Sunday, August 14, 2011

Investment Banks of the Plain

It’s not as pretty in real life as in a museum.
Robert Rauschenberg, Monogram, 1955–1959

Passion aficionado and sesquibajillionaire Ken Griffin has finally “given up his dream”—according to a slightly breathless New York Times DealBook—to create an investment bank with the heft and prestige of Goldman Sachs. According to reports, he is shutting down the sell-side equity research division of his hedge fund, Citadel Securities, and putting his runty investment bankers out on his front lawn in a cardboard box marked “PUPPIES – 20¢ Eech, or Free 2 a Gud Home.”

Somewhere, Lloyd Blankfein is heaving a sigh of relief... — No, scratch that. He’s saying “Ken who? He was trying to build what?”

I mean seriously, people, the only sleep Lloyd Blankfein and the other CEOs of established Wall Street firms lost over Griffin’s quixotic quest these past three years has been prior to industry social functions—like the Robin Hood Foundation gala, where hedgies compare the size of their penises charitable contributions in public—where they’ve had to listen to him boast about how he was going to eat their lunches, before asking in a hushed aside whether they knew any good candidates to head his pissant investment bank. And the only reason they lost sleep, and didn’t spin on their heels and sprint away the minute they caught sight of him, was because the hedge fund side of his business was such a monstrous (potential) contributor to their sales and trading and prime brokerage revenues.

In contrast, Ken Griffin’s investment bank was a bad joke.

* * *
Now, an onlooker sympathetic to Griffin’s chief premise—that there was an opening in 2008 for another major investment bank, one which could compete with reputationally damaged, financially weakened giants like Goldman, Morgan Stanley, and Bank of America Merrill Lynch in the immediate aftermath of the financial meltdown 1—might claim that Ken’s fundamental error was one of execution, not conception. Certainly, he seems to have made a monumental hash of the most important task before him: hiring the right professionals to staff his folly. Over the course of its brief existence, Citadel Securities became an industry laughingstock for the frequency with which Griffin hired and fired the heads of his bank and senior business unit managers. You just can’t do that if you intend to build an investment banking franchise, for the simple reason that no-one below the level of Master of the Universe who doesn’t have fully portable compensation and a self-sustaining reputation will risk their career to work for such a shitshow. And any MoU worth his or her salt won’t sign up either, because whatever ruinously excess pay Griffin had to offer to lure them in wouldn’t be worth the brain damage of adapting to a constant merry-go-round in the executive suite.

Corporate finance and M&A are labor intensive in a way the typical capital markets salesman or trader has no idea: you need good people below you programming the models, writing and producing the pitchbooks, and handling the myriad details of an active deal process to run any sort of functioning business underwriting new issues and doing deals. You just don’t sashay into the office at 7:30 am every morning, plug your headset into the turret phone, fire up the MBS derivative valuation model, and try to make some money. We chase clients and opportunities for years before we see revenue dollar one, and much of the time we never earn anything. But like Woody Allen supposedly said about life, 80% of investment banking is just showing up: year-in, year-out, building presence, reliability, and credibility with clients so that when they eventually do have a deal to do, you have a decent chance of winning it.

Also, unlike much of capital markets, investment banking (corporate finance and M&A, natch) does not lend itself well to economies of scale. It takes approximately the same effort and labor to execute the sale of a $150 million company that it does to sell a $5 billion one. In fact, given the usual relative lack of sophistication and experience of smaller clients, it often takes more. It is a further truism that every deal is different: there are no clients in M&A or equity underwriting where a banker can take a prior deal summary down from the shelf, dust it off, and present it to the client to win the deal. Finally, the scale and financial heft of an investment bank matters less to most clients in selecting new issue underwriters and M&A advisors than does its reputation, credibility, and track record. This is one reason why deals on my side of the house are rarely won by the bank offering the lowest price, and why prices for IPO underwriting and M&A deals remain stuck stubbornly at the same levels they have been for 30 years.

* * *
Notwithstanding my undeniable joy in busting their balls, I admire talented traders and hedge fund managers immensely. They have a rare and distinct skill set and personality which is tailor-made for success in today’s global financial markets. But almost to a man, they are lousy at building real operating businesses. One of the key psychological traits of top traders—their ability to change their minds on the fly, experiment with risk where they see financial opportunity, and change business models as often as they change clothes—is fundamentally incompatible with building stable operating businesses where success and profitability rely upon consistent execution and sustained market presence. Hedge fund managers I know treat operating committee meetings like investment committee meetings: this strategy isn’t working, let’s shut it down; this market is on fire, let’s throw another 20 people at it and see if we can make money; here’s a talented banker in an industry we have never covered, let’s hire her and see whether she can build a business by herself before we give her any resources. You just can’t run a real business—including, believe it or not, an investment banking business—like that. It’s stupid to try.

I suspect Ken Griffin failed at building the next Goldman Sachs for a number of reasons. For one, he misunderstood the source of Goldman’s (and others’) success in investment banking. He thought it derived from their gigantic, market-moving presence in global financial markets. Instead, Goldman has maintained a market-leading spot in M&A and underwriting almost in spite of their position as one of the world's largest hedge funds. Goldman is strong in those areas because it has always been strong there, because it has been a premier advisory bank for almost its entire history. If anything, Goldman's strength as a white shoe advisory boutique enabled its evolution into a world-straddling financial behemoth, not the reverse.

Second, Griffin’s undeniable talents as a hedge fund manager and trader made him far too mercurial to be the strategic visionary behind a major investment bank. While I would not discount the corrosive effect of his famous temper on employee relations, I guarantee you the main reason so many senior investment bankers left so quickly from Citadel is that Ken kept changing his mind about strategy and tactics. Investment banking just isn’t that hard. You pick a strategy, you pick the right personnel to execute it, and you wait. Investment banking on my side of the house requires the virtues of an investor: careful thought, committed investment, and patience. I know few top-flight traders who possess anywhere near the required measure of the latter.2

* * *
In any event, the reverse of Ken Griffin’s strategy—building a world class hedge fund within a full-service investment bank—hasn’t worked out very well either. As soon as a trader gets enough experience and reputation to strike out on his own, he’s gone. Good hedge fund traders who can make money on their own don’t need or want the massive infrastructure, byzantine bureacracy, compliance strictures, and cap on upside compensation which a modern global investment bank demands for its very existence. Perhaps if Mr. Griffin had spent a little more time trying to understand the incompatibility of banks and hedge funds from this, very well-documented direction, he might have spared himself a few years and several hundred million dollars worth of trouble. But then again, I suppose he’ll just chalk it up to just one more bad trade in a lifetime of many: no harm, no foul.

Investment banking + hedge funds. Like most unnatural acts, it always sounds better in concept than it turns out in execution. And it always hurts way more than you expected.

1 I would not be one of them. Investment banking has never wanted for ass-chafing competition in any of the 20+ years I have practiced in it. I daydream fondly about the day it will.
2 Most of them would ask, “Why throw good money after bad?” I (and other investment bankers) would retort, “If the strategy is correct, you have to give it time to bear fruit.” You may guess that traders and investment bankers rarely agree.

© 2011 The Epicurean Dealmaker. All rights reserved.