Sunday, January 29, 2012

The Rape of Persephone

Don't worry. The bruises will heal.
I never saw a wild thing
sorry for itself.
A small bird will drop frozen dead from a bough
without ever having felt sorry for itself.

— D.H. Lawrence, “Self Pity”

Now that Mitt Romney is running for the GOP nomination for President, it seems everybody and his brother is taking a whack at the private equity piñata. James Kwak recently took his turn at bat, and James Surowiecki clocked a couple swings himself. To their credit, both of them do a halfway decent job describing the private equity model, but neither one can be characterized as a fan. Kwak fears that private equity is too tempted by lax and imperfect financing markets to loot the companies they buy and leave creditors and employees in the lurch, and Surowiecki is displeased that so much of the profit in private equity is subsidized by taxpayers. Both of their criticisms hinge heavily on the financial leverage commonly used in private equity investments, so it is worth reviewing the concepts and practices in a little detail.

Private equity firms (or financial sponsors, as they are more commonly known in the trade) normally raise funds from a collection of institutional investors (“limited partners,” or LPs) like state pension funds, university endowments, sovereign wealth funds, insurance companies, and other asset managers. The sponsoring firm acts as general partner for each fund, and has a fiduciary duty to the fund’s limited partners to invest their funds prudently, profitably, and in accordance with the fund agreement. Each fund is an independent legal entity which has a limited life—normally ten years—and the goal is for the private equity firm’s professionals to invest the monies available in a discrete number of majority, minority, or other investments in particular businesses. For each such investment, the sponsor expects to hold the investment for some period of years less than the life of the fund from which the money came, and when the time comes the general partner will sell the fund’s investment on behalf of the LPs and split the profits, if any, with them.

Now most financial sponsors tend to invest in majority, or “control” stakes in discrete companies. That means they purchase a majority of the voting control (and economic value) of a standalone business, and they work closely with the management of the purchased company to realize their investment objectives. Usually, the senior management of the purchased firm holds a substantial minority equity position in the company—normally subordinated to the financial sponsor’s stake, and often in the form of common equity shares and options—which aligns their interests and incentives tightly with the financial sponsor and their limited partners. Sponsors buy these companies wherever they can find them: from private owners, family founders, publicly traded companies, the subsidiaries of larger companies, etc.

* * *

Deeply simplified,1 a typical control buyout looks something like this: Financial sponsor Big Bucks LLC negotiates the purchase of Company ABC for $200 million through its new special purpose acquisition company New ABC. ABC earns operating cash flow, or EBITDA2, of $25 million per year, which means the purchase multiple, or total enterprise value3 to EBITDA multiple, of the business is a very healthy 8 times. Prior to, simultaneous with, or after closing the transaction, Big Bucks sources debt financing to help purchase ABC from one or more lenders, which may be investment banks, commercial banks, hedge funds, or any number of institutional investors. (Some of these direct lenders are the same or similar institutions that invest as limited partners with private equity firms like Big Bucks.) Let’s assume the lenders like ABC’s business and credit profile, so they are willing to lend a generous 5 times EBITDA or $125 million to New ABC to help buy ABC. Big Bucks puts up the balance required, $75 million, in the form of equity. (Pace Mr. Kwak, this is a far more common capital structure nowadays than the 80% debt/20% equity structure he posits in his article. In large part this is due to competition among buyers of corporate assets.) Big Bucks puts a few members of its deal team on the Board of New ABC, and it’s off to the races.

In a perfect world, Big Bucks would like to exit from its investment within three to seven years, having made a hefty return on its limited partners’ money. To do that, the equity value of the company must rise. If the sponsor can realize a final equity value in excess of its initial investment of $75 million, it wins; if not, it doesn’t. It’s as simple as that. There are only three basic ways the final equity value of New ABC can get bigger than the initial investment: the multiple on sale increases, the sponsor uses the company’s cash flow to pay down debt due, and/or the company’s earnings increase. (Remember the lenders must be repaid first, so the equity value is simply the residual of the sale proceeds after debt has been repaid or refinanced. If the debt balance declines—assuming the enterprise value remains the same—equity value must by necessity increase.)

Now the first value creation method—increase in the selling multiple—is almost entirely outside the control of the financial sponsor. It depends on market conditions at the time of sale, many years distant, and demand among buyers for New ABC. Sometimes the sponsor can tilt the field in its favor by buying the asset particularly cheaply, but the growth in the private equity industry itself and the increased competition among rival sponsors has made this opportunity increasingly scarce. In addition, sell-side advisors and investment bankers like Yours Truly do everything in our power to prevent any buyer, financial sponsor included, from buying companies cheaply. Much to private equity’s chagrin, we have gotten pretty good at it.

The second method requires the sponsor to use excess cash flow generated by the business (after it pays suppliers, employees, interest expense, and the like and invests required money in maintaining or improving capital assets and financing the company’s working capital needs) to repay the debt used to buy it. But given that financial sponsors typically try to minimize the amount of equity they put up in the first place (remember: their return on investment depends on having as small a denominator as possible), they usually load the business up with as much debt as prudently possible at the outset. This means, after accounting for cash operating expenses and required capital and working capital expenditures, the typical private equity investment has very little free cash flow to direct toward debt. Unless the company’s earnings and free cash flow increase, the only way to direct more cash toward debt repayment would be to starve capital expenditures, cut operations to the bone, and generally milk the property dry. This is the caricature of private equity as “vulture capitalism” which so many commenters condemn.

But this rarely happens, and almost never intentionally. Because remember: the private equity firm and its investors only make money if they take more money out than they put in. And starving a company of resources it needs to sustain and grow future earnings destroys value. Think about it: the next buyer of the company is almost certain to be a sophisticated buyer itself, and they will figure out pretty quickly if Big Bucks has permanently weakened New ABC’s earnings power. If so, it will pay less, and the reduced debt balance will likely be more than offset by the lower value it offers for the entire business. Levering up businesses with huge amounts of debt and making your equity returns primarily from the paydown of debt with excess cash flow was the old model of the leveraged buyouts of the 1980s. It only worked then because private equity firms could get businesses cheaper than they can now. Fierce competition has shut this sort of financial engineering down.

So the only reliable model for private equity to make the returns it promises to its LPs is to increase the earnings of its portfolio companies. And that is what they all try to do. Sure, a lot of this involves cutting costs, and labor costs are often one of the biggest line items in company income statements which can be trimmed. But private equity also looks to improve the sales and margins of its companies, and this often entails increased investment in productive assets, company infrastructure, and, yes, employees. Many financial sponsors invest additional cash in their portfolio companies over the life of their investment, in order to support increasing sales, improved productivity and margins, and occasionally add-on acquisitions. Their objective is to make the company stronger and healthier than it was when they first bought it, and hence more valuable. Financial sponsors frankly don’t care whether increasing EBITDA and free cash flow comes from cost-cutting or revenue and margin increases—a dollar is a dollar is a dollar, after all—but most of them are fully aware that the latter is normally sustainable in a way the former is not.

* * *

One more wrinkle is worth discussing. This is the relatively recent phenomenon of financial sponsors borrowing additional debt through their portfolio companies during the life of their investment, and using the proceeds to pay equity dividends to themselves and their limited partners. These are known as dividend recapitalizations, or “dividend recaps.” Often, financial sponsors can use such recaps to withdraw money equal to or even in excess of their initial equity investment. This leaves the portfolio company with an increased debt burden and the financial sponsor playing with house money. Many people outside the industry, including our friends Messrs. Kwak and Surowiecki, don’t like dividend recaps, because it loads up the portfolio companies with risky debt while appearing to reduce private equity’s skin in the game. This is very true.

However, having participated in or observed a number of such deals, I must strenuously disagree with Mr. Kwak’s contention that the lenders which participate in such transactions are unsophisticated dupes. They lend with eyes wide open, after having done an impressive amount of company-specific due diligence. Normally, a company is able to take on a bigger debt load because the financial sponsor and company management prove to new lenders that they have improved the company’s earnings power and free cash flow enough to sustain it. In our example, if Big Bucks had sustainably boosted New ABC’s EBITDA from $25 million in year one to $50 million in year three, the same lenders who lent at 5 times EBITDA at the beginning should be more than happy to lend another $125 million to New ABC. Big Bucks could dividend the entire amount to its limited partners and itself, and still have a company with a pro forma value (at 8 times EBITDA) of $400 million, a pro forma debt load of $250 million, and a pro forma equity value of $150 million after the $125 million dividend. Big Bucks’ initial investment of $75 million would have turned into $275 million: $125 million of dividended cash and $150 million of unrealized equity value. This would be an enormous home run, and it still gives Big Bucks and its limited partners an opportunity to ride the value creation curve of New ABC even higher into the future. Leveraged finance lenders are very comfortable with such transactions, and they base their comfort on the visibility and sustainability of company results, and the credibility of the financial sponsor and portfolio company management to sustain and build earnings and cash flow.

Sometimes, of course, the future performance of a private equity company falters unexpectedly, and the debt load craters it. But this happens as often with the initial capitalization of a private equity investment as with one that has had a dividend recap. Sophisticated financial sponsors are not infallible, and neither are sophisticated institutional lenders. Mistakes are made, market and company conditions change, and sometimes earnings can’t keep pace with debt service. Bankruptcy happens, lenders lose money, and employees are laid off. This is a bad outcome, and one which hurts financial sponsors and their investors too. Fortunately, it is relatively rare; rare enough that lenders continue to make such loans and limited partners continue to invest their money with financial sponsors.4 It is also worth keeping in mind that this happens in Corporate America, as well. Financial risk and bankruptcy from excess leverage is not exclusive to the private equity industry.

* * *

Private equity, as I have said many times before, is a valuable part of the financial ecosystem. It is particularly suited to helping businesses which require some sort of transformation, in structure, methods, and/or capital, in order to improve their value. All of these transformations are very difficult if not impossible to accomplish in a publicly owned company which answers to multiple, often conflicting constituencies in the full glare of public attention. For that reason alone, financial sponsors are a useful subset of capital providers, because they work their magic in private. As Mr. Surowiecki points out, they are not net job creators (or destroyers) of any magnitude. But they are not asset strippers, “vultures,” or liquidators, either. Think of them instead as boot camp drill instructors, whipping out of shape or underperforming laggards into top-flight athletes. Sure, they have their failures, but on the whole they do a pretty good job for a bunch of undersocialized ex-investment bankers.

Like every other corporation in America, private equity does benefit from the tax deductibility of corporate debt interest, but, pace Mr. Surowiecki, this loophole is not the secret sauce in private equity’s formula.5 As for the unconscionable and indefensible carried interest tax break private equity gets treating its earned income as capital gains for tax purposes, well, the less said about that the better.

I am trying to keep this a friendly blog post.

Related reading:
James Kwak, What Is Private Equity? (The Baseline Scenario, January 27, 2012)
James Surowiecki, Private Inequity (The New Yorker, January 30, 2012)

1 This example would count as a small, or small “middle market” buyout. While lots of these actually get done, I am using this scale to keep the numerical intuitions simple. In outline, the big buyouts you read about in the financial media look just the same.
2 Earnings Before Interest, Taxes, Depreciation, and Amortization. Don’t ask.
3 Total enterprise value, or TEV, is what the entire business is worth, prior to carving up the resulting cash flows to various stakeholders like lenders and equity owners. It is independent of capital structure.
4 It is worth noting, as I alluded to above, that many of the institutions which lend directly or indirectly to private equity-owned companies also invest as limited partners alongside sponsors. On top of that, many of these institutions happen to be funds managed for the benefit of public and private pensioneers, government employees, teachers and firemen, and other universally regarded good causes. It is a funny fact of private equity bankruptcies that the end result can be value transfer among these different groups.
5 Supplementing my simple example above with a few unremarkable assumptions about earnings growth and free cash flow efficiency, I ran a simple buyout model for New ABC over a five year horizon to test the magnitude of value created by the tax shield generated by debt. Allowing the tax shield, as current tax law does, created an final equity value of $223 million, or 2.97 times Big Bucks’ initial investment, and an internal rate of return of 24.3%. Stripping the tax shield from the same model generated figures of $199 million, 2.66 times, and 21.6%, respectively. While the free cash flow of $23 million over five years generated by the tax shield is nothing to sneeze at, it is dwarfed by the returns generated by growth of the business, and a 2.7% difference in IRR is unremarkable. Similar scaling applies to most private equity investments. The tax shield of corporate debt, while real, is not critical or even a major factor in private equity’s business model.

© 2012 The Epicurean Dealmaker. All rights reserved.

Reflections Upon an Occasion of Little Consequence

Sandro Botticelli, Primavera, ca. 1482

I. Death
Many times man lives and dies
Between his two eternities
That of race and that of soul
And ancient Ireland knew it all.
Whether man dies in his bed
Or the rifle knocks him dead,
A brief parting from those dear
Is the worst man has to fear.

Though grave-diggers’ toil is long,
Sharp their spades, their muscles strong,
They but thrust their buried men
Back in the human mind again.

II. Remembrance
Irish poets learn your trade
Sing whatever is well made,
Scorn the sort now growing up
All out of shape from toe to top,
Their unremembering hearts and heads
Base-born products of base beds.
Sing the peasantry, and then
Hard-riding country gentlemen,
The holiness of monks, and after
Porter-drinkers’ randy laughter;
Sing the lords and ladies gay
That were beaten into the clay
Through seven heroic centuries;
Cast your mind on other days
That we in coming days may be
Still the indomitable Irishry.

III. Life
... A living man is blind and drinks his drop.
What matter if the ditches are impure?
What matter if I live it all once more?
Endure that toil of growing up;
The ignominy of boyhood; the distress
Of boyhood changing into man;
The unfinished man and his pain
Brought face to face with his own clumsiness;

The finished man among his enemies? —
How in the name of Heaven can he escape
That defiling and disfigured shape
The mirror of malicious eyes
Casts upon his eyes until at last
He thinks that shape must be his shape?
And what’s the good of an escape
If honour find him in the wintry blast?

I am content to live it all again
And yet again, if it be life to pitch
Into the frog-spawn of a blind man’s ditch,
A blind man battering blind men;
Or into that most fecund ditch of all,
The folly that man does
Or must suffer, if he woos
A proud woman not kindred of his soul.

I am content to follow to its source
Every event in action or in thought;
Measure the lot; forgive myself the lot!
When such as I cast out remorse
So great a sweetness flows into the breast
We must laugh and we must sing,
We are blest by everything,
Everything we look upon is blest.

IV. Coda
... Now that my ladder’s gone
I must lie down where all the ladders start
In the foul rag and bone shop of the heart.

1 From W.B. Yeats, “Under Ben Bulben.”
2 Ibid.
3 From W.B. Yeats, “A Dialogue of Self and Soul.”
4 From W.B. Yeats, “The Circus Animals’ Desertion.”

© 2012 The Epicurean Dealmaker. All rights reserved.

Sunday, January 22, 2012

All Together Now

Why, yes, I am a rich merchant.  Why do you ask?
“Do you mean, sir, that these birds are cannibals?”

“That’s an odd question, young Master,” the banker said. “I merely said the birds drink blood. It doen’t have to be the blood of their own kind, does it?”

“It was not an odd question,” Paul said, and Jessica noted the brittle riposte quality of her training exposed in his voice. “Most educated people know that the worst potential competition for any young organism can come from its own kind.” He deliberately forked a bite of food from his companion’s plate, ate it. “They are eating from the same bowl. They have the same basic requirements.”

— Frank Herbert, Dune

Steve Randy Waldman got me thinking today.1

In an extensive follow-up piece to a previous post on complexity in finance, Steve answers objections to and elaborates on his argument that not only is opacity integral to the financial system of a complex society, it is essential. You may recall the core of his original idea:

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

I think Steve’s analysis and critique are essentially correct. However, I am much less sanguine than he seems to be when it comes to eliminating much of the opacity and associated “kleptocracy” he finds in our current financial system. My pessimism is based on two rather sizeable barriers: human history, and human nature.

* * *

Human beings, we are told, evolved as social animals. From the very first dawn on the ancient savannah, our ancestors must have struggled with the solution to problems of collective action: how to provide security, shelter, food, and comfort to the members of the group or tribe. Given the natural variability among members of any population—whether along simple biological dimensions of age, infirmity, and strength, or more abstract qualities like ambition, skill, and desire—humans must have come to adopt and practice the division of labor early and often. Some would stay behind to protect the encampment, make and mend clothing, and build and maintain shelter while others foraged or hunted for food. Each member of the tribe would cede some of his or her personal agency to other individuals or groups in exchange for reciprocal aid. In this way, the group became stronger than any one of its members. In this way, through trial-and-error invention of division of labor according to comparative advantage, human groupings created social surplus, and complex societies were born.

Over the course of human history, we have developed numerous systems and institutions to address recurring problems of collective action. We developed standing governments to organize and direct our individual efforts toward persistent common goals, like safety, security, and other large challenges. We developed politics as a means for people to make collective decisions about authority and power in government and elsewhere. We built economies as a means to organize collective and individual economic action toward sustained or increasing prosperity. We developed judicial systems to adjudicate inevitable disputes and promote the cause of justice. Each and every one of these systems requires the individual citizen to surrender a portion of his will and agency to the collective. And each and every one of these entities creates, thrives on, and indeed cannot function without opacity.

Think about it: Do you know how and why decisions are made and actions are taken inside government bureaucracies? Do you know what takes place in smoke filled rooms among politicians and lobbyists, whose horses are traded and for what? Do you trust politicians to have your best interests or even the interests of the people who elect them at heart? Do you trust big business of any sort—insurance companies, oil companies, auto manufacturers, pick an industry—not to cut corners when it increases shareholder returns or executive pay? For that matter, do you trust your local auto repair shop to install the brand new muffler it charges you for, and not a refurbished one? Do you really believe our judicial system promotes justice? Do you trust lawyers?

Each of these social institutions creates opacity through the simple mechanism of dividing people into insiders and outsiders. The insiders have the advantage of knowing how things really work, how to “work the system,” and how to profit—economically, socially, and/or politically—from it. Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. Furthermore, creating specialized entities to handle collective tasks each of us individually neither can nor wants to address creates institutions whose primary aims become self-preservation and continued aggregation of power. Just like in finance, insiders’ privileged position and knowledge enable them to extract rents. It’s just that rents accruing to insiders in areas other than finance can take the form of social prestige, political power, and legal authority, in addition to undeserved money.

* * *

None of this should be particularly surprising to anyone who takes the time to reflect on it. Why do we tolerate opacity in our collective social institutions and rent-seeking (if not outright corruption) in the people who work there? Because, I must believe, after thousands of years of experimenting, we have not come up with any better way. No-one except a criminal really likes a rent-seeker, and no-one but a politician’s spouse likes a corrupt politician, but collectively we have come to accept the occasional example as the price we must pay in order to outsource the prosecution of certain of our interests to other people. It is a convenience tax. And just like any tax, we whine and complain about it, but we pay. “You can’t trust bankers/lawyers/politicians/bureaucrats/pick-an-actor.” Only when the basic services they provide collapse, or the excess rents they extract become too egregious, do we take up our pitchfork and torch to revisit the social contract.

The problem of opacity and rent-seeking by the insiders of the social institutions we empower to promote our collective good is less bad than it might be—and, therefore, more durable as a feature of complex society—for a number of reasons. For one thing, most people in such privileged positions of power really are not crooked cheats simply out for themselves. Most government bureaucrats, politicians, businesspeople, lawyers, and bankers really do believe they are providing a useful and perhaps even noble service. They view their privileges and socioeconomic rents not as perks unjustifiably pilfered, but as concrete confirmation of the worth and value which society—the people, the voters, the market, etc.—places upon their efforts. They think they deserve them.2 Given that society allows or even encourages such actors to enjoy such special privileges, it is hard to argue that they are wrong.

For another, the tax which insiders extract for these services is, in the main, relatively small compared to the good their actions provide to the collective. Steve Waldman himself admits that:

Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

Starkly put, what is a few billion dollars of excess compensation, here and there, if it enables the growth and prosperity of trillions of dollars of global economic activity?3

* * *

Finance is a critical function in today’s complex global economy. It is clear it stumbled badly in performing its basic function, and it seems beyond argument that it has far outgrown its proper place in the socioeconomic sphere and its share, deserved and undeserved, of the economic pie. But I find it hard to imagine any meaningful function performed by the financial system which can be purified into a transparent, corruption-free zone. Among government, politics, economy, and law, modern finance is a relative newcomer in the panoply of social institutions designed to promote the collective good. Given that no-one has demonstrated the ability to make any one of those older systems meaningfully transparent and corruption-free, I remain highly skeptical that we can do so with finance.

Yes, Steve, I admit the baby in the bathwater is fat, obnoxious, and ugly.4 But it is our baby. Do you still want to throw it out?

1 Yes, believe it or not, it does happen on occasion. Steve is particularly good at triggering it, because he normally has such interesting things to say.
2 Hence, e.g., the outraged sensibilities of financiers when you ask them to justify their relatively stratospheric pay: “But that’s what the market bears!” In other words, “I’m worth it!”
3 Especially if, as recent data seem to suggest, intragenerational wealth accumulation is more volatile and intergenerational wealth accumulation is less certain than it used to be. Personally, I am far less bothered by the rise and fall in one or two generations of self-made (finance) billionaires than I would be by the reestablishment of multigenerational dynastic wealth and all the sclerotic, corrupt sociopolitical accompaniments that would bring.
4 Steve also objects that our current financial system is incompetent when it comes to allocating systematic risk. He uses the examples of misallocating capital to faddish investments and the sticking of the unemployed and the indebted taxpayer with the biggest portion of the bill due from the collapse of the housing sector. But this misinterprets the proper role of the finance sector. The proper role is as servant to investors and users of capital. Investment bankers don’t sit in a back room, picking winners and losers like Chinese government ministers; we respond to capital supply and demand. Sure, such a system is widely acknowledged to be wasteful and subject to bubbles and fads, but it also has a long-term record of success I would stack up against any centrally planned economy’s any day. Given a choice between the (fallible) wisdom of crowds and the whim of a rent-collecting government technocrat insulated from market forces, I’ll take the crowds any day. Also, given that finance serves the broader society, why should we be surprised when it responds to the dictates of power by sticking failures to the little guy? That’s just politics.

© 2012 The Epicurean Dealmaker. All rights reserved.

Saturday, January 21, 2012

A Certain Moral Flexibility

Time to circle the wagons
Marty: “When I left, I joined the Army, and when I took the service exam, my psych profile fit a certain... ‘moral flexibility’ would be the only way to describe it. I was loaned out to a CIA-sponsored program, and we sort of found each other. That’s the way it works.”
Debi: “So you... you’re a government spook?”
Marty: “Yes. I mean no. I was before, but I’m not now. Uh, but that’s all irrelevant, really. The idea of governments, nations is public relations theory at this point.”
Debi: “I don’t want to hear about the theories. I want to hear about the dead people. Explain the dead people. Who do you kill?”
Marty: “That’s very complicated, but I think in the beginning it matters of course that you have something to hang on to, you know, a specific ideology to defend, right? I mean, taming unchecked aggression, that was my personal favorite. Other guys liked live free or die, but you know... you get the idea. But that’s all bullshit. And I know that now. That’s all bullshit. You do it because you’re trained to do it, you’re encouraged to do it, and ultimately, you know, you... get to like it. I know that sounds... bad.”
Debi: “You’re a psychopath.”
Marty: “No no no. A psychopath kills for no reason. I kill for money. It’s a job. That didn’t sound right.”

— Grosse Pointe Blank

Your Dedicated Bloggist and Dilettantish Cineaste finally got around to watching Margin Call in the private screening room of the Volcano Lair yestereve, O Dearest of All Readers. Because I am feeling unaccountably magnanimous this evening, I thought I would share with you a brief report of my reactions to the film and a few thoughts which it inspired, out of the goodness of my heart. While you must not expect great film criticism, I believe I can offer a little professional insight which may enhance your experience should you decide to view it.

For let me first say that I recommend the movie unreservedly, not only to professionals within the investment banking industry but also to outsiders still in possession of their moral compass. The lighting, cinematography, casting, and dialogue is, for the most part, pitch perfect, and the movie conveys exceptionally well the mood and atmosphere of the sales and trading end of a big investment bank. The story is simple enough: a junior risk manager played by Zachary Quinto takes over a risk model from his recently fired boss and mentor; he discovers his bank has already begun to seriously violate risk limits in the structured trading book it maintains to warehouse mortgage-backed securities it structures and sells for enormous profit; he concludes the firm faces potential losses which could wipe it out entirely; and he runs his warning up the chain of command, where it ultimately lands in the lap of the firm’s CEO. Where and with whom, as the saying goes, the shit decisively hits the fan.

The film takes place over approximately 36 hours, starting from mass firings at the bank during one trading day, Quinto’s fateful discovery that evening, the hurried, all-hands meetings and consultations among firm management overnight, the liquidation of the firm’s toxic portfolio the following day, and a coda the following night. It is an ensemble performance, and Quinto, Penn Badgley, Paul Bettany, Stanley Tucci, Kevin Spacey, Demi Moore, Simon Baker, and Jeremy Irons all do excellent work. Just like real life, there are no heros, and just like real life the characters spend little time reflecting or moralizing about how they got into this mess. They decide, they act, and just like most corporate bureaucrats they limit their moralizing to variations on “I told you so” and “It’s your fault, not mine.”1

The moral center of the film is carried by Kevin Spacey, who plays the slightly sallow, squidgy Head of Sales and Trading, a 40-year veteran of the firm with the scars to prove it and a personal life in tatters. He is the only one who stands up to Irons’ CEO when the latter decides to liquidate the firm’s entire portfolio of MBS securities. Tellingly, however, his objection is that dumping these toxic securities on unwitting buyers in a fire sale will destroy both his and his salespeoples’ reputations and careers, not that selling securities you know are about to implode to clueless counterparties is wrong per se. Also tellingly, the film is honest enough to show Irons overcoming Spacey’s scruples with a big, fat check, and Spacey accepting it because he “needs the money.” No-one is innocent here, except perhaps those too junior and ignorant to have done more than act as cogs in the immense corporate machine. The callow immaturity of Penn Badgley’s 23-year-old, who gossips about the rumored wealth of his superiors while his firm teeters on the brink of annihilation, is the film’s answer to those who might think that innocence begot by ignorance is some sort of virtue.

Like anyone who works inside the temple, I do have some minor quibbles with the way the film portrays my industry, but they are of little consequence.2 The investment bank is able to extricate itself, at some considerable cost, it seems, from its predicament over the course of one trading day. This keeps the story clear—save yourself and your firm at the cost of your counterparties and your reputation—but correspondingly unrealistic and oversimplistic. Any bank which really faced such circumstances would find its distress telegraphed within minutes of commencing its liquidation, with the consequent disappearance of buyers, massive selling by everyone else in the market, and determined financial attacks on its funding and asset base by hedge funds and lenders alike. No bank could withstand the kind of massive markdowns of its inventory, sold or not, which the movie portrays without calling its very existence into question. Margin Call is not a realistic depiction of what happened to Bear Stearns or Lehman Brothers.

Nor does the movie attempt to explain the financial crisis, or any large component of it. It depicts nothing outside the walls of the firm or actions of its characters. It is a miniature, which drops the viewer in medias res, to look at the behavior of high-powered, well-paid professionals under considerable pressure. It is a study in how bureaucratic organizations respond to life or death threats, and what people who have little choice do to survive. Like most survival stories, it is not a pretty sight.

Perhaps the people in my industry are more callous and calculating than others. It is certain we are more willing than some to sacrifice our own in the name of survival. But I will leave it to you, Dear Reader, to decide whether Margin Call is simply an indictment of investment banking, or an indictment of humanity itself.

1 Nor are there any cardboard cutout villains, unless you consider naked ambition, backstabbing, scapegoating, buck-passing, and covering your ass villainy. I, on the other hand, consider those standard corporate policy at any organization larger than twenty people.
2 No CEO of a major investment bank would wear his hair as long as Jeremy Irons, for example. Period.

© 2012 The Epicurean Dealmaker. All rights reserved.

Sunday, January 15, 2012

All’s Fair...

In the heat of battle, strategy and tactics collapse to one very simple principle: win.

No answer.


The sea rumbled ominously in the distance; the tide lapped and murmured at the two men’s feet.

“You’re late again, aren’t you? Is that your strategy? As far as I’m concerned, it’s a cowardly ploy. It’s two hours past the appointed time. I was here at eight, just as I promised. I’ve been waiting.”

Musashi did not reply.

“You did this at Ichijōji, and before that at the Rengeōin. Your method seems to be to throw your opponent off by deliberately making him wait. That trick will get you nowhere with Ganryū. Now prepare your spirit and come forward bravely, so future generations won’t laugh at you. Come ahead and fight, Musashi!” The end of his scabbard rose high behind him as he drew the great Drying Pole. With his left hand, he slid the scabbard off and threw it in the water.

Waiting just long enough for a wave to strike the reef and retreat, Musashi suddenly said in a quiet voice, “You’ve lost, Kojirō.”

“What?” Ganryū was shaken to the core.

“The fight’s been fought. I say you’ve been defeated.”

“What are you talking about?”

“If you were going to win, you wouldn’t throw your scabbard away. You’ve cast away your future, your life.”

“Words! Nonsense!”

“Too bad, Kojirō. Ready to fall? Do you want to get it over with fast?”

“Come... come forward, you bastard!”

“H-o-o-o!” Musashi’s cry and the sound of the water rose to a crescendo together.

— Eiji Yoshikawa, Musashi1

* * *

Ex-banker and would-be gadfly to the investment banking industry William Cohan posted a very silly opinion piece over at The Washington Post last Friday. In it, he cites his experience as an M&A advisor helping clients sell their companies to explain that he found private equity firm Bain Capital particularly prone to using “bait and switch” negotiating tactics. Mr. Cohan explains:

In my experience, Bain Capital did all that it could to game the system by consistently offering the highest prices during the early rounds of bidding — only to try to low-ball the price after it had weeded out competitors.

Once it had passed through the intermediate competitive bidding rounds and earned exclusive negotiating rights with the company, Bain’s due diligence professionals

would suddenly begin finding all sorts of warts, bruises and faults with the company being sold. Soon enough, that near-final Bain bid — the one that got the firm into its exclusive negotiating position — would begin to fall, often significantly.

Now, I cannot say whether Bain Capital was (or still is) particularly prone to using bait and switch tactics in sell-side auctions. I can say, pace Mr. Cohan’s few counterexamples, that they are definitely not alone in doing so, nor is any private equity firm averse to using such tactics when they calculate it is to their net advantage. Mr. Cohan’s description of the bidding process in a sell-side auction is highly simplified, but basically accurate. Where he goes seriously off the rails, however, is in trying to cast doubt on Mitt Romney’s character and appropriateness for public office based on his own highly anecdotal experience with Bain Capital:

This win-at-any-cost approach makes me wonder how a President Romney would negotiate with Congress, or with China, or with anyone else — and what a promise, pledge or endorsement from him would actually mean.

Would a President Romney, along with a Republican Congress, cut taxes for the wealthy even more than he has pledged to do? Would he not try to balance the federal budget, even though he has said he would? Would he protect defense spending, as he has indicated he would?

I have no idea how Romney might behave in office. I do believe, however, that when he was running Bain Capital, his word was not his bond.

This reeks of a staggeringly naive and simplistic view of finance and politics. Does Mr. Cohan expect us to disqualify Mr. Romney from office because he ran a firm which fielded clever, tenacious negotiators who fought their corner hard? Does he really believe that sharp-elbowed negotiating tactics are unknown and/or frowned upon in the halls of Congress or the state ministries in Beijing? Does he think the American people want a morally squeamish milquetoast conceding their interests at home and abroad because he doesn’t want to get his hands dirty? Does he believe there is anyone in this country under the age of 18 who truly thinks that politicians either do or should honor their promises no matter the consequences or whose interests they injure? Citizens of a complex society expect and demand their elected officials to combine firm principles, moral and ethical flexibility, and tactically astute pragmatism to achieve the goals they have been elected for. That’s why it’s called politics. Anyone who thinks otherwise is a bloody fool.

And attempting to tar Mr. Romney with the brush of his junior partners’ supposedly naughty behavior decades ago—even though Mr. Cohan admits that he never dealt with Romney directly—is transparently tendentious and disingenuous. This does not jibe with Mr. Cohan’s own stated principles of honor and character.

For, speaking as a banker who dislikes private equity firms (and other potential buyers) who bait and switch processes just as much as Mr. Cohan does, let me make this perfectly clear: by doing so, Bain Capital did nothing wrong.

* * *

Selling companies or divisions of companies is one of the cleanest, least-conflicted, and most valuable services investment banks provide.2 It is also one of the most varied and complex processes we conduct. While the end result of most sale processes is the same—money passes from the hands of one party in exchange for the ownership stake of another—the actual sale process for every property is for all intents and purposes unique. The overall structure of a typical sales process is fairly straightforward:

  1. Seller hires sell-side advisor
  2. Advisor works with seller to select sale strategy, identify potential buyers, compile information on business, conduct due diligence, and create marketing materials
  3. Advisor contacts potential buyers for interest in property, signs confidentiality and standstill agreements, and gives buyers preliminary information
  4. Buyers submit initial bids (“indications of interest”) with summary preliminary offer terms
  5. Seller and advisor select buyers to pass into next round
  6. Seller management present further information to selected buyers and buyers begin documentary, legal, and business due diligence
  7. Buyers submit formal offer letters
  8. Seller and advisor pick one or more buyers for further negotiation (which may involved extending exclusive negotiating privileges to one buyer)
  9. Buyer(s) conduct confirmatory due diligence and negotiate legal purchase agreement and other deal documents
  10. Buyer and seller agree final terms
  11. Transaction closes
Although it is not always true, most sale processes nowadays are what Mr. Cohan calls “auctions,” in which the advisor approaches a very broad range of potential buyers, usually both private equity firms and corporate (or “strategic”) buyers. There are two purposes for that: 1) broad participation tends to ensure the highest level of competition among buyers, which tends to produce the highest price and best terms for the seller; and 2) auctions are good for properties which may be unique, poorly understood by the market, and/or for which the “best” buyers are unknown. In the latter case, the broad-based, shotgun approach to the market tends to flush out hidden or unexpected high bidders much more efficiently.

Now, as you might expect from sophisticated financial buyers who have a fiduciary duty to maximize returns on invested funds to their limited partners (and who have their own financial interests in mind, too), private equity firms hate auctions. They much prefer to find a fat, unsophisticated seller without professional representation whom they can wheedle and cajole into negotiating exclusively on terms advantageous to the buyer. Fortunately for Yours Truly and my fellow financial parasites intermediaries, most companies nowadays have heard enough about mergers and acquisitions to realize they are much better served getting professional help, and we professional help are more than happy to persuade them they will get a much better price for their baby by selling it at auction.

As a bidder in an auction, of course, your best strategy is to bid high enough to get into the next round. Unlike my skeleton outline above, though, there can be multiple bidding rounds in a company sale process, so bidders have little incentive to lowball their bids unless they are truly indifferent to winning. On the other hand, the deeper you get into a sale process, the more time, opportunity cost, and direct due diligence expenses (e.g., accountants, lawyers, consultants, etc.) each bidder expends, so buyers will tend to drop out rather than bid on companies they don’t think they can win. The sell-side advisor’s job is to maintain as much competitive tension as possible among the bidders for as long as possible. Ideally, the advisor can run a process where the seller has multiple bidders competing to the very last moment without exclusivity. Such processes are a banker’s dream, for the prices and terms realized for the seller make us look like heros. Plus, it’s a blast to beat up private equity professionals and their lawyers all in the name of client service.

But sooner or later, the usual sale process gets to the stage where the seller grants the buyer exclusive rights to negotiate a final deal. At that point, the negotiating leverage which the seller has enjoyed drops dramatically, and the buyer has every opportunity and incentive to begin whittling away at the price it promised, using new facts discovered in due diligence, weakening industry fundamentals, unfavorable market conditions, or even sunspot activity as an excuse. This is where the sell-side advisor earns his or her fee. He must argue the facts (“No, the complete economic collapse of the Eurozone will have no effect whatsoever on the sales volumes of Acme European Imports, Inc.”), emotions (“My client is beginning to think you’re a real dick.”), tactics (“We have three other buyers chomping at the bit in the wings, and their offers were all higher than the new lower offer you are proposing.”), and anything else he can to weaken the buyer’s attack. Because, you know, at the end of the day the entire process is a negotiation.

Furthermore, private equity firms (and corporate buyers, too) do not have a completely free hand to work bait and switch tactics. The most important restraint is reputation, which Mr. Cohan himself mentioned and demonstrated in his article. Firms which commonly bid high then almost always claw back value during exclusivity periods get widely known for doing that among bankers. The Street can be a very small place. Repeat offenders get put in the penalty box, don’t get shown deals (like Mr. Cohan did), get used as stalking horses to boost the offer prices of preferred bidders, and generally get fucked with by bankers who find them annoying. It is important not to overstate the restraint which reputation imposes on private equity firms, however, because they also tend to be the biggest fee payers in the M&A market, and investment banks (especially those with big leveraged finance operations which private equity uses to fund their purchases) are careful not to shut them out or fuck them over completely. Another restraint is the relationship which private equity buyers need to build with the management of the firm they are buying. Most private equity firms do not want to replace incumbent management—at least right away—after buying a company, so they need to maintain friendly, productive relations with them. If the management is the owner/seller, baiting and switching can really poison a potential future working relationship, if not scupper it completely.

* * *

Bain Capital may indeed have been more inclined to retrade offers during exclusivity periods than many of its competitors, but this may have been due to the legacy and practices inculcated in its ranks by the eponymous consulting firm which spawned it. Bain is notorious for approaching private equity investing with armies of (ex-Bain) consultants, who pore over the books, records, and operations of subject companies looking for areas to improve, like consultants do. Bain may simply have found more flaws and blemishes in their potential purchases than other, less manpower-intensive PE buyers. If they learned to expect that outcome, they may have settled on a strategy to bid higher than others in early rounds because they wanted a chance to win a few deals.

At the end of the day, however, it is important to keep in mind that selling a company is always and everywhere a negotiation: There is no “true,” “honorable,” or “correct” value for a business.3 The tactics, process, and outcome all depend upon the relative negotiating leverage of the parties involved, and it should be no surprise to anyone that the stronger party will win out most of the time. A clever and resourceful sell-side advisor can try to maximize the leverage of a seller with a weak hand, but at the end of the day even genius rainmakers can’t make it rain in the Sahara in August June.4 What is not at stake, however, is an archaic view of “honor and character” that requires a bidder to pay more than it ought to (or, what is the same thing, what it can get away with) simply because some prissy investment banker can’t bring himself to get down in the mud and wrestle for his client.

That’s what they pay us the big bucks for, Bill, not for swanning about in Saville Row suits at The Four Seasons. You should remember that.

More on dirty hands, politics, and negotiation:
In the Nation’s Service (December 29, 2011)
You Realithe, Of Courth, Thith Meanth War (May 3, 2009)
More of a Kickin’ Sitcheyation (May 11, 2009)

1 Eiji Yoshikawa, Musashi. Tokyo: Kodansha International, 1995; pp. 967–968. Spoiler: Musashi kills Kojirō. With a sword he carved from a wooden oar. Pretty badass.
2 Which is not to say it is as clean as the driven snow. See nuance, above.
3 If you remember nothing else of this screed, remember this. Tattoo it on your forehead, backwards, so you can remind yourself of it in the mirror every morning.
4 Update January 16, 2012: A clever and observant critic writes to inform me that, mirabile dictu, August is actually the wettest month in the Sahara, and June is usually the driest. I might claim simple ignorance, which serves me well often, but skeptics among you might suspect my original phrase was a dastardly investment banker ploy to take credit for the rather common as the miraculous: “Well, Mr. Client, you know it almost never rains in the Sahara in August, but through my heroic efforts we were actually able to summon this tremendous monsoon for your benefit. Now, can we talk about fees?”

© 2012 The Epicurean Dealmaker. All rights reserved.

Sunday, January 8, 2012

The Root of Some Evil

Pretty, ain't it?
“It has always seemed strange to me,” said Doc. “The things we admire in men, kindness and generosity, openness, honesty, understanding and feeling are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest are the traits of success.”

— John Steinbeck, Cannery Row

To greed, all nature is insufficient.

— Lucius Annaeus Seneca

Professor Ian Tonks—great name, by the way—put up an interesting column at vox today, in which he discusses recent research he and his colleagues have performed into the postulated links between banker compensation and the financial crisis. He cites a number of interesting results, including the fact that pay for all executives and directors at leading UK companies increased at a substantial rate during the decade preceding the crisis, and at a rate well in excess of pay for all employees, and that executives and directors at finance companies were second in total pay only to “non-cyclical services” firms (including food and drug retailers and telecom). But those looking for his research to confirm their belief that banker pay was tightly tied to company performance will be disappointed:

... contrary to the prediction that pay was over-sensitive to short-term performance, we find that the pay-performance sensitivity of banks is not significantly higher than in other sectors, and in general is actually quite low. Across all industries, we find a weak relationship between executive pay and company performance. The estimates suggest that a 10% additional increase in company share price performance leads to a 0.68% increase in the pay of the CEO, which translates into a £3,726 increase in CEO pay at the median level of £543,200.

We report that although the pay-performance relationship is slightly higher in the financial services sector for both total board pay and pay of the highest paid director, the additional sensitivity is not statistically significant, and is still economically very small. This tiny performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector depended on short-term financial performance. In other words, executives were paid irrespective of performance. In which case, it seems unlikely that bankers were incentivised to take risks, and refutes the suggestion that incentive structures in banks could be blamed for the crisis.

In fact, Professor Tonks and his fellow Order of the Phoenix members1 do find a meaningful correlation between executive and director pay in finance and firm size, which is noteworthy, but the slavering hordes of Occupy Wall Street and well-meaning-but-dim regulators must look elsewhere for evidence that greedy bankster bonuses led to Grandma’s condo in Boca Raton being repossessed.

Problem sorted, right? Not so fast.

* * *

Now, uncredentialed peons like me, who merely work in the industry which everybody and their pet Chihuahua seems to have developed a fully formed opinion on nowadays, do not have pre-publication access to high-powered academic research like that produced by Messrs. Tonks and pals, which is being embargoed from all but fellow travelers in academia. Accordingly, I must read into the Doctor’s slender note some key assumptions about just exactly what sort of data it examined. But, if I read him correctly, I perceive at once a couple of key methodological assumptions which are clearly wrong, and which could have been avoided had the merry researchers simply called a couple of real-life bankers, rather than sallied forth to prove something which makes no sense.

The first problem may be inferred from the Professor’s passing reference to the insignificant correlation between increase in CEO pay and “share price performance.” But if the researchers truly measured “company performance” simply and solely by share price performance, they have got the relationship almost completely ass-backwards. For one thing, everyone who has an even passing acquaintance with the equity markets realizes that public company share prices have only a tenuous, intermittent, and volatile relationship with actual company financial performance.2 For another—and because of this—even the dimmest bulb on the compensation committee of a public company realizes that the CEO and other key executives have only limited direct influence on the evolution of the firm stock price, usually limited to jawboning the market that it is underpriced. Accordingly, they prefer to pay executives for performance entirely (or mostly) within their control. The metrics they use to measure performance are financial ones, including but not necessarily limited to net income growth, return on equity, and perhaps others like asset growth and credit strength, as appropriate. Simplifying greatly, the compensation discussion at most firms—public or private, financial or non-financial—usually boils down to a version of this: “Make a lot of money for the firm, chum, and you’ll get paid a lot of coin.” It is company financial performance which matters most to executive pay, not stock price performance.

This is a common failing of many real and pseudo-academic (i.e., consulting firm) approaches to measuring pay for performance among public companies in general. Researchers get confused by the fact that many firms pay executives with heavy allocations of restricted and unrestricted stock and stock options into believing that stock price performance is the chief or even a major criterion Boards use to pay them. But what you pay somebody does not necessarily have much to do with how much you pay them. This is particularly true in finance, where bankers have traditionally been paid oodles of funny money in order to conserve corporate cash, tie their wealth to the future performance of the firm, and prevent them from leaving the firm voluntarily without suffering material damage to their net worth. I also suspect researchers default to share prices as an input variable to their correlation studies because they are easily available. This is a misleading and lamentable bit of laziness which deserves to be stamped out.

Take it from me: stock prices are an unreliable way to measure corporate performance, and they are an absolutely shitty way to predict executive compensation.

* * *

The second methodological problem which this study seems to suffer from is perhaps more common to finance than other industries, especially in the more highly paid investment banking and corporate banking subsegments. For it is an absolute fact that a very large number of employees in your typical investment bank make enormous amounts of money. Not only do many more bankers than populate the executive suite bring home pay packages which could support small villages in Central Austria comfortably—that is, money which looks like “executive-level” pay anywhere else—but often the CEO and other executive officers of an investment bank are by no means the highest paid employees there. In a decent year, hundreds of employees at large investment banks make millions of dollars, and a substantial subsegment of those bring home tens of millions, if not more. If Messrs. Tonks and friends only collated and computed compensation data for named executive officers and non-executive directors—who, by the way, as non-producers are, relatively speaking, low-paid irrelevancies—then they missed the lion’s share of actual compensation going out the door in my industry. That is certainly the impression I get when I peruse Professor Tonk’s slim précis.

And here is the problem with that: all those uncounted flow traders, M&A bankers, structured products professionals, prop traders, leveraged finance bankers, and derivatives marketers—not to mention all the non-executive group and division heads above them—get paid buckets of simoleons for making money for the firm.

* * *

And this is where I part ways with our dear Herr Professor Doktor regarding his conclusion. If I have correctly identified his study’s methodological weaknesses, not only has he measured the wrong independent variable, but he failed to apply it to the entire set of relevant dependent variables. He doesn’t collect the proper financial performance data—the gross revenue and gross profit metrics upon which investment bankers are paid in the real world—and he doesn’t correlate it against the revenue-producing employees who are producing them. Based upon how my industry actually conducts business and pays its employees, he hasn’t proved anything.

Sadly, Your Dedicated and Evenhanded Bloggist, like many others, would still like to see a comprehensive, data-based investigation of the question which Professor Tonks addresses. Unfortunately, I do not know how one could go about this without at least acquiring time series of aggregate payroll data for all revenue-producing employees at each financial firm, correlated against preferably group or divisional level revenue and profit results. You can just imagine how well that request would go over in the offices of Jamie Dimon or Lloyd Blankfein.

For my part, I continue to believe some banker bonuses were indeed contributory to the financial crisis. My industry’s pay practices and culture were built over decades when the vast majority of business investment banks conducted was agency business. Business like M&A, where you earn a fee for helping a client buy or sell a company, or security underwriting, where you earn a fee for placing client securities with outside investors, or securities market making, where you earn a spread for standing between buy- and sell-side investors as a middleman and temporary warehouser. None of these businesses entailed any material amount of persistent or hidden financial risk to investment banks: we did the deal, we got paid, and we moved on. There are no meaningful, dangerous “tail” exposures from such activities. Accordingly, investment banks got used to toting up the profit and loss for each banker and each business line at the end of each year and paying out a percentage of that as compensation to the people who either brought the money in or who could argue most persuasively they had. Simple.

The problem arose when investment banks (and their bastard cousins and often ultimate owners, commercial or universal banks) began conducting business as principals, either explicitly and in full knowledge, or—most dangerously—in total ignorance. Mouthwateringly profitable leveraged lending, structured products, complex derivatives, and proprietary investing of all kinds meant that investment banks no longer conducted business as short-term conduits of temporary risk, but began accumulating long-term financial risks on or off their balance sheet, often without their own knowledge. But when this happens, the old view that Joe in Structured Products should get a massive bonus in February because he brought in $100 million of fee revenue to the firm this year cannot cope with the fact that Joe’s fabulous trades expose the firm to $1 billion in potential losses over the next five years. Even if some investment banks did develop robust and accurate risk-pricing models which accurately tallied and kept track of the massive tail risks metastasizing on their balance sheets—and recent history puts this assertion in considerable doubt—almost none of them drew the connection to compensation practices. Projected firm profits on trades like Joe’s should never be totaled up front when determining Joe’s pay; they should be amortized over the life of the potential risks the ongoing trade poses to the firm. Most banks just didn’t seem to get this important point.3

* * *

There really is a story to be told in here, somewhere, about exactly how and how much banker bonuses contributed to the aggregation of huge hidden and misunderstood risks in the global financial system. From what I can glean from limited evidence, Professor Tonks’ study is not it. Perhaps one day some academic will actually make the effort to understand how my industry works before they design a study to explain it.


Related reading:
Ian Tonks, Bankers’ bonuses and the financial crisis (vox, January 8, 2012)

UPDATE January 10, 2012: Subsequent to the initial publication of this piece, certain readers inside the sanctum sanctorum of the academic priesthood (or their acolytes) were so exceedingly kind as to direct me to the prepublication version of Professor Tonks et al.’s paper, here. As I suspected, this merry band of scholars only looked at aggregate director pay and highest director pay (usually, but not necessarily, the CEO) as dependent variables, and did not examine compensation to revenue producing ranks within financial institutions. This, as I explain above, is simply and irrevocably wrong. I also can confirm these scamps measured company performance primarily by calculating total shareholder return, based upon the following logic:

The most important measure of company performance is the total shareholder return, since the purpose of performance-related pay is to align the interests of the directors with those of the shareholders.

But this, as I outline above, completely begs the question of how bankers actually are paid and replaces it with the hoary old shibboleth about how they should be paid. This is not research; this is theology. The academics also did try to correlate director pay to slightly less silly measures, like earnings per share, return on assets, and revenue growth, but presumably they found little enough correlation between these variables and Board pay either. As I explain at nauseating length above, they were simply looking in the wrong place(s).

My arguments and conclusions remain unchanged.

1 Gratuitous Harry Potter reference. Sorry.
2 Consider, for example, what happens when a company posts impressive, even record, financial results (most usually net income growth) but fails to meet or exceed investor expectations: the stock price goes down. Consider, as well, a company which posts exceptional results in a falling market: more likely than not, the stock price falls then, too. Stock price is a lousy short-term and even intermediate-term indicator of absolute financial performance, if for no other reason than stock price is (supposed to be) a forward-looking measure, and financial performance is backward looking. Lots of academics seem to have trouble grasping this distinction.
3 And paying Joe 30–50% of his total compensation in unvested stock and options didn’t help much either. Sure, he had to stick around to cash it in, and therefore he was concerned with the continued existence and good stock price performance of his employer, but neither of those things are much that Joe, or anyone else not in the executive suite (and sometimes even there), can do much about. Long-term stock compensation is a pretty weak disincentive to risk-taking; producers like Joe focus much more on booking huge profits—and hence huge bonuses—right now, and devil take the hindmost. I confess I have occasionally argued the opposite side of this too strenuously in the past.

© 2012 The Epicurean Dealmaker. All rights reserved.