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Gentlemen prefer bonds

If you congratulate Robert Diamond Jr. on running Britain's most successful debt underwriter, he won't take it as a compliment. In fact, he's more likely to get annoyed. The 50-year-old, American-born chief executive of Barclays Capital has far loftier ambitions.

If you congratulate Robert Diamond Jr. on running Britain's most successful debt underwriter, he won't take it as a compliment. In fact, he's more likely to get annoyed. The 50-year-old, American-born chief executive of Barclays Capital has far loftier ambitions.

"We want to be the No. 1 European bank in the areas that we're in," he says. "Capital raising, risk management, government bonds, derivatives, foreign exchange, all of it."

The investment banking subsidiary of British universal bank Barclays has already come a long way since 1997, when it was created from the debt-underwriting business of Barclays de Zoete Wedd in a highly contrarian - and controversial - move. At a time when most European and U.S. banks were furiously building up their equities platforms to capture the fruits of the bull market, Barclays decided to get out of that business entirely and stick instead with credit products. The rest of BZW was sold off to Credit Suisse First Boston Corp. Parent company chief executive Martin Taylor resigned in a huff, in part because of internal disputes over the investment bank's future, and Barclays Capital lost money in its first full year of operation.

Now the seemingly oddball strategy has begun to show signs of paying off, thanks in good measure to historic levels of debt market activity triggered by interest rate declines in the U.S. and around the world. Indeed, since the stock boom turned into a bust, Barclays Capital has mined a lucrative niche at a time when most full-service investment banks are suffering. It reported operating profits of Ï377 million ($541.9 million) in the first half of 2001 (the last period for which results are available), up 22 percent over the same period in 2000, thanks to rising fee income and cost reductions from technology and infrastructure improvements. The firm's cost-income ratio has been declining steadily, from 70 percent in 1999 and 68 percent in 2000 to about 60 percent last year - a good showing in comparison with other European investment banks - especially considering that Barclays Capital is aggressively adding personnel. The investment bank accounted for 17.6 percent of its parent's operating profit in the first half of last year. In recognition of his contribution, Diamond took home a £10 million bonus.

Another symptom of success: Barclays Capital stands out as one of very few investment banks anywhere healthy enough to be adding staff. Last year it boosted its payroll by about 400 people - roughly 10 percent - to a global total of 5,000, even as its parent bank closed 171 branches and eliminated 7,500 jobs. And Diamond plans to increase head count over the next year by a further 7 to 10 percent, hiring mainly in Europe and in the U.S., where the firm now has about 1,400 employees and where it's determined to join the upper tier of financial institutions.

Still, the bank has a long way to go before it becomes a global front-runner. It remains far back in the pack by many measures; though the value of issues it lead-managed doubled to $73.1 billion last year, it ranked only 13th in global bond underwriting in 2001, up from No. 16 in 1999. In the midst of an aggressive U.S. sales push, Barclays Capital still ranks just 14th in dollar-denominated bond underwriting. It holds a mere 1.1 percent of the U.S. debt underwriting market, which is dominated by J.P. Morgan Chase & Co., Citigroup and Bank of America Corp. Nearly a quarter of the firm's business in 2001 came from Britain, where it underwrote $16 billion worth of bond issues and placed far ahead of No. 2 Citigroup. On the Continent, Barclays Capital ranked 11th, with $26.8 billion in euro-denominated bond underwriting - miles behind market leader Deutsche Bank's $63.4 billion.

In January UBS Warburg downgraded the parent bank's stock from buy to hold, on the grounds that 2001 was a record year for the fixed-income business and that Barclays Capital is unlikely to repeat its earnings performance. (Now at about £22, the stock is trading just slightly above where it was a year ago.) Its return on equity in 2001 was a solid but unspectacular 23 percent, and UBS Warburg expects that to fall next year.

Diamond believes his bank can overcome the competition, formidable though it is, on the strength of its good name and rich balance sheet. Parent Barclays has a pedigree dating back to the late 17th century and is Britain's second-biggest bank, with £364 billion in assets. Its deep pockets, double-A credit rating and well-known brand pack a punch - its money management subsidiary, Barclays Global Investors, is the world's biggest institutional fund manager. Barclays Capital maintains a much closer relationship with its parent bank than did predecessor BZW.

That, its executives believe, is a tremendous selling point. Companies the world over are increasingly demanding access to bank balance sheets, and particularly loans, notes John Leonard, who covers European banking for Schroder Salomon Smith Barney in London. And the investment banking powerhouses Goldman, Sachs & Co., Morgan Stanley and Merrill Lynch & Co. are increasingly loath to commit capital.

So Barclays quite deliberately decided to concentrate on its specialty - debt origination - during the hottest bull market in stocks of the last century. Management's theory was simple: The equities business, with all the research and trading that comes with it, is profitable for only a handful of firms, and Barclays had no chance at making it into the senior leagues in full-service investment banking. Hence, staying broad based - even with an outfit as storied in stocks as BZW - was a money-losing proposition.

"There was a recognition by the senior team here in '97 that in the world in which we were living, an all-singing, all-dancing, U.S.-like, full-service investment bank based on a small domestic platform was not possible," explains Diamond, who in 1996 left his position as head of global fixed income and foreign exchange at CSFB to join BZW as head of global debt. "There's no question there are two or three good firms out there that are absolutely first class in executions and make money year in and year out. But I would question how I would create a business plan to compete with those two or three, as opposed to ending up looking like the ten or 15 that most years are losing money."

The future of Barclays Capital, management decided, lay in the vast new debt market created by the euro in January 1999, when monetary union formed a huge pool of capital. "If it weren't for the advent of the single currency, I don't think any of this could have happened," says Diamond. Besides the anticipated surge in euro-denominated corporate debt issues, he and his colleagues saw the "massive secular downward shift in rates" in Euroland as an unprecedented opportunity. "That's what led to the explosion of buy-side interest in credit products," he says.

Whether Barclays can tap into that demand outside its home market is another question. Diamond believes that his bank has strengths that American and Continental rivals lack. "We offer an integrated credit proposition," he says, citing by way of example a $357 million private debt placement for Kellogg Co. in November. The cereal company wanted to raise money in sterling to make a U.K. acquisition, but the market was turbulent, says Barclays Capital global debt chief Grant Kvalheim. So Barclays did the placement in dollars and swapped into pounds later. "This is about cross-selling, about deeper and more important relationships with our clients," says Diamond. "We want to be more than just the house bank lending money."

Aggressively hiring talent from market leaders is one way Barclays is trying to get ahead. Diamond tried and failed spectacularly last year to lure a team of top U.S. debt specialists from CSFB. The bankers, led by North American bond head Jack DiMaio, stayed put after CSFB agreed to shell out an extraordinary $300 million over three years. (The guarantee has since been renegotiated.) But the costly episode, which helped lead to the ouster of CSFB chief Allen Wheat, also had the effect of a splashy help-wanted ad and landed Barclays some high-profile deal makers.

Most notable among them was Kvalheim, who had been Deutsche Bank's chief of global debt in London and who defected to Barclays in May with his own 40-strong team of bond specialists from all over the world, including Europe head John Winter. Kvalheim, who was a close friend of the late Edson Mitchell, Deutsche's investment banking boss, had been instrumental in building up Deutsche's London-based investment banking unit. Now he is the point man in Diamond's worldwide expansion strategy and, insiders say, has boosted Barclays' credibility outside Britain.

Big corporate customers that have tapped Barclays to underwrite bond issues over the past several months include Ford Motor Co., France Télécom, Honeywell International, KPN and McDonald's Corp. Barclays Capital is particularly proud of a E4 billion ($3.54 billion) bond offering in late 2001 for General Motors Acceptance Corp., the biggest euro-denominated debt deal ever for a U.S. corporate issuer.

Another big-name recruit is Hans-Jörg Rudloff, who joined Barclays Capital from CSFB in May 1998. A Eurobond market legend, Rudloff is known for his extensive industry connections. As chairman of the firm's executive committee, his job is to be a supersalesman, expanding Barclays' industry relationships on both the sell side and the buy side.

"When I came to Barclays, what they had built with great care and skill was a trading and product platform," Rudloff recalls. "One element that was missing to do investment banking was an outreach system. They had no marketing and no marketing mentality. We put a team in place, slowly but surely, that now provides the backbone in obtaining mandates and selling securities, particularly in the corporate sector." Hiring more bankers in continental Europe and the U.S. is a priority for Barclays, he adds.

To build its book in the U.S., Barclays is following the same pattern as just about every other big commercial bank trying to muscle into the securities business - it is trying to leverage its lending relationships. Recently, for example, it helped raise $4 billion for FirstEnergy Corp., an Ohio utility that needed the money to help finance a merger in November with GPU, a northeastern American utility. Barclays was joint book runner and co-lead manager of the offering, along with Citigroup and Morgan Stanley.

"We have had a long relationship with Barclays on the commercial banking side," says FirstEnergy CFO Richard Marsh. "We believe that for all our major banking relationships, it's important we have access to the balance sheet."

In tough economic times, such thinking is increasingly typical among CFOs, Barclays Capital executives say. "Virtually every corporate we do deals for, we also have a lending relationship with," says Europe chief Winter.

The bank's big balance sheet is also a boon to its £3.4 trillion derivatives business, which is big enough, analysts say, to make Barclays Capital competitive with Deutsche, UBS and the strongest U.S. houses. And the parent bank's double-A credit rating makes the firm a particularly strong counterparty. In InstitutionaI Investor's annual derivatives survey (see page 87), Barclays Capital climbed from No. 17 in overall client satisfaction in 2000 to No. 11 last year.

Indeed, Diamond has produced results in a short time, owing to a combination of skill and luck. With equity issuance as well as mergers and acquisitions subdued by the bear market in stocks, debt specialists in general are thriving. Barclays Capital's trading revenues alone in the first half of 2001 were a healthy Ï570 million, 37 percent higher than the year before, and fee income grew 64 percent.

But skeptics maintain that while Diamond's vision seems sound, his global aspirations may be premature. Barclays Capital excels at dealing with British issuers and with companies seeking access to British investors. But although the advent of the single currency may have shaped its new strategy, the bank has yet to make much headway in Euroland underwriting mandates. There is also a common perception that Barclays Capital's prowess in underwriting is not matched in such enterprises as risk management, derivatives or foreign exchange and commodity trading. In other words, say critics, it's just a big, plain-vanilla bank.

Rudloff believes that's an unfair characterization. "I think I have a very good feel for derivatives operations," he says. "The one at Barclays Capital matches anyone in the market. We have excellent control over the business, and it's the most profitable side of the business." Rudloff adds that the bank has recently hired a number of derivatives specialists, mainly from Deutsche Bank's Bankers Trust Corp. unit.

Despite the challenges, the firm's debt-focused game plan makes sense to many analysts - and is probably one reason the parent bank's shares were up 3.4 percent in the 12 months ended January 7 while the average U.K. bank stock fell 2.8 percent. SSSB's Leonard compares the strategy to that of the old Chase Manhattan Corp. before its merger with J.P. Morgan. "Chase had a strong presence in fixed income without attempting to do equities and M&A," he says. "I think in some ways it's a fairly logical separation."

But, Leonard adds, "there are fewer degrees of freedom to differentiate yourself in debt than in equities. It's more a volume-commodity business. If you're going to be successful, you've got to do it on size. You need critical mass to compete with the largest players, particularly in North America."

Critics say that despite its commitment, Barclays Capital could have problems achieving that critical mass in the U.S. They note that it hasn't yet been able to break into the top ten in continental Europe. "There wasn't a lot of competition in Europe," says a former BZW banker who is now at a leading global firm. "They had an opportunity there, and they still do have an opportunity, with their background in the sterling market and their perceived understanding of credit. But they haven't really concentrated on Europe. They haven't been able to leverage the same amount of bond business out of the euro as Goldman, Deutsche and the others."

Kvalheim finds such comments "a bit harsh" and notes that Barclays has made it into the top ten this year in euro corporate issuance. But, he admits, "Clearly, we need to be a bigger factor in continental Europe: We need to do a better job originating deals." The people who came along with Kvalheim from Deutsche included members of the French and Spanish teams, who were hired to help Barclays achieve that goal.

Another senior Barclays official says the bank still has some manpower gaps that impede its ability to be one of the majors. "We're like a soccer team that wins cup games," he comments, "but we're not strong enough to hold a top position in a sustainable fashion, playing three or four games a week."

While Kvalheim agrees the bank needs to do better in euro underwriting, he seconds his boss's U.S. ambitions. "Expanding in continental Europe is absolutely our first priority, but expanding in the U.S. is also important," he says. "It's far and away the largest feed bowl. We cannot fulfill our ambition to be a global player without expanding in the U.S. It's just impossible."

The other big strategic issue, of course, is whether Barclays Capital can achieve its global goal without becoming a full-service investment bank. Debt-focused Chase wound up acquiring investment banks right and left, buying the U.K.'s Robert Fleming Holdings and San Francisco technology boutique Hambrecht & Quist before springing for J.P. Morgan. If Barclays were to go that route, it too would probably choose a merger or acquisition.

Kvalheim does not rule out a foray into equity underwriting and advice. "There are a lot of ways it can go," he says. "We have to look at the strategic alternatives. It's likely if we decided we were going to break out of our defined model, we would do it through acquisition."

But Diamond insists he has no such plans. And he is no longer a lone maverick in his approach. Another U.K. bank, Royal Bank of Scotland Group - forged from the recent merger of Royal Bank of Scotland and National Westminster Bank - is also pursuing a strategy of debt underwriting and balance-sheet lending while leaving equity issues to the bulge bracket. For now, Diamond says he will stick with his strategy. And he takes the long view. "I have no intention of being a one-year wonder," he says. Tune in again after the stock market picks up.