The financial crisis destroyed wealth indiscriminately, affecting every asset class — and every financial services firm — in the industry, but the subsequent rebound has been far more selective. Some firms have profited handsomely, but many — particularly, small retail shops — have not, suggesting much more industry consolidation to come.

The past year has been one of unprecedented turmoil for the financial services business, with a couple of Wall Street’s biggest firms failing, and the rest either rushing into mergers or converting themselves into banks in order to survive. By comparison, Bay Street’s biggest players have come through it all relatively unscathed. And much like their rivals in the U.S., Canada’s big, bank-owned dealers have begun profiting handsomely on the heels of the economic recovery.

However, the proverbial rising tide is not lifting all boats. Indeed, many of the industry’s small retail shops are still struggling, and a good number of them may not survive for too much longer.

On the surface, it appears that the Canadian brokerage business has rebounded impressively from the depths of the financial crisis, says Ian Russell, president and CEO of the Investment Industry Association of Canada. However, he points out, revenue and profitability data reveal that many of the industry’s small firms are being left behind in the recovery.

The large, integrated dealers are thriving, he says, as several of their major business lines have rebounded. Earlier this year, their corporate finance business recovered, with both debt and equity issuance increasing, as exchange-listed firms sought both to repair their balance sheets in the aftermath of the crisis and take advantage of the record-low interest rates.

Indeed, according to the latest data from Thomson Reuters, total equity and equity-related issuance through the first nine months of 2009 in Canada was $35.5 billion, up by 88% compared with the same period last year.

The bank-owned dealers dominate this business, with CIBC World Markets Inc. as the league leader in equities, followed by RBC Capital Markets Corp.and TD Securities Inc. CIBC was also the top player in the retail structured products business, while RBC dominated the preferred share market.

Similarly, debt issuance was up by 20.5% through the first nine months of the year, to $110.8 billion. RBC was the leader in this field for the period, followed by TD and CIBC.

On top of the revival in corporate finance business, Russell points out that there were also some large mergers and acquisitions in the first quarter of this year that boosted the large, integrated dealers’ revenue. The recovery in debt markets has rejuvenated the trading businesses of the large firms as well. And the rebound in equities markets over the second quarter of this year has ignited some mid-cap and junior financings and M&A, which, Russell says, has really benefited the institutional boutique firms — such that their profitability rose by an impressive 45% in the second quarter vs the prior quarter.

Some of the retail business has restarted as well; but, for the most part, the institutional side has led the market rally. And, to the extent that retail has revived, once again it’s the large, integrated dealers that are the chief beneficiaries.

There are a couple of reasons why the small shops appear to be getting left behind in the recovery, Russell suggests. For one, many of them are purely equities-focused, and they don’t have the fixed-income business to offer clients at a time when there’s strong demand for it.

Also, given the rock-bottom interest rate environment, smaller firms don’t have their traditional spread revenue (earned on clients’ cash balances) to fall back on.

Finally, the retail investors that are actively participating in this market rebound tend to be the high net-worth, sophisticated clients that are typically the preserve of the sort of high-quality, experienced brokers that now hang their hats at the larger firms.

The result is that many of the small, retail firms just aren’t making any money. According to IIAC data, there are about 80 firms that are currently either losing money or just breaking even.

That doesn’t mean that all 80 are in trouble, however. Russell points out that even in bull markets, there are about 40 firms that are just breaking even because they are run as partnerships that essentially pay out all of their earnings.

@page_break@During the depths of the crisis, the number of unprofitable firms rose to about 110, but many of these have since made their way back to profitability on the heels of the recovery. That leaves another 40-odd firms that haven’t been able to get back in the black, even as markets have rebounded — and those are primarily the small, retail firms that just haven’t been able to participate in the bounce-back.

For now, many of these smaller firms are suffering a death by a thousand cuts, hoping that they can hang on long enough for the market to turn decisively around. But Russell doesn’t see much hope for these firms in the foreseeable future if markets stay more or less as they are now — that is, somewhat volatile and uncertain, with no quick return to a convincing bull market.

Given that these firms are already demonstrating that they can’t make any money in this environment, they probably are going to have to consider selling out or somehow restructure to survive.

Russell expects that for many of them, it’s probably only a matter of time before they have to seek a deal of some sort. “These small firms have limited strategies,” he says. “They don’t have scale. In many cases, they don’t have a mix of business. And those firms are ultimately going to have to be faced with some big decisions.

“We’ve always been surprised by the resilience of the small firms,” he adds. “They survived the tech crash and they’ve been through bear markets before. But, this time, it’s going to be tougher.”

As a result, Russell estimates that at least 20 firms will disappear over the next year or so, either through M&As or simply by going out of business.

Fortunately, there are also plenty of buyers out there for these small, struggling shops. Indeed, Russell says, there are probably more firms looking to buy than there are committed sellers at this point. He suggests that the potential sellers are still very cautious about signalling their intention to sell outright. They may be holding onto hope that they can arrange a joint venture or some other sort of transaction that will enable them to survive somewhat independently, when what they really need to do is sell.

Meanwhile, buyers are looking for strategic transactions to add scale or to diversify by region or business line. Although the larger firms are interested in growth by acquisition, Russell suggests, they will also be selective in the brokers they add. And they are generally looking either for proven producers who will benefit from a broader product range and more robust platform offered by a larger firm or for younger brokers who have a promising future but could use the training and support resources of a larger firm.

With so much potential for industry consolidation, the IIAC is actually stepping into the pool of possible dance partners and offering its services as a matchmaker. Russell says that the association decided to play this role because it was hearing so much interest from small firms in doing deals, and Russell realized that the IIAC is a natural intermediary for these sorts of strategic transactions, as it knows all the players and has a good sense of who’s looking to do what.

The IIAC’s offer to serve as matchmaker has garnered a lot of interest on both sides — from buyers and sellers — Russell reports, and he has put some firms in touch with one another; although, as yet, a transaction has not happened as a result of his efforts.

Nevertheless, whether firms are introduced through the IIAC or they find each other on their own, it appears that the business is set to undergo some fundamental changes. And although Russell expects to lose about 10% of his members over the next year, he maintains that this consolidation is not necessarily a bad thing.

He sees it benefiting clients, as their brokers move to more established shops with broader product offerings, better technology and more efficient businesses.

“I would be concerned if we were just consolidating into the nine integrated firms, but we’re not,” he says. “There’s still a healthy contingent of smaller firms out there, too.”

And there will surely be small firms in the industry’s future as well, but they won’t be able to run the same sort of basic, undiversified businesses that have survived in the past. Russell believes that business model is now obsolete: “That’s over, it’s finished — and it’s not coming back.”

One day, the financial services industry, along with the markets, will rebound convincingly. But when that day finally comes, the industry may well look a lot different than it has in the past. IE