By Joseph S. Fichera
First released in 1988
The headlines now are filled with stories of Wall Street’s woes. Thousands are losing their jobs. Once powerful firms are being humbled by their own increasing debt and management problems. Many firms are turning to management consultants, a sure sign of widespread turmoil and desperation, for answers. How did an industry that could boast the highest returns, the brightest talent and the greatest compensation get to be in such trouble?
Part of the answer rests in the compensation system that fueled the explosive growth of investment banking. The bonus system — the annual ritual of money and merit. It is at bonus time that bankers, traders and salesmen look to getting their rewards. This is the time when the legendary endless hours, extraordinary creativity and plain hard work get the big payoff… for the year’s work.
And, that is it. The bonus was simply for a year’s work; but more importantly, the entire focus of the year’s work was the bonus.
Does this short-term system serve the long-term best interests of clients and Wall Street firms themselves, particularly now? The bonus system has had an insidious effect on the economy, Wall Street’s clients and ourselves as investment bankers. It directly skewed the structure of many Wall Street firms and, thereby, the national economy. It guided the energy of many of our society’s best and brightest members, making their perspective short and their attitudes increasingly arrogant. It often undermined and diluted traditional standards of excellence.
But, the Wall Street bonus system reflects a larger societal problem, not simple greed as many believe, but the almost insatiable desire to have everything now. Bonuses are simple and logical. There is nothing wrong with the concept. But, the amounts involved on Wall Street, in practice, are enormous, almost unreal. And, now in the midst of extraordinary turmoil perhaps the way we pay ourselves must be challenged.
Wall Street bonuses have become legendary. It is not unusual for a 28 year old with three years experience to earn $200,000, 70% of it in bonus. Senior officers (only seven to ten years experience) can earn $800,000 to $1 million or more, 90% of it in bonus. Multi-million dollar bonuses are not unheard of either. Bruce Wasserstein, First Boston’s former head of Mergers and Acquisitions reportedly earned $6 million (many times the size of an average lottery in the United States) the year before he left First Boston to form his own firm
By Wall Street standards, do these people deserve bonuses of such magnitude? Absolutely. Why? Because they have contributed many times their bonus in revenues to the firm. All those revenues in the year the bonus is determined deserve to be rewarded.
UPSIDE DOWN INCENTIVES
In the past, year-end bonuses were necessary largely because profitability of the firm was not known until the end of the year. Most investment banks were relatively small and stable partnerships in which the key employees shared in the firm’s risk. The profitability of the firm fluctuated during the year and the bonus system paid employees once profits were known.
The simplicity of that system today, with the vast amounts of money at stake, masks the practical incentives it creates for investment bankers (associates, officers, directors — everyone) to produce those revenues. Firms are managed differently because of the bonus system; clients receive different advice and services because of their individual banker’s potential bonus.
Basic business principles get ignored. Teamwork is limited to the fewest possible numbers within a firm to ensure narrow credit is given for a deal. Bankers become like “independent contractors,” more loyal to the bonus driven deal than the employer. Mediocre performance, products and services become increasingly tolerated so long as the fees come in. Management becomes wholly opportunistic allowing little time for investing in the bankers (planning, training or developing them) or in clients and prospective clients who don’t have a deal pending. And the financial products and transactions marketed by the front line bankers are dictated first and foremost by the revenues to be generated in the current year, the year the bonus is paid by the then-current employer.
THERE IS NO TOMORROW
For investment bankers, standard definitions of time change because of the bonus system. Short-term becomes “this month or next,” long-term becomes “December” i.e. the last month in the bonus cycle and the distant future becomes anything that does not or will not take place until the following year, i.e. after this year’s bonus has been paid.
Bonuses reduce the investment bank’s productive work year by usually 5-7 weeks. That’s about the time that everyone negotiates and awaits bonus decisions. Few bankers work at the same pace during this critical time since if they don’t like the bonus they may just want to leave.
During the year, the potential bonus influences each banker’s day-to-day activities and strategic decisions. For example, when an investment banker is doing new business development and must decide how to use his/her most valuable asset, time, he/she has a strong incentive to ignore the concept of “present value,” perhaps the most basic business principle. Every business school student is taught that if one has to choose between two projects of equal risk — Project A which pays one nothing in the first year but $500,000 in revenue a year for ten years thereafter and Project B which pays one $1 million in the first year and nothing thereafter — one should choose Project A. The present value (by any reasonable discount rate) of the future revenue of A, even when added to getting nothing today, exceeds the $1 million payout of Project B.
But, the investment banker, whether he/she is choosing which clients and prospects to call upon or which financial products to market chooses B, because it maximizes the likelihood of a bigger bonus this year. The revenue of A is in the “distant future.” Besides the banker may not even be working at this particular firm when that future revenue would be paid. He/she may be somewhere else with an even bigger, perhaps guaranteed, bonus.
In 1984, for example, bankers at Shearson Lehman aggressively marketed to clients and prospects a highly profitable new financing product called Money Market Preferred (MMP) stock. MMP is a preferred stock whose dividend rate is reset, subject to a cap, every 49 days by an investor auction. Substantial and irreversible economic penalties are imposed on the issuer if ever an auction fails to sell all shares, even if by a single share, or the issuer needs cash and skips a dividend.
MMP was more immediately profitable than similar financing instruments. The investment bank would receive $1.5 million up front for every $100 million sold through them. The security would be sold to investors who would normally buy commercial paper (CP). If the client issued the same amount of CP, the banker would receive less than $100,000 in fees. If the client sold other forms of quasi-equity (like subordinated capital notes), it might pay $3/4 million in fees but pay a higher fixed rate to investors for 10-12 years. With MMP, clients got the lower commercial paper rates and equity accounting; the investment banker received the higher equity fees and sold it like commercial paper. MMP quickly became popular among bankers at all the major investment banks.
But a focus on short-term benefits proved costly. Despite a precarious banking environment in Texas and a fledgling market for MMP, MCorp, a large Texas Bank, became one of MMP’s first issuers with a $125 million deal sold through Shearson. In less than 2 years, however, MCorp’s credit rating plummeted, the cap which was designed to adjust for declining credit quality such as this was discovered to be too low, the auctions, which were required to occur every 49 days, failed amid a flurry of publicity and the penalties kicked in. Starved for cash, the bank suspended dividends within another year and the final penalty took hold. Shearson protected investors by buying their stock back but could not protect itself. In 1988, it took a $70 million write-off for the MCorp MMP it owned.
FAR REACHING EFFECTS
For the national economy, a “successful” investment banker completes transactions which create more high-yield debt ($3 1/2 million in revenue to the bank up-front per $100 million raised), mergers/divestitures (1% on the value of the companies combined or sold regardless of effort), leveraged buy-outs, complex financings, restructurings ($7 million per $100 million on straight equity; whatever you can get on others.) Deals, deals, deals, deals. Is it in the best interests of the client, is there downside, is there any value added? These are value judgments best for the banker to avoid and left to the client. Should it be done now? If the client is going to do it, it is better to do it now than later.
In an environment dominated by the annual bonus, traditional client service (time spent analyzing, advising, informing or counseling) plummets. Since, unlike lawyers, bankers are not paid on the hours of their work, a banker must, first and foremost, chase profitable deals. Reliable service to existing clients will be the first to be sacrificed unless it is directly profitable. One bank, which often boasted in new business competitions how big they were and that they “would always be there,” dumped complete lines of service — commercial paper, tax-exempt bonds. Clients were informed they were no longer profitable only when they read their morning newspapers.
Meanwhile, the senior managers of investment banks scramble to set up specialty merger groups, merchant banking units, junk bond operations, bankruptcy/restructuring operations. A couple of years ago it was master limited partnership groups. Next year? This annual bonus focus forces them to spend less time on understanding and controlling the costs of doing business or training staff and more time on finding more revenue producers to join the firm.
And for some investment bankers in their 20’s and 30’s, the huge bonuses, after only a few years work, create a self-deluding perspective. Since they are being paid two to three times the amount earned by the average corporate treasurer who has worked for his company 15, 20 years, many believe they are worth it. There is often little deference to the client and a great deal of assurance in every thing they do, even though they have been doing it for such a short time.
REVENUE PRODUCERS AND BONUS POOLS
How did all this happen? Is it simply the fault of investment bankers, a matter of greed solely on their part? Is it necessarily bad for client or banker?
In the 1970’s and 1980’s three forces combined to vastly increase competition on Wall Street and create a new class of bankers called “revenue producers.” First, corporate financial staffs grew in numbers and in sophistication. They became more capable of independently evaluating capital market products and strategies.
Second, the time needed to complete transactions and decide whether to do them at all shortened significantly. Securities laws changed, computer and electronic communications increased efficiency and the capital markets became more volatile. Decisions could be, and, more importantly, needed to be made quickly.
Third, the securities industry underwent extensive deregulation of fees and services. Deregulation created enormous pressures to gain new business to maintain profit margins on existing capital. Bankers went looking for transactions, often initiating them, at a time when clients were ready and receptive to do new business. With deregulation, the banker that became a “revenue producer,” which meant deal flow from whatever source, became a highly valued individual.
The revenue producer had to be transaction oriented to thrive. New products were produced which created new transactions and new revenues. Corporations, entrepreneurs, multinationals cooperated in promoting a vision as far out as the next deal. If there were not a lot of people willing to do deals with whomever and pay the fees, the individual banker wouldn’t have a chance. John Kennedy once said “A high tide raises all boats,” and with the economy in expansion for seven years, transactions have been explosive.
THE RISK OF RELATIONSHIPS
However, most bankers assert publicly that long-term client relationships, not just transactions, matter to them most. You won’t be in business for long if the clients are not happy and they are only happy if you have done a superior job. Investment banking is a service industry. Repeat business is essential to the stable functioning of the industry and it comes from satisfied clients.
Clients also claim a desire for a long-term relationship with their investment banker. Yet, most believe that exclusive relationships are risky. Exclusivity does not guarantee the best ideas first and always, nor the best implementation at the lowest cost. For example, Morgan Stanley, Exxon’s sole banker for decades, has worked for the company only once in the last 12 years. An open door served Exxon better. It is a difficult door to get through and once in, for Exxon and most other clients, the operative phrase to describe the treatment of bankers is the one used by Ronald Reagan to describe the Soviet Union, “trust, but verify. ” Some clients, however, go further. Frederick Zuckerman, Treasurer of Chrysler Corporation, said in an interview in Institutional Investor magazine, “Whenever I talk to an investment banker, I always think of what is in it for him or her. They only get paid when you do the deal. And when you say that, they look in horror and say, ‘But, we want your business next week, next month and next year.’ And I say, “I still have my hand on my wallet.”
The sad fact is that client relationships are now far too risky for the banker to depend upon to build his bonus. Clients appear quick to abandon relationships for a better idea or a lower cost. Never mind that some say that bankers have taken relationships for granted and allowed their competitors to develop the better idea. The incentive is clear, if you want a bigger bonus keep moving, keep producing revenues from whatever source.
Are the long-term interests of the client and banker better served? Probably not. A client’s shortened perspective has been served by an even shorter one. The traditional long-term partnership between banker and client has been attenuated. Wall Street’s layoffs and closings are dramatic evidence of a once stable industry in turmoil.
SIMPLE GREED IS NOT THE PROBLEM
With the RJR Nabisco deal, the continuing saga of Boesky et al. and the popularity of the movie “Wall Street,” it has become increasingly fashionable to blame Wall Street’s woes on simple greed. But, simple greed is not the problem. It is the almost unquenchable desire not to have everything but to have everything now, immediately, that is the problem. This is not the greed that fuels entrepreneurs. It is self-destructive and short-term. Wall Street bonuses amount to a system that, in trying to give its members just rewards, has created a self-destructive short-term view.
This problem has not been created by nor is it unique to investment banking. It confronts many of our institutions. Wealth over a lifetime has long since been abandoned. Wealth for one’s children, the next generation, is mere nostalgia. Wealth today is the only objective.
WHAT TO DO
The management challenge is to provide a way for a long-term view to be seen by bankers and clients as the most profitable. For this to occur it will take changes in policies as well as people. Perhaps in the midst of turmoil it will be easier to get people’s attention.
1) An individual banker’s compensation in cash should be reduced in favor of stock or other instruments that are tied to the future profitability of the firm. Loyalty between bank and banker must be enhanced.
2) Banks must resist the temptation to hire bankers that they can buy. The ease with which some bankers can go from firm to firm encourages loyalty to the bonus rather than the firm.
3) Managers must reward quality performance as well as quantity of revenues produced. Bankers must see in their paychecks that excellence matters whether or not it results in a transaction. These managers should also be more involved with the way things are done between the client and the bank rather than simply knowing what transactions occurred and revenues booked. Officers should be required to spend time developing associates and other talent within their firms to reduce the reliance on hiring from the outside.
4) Bankers should be held accountable for transactions after they close. This means any revenues or losses occurring to the firm on an ongoing basis should be considered when determining current compensation. By this officers will be more concerned about what others in their firm do as well as the long-term effect on their clients of the transactions they initiate.
5) Banks should explore billing clients for advisory services rendered on an ongoing basis not just related to a deal. This would reduce the dependence on revenue from transactions. Deal fees could be offset with advisory retainers. Already various boutiques and smaller concerns have begun creating a corporate finance services niche. They argue their independence allows them to be more thoughtful and forward thinking for the corporate treasurer.
6) The cycle of M & A advisory and merchant banking services as conduits for ancillary transactions and the revenue that result from them must be broken. Merchant banking should be kept separate from traditional investment banking functions so that these deals stand on their own. M & A fees could be reduced in favor of bankers paid for the additional value they create for shareholders.
7) Clients should be asked to evaluate their bankers, not through informal methods, but directly and specifically. The length of a client relationship should be a factor in a performance evaluation. Once a client is added to the bank, revenue from repeat business should be more highly valued in evaluating a banker’s performance.
THE FUTURE OF INVESTMENT BANKING
Wall Street needs more individuals with vision and discipline, the type that would forgo current bonus income for long-term gain. These individuals will understand that to focus on the long-term and on client service means getting the better idea before the competitor — a sense of urgency for excellence. It means telling the client when someone else has a better idea and not resisting it because it imperils your bonus, telling the client when he/she is wrong even if it sacrifices transaction revenue for the current bonus pool. It means the best advice without guarantees, the best implementation with a thoughtful vision of the future.
We must not think that Wall Street’s current turmoil is just another short-term crisis to be endured. Given the social backlash against the industry and the financial strife ahead, it is in our best interest to identify, analyze and discuss these issues not simply dismiss them. We must look into ourselves into the culture we have created, for both the problem and the solution. Unfortunately, the prospects for orderly change, however, will be low so long as there are firms willing to pay almost any price for talent.
Change will occur either from disaster or the enlightened entrepreneur who is willing to sacrifice for a goal. If we act now to change this system, the long-term interests of our clients will be served and we will remain in control of the future of investment banking.
© Copyright Joseph S. Fichera 1988