Investors leafing through First Union Corp.'s second-quarter earnings announcement were jolted to discover that merchant banking - formerly a quiet backwater at the North Carolina superregional - delivered $44 million, or 16 cents a share, to the company's bottom line.
The profits came from cashing in on two major investments initiated by First Union Capital Partners. They also represented the first time that the five-year-old merchant banking unit contributed significantly to the parent company's earnings.
Officials at the bank company, which is expected to report its third-quarter earnings this week, insist that the on-again, off-again boost from merchant banking will be a pattern.
As other bank companies have discovered, earnings contributions from merchant banking are occasionally helpful but not to be depended on.
W. Barnes Hauptfuhrer, a managing director who runs the proprietary investment group at First Union, said the unit probably won't report any capital gains for the rest of this year. He added that he expects it to provide annual contributions of around $10 million for the foreseeable future.
|A Flea on the Elephant'
"This is a niche unit that is going to add supplemental income sporadically," said Mr. Hauptfuhrer, a former Wall Street investment banker with Kidder, Peabody & Co. "At the end of the day, we'll still be a flea on the elephant.
First Union is the nation's ninth-largest bank company, with $72 billion of assets. First Union Capital Partners currently manages a $150 million portfolio of equity investments.
Mr. Hauptfuhrer said merchant banking will never constitute more than 1% of First Union's assets. But that still leaves plenty of room to grow - up to $700 million at First Union's current size.
"The bad news is we can only contribute so much to profitability," Mr. Hauptfuhrer said. "The good news is we can only contribute so much to any kind of credit problems."
Merchant banking is a discipline in which a lender also makes equity investments in a company or provides subordinated debt.
U.S. banks first began establishing discrete merchant banking units in the late 1970s to protect their corporate relationships from poaching by nonbank financial institutions who were offering equity to their clients -- and also to boost income.
Because of the high level of expertise required and the risk involved, only a few large banks became major players. They include First Chicago Corp. - which on Wednesday reported that venture capital contributed $117 million of net income, or 42% of its earnings, during the third quarter; Chemical Banking Corp.; Citicorp; Bankers Trust New York Corp.; and Chase Manhattan Corp.
First Union and Bank of Boston Corp. were among the few regional banks to take up the challenge.
First Union essentially imported its merchant banking expertise from Wall Street by hiring Mr. Hauptfuhrer and three other specialists from Kidder Peabody in 1988. Since their arrival, the unit has been stoked with in-house talent, giving it a crew of 15 employees today.
In 1991, the merchant bankers cashed in their first capital gains, adding $10 million to the parent's bottom line. That was followed by gains of $20 million in 1992 and the $44 million this year from the second-quarter liquidation, according to Mr. Hauptfuhrer.
He also noted that merchant banking contributes fee income through corporate advisory work and net interest income that doesn't get directly credited to it on quarterly earnings reports.
"We've only been reporting capital gains, but have contributed fee income and net interest income throughout these years," Mr. Hauptfuhrer said.
He noted, for example, that his unit has converted about 22 of its clients to customers of First Union's commercial banks over the years.
"Merchant banking is a good business to be in because it's a good adjunct to the lending business," said analyst Moshe Orenbuch, with Sanford C. Bernstein in New York.
First Union clearly welcomes the contributions.
Last month, First Union awarded its "President's Cup" to the merchant banking group for best performance by a non-bank subsidiary, based on return on equity, net income versus budget, and overhead efficiency.
Some banking industry veterans of the equity investment game also are showing respect for their southern competitors.
"We've seen them in some transactions and we think quite highly of them," said John Canning Jr., the president of Madison Dearborn Partners Inc., a merchant banking unit that First Chicago spun off in January. "They know what their strengths are. They're concentrating on smaller, more regional transactions in which they can be dominant."
Mr. Hauptfuhrer said the big payout in the second quarter derived from investments made in 1989 in World Acceptance Corp. and CompUSA Inc..
First Union originally invested $10 million in World Acceptance, a former consumer finance subsidiary that the bank company sold to its management in 1989.
Mr. Hauptfuhrer's unit reaped some gains on the deal by helping take the Greenville, S.C.-based company public in 1991. It also kept a 33% stake in the unit, which was sold in the second quarter.
CompUSA was a growth company in which First Union initially invested $5 million, adding another $3 million in January 1991.
When the company went public in December 1991, First Union booked some gains. It added more the following October when the Dallas-based computer superstore chain did a secondary offering.
First Union closed out its remaining stake of under 5% by selling stock in the open market during the second quarter.
CompUSA, which has expanded its chain of superstores from three to 50 since 1989, was clearly a merchant banking home run for First Union. Another potential star is Chattanooga, Tenn.-based Chattem Inc., a fast-growing maker of health products and beauty aids.
Mr. Hauptfuhrer's group bought 27% of the company for $14 million earlier this year. At the same time. First Union's Tennessee bank subsidiary extended a $90 million loan with a $10 million credit revolver to Chattem, making it the bank's largest corporate customer.
Merchant banking investments typically involve leveraged deals or emerging growth companies, and are not expected to deliver a return for three to five years.
However, some investments offer the possibility of quicker awards. For example, Mr. Hauptfuhrer noted that First Union invested $3 million apiece earlier this year in two companies that over the last 10 days filed initial public offerings with the Securities and Exchange Commission.
According to their prospectuses, the value of First Union's investment in Pets Stuff Inc. of Roswell, Ga., is now worth about $7.5 million while its stake in Gourmet Coffees of America Inc., a Florida-based company, has risen to about $15.6 million.
45% Rate of Return
Mr. Hauptfuhrer calculated that he and his colleagues have achieved a 45% annual rate of return on investments since they set up the merchant banking sector. But he acknowledged that it will be difficult to maintain that level in today's environment of lower returns on investment.
"We'll have some winners and we'll have some losers, and hopefully that blended rate of return will be one that makes us an attractive business to be in."
The equity portfolio he currently manages has about $25 million of unrealized gains on its books. But since the investments are at different stages of maturity, it would be nearly impossible for first Union to cash them all out at the same time in any particular quarter.
For that reason, merchant banking can't do much for First Union in terms of goosing quarterly earnings on any predictable basis.
"It doesn't loom large in our earnings forecasts," said Mr. Orenbuch, the analyst. "I don't think we're willing to give them a lot of credit for nonrecurring earnings.
"On the other hand, it's real capital and book value when you earn that money."