William D. Cohan, a former managing director at JPMorgan Chase & Co. and former VP at Lazard Frères, explains why M&A bankers don't merit mega-bucks.
The end of the first quarter of 2007 brought the news that global announced M&A deal volume for the three-month period topped US$1.1trillion - making this first quarter the busiest first quarter on record. Not surprisingly, the investment bankers shepherding all these deals are positively giddy, as they and their firms will soon collect - and divvy up - some US$5bn in fees just for putting them together.
But as the bankers prepare to drive off - yet again - with their new Ferrari 612 Scagliettis and Bentley Continental GTs, it is more appropriate than ever to ask why investment bankers get paid so much anyway. What do they do that could possibly justify multi-million dollar paydays year after year?
No pain, lots of gain
Unlike investors, entrepreneurs and some private equity and hedge fund moguls, investment bankers take no financial risk - zero! - for their excessive compensation. In case anyone wonders, M&A bankers provide specialised advice to their clients on mergers, acquisitions and divestitures. These assignments can be successfully concluded in a week's time for a merger of two determined public companies, although far more often these deals take months, and often years, to consummate.
Another type of investment banker - the so-called 'coverage bankers' - have less specialised skills than M&A bankers; they are in charge of the 'overall relationship' with a client and are responsible for 'delivering the firm' and all of its products - M&A, debt and equity underwriting, research, money management, clearing - to corporate executives. Coverage bankers also have the arduous task of taking clients to the Super Bowl, Final Four and the Masters. The bankers' fees are received only when the deal closes.
These responsibilities are hardly rocket science, world changing or socially redeeming. True, for the bankers involved the hours are long, the travel gruelling and unrewarding and the internal politics brutal, Darwinian and utterly unattractive. The old saw about investment bankers - "You won't know your children, but you'll get to know your grandchildren really well" - is sadly still true. But the excessive pay more than makes up for any inconvenience: managing directors at top Wall Street firms routinely receive several million dollars a year; the best can easily make more than US$10m, especially in a hot market. In contrast, Wall Street lawyers get paid by the hour - as much as US$750 per - regardless of whether a deal closes or not.
Adam Smith would not be pleased
One thing is certain about the enormity of these fees: they are not based on strictly free-market forces, any more than the price of a litre of gasoline is set simply by supply and demand.
Like OPEC, investment banking services are controlled by a cartel of the same top 15 Wall Street firms, year after year. The firms set the price of their M&A services using a uniform 'fee grid', which provides for a fee equal to a sliding percentage on the deal size: the larger the deal, the smaller the percentage.
For raising capital, the pricing is even more rigid: for instance, 7% for an IPO or 3% for a high-yield deal. But while the percentages are small, the absolute amounts of the fees are huge. Unlike OPEC, though, Wall Street firms do not meet together behind closed doors to agree on prices. They are far too clever to commit such a blatant felony. Rather, there is a more subtle form of collusion that depends on anecdotal evidence about what competitors charge. The information is not hard to come by. For the top firms, the key is to not break ranks and give discounts (although this does occasionally happen).
But it takes two to tango, as they say. Corporate CEOs are the ones paying these ridiculous fees to the investment bankers, in part because of the cartel - after all, access to capital is the life blood of capitalism - and, as important, because CEOs and boards of directors consider the advice they get from bankers an insurance policy if things go wrong. The fee is akin to an insurance premium.
Time for a change
Temperately-inclined bankers might rein in their excessive fees. But, let's face it - Wall Street has never been very good at cutting its own compensation.
Accordingly, the time has come for corporate CEOs, boards of directors and shareholders to break the investment banking fee cartel. Stop paying millions for services worth far less. There is plenty of evidence it can be done, too. One need only see how tightly screwed down the banking fees are when Wall Street is paying them to itself.
Look no further than the below-market fees paid by Lazard to Wall Street for its own IPO in May 2005 - 5% instead of 7%, saving the firm around US$17m - or the rock-bottom fees that Blackstone is expected to pay to Wall Street for its highly anticipated IPO. According to one banker involved, his firm is doing the deal "for charity". All it takes is a little courage.
· William D. Cohan is author of The Last Tycoons: The Secret History of Lazard Frères & Co., published by Doubleday Books.