The Burning Ones

In memoriam, September 11, 2001:

Er ruft spielt süßer den Tod der Tod ist ein Meister aus Deutschland
er ruft streicht dunkler die Geigen dann steigt ihr als Rauch in die Luft
dann habt ihr ein Grab in den Wolken da liegt man nicht eng

He calls play death more sweetly Death is a master from Germany
he calls stroke the violins darker then you'll rise as smoke to the sky
then you'll have a grave in the clouds there one doesn't lie closely

— Paul Celan, Todesfuge

May all the innocent victims of unreasoning hatred and man's inhumanity to man rest in comfort and peace. Heaven knows there are far too many of them.

© 2009 The Epicurean Dealmaker. All rights reserved.

Never Say Never

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

— Romeo Void, Never Say Never

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

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

* * *

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

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

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

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

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

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

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

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

* * *

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

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

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

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

* * *

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

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

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

* * *

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

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

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

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

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

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


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

© 2009 The Epicurean Dealmaker. All rights reserved.

Killing People Is a Bad Habit

Chamberlain's wife: "You glisten too brightly."
Sanjuro: "Glisten?"
Chamberlain's wife: "Yes, like a drawn sword."
Sanjuro: "A drawn sword?"
Chamberlain's wife: [Nods] "You're like a sword without a sheath. You cut well. But the best sword is kept in its sheath."

— Tsubaki Sanjuro

In the highly stylized Kabuki world that is investment banking, there are few documents more abstruse and impenetrable to common understanding than the engagement letter.

This is the contractual document, prepared by the investment banker and his or her legal department and ultimately co-signed by the client, which encompasses the terms under which the banker will work for the client on one or more particular transactions. As such, and as one might reasonably expect, the business terms of such an engagement are relatively straightforward:

• Exactly what would you like us to do for you?
• How long will we work on this for you?
• How many shiny simoleons will you pay us for working on it?; and
• What do we do if things go wrong?

In addition to the usual inclusion of a promise that the bankers won't sell your company's data down the river at the first opportunity—the hallowed confidentiality provision—there really isn't much need for a hell of a lot more in the letter. Find a deal, do it, get paid, and play nice along the way. Simple, right?

* * *

Sadly, we no longer live in prelapsarian times. Ever since the first in-house compliance lawyer slithered down the tree in the Garden of Eden carrying an apple and an Indemnification Provision in its mouth, investment banks' engagement letters have suffered the same legalistic blight that has afflicted every other area of business documentation. Now they are almost comically bloated and opaque fugues of defined terms, parenthetical meanderings, comprehensive itemizations of minor variations on picayune themes, and "provided, howevers":

This letter, when executed by the parties thereto, will constitute an agreement (the “Agreement”) between Company XYZ (the “Company”) and The Devil's Rejects, LLC (“Advisor”), pursuant to which the Company agrees to retain Advisor and Advisor agrees to be retained by the Company under the terms and conditions set forth below.

Responsibility is neatly encapsulated and evaded:

Neither Advisor nor any of its affiliates (nor any of their respective control persons, directors, officers, employees, or agents) shall be liable to the Company or to any other person claiming through the Company for any claim, loss, damage, liability, cost, or expense suffered by the Company or any such other person arising out of or related to Advisor’s engagement hereunder except for a claim, loss, or expense that arises primarily out of or is based primarily upon any action or failure to act by Advisor, other than an action or failure to act undertaken at the request or with the consent of the Company, that is found in a final judicial determination (or a settlement tantamount thereto) to constitute bad faith, willful misconduct, or gross negligence on the part of Advisor.

A close reader of such a contract might begin to wonder just which services exactly the investment bank is supposed to provide under its engagement:

The Company will furnish to Advisor such information as Advisor reasonably requests in connection with the performance of its services hereunder (all such information so furnished is referred to herein as the “Information”). The Company understands and agrees that Advisor, in performing its services hereunder, will use and rely upon the Information as well as publicly available information regarding the Company, the Target Company, and any other potential acquisition candidates and that Advisor does not assume responsibility for independent verification of any information, whether publicly available or otherwise furnished to it, concerning the Company, the Target Company, or any potential acquisition candidates, including, without limitation, any financial information, forecasts, or projections considered by Advisor in connection with the rendering of its services. Accordingly, Advisor shall be entitled to assume and rely upon the accuracy and completeness of all such information and is not required to conduct a physical inspection of any of the assets or liabilities of the Company, the Target Company, or any other entity. With respect to any financial forecasts and projections made available to Advisor by the Company and used by Advisor in its analysis, Advisor shall be entitled to assume that such forecasts and projections have been reasonably prepared upon bases reflecting the best currently available estimates and judgments of the management of the Company.

And that, by the way, is not the worst I have seen, not by a long shot.

Of course, engagement letters are written this way because they are authored and negotiated by lawyers. Lawyers whose job it is to maximize their own client's options, deniability, and wiggle room under the contract at the expense of their counterparty's. The businessmen and bankers who strike the original deal usually have a far more optimistic (some would say naive) view of the relationship, and high hopes the investment bank can help the company strike an attractive, well-priced deal in a reasonable amount of time. It is only when things go bad and the shit hits the fan that the parties begin to point fingers at each other, and the entire mess devolves into a particularly nasty cat fight. Lawyers draft and negotiate engagement letters with just this sort of scenario in mind. I suppose one shouldn't complain: that's what we pay them for.

* * *

As far as an investment bank goes, the truly important thing in an M&A deal is to get paid. Huge quantities of verbiage are shoehorned into engagement letters to delineate details on exactly when this will happen and how many greenbacks need to change hands. It is so important that many banks demand the client pay a fee upon completion of a deal substantially like the one contemplated in the agreement letter even if the bank's engagement has been terminated. This is called a fee "tail," and investment bankers will bargain hard for a tail of up to two years after termination of the original engagement. You can see their point of view: they want to get paid if their former client completes a deal like the one they advised them on within a set period of time. That way, the client is not tempted to get close to agreement, fire the banker, close the deal, and then refuse to pay just because the contract is dead.

You just can imagine how tickled this makes most clients (and their lawyers) feel when they see that little gem. The fee tail and the indemnification provisions—wherein the bank asks the client to protect it from any and all third party claims over the deal come Hell, high water, or four scary looking guys on horseback—are usually the most hotly negotiated terms in an engagement letter. Those are the areas where most disputes, if they do come, will come.

But here's the rub.

Lawyers for investment banks try to draft airtight, ironclad engagement contracts so, if worse comes to worse and the client breaches the agreement, they can sue them for specific performance and/or damages. But I ask you: what kind of fool of a service provider regularly sues its clients? A damn fool, that's who.

The ability to sue your client over breaches in an engagement contract is a nuclear option, at best. For one thing, you better have a pretty airtight legal case, or you are going to look like seventeen kinds of idiot when the judge throws your suit out of court. For another, clients talk, and you can rest assured the fact you are suing Bobby Joe for a little ol' M&A fee on some pissant acquisition is going to get around the Dallas Petroleum Club damn quick. You better hope everyone there thinks Bobby Joe is a lying prick and a complete dickwad, or you can bet your M&A workload in the energy sector is going to suffer a nasty spill going forward.

The only time it makes sense to sue a client over an engagement letter is when the client's behavior is clearly fraudulent, the client is disappearing or doesn't matter in some way, or the money involved is just too big to let go. For that reason, I have seen very few instances over my career where investment banks have taken their clients to court to enforce an engagement contract. (I actually testified on my employer's behalf in one such case years ago, but that client was a complete dickwad, so it made sense. We won.) Usually, the better part of valor—and the better business decision—is to tear up the engagement letter and chalk it up to experience. Most of the time that is the only effective way for an investment bank to buy its way back into the good graces of a frustrated and unhappy client anyway.

* * *

None of these motivating conditions apply in the case of recovering alcoholic struggling insurance company AIG or its majority owner, the Federal Reserve Board, however. Hence, I have to respectfully disagree with Michael Corkery at The Wall Street Journal. In an article today describing how AIG's new CEO is slowing down or postponing the raft of asset sales his predecessors initiated in an attempt to repay taxpayers and how this threatens a huge fee backlog for Wall Street, Mr. Corkery seems to take comfort that some of those fees are protected under contract:

To be sure, the banks may have pocketed many of these fees already or have contracts that AIG and the Federal Reserve, which is heading the restructuring effort, have to keep.

Fortunately, I do not work for any of the firms Mr. Corkery lists. If I did, I would find the existence of any such signed engagement letters very cold comfort indeed.

The prospect of suing the Government of the United States of America to collect a contracted fee on a nonexistent deal strikes me as one of the least intelligent decisions any major Wall Street investment bank could possibly consider nowadays.

And, given recent history, that is truly saying something.

© 2009 The Epicurean Dealmaker. All rights reserved.

Fooled by Fabulousness

Herewith do I present you, Dear Readers, 17 minutes, more or less, of Alain de Botton nattering on about meritocracy, justice, luck, envy, snobbery, and other foibles from the "human anthill," via that unnamed media organization which still refuses to pay lucrative royalties to Yours Truly for the use of his patented, copyrighted, and thoroughly well-known global sobriquet.

Perfect material for wasting time on a slow summer Tuesday and/or stimulating unused centers of reasoning within your brain, depending on your personal capabilities, receptivity, and preferences. I find de Botton's critique of the cult of meritocracy from the importance of happenstance in individuals' lives to be one of the more insightful nuggets within his talk. In this manner, his perspective is not unlike what I find to be one of the few useful strains of argument still emanating from that vast edifice of megalomanical pontification which used to go by the name of Nassim Taleb.



Notwithstanding any other bits of educational or morally enlightening value, I think one of the more entertaining parts was the fake headlines de Botton got the cheesy UK tabloid Sunday Sport to compose based on famous tragedies from the Western tradition. My favorite: the editors' catchy summation of Sophocles' Oedipus Rex as "Sex With Mum Was Blinding."

(Hat tip: A Fistful of Euros, via Dealbreaker. Yes, really: Dealbreaker. It must be a slow month for ridicule in the financial sector.)

© 2009 The Epicurean Dealmaker. All rights reserved.

The Limits of Sympathy

The utility of biography, Dr. Johnson argued, rests on the fact that we can enter by sympathy into situations in which others have found themselves. Parallel circumstances to which we can conform our minds shape every life. Even the great are not removed from the factors common to all: "We are all prompted by the same motives, all deceived by the same fallacies, all animated by hope, obstructed by danger, entangled by desire, and seduced by pleasure." I must confess that twenty years devoted to the biography of Newton have not in my case confirmed Dr. Johnson's dictum. The more I have studied him, the more Newton has receded from me. It has been my privilege at various times to know a number of brilliant men, men whom I acknowledge without hesitation to be my intellectual superiors. I have never, however, met one against whom I was unwilling to measure myself, so that it seemed reasonable to say that I was half as able as the person in question, or a third or a fourth, but in every case a finite fraction. The end result of my study of Newton has served to convince me that with him there is no measure. He has become for me wholly other, one of the tiny handful of supreme geniuses who have shaped the categories of the human intellect, a man not finally reducible to the criteria by which we comprehend our fellow beings, those parallel circumstances of Dr. Johnson.

— Richard S. Westfall, Never at Rest: A Biography of Isaac Newton ¹

Lest you be overawed by the towering, alien intellect of Mr. Westfall's great subject, O Intelligent and Humble Reader, do not forget that it was this same Isaac Newton who is known to have invested a large sum in stock of the South Sea Company near the peak of its bubble in 1720² and who was reported by his niece to have lost £20,000 (or £3 million in today's money) upon its ultimate collapse.

Or, as the great man himself is reputed to have said:

I can calculate the motions of the heavenly bodies, but not the madness of people.

* * *

With all due deference and respect to my learned colleagues in the study and practice of quantitative finance, I will side with Sir Isaac and state that we still have a great deal of work to do before we can confidently predict the madness of our markets.

But then, I'm just an old fogey who finished math at linear algebra and differential equations. What do I know?

¹ Richard S. Westfall, Never at Rest: A Biography of Isaac Newton. Cambridge: Cambridge University Press, 1983, p. x.
² Ibid., pp. 861–862.

© 2009 The Epicurean Dealmaker. All rights reserved.