Acquisitions Drive Consolidation And Convergence of Stock Specialists

In a move that will bolster its ability to process trades of foreign companies’ shares, Goldman Sachs Group Inc. bought stock specialist firm Walter N. Frank & Co. for an undisclosed sum in May. The deal was the latest in a series of transactions that have both consolidated the niche embracing the specialist firms charged with keeping orderly markets in shares of publicly traded companies and converged specialists with other players in the securities industry. The headliner transaction was the acquisition by Goldman Sachs, the acknowledged leader in the convergence trend, of Spear, Leeds & Kellogg LP, one of the largest and best-known specialists, for $5.6 billion in 2000. Specialists largely function on the floors of stock exchanges. In the Nasdaq system, there are multiple, indeed competing, market makers for company shares. The revamping of the specialist sector dovetails with the far-reaching series of strategically driven shake-ups within the securities and investment banking fields that have included the mega-expansion and the globalization of equities trading. In the modern setting, specialists need increased amounts of capital to handle bigger books of securities and finance technological upgrades of their trading systems. Joining up with investment banks – and vaulting a traditional securities industry demarcation line – has been one way to meet the pressures of the 21st Century; merging with each other to gain mass has been another. More deals of both varieties are expected. The Walter N. Frank acquisition “is a strategic, fill-in application that will contribute to Goldman’s relationships with the international companies whose shares it will process,” says Joel Gomberg, a securities industry analyst at William Blair & Co. Bulking up in equities Since 2000 Goldman also has picked up the specialist firm Ben Jacobson Inc. as well as options trading firm Hull Group. These acquisitions have served the purpose of allowing Goldman to increase its income from its equity businesses, which are less prone to ups and downs than other business segments such as investment banking. Specialists manage the auction market in the specific securities allocated to them. They traditionally have been independent companies that trade equities across a range of industries. Although Goldman sees an upside potential in broadening its specialist holdings, the first quarter of this year was not been kind to the business. In a recent press release, the New York Stock Exchange (NYSE) said that first quarter revenue fell 33.6% to $38.55 billion from $58.06 billion in the same quarter of 2001. Profits at specialists also fell 36.6%, to $92 billion from $145 billion a year earlier. By picking up Walter N. Frank’s 74 listings, Goldman’s specialist unit will now handle 579 stocks, one more than the former No. 1 specialist, LaBranche & Co. Inc., which went public. Walter N. Frank had been the smallest specialist on the NYSE floor, where foreign listings are still a small, albeit growing, portion of the listings. LaBranche’s percentage of share volume will remain higher, with 29.8% of the volume, compared with Goldman’s 21.2%, according to NYSE figures. One of the main attractions of Frank for Goldman was its specialty in ADRs (American depositary receipts), which are becoming a larger force in U.S. securities trading as more foreign companies seek exposure to North American investors. About 30 of the issues Frank handles are ADRs. Putnam Lovell Securities Inc. brokerage analyst Todd Halky says, “The whole brokerage consolidation game is based on the fact that there are only a limited number of listings.” He notes that critical mass is vital in making stock trade processing profitable and to ensure that it is, participants are increasingly looking to capture additional market share. “The best way to succeed as a specialist is to increase a firm’s revenue-capture per share traded, and to do that, size matters,” he says. Halky explains that the only way a given specialist can increase the number of companies it represents is through IPOs or by winning new ADR listings. Due to current market conditions, there won’t be many new IPOs for a long time, so the main potential engine for growth is to attract seasoned ADRs, he states. Presu-mably, specialists like Frank, which already represent a number of foreign companies, will be the beneficiaries of any new ADRs that are issued. And Goldman will not be alone in beating the bushes to drum up new ADR listings. Andrew Karolyi, a business professor at Ohio State University believes that Goldman’s acquisition of Frank, a specialist with a significant number of ADR companies, makes sense because more companies are choosing to list in New York. “There has been a major effort by NYSE president Richard Grasso to attract more global blue chip companies to list on the New York exchange,” he says. In addition to having the marketing power of the exchange behind it, Goldman will likely benefit from efforts by the NYSE to not only increase the number of companies using ADRS but also to increase the liquidity of the foreign companies that are represented in the NYSE ADR pool. “Some books like Telemex, the Mexican phone company, have been models of liquidity, others have been more stagnant,” Karolyi notes. He adds that the exchange is making concerted efforts to build up the volume side of the business as well. Any successes from these marketing efforts will make Goldman’s investment in Frank more lucrative, he states. Karolyi also cautions that there are distinctive elements of “running” an ADR book, which would have been difficult to build from scratch. As an example, he points to the fact that some staff members at ADR specialist firms have to work unusual hours so they can be in touch with the company during its business hours. In another sign of the higher profile of ADR trading, in June Standard & Poor’s launched an index of foreign company shares that trade in the U.S. in dollar-denominated securities. The index will consist of 261 ADRs from 26 markets in Europe, Asia, and Latin America and will be weighted according to market capitalization. It was developed with J.P. Morgan Chase & Co. “The S&P ADR Index will offer pension plans and other institutional investors an easy-to-replicate index of large-cap international stocks without the complexities and costs of cross-border trading,” says Robert Shakotko, a managing director at Standard & Poor’s. The Goldman acquisition is the latest move in a long consolidation process that has reduced the number of specialists at the NYSE from more than 100 about 10 years ago to seven now. Halky says that he expects more acquisitions to take place among the remaining seven. He points to the only two private specialist firms left of any significant size, Performance Specialist Group LLC and Susquehanna Investment Group, as likely targets for acquisition. Halky says that both Perfor-mance and Susquehanna are too small to represent a large investment bank’s first foray into the specialist business, but if a large organization is contemplating entering the business, it would be more likely to buy LaBranche, while Performance and Susquehanna would more likely be taken out by a player who already has its hand in the sector, he notes. Other deals in the space have seen the largest specialist in terms of total volume, LaBranche, take out Robb Peck McCooey Financial Services in March 2000. LaBranche also bought Bocklet & Co. in May 2001. For most would-be acquirers, one advantage to buying specialists is that the integration problems are minimal, says Halky. “You are going to get some synergies from combining the back-office operations of Spear, Leeds & Kellogg with Frank and there isn’t much integration risk as these companies don’t carry a lot of infrastructure cost. Most of the costs buyers will have to assume are compensation and benefits.” He also believes that Frank will benefit from an upgrade in the firm’s technology and systems that Goldman is expected to provide.