FBR Capital Markets, a 21-year-old investment bank hobbled during the financial crisis by a bloated cost structure and ties to a mortgage REIT, seems to be making all of the right moves. But it is still waiting for them to pay off.

The Arlington, Va., firm is now completely separated from its former parent, which invested in mortgage debt, and it has slashed costs even while expanding into M&A, corporate restructurings and debt capital markets.

But the 500-person firm, which has $200 million on its balance sheet and no debt, lost $40.6 million in the first three quarters of this year.

"We actually have more revenue capacity than we did when we had 780 people" in 2008, said Richard Hendrix, FBR's chief executive.

Getting FBR to the point where it is "consistently profitable" is important not only for shareholders and employees, but also for the business itself and for removing obstacles to winning mandates, Hendrix said.

"We are a financial adviser and an underwriter of securities," he said. "We operate in a very competitive industry, and not performing financially ourselves can introduce unnecessary and challenging questions in the minds of potential clients."

In Hendrix's own words, FBR has been "a pretty complicated story" for the last five or so years.

A group of professionals who had worked together at the Washington brokerage Johnston, Lemon & Co. founded Friedman Billings Ramsey Group in 1989. At the start, it had a pretty traditional research and trading business model and was heavily focused on financial services. Early on, its analysts made a timely call when they recommended that clients get out of thrifts and short them before the savings and loan crisis.

A couple of years later, analysts made another timely call to buy financial services stocks, and Friedman Billings Ramsey launched an investment bank to help recapitalize banks and thrifts. It continued to expand by adding energy, industrials and specialty finance investment banking services. The company went public in 1997, and six years later it merged with Arlington Asset Management Corp., a REIT it had originally created to serve as a source of merchant banking capital. (The merged business kept the Friedman Billings Ramsey name.)

Hendrix said the businesses were combined for what "at the time were good reasons" — the REIT's stable income complemented the investment bank's more volatile earnings. But a decision was made subsequently to "add a lot of credit risk to the REIT."

The investment bank began separating itself from the REIT in 2006 through the creation of a business unit, FBR Capital Markets. Friedman Billings Ramsey sold a minority stake in the banking unit to investors such as the private-equity fund Crestview Partners (which has a 12% stake in FBR).

The unit was spun off in June 2007, as the subprime mortgage market was collapsing, with the REIT initially holding on to own about half of its stock. Last year, FBR purchased the REIT's remaining holdings, and the REIT changed its name back to Arlington Asset Investment.

"It actually confused clients to a large degree, as well as investors," Hendrix said. "It was not easy to figure out what was happening with our business, if you looked up the ticker all you saw or heard was 'subprime mortgage.'"

Disassociating itself from the REIT was just half the battle, he said. "We have had to be really aggressive about cost cutting." The REIT "threw off so much in the way of earnings that it was difficult to see what the expense base was inside FBR."

One side effect was "it made it easier than it should have been to grow head count in anticipation of growth in the business."

By late 2008, at the worst part of the financial crisis, when the market "appeared more likely than not to be contracting by 50% or more, we just had an unsustainably high cost structure," Hendrix said. FBR has since taken its head count down to just under 500.

"It will come down further, though not through layoffs, just through managed attrition," FBR's CEO said. "We have radically re sized the business in terms of people and the expense base, but we've been able to do it even as we've added additional businesses," such as options trading and convertible bond and high-yield trading and underwriting.

The firm also has broadened its merger and acquisition advisory business.

Hendrix conceded that FBR is "still emerging from a little of the overhang of confusion" about its brand. Nevertheless, "we've done a lot of really good work in the last year and a half raising capital in cutting-edge transactions."

One of those novel deals took place last year, when FBR advised an investor group led by the Georgia banker Joe Evans. The investment bank raised $300 million from 28 institutional investors, and Evans' group used the proceeds to buy State Bank & Trust Co., which then served as an acquisition vehicle for a number of failed banks.

"That was a really important deal, because, right at that time, the FDIC was rewriting the rules around eligibility for bidding for failed institutions," Hendrix said "We spent a lot of time figuring out how to get a broad group of investors together without any investor owning more than 9.9%. We were fortunate that we were working with a tremendous bank CEO, exactly the right team and, at the time, exactly the right ownership structure."

Also, the company has gotten some notice from its role raising $1.3 billion in July through a stock sale for Air Lease Corp., a company started up by the former American International Group veteran Steven Udvar-Hazy.

In the coming years, Hendrix said, the banking industry will remain an important source of business for his firm and the investment banking industry.

"Some good-sized banks still haven't repaid their Tarp funds. They're waiting for a higher stock price … but ultimately they are going to raise capital," said Hendrix.

At the same time, "a lot of small banks that have been able to defer loan problems — the so-called zombie banks — will raise capital" and charge the loans off, "because it's the only way they can re initiate growth," Hendrix said. "Their boards will ultimately come to the conclusion that they're not doing anything for shareholders by sitting there and waiting for things to improve."

Tom Murphy, a co-founder at Crestview and a director at FBR, said the investment bank has a good management team and is well positioned to grow as it comes to the next part of the business cycle.

"We very much like the opportunities that lie ahead for FBR," Murphy said. "We're patient investors, and we believe our patience in FBR will pay off. They are gaining dollar and market share in their verticals, so we're reasonably optimistic for FBR"

The business model "fits neatly between really small players with an industry or product specialty" and the bulge-bracket firms. FBR offers a broader range of products than many middle-market firms, which "allows them to stay with clients longer."

In addition, "having $200 million-plus in cash and no debt is an unusually liquid, stable capital structure for a company this size," Murphy said. "It gives them flexibility to do things."

Devin Ryan, an analyst at Sandler O'Neill, also praised FBR's "very clean" balance sheet.

"Now, as we start to see some cyclical improvement, they're very well positioned. They have capital to deploy," according to the Sandler O'Neill analyst.

Ryan expects FBR to put that capital to work "in more productive assets," either through acquisitions or organic growth in some of its existing businesses.

FBR officials have said during recent conference calls that they are looking at purchases in the asset management sector, which has steadier revenue than investment banking and has helped many Wall Street firms weather drops in fee income from advisory work.

Though his firm may be considered a boutique or middle-market investment bank, Hendrix said it has gone head-to-head with some of the largest investment banks by offering better execution and distribution of stock offerings for issuers.

"We do very large sole-managed and book-run transactions. That's most of our business, which is very different from other midsize firms," he said. "We have an equity sales force as large as most bulge brackets, and we are broader in terms of distribution than the bulge bracket. The biggest firms focus intensely on the top 50 accounts, where most of the flow trading is," and those accounts typically get 80% to 90% of the shares from a securities offering.

Hendrix said his firm's professionals "spend a lot more time with small, midsize money managers, many of whom had been at bigger money management firms previously and left to start their own companies. As a result, we have a group of 1,400 accounts, 800 with whom we are very active."

Last month, FBR underwrote a $90 million follow-on offering that Hendrix said "looked more like an IPO." He would not identify the issuer, because the transaction was a private deal, but he did say his firm placed the shares with 80 accounts, none of which took more than 10% of the deal.

By comparison, big investment banks treat this sort of financing in a more commodity-like fashion, he said, because they are less concerned with how the actual securities are distributed.

"We are more focused on ideas, execution and the ability to access capital either more quickly, more efficiently or at better prices than a bigger firm."

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