Wednesday, September 9, 2009

Never Say Never

I might like you better if we slept together
I might like you better if we slept together
I might like you better if we slept together
But there's something in your eyes
That says "maybe."
That's never.
Never say never.

— Romeo Void, Never Say Never

Goldman Sachs CEO Lloyd Blankfein gave a speech earlier today in Frankfurt, Germany at the Handelsblatt Banking Conference. As befitting an address delivered by an anointed power broker and Führer of vampire squiditude, it was an anodyne and uncontroversial exercise designed to smooth the brow of regulators, populist demagogues, and Rolling Stone correspondents alike. Even so obstinate a heretic in the despite of investment banking as Felix Salmon seemed to approve, or at least did not find it too objectionable.

While I personally did not object to the bulk of Mr. Blankfein's peroration, I would be less than candid were I to confess I had no reservations with his remarks. Of course, being Dedicated and Discerning Readers of mine, you already suspected that.

* * *

Amidst the other chestnuts which Lloyd chose to strew before the upturned gaze of his rapturous audience was this summation of Goldman's "detailed principles of compensation":

  • The percentage of compensation awarded in equity should increase significantly as an employee’s total compensation increases.
  • For senior people, most of the compensation should be in deferred equity. Only the firm’s junior people should receive the majority of their compensation in cash.
  • An individual’s performance should be evaluated over time so as to avoid excessive risk taking and allow for a “clawback” effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.
  • No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer term interests of the firm and its shareholders.
  • To avoid misaligning compensation and performance, multi-year guaranteed employment contracts should be banned entirely. The use of these contracts, unfortunately, is a common practice in our industry. We should all recognize that they are bad for the long-term interests of our industry and the financial system.
  • And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

The first two points say the same thing: the more money you make, the more funny paper you get crammed down your gullet instead of cash. This makes complete sense, and amounts to a restatement of standard industry practice.

It's true that senior management expects its junior bankers to work so hard and so long they will not have any time to spend their disposable income or even rest their weary heads on a surface more closely resembling a pillow than the stained carpet under their desks. Nevertheless, common sense and common decency dictate that one should endow one's foot soldiers with enough legal tender to pay their rent and buy an occasional meal on their own dime. Paying 22-year olds pulling down $85 to $100 grand more than token amounts of unvested stock is guaranteed to be counterproductive, if only because they will be forced to commute to work from New Hampshire. (You try finding a halfway decent apartment in Manhattan for less than two grand a month.)

As a corollary, beyond a certain level, cash compensation—while nice for the recipient and his hangers-on—can only encourage a distorted worldview, negative social externalities like inflated real estate and luxury goods prices, and disturbingly louche behavior. Far better to align an investment banker's incentives with those of his firm and external shareholders by stuffing him to the gills with long-dated unvested stock and options and forcing him to hold onto them for years. Heck, this also has the neat side benefit of boosting the investment bank's equity capital base with the hard-earned sweat equity of its indentured servants most productive employees. (Too bad ol' Lloyd didn't follow his own advice back in 2007, when he took 40%, or $27.4 million, of his record $68.5 million total compensation in cash.)

Lloyd's third point is all very well and good, too, albeit a little vague. He does not really explain what this "clawback" mechanism looks like, or when it would apply. It could be explicit, and actively applied—for example, in the case of fraud or a profitable trade blowing up two or three years after it was booked—or implicit, and tied to the overall results and share price of the firm.1 I think Goldman's senior executives are clever enough to leave it vague. It gives them more power over any employees who decide to get uppity or fractious.

Point number four is a fine, well-intentioned principle more honored in the breach than in the observance across Wall Street. Interestingly, Goldman Sachs is one of the few firms which pays more than lip service to this ideal. Compensation is one of the most powerful tools in the investment banking manager's arsenal, outside of firing someone and frog-marching their ass out the front door. If senior management uses it to explicitly reward teamwork—by, say, paying a good bonus to a banker who had a crappy year personally but helped out unselfishly elsewhere—and punish its opposite—by docking the pay of a productive banker who steals credit, backstabs, and generally acts like a complete asshole—then you will see marvelous improvements in the level of teamwork across the organization. You might even become Goldman Sachs in time.

Finally, Lloyd's last point strikes me as a little draconian. In my view, it's a little unreasonable to expect a 30-year veteran of the firm to live in relative penury because he can't withdraw any portion of the $250 million he's got socked away in Goldman stock until he retires in five years. If anything, such restrictions might encourage just such a seasoned, experienced banker to retire early in order to enjoy a little of his ill-gotten gains for a change (or at least get his wife and mistress off his back). This happened more often than not during Goldman's pre-IPO partnership days, by the way, when the compensation system followed just such a principle. You got fabulously rich as a Goldman partner, but you couldn't enjoy it until you were too old and tired to do so. We no longer live in such self-denying times, so it is silly to think such a plan would fly. Just make sure the locked up portion of the senior exec's stock is big enough relative to his total wealth, and you will definitely keep his eye on the ball. More than that will encourage cheating, borrowing against unvested stock, and other potentially risky and counterproductive behaviors.

* * *

Where Lloyd and I truly part ways is at his fifth, or penultimate point, about guaranteed employment contracts. He is not shy about declaring his dislike of them, and wants them banned. I disagree with him in principle (more later), but I also think it incumbent upon me to inform my Loyal Audience that the Grand Poobah of Broad Street is talking his book.

Goldman is well known across the Street for not offering multi-year guarantees to senior recruits (presumably single year guarantees are okay). There are sensible business reasons for resisting them: they increase fixed costs in a highly volatile business, they diminish short-term pressure to perform for their beneficiaries, and they increase resentment among the rest of the bankers who do not have guarantees. They also prevent managers from using compensation as a tool to enforce teamwork, at least while the guarantee is in place. I know for a fact, however, that Goldman has given very lucrative guarantees to senior recruits in the past, so it is not completely unheard of there. But mainly Goldman dislikes guarantees because they are more likely to have their producers poached by the competition than to be poachers themselves.

As befits a shop that focuses intently on building and preserving a strong and unique culture, Goldman prefers to grow its bankers internally. They are big enough, and successful enough, that they rarely need to search for senior bankers from outside the firm. The rest of Wall Street, on the other hand, views Goldman as its farm team: an outstanding source of well-trained, hard working bankers who make up for any personal shortcomings with an impressive carapace of mystique. Hence, when competitors come knocking on Goldman bankers' doors, they bring big, fat, multi-year guarantees to shake them free from the mother ship. If the banker is amenable, then Goldman must decide whether to counter the poacher's offer with a guarantee of its own or suffer a potentially painful defection. Neither is a pleasant alternative.

You can see why Blankfein hates them, but that is no general argument against multi-year guarantees.

* * *

Most investment banks use multi-year guarantees to recruit senior producers: Big Swinging Dicks, in the parlance of our time. They hire guys and gals with big clients and big Rolodexes to build new businesses or to ramp up penetration and market share in existing lines. They pay guarantees, and suffer the associated disadvantages and risks attendant upon them, because they have to.

I know it sounds hard to believe nowadays, but investment bankers are a surprisingly risk-averse bunch of people, at least when it comes to their own personal financial situation.2 Getting one to jump ship from the sweatshop hellhole he knows—where he has history, understands the labyrinthine internal politics, and pretty much knows who is out to get him and who has his back—to another sweatshop hellhole he doesn't is no easy matter. The average banker would be a fool not to push for a guarantee, and, if he has been recruited to build a new business which will take several years to get off the ground profitably, he would be a fool not to press for a multi-year guarantee.

Recruiting banks pay it because it is an investment. By "buying" a revenue-generating banker, they are buying a producing asset, just like an offshore drilling platform or a new assembly line. Who wouldn't expect to pay a lump sum to get control of such an asset? Last time I heard, it was common practice to pay signing bonuses to new recruits across a wide range of industries, and senior executives have enjoyed multi-year guarantees for years as a perk of their job hopping. Proven assets of production are valuable, no matter the industry, and they cost money to acquire and maintain.

* * *

More to the point, one of the most prevalent knocks against guaranteed compensation is that it supposedly increases investment bankers' risk appetite. This is just nonsense. If the bank has hired well, a guaranteed bonus allows the recruited banker to focus on all the things he was hired to do, like building a business, establishing and developing internal and external networks at his new employer, and contributing to a long-term sustainable franchise. By definition, he does not have to worry about short-term results, so he has no incentive to chase ambulances or pursue high-risk, high-reward opportunities. One of the tricks about guarantees you eventually learn as a banker is while the contract states they are guaranteed minimums, the reality is that they are guaranteed maximums, as well. There is absolutely no incentive whatsoever to hit the cover off the ball, or to chase bad business for short-term gain.

Of course, this caveat does not apply if the multi-year guarantee is not fixed, but rather takes the form of a percentage of revenue or operating profit.3 There, you can plainly see there is every incentive to pursue revenue at the expense of risk. Such arrangements could indeed worsen a bank's risk position if they are not monitored carefully. Nevertheless, as Lloyd himself states,

it is important to recognize that while incentive structures should be improved across our industry, that is no panacea for poor risk management.

Compensation is a necessary method of managerial control, but it is not a sufficient one. I continue to maintain that it was not even the determining one during the recent financial crisis.

I am not insensitive to the fact that the compensation figures we investment bankers bandy about as a matter of course seem outrageous, if not obscene, to the vast majority of citizens outside our incestuous little bubble. This has always been the case. What makes it different now is that everyone is paying attention, due to the not inconsiderable fact they have pulled my industry's collective chestnuts out of the fire at great and painful collective expense. Joe Sixpack now has a vested interest in how we do things, and he is not pleased by what he sees.

Nevertheless, far too much of the heat generated in the mainstream media and blogosphere about compensation is, for all intents and purposes, beside the point. Guaranteed compensation is just one more red herring in the net.

1 If you doubt the efficacy of such a mechanism to claw back years of potentially inflated results and unwarranted stock price appreciation, I suggest you have a chat with your local Bear Stearns or Lehman Brothers employee over a few beers one evening. Just remember to bring lots of Kleenex, and expect to pay the bar bill yourself.
2 It's not that hard to believe, if you think it through. If you had set up a lifestyle which cost north of half a million to a million dollars per year—not so outrageous for a family of four in New York City, by the way—and all you had to support it was a "guaranteed" salary of $400,000 plus whatever cash savings you could liquidate until your next bonus—which could be anything from $0 on up—you would be pretty damn conservative, too. It takes a lot of money in the bank—liquid money; cash money—to get your average investment banker to relax about money. Then again, given how much stock most big banks stuff their senior bankers with, why should any of them ever relax? Just ask former centimillionaires Dick Fuld or Jimmy Cayne to answer that one.
3 During the portion of my career when I worried about such things, these were relatively rare situations. Perhaps they have become the dominant form of multi-year guarantee out there, but I doubt it.

© 2009 The Epicurean Dealmaker. All rights reserved.