Primus inter Pares

No! I am not Prince Hamlet, nor was meant to be;
Am an attendant lord, one that will do
To swell a progress, start a scene or two,
Advise the prince; no doubt, an easy tool,
Deferential, glad to be of use,
Politic, cautious, and meticulous;
Full of high sentence, but a bit obtuse;
At times, indeed, almost ridiculous—
Almost, at times, the Fool.

— T.S. Eliot, The Love Song of J. Alfred Prufrock

Bruce, you sneaky bastard.

By now, most of you in the hermetic little world of finance have discovered that Bruce Wasserstein passed away Wednesday. He snuck out of the theatre early, making some excuse or other about taking a phone call or smoking a cigarette or something, and never returned. He left so quickly and quietly it feels like he skipped out on a debt. He was 61.

It is a measure of how much the world has changed from the days when the so-called "Father of M&A" bestrode the financial markets like a colossus that the ripples from his passing have already begun to dissipate. He has already disappeared from the front page of The Deal.com, the online version of the M&A newspaper of record which he conceived over a decade ago and supported until his death, hurried off by the bustle of current deals and events. From my admittedly narrow vantage point atop a skyscraper deep in the heart of the least American part of America, I cannot tell whether his passage even registered with the country at large. "Bruce who?," most people probably asked, "Wasn't he the boy who got trapped in the balloon?" Sic transit gloria.

In some respects, I think Bruce would have wanted it this way. Dealmaking is a guerrilla war that never ends, fought in both sunlight and shade, in clamor and in silence. When your captain is killed, you pause to recite a hurried prayer, then you step over his cooling body and move on. There are no battlefield monuments in this war. Nor should there be.

On the other hand, there was part of Bruce—a big part—that loved the limelight and craved being the center of attention. In this way, he was completely unlike T.S. Eliot's attendant lord. During his heyday in the 1980s, Bruce intentionally broke the mold of the modest, retiring consigliere to become a prime mover himself. He abjured the merger advisor's traditional place behind the throne of the CEO or the private equity mogul to become a kingmaker, a catalyst, and a decision maker in his own right. He grabbed the spotlight away from companies and firms actually doing the deals and shone it upon himself. In the process, he shone a light into the heretofore obscure and recondite universe of M&A bankers, and he helped raise awareness of them and their trade far beyond the claustrophobic little world of central and lower Manhattan and the boardrooms of major corporations. Bruce became the story.

And some people never forgave him for that.

* * *

Like most complicated men, Bruce Wasserstein leaves a complicated legacy.

He was brilliant and precocious, sure. He was also loud, arrogant, and overbearing, but he could sweet talk a pit bull off a juicy bone. He was principled and opportunistic. He could be simultaneously disheveled and as smooth as glass.

As the mainstream media has done the rounds of his peers, clients, and competitors, many have come to call him an innovator in the field of M&A. I think this misses the mark. Sure, Bruce was smart as hell, and thought up some pretty tricky maneuvers in his day, alongside a pretty long list of other people. But it's not like he made the kind of enduring contribution that, say, über-attorney Marty Lipton did when he invented the poison pill. There is no M&A Heimlich Maneuver with Bruce's name on it. It would be foolish to look for one.

Being smart and effective in M&A requires being able to apply techniques, approaches, insight, and analysis to an ever-shifting set of contingencies and personalities in the context of a potential deal. At base, it is a tactical art, and Bruce was a master tactician. Virtually no deal is exactly like another, just as no client, deal rival, or competitor is like another. You need to be able to sense shifting strengths, weaknesses, threats, and opportunities and craft an approach to deal with them in real time. It is an art that requires quick, perceptive, deep, and supple thinking. Like chess, it encourages you to think several moves ahead. Unlike chess, legal moves are practically unlimited, and each of your pieces has a sometimes distressingly unique personality and often requires tremendous persuasion just to get off its ass and move already.

Unlike many M&A bankers, however, who are good in the trenches of individual battles, Bruce proved himself capable of waging a war as well. Like the best generals, he could think not only tactically but strategically. This, for me, is most clearly demonstrated by his masterful campaign to wrest control of the storied investment bank Lazard from the iron grip of Michel David-Weill. By the time David-Weill hired Wasserstein to help bolster his firm's sagging fortunes, Bruce had already made a large fortune pawning off his old boutique to Dresdner Bank. It is not clear to me he was looking for much more than a comfortable perch to while away the twilight of his career and enjoy his newly monetized wealth. However, soon after he arrived, Bruce must have sensed an opportunity to gain control of the factionalized firm from its imperious owner, and he set about doing so. Long story short, he totally remade the firm by hiring tons of expensive new bankers, which had the simultaneously happy effect of stacking the ranks with Wasserstein loyalists and draining so much cash from Lazard's coffers that David-Weill and the other absentee owners ultimately had to agree to take the firm public. In the midst of these maneuverings, Bruce executed a neat judo flip and defenestrated the fearsome David-Weill from the firm which had been his lifelong legacy. It was a masterpiece of strategic dealmaking and boardroom Realpolitik.

But Bruce could often be his own worst enemy. He famously detested the moniker "Bid 'em up Bruce" which rival dealmakers painted him with early in his career, but the label stuck, and for good reason. Furthermore, his determined cultivation of the limelight and naked pursuit of his own self interest severely colored most corporate and private equity dealmakers' perceptions of him. Shortly after he achieved notoriety on Wall Street—and, later, in the broader corporate and dealmaking world—people began to view Bruce as a form of plutonium. In other words, a really powerful substance that was extremely effective in limited—often hostile—circumstances, but one which could poison the unwary user if not handled with extreme care.

Many CEOs and Boards of Directors held their noses when hiring Bruce, and kept their hands on their wallets at all times when he was in the room. A common complaint of dealmakers at the time was that there were always at least five competing motives at play when a client discussed a potential deal with Bruce: the client's own, Bruce's own obvious self-interest, and three other motives percolating in Bruce's head which might or might not become apparent over time. The only thing most clients were certain of was that Bruce's motives were only coincidentally aligned with their own. Often, companies which had already retained advisors would hire Bruce's firm as well, just to prevent him from working for real or potential competitors on the deal. They would then pointedly fail to invite him to meetings. Bruce probably took umbrage at this kind of behavior, and I am sure some of it was unfair, but you can be sure he cashed the fee checks anyway. I certainly would have.

* * *

I do not have a strong handle on Bruce Wasserstein as a person. He was neither mentor nor friend to me, and we crossed paths only a few times over the course of my career, and not meaningfully.

But I did admire how he aged over time. He seemed to lose some of his rough edges and arrogance with age and success, and he developed a personal gravitas that was both pleasing and impressive in recent years. Some of the most heartfelt tributes to him I have seen have come from the field of journalism, which he had a lifelong passion for, and which he supported with money and influence for decades. It appears he could stay in the background, in a supporting role, where his media properties were involved. This does him great credit.

His peers and rivals have lined up to offer praise and remembrance as well. I suppose I am too cynical, but my investment banker's radar has picked up far too much preemptive posturing and self-aggrandizement in most of these supposed encomia. Even in death, Bruce's competitors feel the need to measure themselves against him. Which, I suppose, is a fair measure of his stature.

At an industry conference in Cambridge today, David de Rothschild said

he was “extremely sad to see someone of that caliber go” and that “no normal banker should feel any different to see such a competitor go.”

Methinks this smacks of too much protest. Every senior investment banker—and hundreds of senior executives outside the industry all over the world—is perfectly justified in having mixed feelings about Bruce Wasserstein's passing. On the one hand, a brilliant and tremendously influential industry figure—one who arguably did more than anyone else to transform the M&A industry—has passed away, and the industry is the poorer for it. On the other hand, Bruce was a fearsome and clever competitor and adversary to many of us, and I am sure a substantial number of people around the world breathed a somewhat guilty sigh of relief at the news of his passing.

After all, I do not recall any of the leaders of Europe suffering particular regret at the news of Napoleon Bonaparte's death, either.

* * *

For the dead, we owe only honesty and respect. For the living, we owe our sympathy.

In closing, let me acknowledge that Bruce was also a human being, with family, friends, and others who cared for him. I extend my personal sympathies to each and every one of them for their loss.

Exalted and sanctified is God's great name
in the world which He has created according to His will
and may He establish His kingdom
may His salvation blossom and His anointed near
in your lifetime and your days
and in the lifetimes of all the House of Israel
speedily and soon; and say, Amen.

© 2009 The Epicurean Dealmaker. All rights reserved.

Wherein I Go Mosquito Hunting with a Howitzer

I guess James Kwak ate a bad oyster or two at the Yale Law School cafeteria this evening. He rants:

Further Proof That Nothing Has Changed

Overheard on the streets of New Haven, just ten minutes ago:

Two young women, almost certainly Yale undergraduates, are walking down York Street, discussing their efforts to get jobs as bankers.

Student #1: “Why does everyone want to go into banking?” [Note: When an Ivy League undergrad says "banking," he or she invariably means "investment banking," meaning underwriting or trading.]

Student #2: “We should advertise – ‘Being a lawyer is so much better than banking.’”

Student #1 (after a pause): “Seriously, everyone wants to go into banking.”

End scene.

Also further proof that no one does campus recruiting better than a Wall Street investment bank. Or do undergrads these days want to work in industries that are best known for torpedoing the entire economy through a combination of greed and incompetence (and abusing their customers along the way)?

At least, after the last twelve months, no one can claim that he didn’t know what kind of business he was getting into.

By James Kwak

I mean, seriously, Jim, what the fuck?

* * *

Let me respond to Mr. Kwak's apparently throwaway anecdote with a few of what I hope will be corrective observations.

First, unlike Mr. Kwak, I do not pretend to know what Yale undergrads mean by "banking" or "investment banking." But as a practitioner with almost twenty years in the business, I can most reliably assure him there is more to investment banking than securities underwriting and trading. Depending on which kind of investment bank we are talking about, its business can comfortably encompass not only these, but also mergers and acquisition advisory, restructuring advisory, corporate lending, leveraged finance, derivatives, structured finance, proprietary trading, and even private equity investment. These are all very different businesses, with different career paths, different duties and responsibilities, and different cognitive and personality requirements for individuals who might choose to enter them.

An individual who might make an excellent corporate financier is almost certainly incapable of being an outstanding trader, and vice versa. I should bloody well hope that any Wall Street recruiter worth his or her salt has identified the different career paths available at his or her firm for the benefit of the wide-eyed young undergraduates and clarified their different requirements. If not, they should damn well be fired.

Perhaps it would bolster Mr. Kwak's understanding if I were to draw an analogy with his current career path. Saying that investment banking consists solely of underwriting and trading is almost exactly analogous to saying the practice of law consists of no more than intellectual property management and environmental litigation. (Which, for those of you not well versed in the intricacies of the legal industry, is fucking preposterous.)

I don't know how current Ivy Leaguers think, Mr. Kwak (and I suspect you don't either), but if you're going to presume to talk about my industry in a public forum, I suggest you get it right.

* * *

Second, Wall Street investment banks do do campus recruiting better than anyone else, or at least they used to. Part of this can no doubt be attributed to the fact that successful investment bankers like me are devilishly charming, stunningly handsome, scathingly brilliant, and in every other respect fucking paragons of the best and brightest an Ivy League education has to offer. Of course, even those nattering nabobs of negativism like Mr. Kwak who would deny the preceding have to admit upon examination of the facts that Wall Street's recruiting efforts on university campuses have been massively successful for the simple reason that—for a certain type of Ivy League individual—these jobs are fucking awesome.

How so, you ask? Well, let me count (a few of) the ways.

For one thing, they are exciting.

Unlike, say, 99.6% of all other jobs available to a wet-behind-the-ears idiot in proud possession of little more than an expensive college degree, becoming an investment banker fresh out of college is a huge rush. Depending on what role they perform, new entrants just weeks into the job can participate in billion dollar underwritings, multi-billion dollar mergers, complicated cross-border restructurings, or devilishly complex trading programs, all the while possessing a level of experience formally known in the industry as "jack shit."

In what other industry, I ask you, can a 22-year-old who just stopped wetting the bed three weeks ago participate in a deal which runs for weeks on the cover of The Wall Street Journal or the Financial Times? To be sure, he is probably doing little more than making copies, getting coffee, and trying not to look as stupid and lost as he feels, but at least he is in the room. Contrast this, if you will, with a fresh McKinsey recruit tasked with interviewing shop floor supervisors to develop a human resources inventory for a ball bearing manufacturer in East Bumfuck, Illinois. Or a pre-law student who spends 80 hours a week in a windowless basement cross-checking sale-leaseback contracts for a patent dispute in Moldavia. On average, young investment bankers spend less time traveling that management consultants and more time sleeping than corporate attorneys. Plus, they get to tell their friends and family that they carried Bruce Wasserstein's bags. What could be better?

For another, investment banking jobs are challenging.

Excluding certain training programs for elite military units, there are few career choices available to a young person as emotionally and intellectually challenging as investment banking. The pressure is intense, the expectations of your bosses and clients completely insane, and you swim in a Sargasso Sea full of assholes who would as soon rip your head off as look at you. It is an environment, if you can survive it, that fosters an intense esprit de corps among your peers and immense personal pride in your own accomplishments. As such, it can be considered emotional crack cocaine to those hyperaggressive, intensely driven, super-competitive young psychopaths whose mommies and daddies have pushed them down the Deerfield–Harvard–Goldman Sachs path to Übermensch-dom from infancy.

Long gone are the days when investment banking was a quiet backwater for the idiot sons of wealthy WASPs. For decades now, socially ambitious families have been steering brilliant little Bobby and Sally toward positions at Goldman Sachs and Morgan Stanley as the pinnacle of social achievement. Bobby and Sally have drunk this goal in with their mother's milk. Surely you don't think a little recession or crisis is going to change that right away, do you?

And, finally, there is the money.

Surely I don't have to explain about the money.

* * *

Third, I really do take exception to Mr. Kwak's pusillanimous little swipe at my industry for "torpedoing the entire economy." Admittedly, several large investment and commercial banks utterly failed to cover themselves in glory during the recent crisis. I have said so myself, repeatedly, in these pages. However, notwithstanding Mr. Kwak's insinuation, investment bankers were far from alone in contributing to the epic clusterfuck we have just lived through. We had plenty of help from shortsighted and incompetent regulators, meretricious and ignorant politicians, and greedy and disingenuous investors, not to mention millions of ordinary Americans who apparently believed it was their God-given right to own a million dollar house and three plasma televisions, no matter how little money they made.

In fact, I think you might have to look long and hard to find someone who was not culpable in some way for what happened. I, for one, would not automatically exclude the other professional enablers of corporate and institutional idiocy in our economy: the management consultants and the lawyers. It is a well-known fact that Mr. Kwak's own alma mater, McKinsey, has been the strategic consulting firm of choice for almost every major Wall Street investment bank for decades. Bang-up job, Jim.

* * *

Anyway, I grow tired of shellacking Mr. Kwak's flimsy, ill-considered post with the Howitzer of Truth, so I will try to close on a more productive note.

For those youngsters still considering a career in investment banking, I would offer the following. On the positive side, the excitement, challenge, and relatively plentiful monetary rewards of a career in my business should remain. The fundamental nature of the business, and the need for our services in the economy, will not change. On the negative side—and diminishing somewhat the preceding attractions, at least for a time—the industry will shrink, and this will make it harder both to get and to keep a job. Some subspecialities on the trading side might disappear completely.

But if you are smart, aggressive, driven, and competitive, I can think of few industries better suited to your personality than mine.¹ (And, unlike elite military units, people rarely shoot at investment bankers. At least not yet.) You may not receive the kind of social admiration and approbation of your career that you and your parents were looking forward to, but the personal rewards of doing well in one of the toughest professions out there will remain.

And, in any event, you will always be able to sneer with impunity at the lawyers.

UPDATE: To his credit, James Kwak has removed the egregious crack to which I took offense, calling it "gratuitous," and replaced it with a more anodyne remark. I will let my comments stand, however, since his original swipe was of a kind with many of the ludicrous comments attending his post. It is also sadly symptomatic of a persistent knee-jerk tendency in the media and the populace at large to scapegoat investment banking for all our current troubles, whereas by my most recent calculations we can legitimately be blamed for only 16.27% of the crisis.

POSTSCRIPT: Some correspondents have taken exception to my apparent boosterism of entry-level career opportunities in investment banking. Should any of you be of like mind, might I gently suggest you reread my remarks with a more critical eye? You might detect a faint whiff of a commodity somewhat rare in these over-strident times: irony. Just a thought.

¹ Especially if you're a girl.

© 2009 The Epicurean Dealmaker. All rights reserved.

Cold Pastoral

Heard melodies are sweet, but those unheard
Are sweeter; therefore, ye soft pipes, play on;
Not to the sensual ear, but, more endeared,
Pipe to the spirit ditties of no tone:
Fair youth, beneath the trees, thou canst not leave
Thy song, nor ever can those trees be bare;
Bold Lover, never, never canst thou kiss,
Though winning near the goal —yet, do not grieve;
She cannot fade, though thou hast not thy bliss,
For ever wilt thou love, and she be fair!

...

O Attic shape! Fair attitude! with brede
Of marble men and maidens overwrought,
With forest branches and the trodden weed;
Thou, silent form, dost tease us out of thought
As doth eternity: Cold pastoral!
When old age shall this generation waste,
Thou shalt remain, in midst of other woe
Than ours, a friend to man, to whom thou sayst,
"'Beauty is truth, truth beauty,' —that is all
Ye know on earth, and all ye need to know."

— John Keats, Ode on a Grecian Urn

Enjoy your weekend.

© 2009 The Epicurean Dealmaker. All rights reserved.

Res Ipsa Loquitur

Subsequent to my recent half-hearted cudgeling of the Shaggy Horse of Shareholder Governance as an important contributor to the excessive pursuit of risky returns by publicly-owned financial institutions, my argument received overwhelming reinforcement today in the pages of the The New York Times Dealbook from the person of scarily smart and excessively erudite Delaware corporate jurist Leo E. Strine, Jr.

Not only did Herr Professor Doktor Strine take the heretofore only slightly bruised nag out back and decisively beat it to death, he skinned it, deboned it, rendered its fat for glue, and gilded its hooves into four rather fetching ashtrays for the Court of Chancery's waiting room. In short, in your Humble Correspondent's considered opinion, he nailed it.

In a nutshell, the Esteemed Vice Chancellor most assuredly does not agree with those who believe that all public shareholders were innocent dupes taken along for a ride by evil, greedy, grasping investment bankers and their bosses in the recent run-up to the crisis:

Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage.

He continues:

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather [than] durably.

This is consistent with my view, that public shareholders of investment banks, as a group, did not act to brake the risk taking of their employees at all, but rather encouraged and rewarded it, or—what is perhaps more pertinent—punished any executive who did not embrace such activity wholeheartedly.

* * *

What I find most interesting about Mr. Strine's remarks is the salient distinction he draws among the motivations and behavior of different kinds of public shareholder. To the best of my admittedly limited knowledge, this is the first instance I am aware of where anyone has focused on this issue to this extent. He draws from it some useful policy prescriptions:

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

Of course, this analysis and argument applies more broadly than just to publicly owned financial institutions. However, given the extreme sensitivity said financial institutions have proved to have toward excessive risk taking, and the genuinely calamitous negative externalities they have inflicted on society at large as a result, I think the Honorable judge's recommendations have particular force in their case.

In any event, I believe Mr. Strine's analysis should conclusively disabuse participants in the current debate over financial regulatory reform of two related notions. The first is the red herring that somehow stronger corporate governance by public shareholders over investment bank Boards and executives would have prevented the kind of reckless risk taking that brought these firms—and the global economy at large—to the brink. The second is the canard that all public shareholders are alike, and they all share the same interests and motivations.

Realizing that the second of these is false, and that Fidelity Investments and SAC Capital do not have the same investment timeframe and objectives as Aunt Millie or even the Ohio Teachers Pension Fund, would have a highly salutary effect on the beliefs and behavior of truly long-term shareholders.

If nothing else, getting Aunt Millie to realize she is the only one in the shark tank without a safety cage should do her a world of good.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part IV

Westley: "Who are you? Are we enemies? Why am I on this wall? Where is Buttercup?"
Inigo Montoya: "Let me 'splain. ... [pause] ... No, there is too much. Let me sum up."

— The Princess Bride

* *

EDITOR'S NOTE: This is the fourth and final installment of a multi-post treatise on investment banking compensation. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry;
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay; and
• Part III: Seed of Destruction, about risk factors and risk management in the industry

This post attempts to tie together the preceding entries and come to some sort of reasoned conclusions. Fasten your seatbelts.

* *
— Part IV: Darkness Calls —

We have covered a lot of territory already. Let me sum up.

Traditionally, investment banks acted as intermediaries or agents for wholesale capital markets transactions, not principals. As such, while they did perform services that exposed capital to risk, traditionally these risks were of short duration, relatively small, and very well contained. Risky activities such as these are concentrated on the capital markets (or sales and trading) side of the business, and consist of using the bank's capital on a temporary basis to facilitate securities issuance or securities trading by their institutional customers. Due to investment banks' privileged position at the nexus of market flows and information and their ability and inclination to trade rapidly in and out of positions, banks have historically been able to conduct such business pretty successfully using relatively small amounts of equity capital.

Because their business is designed to make money off the flow and volume of transactions in the marketplace, rather than off sustained price appreciation or direct investment, investment banks have a business model and a culture which focuses almost exclusively on chasing transaction fees, or revenues. Since markets are often volatile, and revenue opportunities are fleeting, there is an institutional bias within investment banks to chase and book revenue first and worry about consequences later. With its low fixed salary component and theoretically unlimited upside incentive bonus, compensation for revenue-producing investment bankers is explicitly designed to encourage this pursuit.

On the other hand, investment bankers historically were very good at managing their business risks. Capital markets risk used to be managed by senior partners who had been traders themselves, and who had complete visibility and understanding of the risks in the bank's trading book.¹ Encouraging and supporting this hands-on supervision was the fact that senior trading partners typically had a major portion of their own personal wealth tied up in the equity capital of the firm, along with that of senior management and other partners. Accordingly, risk management was a very high priority for all of the firm's key decision makers, and it acted as a powerful and effective brake on the countervailing tendency for bankers to pursue revenues at all costs.

Using this time-tested model, traditional investment banks used to do pretty well for themselves. They ate what they killed, feasting in times of plenty and tightening their belts in times of famine. Because the bankers were the owners of the firm, they kept a pretty tight balance between revenue generation and capital preservation. Accordingly, firm-threatening or -ending mistakes were rare.

But this was not a model suited to rapid growth or global scale. And as the capital markets continued to grow, and the global economy became more connected, the old partnership model of investment banking began to disappear.

* * *

In its place arose large, publicly-owned global investment banks and—with the gradual erosion of Glass-Steagall barriers between commercial and investment banking—large, integrated "universal" banks. Banks funded their expansion with increasing doses of outside capital—other people's money—and merged and acquired their way to greatness with their peers. Unfortunately, with increased scale many of the built-in checks and balances of the partnership model began to break down.

Large public banks did retain much of the partnership compensation model, which deferred ever more of a banker's pay the higher up he got and the more he made. But keeping risk management a central concern for every banker was never a principal reason for this. Instead, banks were much more concerned with preserving cash and attempting to lock up bankers with deferred equity so they could not leave for a competitor. More importantly, deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made. A banker's deferred equity nut began to look more and more like a ball and chain, rather than a direct link and meaningful incentive to control the overall risk of his employer.

Exacerbating this was the professionalization of risk management at large investment banks. As banks got bigger, and their trading books swelled with ever more complex securities, grizzled old traders with big equity stakes in the firm no longer had the experience or the bandwidth to monitor their underlings' trading positions. Instead, professional, dedicated risk managers—who often came from a structuring or academic background, not sales and trading—took over the role of trying to say "enough" or "no" to the hotshot revenue producers. Given the revenue-worshipping culture embedded at the core of every investment bank, such a system was bound to fail, as the big swinging dicks with real skin in the game ignored, bullied, or coopted the sniveling little (equity-less) PhDs sent to rein them in.²

Adding to the problem, the only people with enough skin in the game and the power to do something about firm risk—senior executives—became increasingly beholden to outside public shareholders. Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves.³ They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

Finally, the growth in investment bank balance sheets and the increasingly complex securities either demanded by customers or manufactured "on spec" by revenue hungry bankers led to increasing concentrations of opaque and badly understood risk in many banks' trading books. Market making shaded into speculative trading, which morphed into full-blown proprietary trading (and even internal hedge funds at some banks). Investment banks began to accumulate—apparently without their full knowledge—poorly understood contingent obligations that hinged upon their traditional market-making role as buyer of last resort for securities they underwrote. Risk seems to have been misunderstood and significantly underestimated by almost everybody in the financial markets, but when the shit hit the fan, investment banks were uniquely positioned to have most of it blow right back onto them.

Of course, increasing leverage and lax regulatory oversight played a role, too. But leverage acted as an accelerant and a conduit for contagion across market sectors, and sloppy supervision added to the general haze of ignorance and the thicket of unintended consequences. Neither was the ultimate source of the breakdown in the financial markets. Had they not been present, the fire might not have spread so quickly or so broadly. But make no mistake: the fire would have started anyway, and it still would have burned down a pretty big swath of the financial forest.

* * *

So, what can we conclude from all this?

Well, for one thing, the need for traditional investment banking services—intermediating capital flows and financial transactions for all comers—is not going to go away any time soon. It is simply impractical to imagine a world without investment bankers, no matter how eagerly the torch and pitchfork crowd would love to do so. But it seems to be a somewhat paradoxical business, one best suited to entities which combine extremely aggressive pursuit of revenues with a highly developed aversion to risk. The old partnership system, where the revenue producing bankers were also the owners and providers of equity capital, seemed to work pretty well. The currently much-maligned system of investment banking compensation is a relic of that earlier time, but it does not seem to balance these tensions well in today's huge, publicly-owned global investment banks.

Instead of the old integrated risk model, we now seem to have one where outside investors have high risk tolerance, revenue producing employees have low risk tolerance but cannot effectively influence it, and professional risk managers tasked with controlling it are politically and economically disenfranchised. This is not an unavoidable outcome of the current model, but it certainly makes the whole system far more difficult to manage. Unfortunately, there is absolutely no way to recreate entities the size of Goldman Sachs or Citigroup with purely private partnership capital. Even if you could, I am not sure you could avoid the span of control, scale, and complexity issues bedeviling these enterprises.

One solution, of course, is to shrink investment banks down to a more "manageable" size, whatever that means. The immediate question this raises, however, is whether such smaller banks could perform their systemic function in today's highly integrated global financial system adequately. The next question, if we determine they cannot, is whether we would miss them. My crystal ball is too cloudy to offer an opinion on that one, although I can guess what Matt Taibbi would say.

* * *

In any event, I hope I have convinced those hardy souls who have soldiered along with me this far that investment banking compensation was not the sole source of our current troubles. It is part of the puzzle, make no mistake, but it is not the only piece. Therefore, fixing it and nothing else will not right the ship.

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

Perhaps a solution could be structured which balances all of the competing pressures and strains that the modern investment bank encounters. It would be complicated, involve multiple variables, and require constant monitoring, adjustment, and correction to adapt to ever changing market conditions. It sounds like a fun project for Larry Summers and crew.

Sadly, they never taught multivariate optimization techniques on the savannah when I was coming up in the business. I guess I'll just sit here, gnawing a wildebeest bone, until somebody tells me what to do.

— THE END —

¹ Capital markets activities are the only significant source of firm-wide risk for the traditional pure investment bank.
² This was made worse by the fact that the huge expansion in most banks' capital markets operations during the Great Moderation meant that Capital Markets grabbed the political reins of power from their partners in M&A and Corporate Finance. (Investment banks allocate power based on the Golden Rule: He who brings in the gold gets to make the rules.) Since M&A and Corp Fin bankers enjoy little direct upside from increasing sales and trading revenues but face a lot of downside if sales and trading blows up, they tend to be strong advocates for clear risk limits and controls in the trading book. But the traders were the ones bringing home most of the bacon, so M&A and Corp Fin bankers had no choice but to shut up and view the ballooning risk with increasing disquiet.
³ If Fidelity or another outside investor got worried about Lehman Brothers, they could (at least theoretically) sell all their shares. Dick Fuld and most of the other bankers at Lehman had to watch helplessly as a lifetime's worth of deferred compensation evaporated into thin air when the firm collapsed.

Photo credit for the series: Nathan Myhrvold's 2007 photo essay on lions in Botswana, Africa. Warning: blood, gore, and sex galore. Now do you see the connection?

© 2009 The Epicurean Dealmaker. All rights reserved.