile acquisitions and headlines provides evidence that we've entered into a new M&A cycle. Commonly touted interrelated factors conducive to overall M&A activity that appear to be present are rising share prices, senior management confidence, a positive trajectory to the economy, and access to financing. Certain company- or industry-specific factors such as high cash balances, low organic growth prospects, and shifting industry dynamics are also present.

If you want to place your bets on M&A, there are at least two ways you can do it. One, you could speculate on the highest-potential acquisitors and acquisition targets. Or you could invest in the pick-and-shovel investment banks that are providing and booking revenue for M&A financial advisory services.

Below is a table of some of the boutique financial advisory and larger investment banks that we cover along with their proportion of revenue related to financial advisory:

As can be seen from the table, the financial advisory boutiques Evercore Partners EVR, Greenhill & Co. GHL, and Lazard LAZ are best positioned to ride a wave of M&A deals to superior earnings growth. The dominance of trading, underwriting, and other activities at the more diversified investment banks such as Goldman Sachs GS, Jefferies JEF, and Morgan Stanley MS make them less than optimal investments to express an opinion on growth in M&A activity.

Moaty Lazard Has Downside Revenue Protection and Upside Potential
Of the three boutique-ish investment banks, we are partial to Lazard for three reasons. First is that Lazard has the largest geographic footprint of the three: Evercore has offices in three countries with strategic alliances in three more, Greenhill has offices in six countries, and Lazard has offices in 26 countries. A global geographic footprint and local expertise are a competitive advantage in a world with increasing amounts of cross-border M&A. A larger geographic footprint could also fortify revenue if economic recoveries across various countries are uneven.

Second, Lazard has the greatest downside protection in any possible double-dip recession scenario. All three firms have countercyclical restructuring advisory services to complement their M&A services that should do well in a double-dip. That said, Lazard is considered one of the preeminent names in the restructuring field. The difference in ability to weather a double-dip is evident from the cyclical 2007 advisory revenue peak to the 2008 trough for Evercore or 2009 trough for Greenhill and Lazard. Evercore and Greenhill's advisory revenue fell 39% and 41% respectively, while Lazard's investment banking and other advisory revenue only decreased 20%.

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