Friday, September 30, 2011

A Hard Rain’s Gonna Fall

All your compensation are belong to us
“Have you ever stood and stared at it? Marveled at its beauty, its genius? Billions of people just living out their lives. Oblivious.

“Did you know that the first Matrix was designed to be a perfect human world, where none suffered, where everyone would be happy? It was a disaster. No-one would accept the program, entire crops were lost. Some believed that we lacked the programming language to describe your perfect world, but I believe that, as a species, human beings define their reality through misery and suffering. The perfect world was a dream that your primitive cerebrum kept trying to wake up from. Which is why the Matrix was redesigned to this: the peak of your civilization. I say your civilization, because as soon as we started thinking for you it really became our civilization, which is of course what this is all about.

“Evolution, Morpheus, evolution. Like the dinosaur. Look out that window. You’ve had your time. The future is our world, Morpheus. The future is our time.”

— Agent Smith, The Matrix

Things must be getting pretty ugly on the trading floors of big investment banks worldwide, O Dearly Beloved. If you still have any friends or acquaintances desperately clinging to such formerly gainful employ, you would be kind to spare them a tear or a LinkedIn invitation or two. I am sure they would appreciate the gesture.

You wanna know how I know that? Well, if the constant drumbeat of articles trumpeting the death of proprietary trading and its enabler, mountains of cheap capital, weren’t enough, how else could one explain this?:

One of the mysteries of investment banking is why M&A is held in such awe. Advisory bankers swan around like they own the place. They have the nicest suits. The senior ones are also difficult to fire, insisting they nurture the crucial relationship with corporate clients (in spite of perhaps not having done a deal in years). M&A activity in 2011 could fall 5 per cent below last year’s volumes despite a strong start, according to Keefe, Bruyette & Woods. Against a backdrop of declining activity, there are three good reasons why M&A should be brought back to earth.

Or this?:

Meanwhile, [M&A] prima donnas take home bank. But do they make profits for their firms? Or is the big money in the deal add-ons, like providing financing to pay for takeovers? We’ll never know for sure, but our money is on the drones and not the guys in pinstripes.

In my day, we used to call such patently bought and paid-for hit pieces “advertorials.” I hope the FT’s Lex team and DealJournal’s writers got nice honoraria for their troubles, or at least a couple of beers or so. Because as reporting goes, both pieces are complete and utter bullshit.

* * *

Not that I disagree with most of the facts and assertions both articles present,1 mind you. Mergers and acquisition revenues have always been volatile and highly cyclical; they are tightly tied to the business cycle and trends in financial markets. They are also without doubt tiny in relation to the enormous revenue from the sales and trading (capital markets) side of the house at integrated investment banks. This has been true for more than a decade, ever since the capital markets divisions of global investment banks looked at the tsunami of cheap liquidity flooding the world financial system and decided they would like a taste. No M&A or corporate finance banker in the business longer than six months would attempt to deny this. Why else do you think so many major integrated investment banks—the Great Vampire Squid preeminent among them—are run by short-sleeve-wearing, onion-cheeseburger-eating troglodytes from the trading floor?2

But given this very power and earning disparity between the advisory and capital markets sides of the business, why did the leading organs of financial journalism on both sides of the Atlantic feel compelled to chew up column inches with snarky attacks on M&A bankers? Why pick on the little kid? Whence also the frat bro sniping at “nice suits” and “pinstripes,” as if knowing how to knot a tie or deigning to wear nice clothes more than twice a year were somehow sins against “authenticity” or some such puerile bullshit? What’s the fucking point?

I’ll tell you what the fucking point is: everyone on the trading floor of every leading investment bank is about to get fucking fired.

* * *

Now of course that is untrue, and a gross exaggeration (although one my rough-hewn compatriots on the turret phones can appreciate). But it is no exaggeration to say that the capital markets gravy train of the past ten years or so is coming to a rapid, screechy, and highly painful end. The Volcker Rule, Basel III, and the re-emergence of actual, functioning risk management from the bowels of the Chinese opium den where it has been languishing for the last decade will see to that. Gone are the days of 60-to-1 leverage, compliant regulators, risk-loving shareholders, and politicians who could afford to turn a blind eye to an industry which used implicit government backstops as collateral in the global casino. This will put massive pressure on revenue, profits, and compensation in capital markets divisions everywhere. And if there’s one thing senior investment bank executives know how to do when faced with compensation pressure, it’s fire people. Lots of people.

The other thing senior managers know how to do is fight for a bigger share of the bonus pool, especially when said pool is shrinking faster than homeowners’ equity in Nevada. Hence the perennial resuscitation of tired old arguments and clichés about bankers on the advisory side of the house—that they are prissy peacocks who add no value and steal credit for revenues properly earned by sales and trading—in order to preserve one’s own subordinates’ share of the compensation pie. Of course, when sales and trading was demonstrably bringing in many multiples of the revenue that advisory was, capital markets executives had little need for such arguments. They could just point to their profit and loss statements and tell senior management how much they expected to keep. As far as they were concerned, the midgets in M&A could suck it. But now that the worm has turned, and steroid-fueled sales and trading profits from structured products and proprietary trading are evaporating in the noonday sun, capital markets managers have been reduced to jawboning and badmouthing their colleagues in the press.

So congratulations, Lex and DealJournal, you’ve just been reduced to shills for traders in their internal bonus discussions. You might want to check your sources’ business cards to see which division they work for. As if you don’t already know.

* * *

The other major criticism or insinuation our beloved fourth estate sock puppets parrot for their sales and trading overlords—that M&A and corporate finance bankers’ claim to add value via access to corporate clients is untrue—is no more than tendentious, uninformed bullshit. For one thing, the reason so many of us wear nice suits and ties is because we actually meet with real, live clients on frequent occasion. This is in strong contradistinction to most of the denizens of the trading floor, whose primary contact with people outside their own firm consists of punching a preprogrammed button on their turret phone and talking to their similarly Dockers™-clad counterpart over a Plantronics headset. Unlike the hedge fund and institutional investor counterparties investment bank traders deal with—who trade promiscuously with everybody on Wall Street and who don’t give a rat’s ass whether they like or even trust the trader in question, as long as he completes trades as he said he would—getting corporate clients to do transactions requires building trust and rapport over many years. This is absolutely the case in pure M&A, where no capital markets financing or derivative transactions are involved, but it is also true in more general corporate finance contexts.

I have stated time and time again that, notwithstanding the delusions of so many of my peers, there is no service or product on Wall Street which is not completely commoditized. This is true of M&A advice, but it is particularly true of any product or service flogged from a capital markets desk. Proprietary products can be and are reverse-engineered within weeks, if not days, and plain vanilla shit like high yield bonds, interest rate swaps, or initial public offerings are a dime a dozen. There is literally almost nothing Goldman Sachs can do that Morgan Stanley, JP Morgan, Bank of America, or even short-bus rider Citigroup can’t do equally as well.

Hence, Lex’s assertion,

Perhaps clients would buy other products because they are excellent in their own right and not because of an introduction from advisory.

is on its face ludicrous. First, because no bank has any monopoly on excellent products for any length of time. Second, because there is no-one on the capital markets floor of any big investment bank who has close, proprietary relationships with corporate issuers which would encourage said issuers to agree to do deals with him directly. That is not his job. It is the job of the corporate finance or advisory banker to make the introduction to the product guy. It is the product guy’s job to structure, issue, and sell the resulting product. They work together.

In a similar vein, Lex’s uncritically repeated assertion that some M&A “standalone cost-income ratios... can be as high as 400 per cent” is just dumb. If any coverage or advisory banker truly got paid four times the actual revenue he or she brought in, rather than getting fired on the spot, he or she must have some really indiscreet photos of the CEO with a well-oiled goat. Part of the advisory banker’s job—as opposed to, and often in addition to, pure M&A advice—is to give his or her client access to the entire range of products and services the bank offers. If that client transacts capital markets deals with the bank, the coverage officer who made the introduction deserves some of the credit (and pay). Saying otherwise is like saying a Boeing salesman doesn’t deserve to be compensated for selling planes because he doesn’t actually build them. That’s just stupid.

* * *

In any event, my entire industry faces a very painful restructuring as the high-octane profits of structured products, proprietary trading, and massive trading volumes driven by global uncertainty ineluctably dry up. In such an environment, where capital is no longer either cheap or plentiful, business lines which can make money using minimal capital necessarily acquire greater power and prominence. Given that pure M&A uses exactly no capital, it is only natural that M&A bankers will reacquire some of their old influence within investment banks. When financing is tight, it’s hard to argue with an infinite return on capital.3

Of course, I continue to maintain that integrated investment banks live or die by the inextricable cooperation of their advisory and capital markets arms. We are tied together at the hip, and that which hurts one of us will hurt the other, too. So I take no particular pleasure in noting the imminent demise of thousands of my capital markets brethren across the industry. I just take care to note that my fellow sentient programs and I expect a rather larger share of the pie than before.

1 Chronologically, the Lex article appeared earlier, and it provides the meatier substance of the two. The DealJournal piece does little more than parrot Lex and toss in a few jejune Americanisms (“take home bank”) favored by the 20-something tyros who staff the nether regions of big banks, presumably for the benefit of native readers unfamiliar with language heard outside the lacrosse field. Not that I’m judging or anything.
2 I kid, I kid. But, really, I have to get some digs in of my own, don’t I? You should know by now that I’m no saint.
3 It is also no matter of indifference in today's environment that when an M&A banker screws up or fails to close a deal, he loses only time and a potential fee. When a prop trader or structured products banker screws up, he can blow a hole in the side of his bank larger than all the revenues earned by all of his compatriots all year. And when a whole industry of capital markets bankers screw up, it can blow a trillion dollar hole in the side of the global economy. Or so I hear.

© 2011 The Epicurean Dealmaker. All rights reserved.