Sunday, May 1, 2011

Twilight of the Übermenschen

Are you shooting at me?
This is the true joy in life, the being used for a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the being a force of Nature instead of a feverish selfish little clod of ailments and grievances complaining that the world will not devote itself to making you happy.

...

Beware of the pursuit of the Superhuman: it leads to an indiscriminate contempt for the Human.


— George Bernard Shaw, Man and Superman

* * *

Steven Davidoff opens a recent piece at The New York Times DealBook blog with the following words:

Reputation is dead on Wall Street.

This is powerful language. What does he mean?

Well, for one thing he means that the reputations of individual investment banks are no longer coterminous with the reputations of their executives and employees. He ascribes this to the tremendous growth in scale and complexity of financial markets over the past three decades:

Today’s Wall Street is not the Wall Street of 1907 when J.P. Morgan single-handedly used his reputation and wallet to stem a running financial panic.

Until the 1980s,... Wall Street was made up of traditional partnerships. These were small groups of investment bankers who represented companies in offering and selling securities and occasionally acquisitions. These bankers put their individual reputations on the line, because there were so few of them. Morgan Stanley, for example, had only 31 partners in 1970 and fewer than 1,000 employees.

But this began to change in the 1980s. Trading markets became much more sophisticated, and trading and brokerage became the investment banks’ primary business. This is a technology game. The better the technology, the better the trading and brokerage operation. Individuals became less important.

The growth of more complex capital markets and a global economy also created much larger financial institutions. Morgan Stanley now has more than 62,000 employees. These banks could use their assets and position to compete in the market for finance and trading. Again, individuals were less important as size dominated. A client now trades or does business with a bank based on its positions or ability to make a market or loan. The executive at the bank executing the transaction is unimportant.

In one respect, this is true. Lazard is no longer Felix Rohatyn. Goldman Sachs is no longer Sidney Weinberg. The First Boston Corporation is no longer Bruce Wasserstein and Joseph Perella. But this is old news. All those investment banks (or their successors) have become institutions in the sense that no one larger-than-life personality defines its image, its reputation, or its capabilities.

Professor Davidoff also points out the inverse: that an individual's reputation is no longer irrevocably tied to that of his or her current or previous employers. Both of these observations make intuitive sense. The tremendous scale of large global investment banks normally renders one individual too small and insignificant to make much of a difference. Rarely does a customer deal with one person when they transact with an investment bank nowadays; there are teams and teams of faced and faceless individuals who do a client's bidding. Even in the case of senior executives, who arguably should make a difference and presumably direct and/or set the tone of their firm's operations, the organization is too large and diverse to imbue most individual transactions with significant impact on those executives' reputation. Most customers nowadays are smart enough not to lay the blame for every botched JP Morgan mortgage at Jamie Dimon's feet.

In fact, investment banks have followed the lead of the rest of Corporate America and become brands. This is simply a natural evolution of the economy, in which people no longer purchase goods and services based on the local, individual reputation of a merchant known directly to them. Brands separate reputation from individuals and make it portable across geography, time, and whoever happens to be preparing your Jamba Juice across the counter. Some investment banks—notably Goldman Sachs in the 1980s and 90s—used to make a concerted effort to sublimate individual bankers' reputations and even identities to that of the mothership. Others cultivated the star culture, to greater or lesser success. But now, even a well-educated insider would be hard pressed to identify a material number of individual superstars on Wall Street. Every bank has become a brand first. In my business nowadays, the name on your business card that matters most is not yours; it's the name of your employer.

* * *

But the Professor's description of investment banking is incomplete. If superior technology and gobs of capital were all it took to compete, my industry would have been taken over years ago by the lumbering behemoths of commercial banking. They have always been bigger than investment banks, have much more capital, and have plenty of money to spend on technology and plenty of experience automating financial transactions. And yet the past few decades are littered with examples of huge commercial banks—mostly foreigners—spending lavishly to buy their way into investment banking, only to trip over their own genitals and transfer billions of shareholder euros or yen into the pockets of footloose investment bankers (and thence to their wives, mistresses, and Maserati dealers). Where investment banks and commercial banks have successfully merged, it has almost always been the case that the investment bankers came out on top.

Furthermore, if automation and capital were the only factors which mattered, we should expect to see much more price competition among investment banks than we do. For, as I have mentioned in these pages many times, virtually everything investment banks do is highly commodified. There is almost no transaction, product, or service that Goldman Sachs can deliver to their customers which Morgan Stanley, JP Morgan, or any number of competitors all over the globe cannot deliver that is indistinguishable in terms of perceived quality and actual price. This is particularly true in the areas which Professor Davidoff focuses on for his examples: capital markets lending, underwriting, and trading. We can't even distinguish our product offerings by flavor, like Coke and Pepsi can.

Finally, Professor Davidoff's image of global investment banks as well-funded, highly automated factories staffed by faceless automatons fails to answer a nagging question: Why do investment bankers make so much money? If labor is so interchangeable and replaceable, how come 50% or more of revenues in my industry has historically gone and continues to go toward compensation? If we bankers are so meaningless to our customers, how are we able to skim so much cream off the top? Do not forget that the average Goldman Sachs employee makes roughly ten times the median income of a family of four in this country. And there are plenty of clerks, washroom attendants, and janitors in that average. The average investment banking professional—supposed faceless cog in a vast financial factory—brings home pay which would make the average pasha blush.

If superior technology and vast capital were all that mattered, the Gucci-clad wage slaves would not be bringing home so much of the bacon. If something else wasn't at work, investment bankers who sell non-proprietary, commodified financial services like leveraged loans, equity underwriting, and, yes, even mergers & acquisitions advice would get paid like glorified bank tellers; that is, like corporate lending officers. The only ones who would make any serious money in such a firm would be the topmost executives and the shareholders, just like most of the rest of Corporate America.

Why isn't that the case? Because Professor Davidoff has missed the key, defining feature of investment banking which differentiates it from other financial activities, which provides the "value add" that our customers are so willing to pay so much for, and which explains why labor captures so much of the firm's value. He has missed the fact that investment banks are not factories.

Investment banks are networks.

* * *

I have made this point many times before.

Notwithstanding what they like to tell you, investment bankers don't really sell "ideas." They sell connection, and access, and they are successful to the very extent they can maintain themselves in the flow of market information. Investment banks derive their market power and importance by maintaining dense and robust information networks across the numerous markets they participate in. This makes them better traders, better investors, and better advisors.

When our clients ask us to underwrite a debt or equity offering, they want access to our network of contacts among buy side investors and our network knowledge of the capital markets. When counterparties trade financial instruments like securities and derivatives with us, they want access to the breadth and depth of our trading network and the capital of our trading counterparties and our own proprietary books. When a client asks us to advise them on a merger or acquisition, they want access to our network of potential buyers and sellers and our network knowledge of the M&A markets in their industry. Networks are absolutely central to the power and value which investment banks bring to their clientele. It's what we're selling.

And networks lie at the nexus of the conundrum we have been considering. For having a differentiated network in a particular area can enable a bank to distinguish itself from its competitors. While any bank can underwrite an initial public offering, a bank which develops a reputation for being the best at, say, health care IPOs can attract new business and maintain market leadership in that area. The peculiar power of networks is well known: they derive their power and effectiveness from their completeness, breadth, and depth. And these features make it easier to attract new connections into the network to make it stronger. Network strength builds upon itself.

The other particular feature of networks is that they consist of interconnections made among nodes. A moment's thought will convince you that, in the case of networks comprised of constantly changing information and personal relationships, the nodes of an investment banking network are its people. Investment bankers are powerful—and get paid a lot of money—because they are custodians of their firm's power: its networks. You simply cannot automate the most interesting market knowledge or access to external aggregations of people and capital which are constantly forming and reforming, much less the personal relationships and insights which most of these are based on. Furthermore, that knowledge is portable. If a banker ups and leaves, he or she takes his or her network of contacts, knowledge, and relationships with him or her, usually to a competitor.

This is the source of the peculiar tension between individual investment bankers and the "platforms" from which they operate. Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.

* * *

So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.

One last thing is worthy of note. The network of relationships and market knowledge which each investment banker carries is a local one; that is, it is limited in scope and power to the industries or markets he or she participates in. My knowledge of M&A, capital markets, and the participants and dynamics of Industry X is valuable to my clients in that industry, but it is largely meaningless to a proprietary trader on my firm's govvie desk or a structured products banker packaging and selling mortgage derivatives, much less to their clients or customers. This has always been true. What has changed is that banks have gotten so big, global, and interconnected that the network of any individual employee—no matter how prominent—has become incrementally less important to the overall picture.

Which is only to say that, were he to work at a big global investment bank today, living legend and networker extraordinaire Felix Rohatyn would probably be just another schmuck with a corner office.

Of course, he'd probably be paid a lot more, too.


© 2011 The Epicurean Dealmaker. All rights reserved.