Oh, no. Not again.I can only assume my secretary was late posting my subscription renewal to the Financial Times last month. How else can I explain the appearance of yet another Yahoo in Monday's FT opinion pages blathering on about the proper way to rein in investment banking compensation?
Either that, or Paul Murphy and Helen Thomas over at FT Alphaville are encouraging their ink-stained colleagues to taunt Your Dedicated Correspondent with inflammatory commentary in hopes I will cause more catfights in the Alphaville comments section. If so, my friends, I can only warn you you are playing a very dangerous game.
I thought my fellow-travelers and I had done a creditable job of beating back the self-righteous, ill-informed attacks launched from various quarters on the vexed subject of banker pay, but it appears there are a few more heads out there in dire need of lopping off.
Sadly, Hercules I am not. I must admit that the apparent futility of this battle—and the hostility of many of the onlookers—sometimes makes me feel like I'm playing Whac-A-Mole in the hotel lobby of the 14th Annual Prairie Dog Convention. Nevertheless, in weary obeisance to my Faithful Readers' claims of duty and honor, I will take keyboard and mouse in hand and sally forth once more in defense of my embattled profession.
The Yahoo in question this time, interestingly enough, is a former investment banker himself. According to his book jacket blurb, William Cohan spent 17 years as an investment banker on Wall Street. Before he joined JP Morgan Chase, he apparently haunted the corridors of legendary investment bank Lazard Frères for six years, enough time for him to take copious notes sub rosa and gather enough sources to write the kiss-and-tell history of Lazard which has presumably funded his retirement.
You might think someone who served time in the bowels of a legendary M&A advisory firm and as a senior banker at an integrated investment bank as prominent as JP Morgan would have learned a thing or two. Based on his opinion piece, however, you would be wrong. Perhaps this is explained by the fact that Mr. Cohan book-ended his banking career with stints in journalism and book writing (q.v. ink-stained wretches, above), but there it is. I, for one, take issue with his remarks.
[As an aside, I will now take a brief detour from my prepared remarks to address Mr. Cohan's so-called arguments. For those among you who do not find shooting fish in a barrel educational or entertaining, or who feel that even dignifying the remarks of an apparent devotee of the Martin Wolf School of Irresponsible Exaggeration with counterargument only encourages more such driveling, I can sympathize. I suggest you skip ahead to the next section, where I lay out more substantive fare.]
Mr. Cohan launches his tirade with the following:
It is no exaggeration to lay the blame for the financial crisis and a host of others - among them, the internet bubble (1999) and the telecommunications bust (2001) - on Wall Street's compensation system.
Uh, sorry, Bill, I beg to differ. I think it is a massive and ludicrous exaggeration to say anything of the sort. Sure, banker compensation structures may have been a contributing factor to these bust-ups—if only because they did not act as a brake, and may in fact have acted as an accelerator, to the other multifarious causes driving the markets over a cliff—but the sole or even principal cause, as you imply? Not even close.
Ignoring that somewhere between 50 and 60 cents in every dollar of revenue that Wall Street receives is paid out in compensating its employees, is it any wonder that when you reward bankers with absurd sums to generate innovative securities - collateralised debt obligations or mortgage-backed securities - they react the same as one of Pavlov's dogs?
What's your point here, Bill? That people respond to incentives? Or that investment bankers drool a lot? Bankers were paid (by investors, mind you) to innovate. So what? Are you claiming that innovation itself is bad, or did you just forget to draw a conclusion?
Or, since mergers and acquisitions bankers get paid and promoted only if deals close, is there any surprise that their agenda is to push deals to close, not to offer unbiased advice?
Ah, now this is a decent point. We'll come back to it later.
These perverse incentives are exacerbated by Wall Street's lack of accountability. Huge bonuses are deposited and consumed long before the bad deals that generated them can slam investors.
Annghk! Wrong again. The banks everyone complains about nowadays almost uniformly pay their bankers and traders bonuses which contain a large proportion of restricted stock and options. This funny money vests over several years, usually well after most of the M&A deals or capital markets trades they were paid for have succeeded or gone sour. If anything, investment bankers' pay is tied up longer that the poor slobs they are supposed to be diddling with lousy deals. I have beaten this dead horse so many times that I won't even bother to supply the links.
If Bruce Wasserstein's "dare to be great" advice to Robert Campeau in the late 1980s on his acquisitions of Allied Stores and Federated Department Stores ended up being more than a little off the mark, should Mr Wasserstein be held responsible? Or are bondholders, shareholders and employees left to bear the brunt of bad advice?
Of course Mr Wasserstein should have been held accountable. But he was not. By the time the deal cost investors billions, he had left First Boston for his eponymous firm. As chief executive of Lazard - where the stock price declined 14 per cent in 2007 - he is now lionised and overcompensated. Mr Wasserstein is not alone. He is joined by countless other masters of the universe who provided the rationale for such flops as AOL-TimeWarner, DaimlerChrysler and Alcatel-Lucent.
What the hell?
I like to make fun of "Bid 'em up" Bruce as much as the next guy, but this is ridiculous. Are you seriously proposing that Bruce should have been on the hook for Campeau's Folly? How? And if him, why not all of the other bankers, lawyers, and accountants who were party to what you seem to characterize as a massive gang rape of Mr. Campeau's lenders and shareholders? This is just goddamn silly. Bruce is a salesman, for chrissakes, a middleman. Since when in the history of capitalism has anyone gone after the middleman when the washing machine broke down or the home value plummeted, unless sales fraud was involved? (Who knows, maybe Messrs. Cohan, Wolf, et al. are at the vanguard of a new economic paradigm.)
Furthermore, I find the implied infantilization of Robert Campeau (and by extension all other investment banking clients) and deification of Bruce Wasserstein (and by extension all other investment bankers) both unconvincing and personally offensive. Whatever Bruce advised him to do, Campeau was the customer in their relationship. He made the final decision. Do you really believe that a successful, well-paid businessman like Robert Campeau could really be browbeaten into a deal he didn't like by Bruce or anyone else? (Even if he could, what about his Board, or his outside counsel?)
Contrariwise, do you really think no sentient person can resist the siren call of a silver tongued investment banker? How much M&A did you actually do, Mr. Cohan? I wish any one of my clients was as pliable and accommodating to my advice as you seem to think they are. If they were, in my humble opinion they would make far fewer mistakes, deals or no deals.
While M&A bankers like to make the specious argument that their reputations are at risk when they give bad advice, for the anonymous bankers that manufacture and trade CDOs, leveraged loans and derivatives, there is not even that minor brake on bad behaviour. Unless, of course, things reach epic proportions and then we know them by their names: Jérôme Kerviel, Nick Leeson and Joseph Jett.
Here your argument completely runs off the rails. Kerviel, Leeson, and Jett were frauds, Mr. Cohan. They didn't structure anything, they just perpetrated rather simplistic trading deceptions against their investment bank employers because they got in over their heads and were too dumb to get themselves out. Greed wasn't even the principal motivation for these guys. Wrong straw men, Bill.
[Now back to our regularly scheduled program.]
Mr. Cohan's proposal on how to pay investment bankers does get to the heart of an interesting discussion, even if it is completely wrongheaded. He states:
What is a remedy for this vicious cycle? At the risk of seeming disingenuous, since I benefited from this system for 17 years, I propose an extreme makeover for compensation. M&A advisers should be paid by the hour for their advice, just as their well-paid deal colleagues in the legal and accounting professions. This would rein in unnecessarily massive M&A fees and return to the days of unbiased advice. Changing compensation for bankers who innovate and sell financing is harder but must include a way to hold back a large percentage of the pay until - and when - the success of the product can be determined over time. It is evident that the excess that led to the sub-prime crisis was not worthy of reward.
Of course he blunders into the same quagmire Martin Wolf did in proposing that traders who work for investment banks get paid in the same way that hedge fund traders do, but he clearly didn't think that part out. Rather, it is his proposal that M&A bankers get paid by the hour, like lawyers do, that I want to address, since it goes to the heart of what being an M&A advisor means.
First of all, it is important to understand both what M&A bankers are good at—where they bring true value—and what they are not good at. M&A bankers are good at collecting, digesting, and sharing competitive market intelligence; identifying and engaging good or likely counterparties for actual or potential deals; negotiating purchase price, structure, and other deal terms for the benefit of their clients; and helping parties to an agreed deal withstand the vicissitudes of fate, clashing egos, and unruly markets to bring a deal to the closing finish line. They are connectors, networkers, traffickers in information, and deal-doers. Fixers.
What M&A bankers are not—notwithstanding their propaganda and self-perception—is idea men (or women). It is not their job to think big thoughts, to construct grand strategic visions of their clients' and their clients' industries' futures, to be thought leaders. That is their clients' job, the job of their customer's CEO, Chairman, and/or Board of Directors (and sometimes the management consultants these executives hire to do their thinking for them). While M&A bankers often talk about bringing deal "ideas" to their clients for discussion and action, what they really bring is opportunities.
This is as it should be, for no M&A banker knows as much about a company or its industry as that company's senior executives (unless the latter are congenital idiots). The CEO and his or her Board should develop over time a well-reasoned view of the other companies in their industry, their relative strengths and weaknesses, and their potential fit as acquisitions, merger partners, or purchasers of their own company. What a good M&A banker can bring to the discussion is a well-judged view of the strategic visions, deal-making proclivities, and potential competitive responses to possible transactions the client's peers are likely to have. In addition, the M&A banker can provide an informed view on how the financial markets and company shareholders would react to a particular deal or company strategy, and—in the case of a particular deal—some sense of the probable clearing value of a particular asset.
These are all critical inputs to formulating M&A strategy, which no company executive—no matter how smart or well-connected he or she may be—can expect to discover without outside help. As I have said many times in the past, an M&A banker rarely focuses on the Who and the Why of a potential transaction—unless the opportunity truly arises from a direction completely outside the company's normal purview—but rather the How, the When, and the How Much.
As an aside, a not-inconsiderable amount of the average M&A banker's time is consumed with discovering (or manufacturing) deal opportunities and presenting them to potential clients in order to get hired to do them. This is particularly true in times like these, when live deal activity is languishing at a low ebb. Most of these presentations fall on stony ground, but this marketing activity has the supposed ancillary benefit of building the banker's trust and credibility with his clients, as well as feeding supposedly valuable market intelligence to them. In some industries, where capital raising is a more reliable source of banking revenues than M&A fees, bankers spend more time pitching M&A deals than doing them, with the hope that grateful clients will repay the favor with juicy underwriting fees. This is (or was) particularly true of the private equity industry, for example.
Second, it is useful in the context of this discussion to understand how M&A bankers normally charge their clients for services. In outline, it is simple enough. For every deal, bankers usually charge their clients a success fee which is based on a percentage of the total transaction value (debt, equity, leases, plus anything else the banker can convince the client to agree to). This fee is paid upon the actual closing (legal completion) of a transaction. The percentage charged is subject to negotiation between banker and client, but usually the banker tries to start from his or her firm's internal fee schedule, which is calibrated to what the firm thinks the market will bear. The fee schedule usually takes the form of a sliding schedule of percentages that starts somewhere around 1 or 2% for "small" transactions (around $100 million in size) and goes down from there as total transaction size increases. "Rack rate" fees for billion-dollar-plus transactions can range from 0.75% all the way down to 0.10% and lower.
A traditional complication to this success-only formula is that bankers usually try to get their clients to pay them a retainer at the start of a deal. This can be viewed as a sort of good faith deposit, which is non-refundable if the deal does not close and which is credited against the success fee if it does. Retainers are normally quite modest (at least in investment banking terms), ranging around $200,000 or so. Other variations can include interim payments, such as fees due when the bank delivers a fairness opinion to the client's Board of Directors, or partial success fees triggered by the achievement of certain milestones prior to actual closing, like, e.g., the signing of a definitive purchase agreement. Like retainers, these are often (but not always) credited against the ultimate deal success fee.
In any event, you can see that the normal arrangement of fees in an M&A deal pays almost (or exactly) nothing to the banker if the deal does not conclude successfully. You can also see that, notwithstanding the small percentage applied, a successful deal can generate a very large check to the investment bank, amounting to tens of millions of dollars or more for a big transaction. (Presumably this is what spurs Mr. Cohan's outrage at "unnecessarily massive M&A fees." I, for one, find it hard to get exercised about a $20 million fee when it represents only five one-hundredths of a percent of the total deal size. I guess that just proves I am the callous and greedy parasite Mr. Cohan believes me to be.) The best part of all, from the bank's point of view, is that this fee requires the use of absolutely no capital whatsoever other than its bankers' time and attention. Return on capital in M&A is, for all intents and purposes, infinite.
In terms of actual deal-doing, the M&A banker usually provides one of two services. He or she can advise the company or entity selling itself, a portfolio company, subsidiary, or collection of assets—known as a "sell-side" assignment—or advise a potential buyer of same, on the "buy-side." Now, a little thought on your part, Dear Readers, should lead you to conclude that the dynamics for these roles are quite different. An M&A banker hired for a sell-side assignment can feel fairly confident of earning a success fee for his or her work. That is because once a client has decided to sell something, it usually gets sold, barring a complete collapse in the asset's value due to external factors or a complete misread of the market in the first place by the investment banker. In fact, the primary risk to closing for sell-side assignments usually boils down to the seller getting cold feet or yanking the asset off the market in a fit of pique. In any event, this is a manageable risk, and if the deal closes, the sell-side banker collects a fee.
This is not necessarily the case for the buy-side advisor, because in order to earn a success fee his or her client has to place the winning bid and close the transaction. Given that the majority of M&A deals involve only one seller and multiple potential buyers, you can see that the math does not work in the buy-side banker's favor. I do not know whether anyone has tried to quantify this imbalance empirically, but I can tell you that some bankers use the rule of thumb that buy-side assignments only result in success fees 10% of the time, whereas sell-side bankers book fees closer to 70 to 80% of the time. In fact, the only real downside to being a successful sell-side banker is that your clients keep disappearing with every deal. (This is not a trivial problem, by the way.)
Finally, there is a subset of M&A bankers who also try to provide their longstanding clients with something you might characterize as general strategic advice. This usually consists of ad hoc market perspective, competitive intelligence, and general informed opinion and advice on all matters having to do with company strategy. This can take the form of a formal, fee-paying assignment—usually in the form of an annual retainer, if the banker has anything to say about it—but normally it is given for free. Most CEOs are unwilling to put an M&A banker on retainer for a number of reasons, including what conclusion their Board might draw about the CEO's own capability for strategic thought and the problem of how you account for such ongoing expenses to the shareholders.
While they would prefer to take the money, most bankers are comfortable with providing such advice gratis, too. For one thing, it allows them to build trust and credibility with their current and potential clients, in the hope that such groundwork will lead to their being chosen when a real transaction is engaged. This is known as marketing. For another, it enables the banker to collect more of that competitive and industry intelligence which is the lingua franca and lifeblood of his or her chosen profession. This comprises market research. In either event, the banker normally views such work as a small price to pay for an option on a success fee jackpot in the future.
By now, hopefully you see the conundrum at the heart of mergers and acquisitions advice as it is currently practiced and which Mr. Cohan so trenchantly identifies. Everything about the way M&A bankers operate and get paid leads a reasonable observer to suspect that their advice, when given, will point always and everywhere to doing a deal, even when that is arguably not in their client's best interest. How then can you trust that your M&A advisor is truly giving you pure, unbiased advice?
Well, for one thing, Mr. Cohan is too quick to scoff at what he calls the "specious argument" that M&A bankers try to give good advice, even if it imperils an actual or potential fee, in order to preserve their reputation. A banker's reputation does matter, in large part because the M&A world at base is a pretty small one. Senior M&A bankers become widely known, certainly among their own particular clients' industries, and clearly bad or biased advice is noted, filed away, and used against him or her in the future without fail. (If by no-one else, then by rival bankers.) That Mr. Cohan can cite the Campeau story so many years after the fact to point to Bruce Wasserstein's reputation proves my point. (Interestingly enough, Bruce remains important in the business in part because he has such a reputation—one he has carefully cultivated—and because having such a banker on your team can be quite advantageous in certain situations.)
More importantly, however, one must realize that the average client does not want or expect his or her investment banker to give unbiased or neutral advice in a deal context. That is what he or she has corporate lawyers for: they are the advisors who have the fiduciary duty to protect their client from adverse legal, regulatory, and environmental outcomes. In addition, the client relies on him- or herself (with the backing—or prodding—of the Board) to exercise the business judgment to say no to unfavorable business terms. In contrast, the client hires the investment banker to try and fix these problems when they arise, to keep the deal momentum flowing, and to make the deal happen.
Now it would be comforting for many clients to feel confident that their banker could flip a switch if a deal turned irredeemably unfavorable to their client and argue against doing it, but I know of no foolproof structural incentive mechanism that can serve that purpose. The customer must trust his or her banker to do the right thing, if for no other reason than that will preserve the banker's reputation and perhaps make the client more willing to hire him for the next deal.
Putting investment bankers on a time clock, as Mr. Cohan proposes, would not fix this problem. In fact, it would be entirely counterproductive, since it would incentivize bankers to find all sorts of excuses to drag out negotiations and slow down the deal process, in order to pad their billable hours. (A complaint, by the way, which many clients of mine have leveled in the past against their paid-by-the-hour outside corporate counsel.) Putting bankers on the clock would just slow down the process of getting to yes or no, not materially change the distribution of the answers.
I must admit I have some sympathy for Mr. Cohan's suggestion, if only because a change in the way clients pay for M&A advice might enable us to charge for the sort of non-deal-related advice we have been giving away for free for years. For many clients I know, there would be real value to having a trusted advisor on retainer you could turn to to discuss corporate strategy, the markets, and everything else without feeling that you were racking up a colossal debt that could only be repaid with deal fees. However, this goes too much against the grain of current practice. Corporate America is not ready to view ongoing strategic advice in the same way they do management consulting or product research and development: as a proper and necessary business expense. And the biggest companies, who could afford it best, often do lots of M&A already, for which they have internal staff and resources that already show up on the SG&A line. Smaller companies, who really need the help, cannot afford the kind of elevated ongoing retainers which could make general advice-giving a viable M&A business line.
So I am afraid we are stuck with the current system as it is, warts and all. I am not smart enough to figure out a viable alternative.
I also cannot vouch for what Stan O'Neal, Chuck Prince, and other finance industry leaders will say to justify current compensation arrangements when they get hauled up before Congress on Thursday. But I bet with commentators such as Mr. Cohan around, we will have a hell of an effigy burning.
Penny for the guy?
© 2008 The Epicurean Dealmaker. All rights reserved.