by John Rolfe
The investment bankers, of course, would disagree:
“We make the capital markets more efficient!”
“We bring together buyers and sellers!”
“We help maximize business value!”
Is it true? Do the bankers really do anything but suck the fat out of an overindulgent capitalist economic system? Yeah. The capital markets aren’t perfect. Those who need money, and those who have the money, can’t always identify each other. The buyers of businesses don’t always know the sellers. Independent third parties are sometimes needed to confirm business value. What many of the bankers don’t grasp, though, is the tenuous nature of the value of the services they provide. As the number of available information sources continues to proliferate, and access to that information becomes less proprietary, the bankers’ ability to extract excess fees from that information will inevitably dissipate. It may happen slowly, but the bankers’ value will diminish and melt away as surely as the Wicked Witch of the West in a South Florida rain shower.
Advisory Work
Historically, the investment banker’s job was to advise companies on their financial alternatives. The investment banker was a confidant to the company’s highest executives, and the relationship between a CEO and his banker spanned an entire career. The banker provided analysis and advice on possible merger and acquisition candidates, guidance on capital structure issues, and even occasional counsel on matters of business strategy. The banker was also the introduction person, the one with the relationships. If the CEO wanted to initiate merger talks with a competitor’s CEO, or wanted to sell a division of his company, the banker was the go-to guy. The banker usually knew somebody at the other company, or knew somebody who knew somebody, who could get the CEO through the door and into the other CEO’s office. The two CEOs would initiate talks, they might get a framework for a deal hammered out, and then the banker would tell the client whether the deal made sense from a financial perspective. All in all, it was exciting work. Bankers didn’t have to spend a whole lot of time chasing new business and could go to sleep every night knowing that they’d added some value for their clients. Moreover, the work was steady. In both good times and bad, there was corporate finance work to be done. If the economy was booming and businesses were building up cash reserves, the mergers and acquisitions side of the business would likely be going gangbusters. When things got tight, the restructuring and strategic advisory piece of the business would compensate.
Bankers still perform advisory work. They still make recommendations to companies on possible merger and acquisition candidates. They still propose levered recapitalizations, stock buybacks, and other restructurings of a company’s capital structure. They still write reports advising a company’s shareholders as to whether an offer that has been made to purchase the company should be considered “fair” from a financial standpoint. There are still a few small, highly focused investment banks that continue to provide good strategic business advice.
In general, though, the advisory side of the business has become much more commoditized. The banker no longer has the lock on relationships. The banker’s information is no longer highly proprietary. Information on companies is now so widespread that there’s very little company-specific knowledge that bankers can truly call their own. The banker no longer brings enough unique added value to the table to necessarily merit a CEO’s granting him a lifelong mandate to provide paid advice on matters of corporate finance.
This shift in the nature of the bankers’ advisory business is illustrated by what, today, is a much more typical advisory assignment—an exclusive sale. In an exclusive sale a company that wants to sell its business calls up every investment banker that it knows. Usually, all the big banks with the well-known names make the list. Sometimes a couple of smaller banks will be on there as well. The company asks each of them to make a fee proposal. Some banks might offer to arrange the sale for 1.5 percent of total sale proceeds, others might offer to sell it for 1.25 percent of total sale proceeds. Some banks might structure a more innovative fee structure that includes a sliding fee scale, incremental incentive payments, or any number of other variations. Ultimately, though, since there’s no longer any meaningful information differential between the different banks, the company will retain whichever bank agrees to make the sale for the lowest fee. It’s a Kmart blue-light special in aisle five.
Once retained, the bank conducting the sale puts together an information booklet on the company being sold and mails it out to all the potential buyers. The information booklet describes the company’s business. It’s full of lots of colorful graphs and fancy fonts. That’s the extent of the banker’s value-added—making the information booklet look pretty. The potential buyers all get to submit bids on the company, and whoever puts in the highest bid walks away with the prize. Just like selling an old Dodge Dart, or a house, or a used diaper pail at a yard sale.
As the bankers’ competitive information advantage has waned, the bankers have gradually been forced to change their approach. They can no longer rely on a relatively small number of loyal clients to generate advisory business for them year in and year out. They now have to spend a much larger portion of their time scrambling to find new clients and new business. To justify their existence, they now have to go out and pitch ideas to whomever will give them an audience in the hope that just a few of the potential clients will sign on for the program. And when those clients sign on, the bankers have got to assume that the next time there’s advisory business to be had with that company, it might not necessarily be them providing the advice. In short, the banking business has become a whole lot more like most other businesses out there—competitive.
Capital Raising
The banker’s second primary function is capital raising. Most growing businesses have an insatiable desire for capital, and few are able to generate enough cash through their ongoing operations to fulfill that desire. That means they have to go somewhere else for the money. They have to go to the capital markets. In the most basic terms, a company that wants to raise money has only two choices; it can either borrow the money or it can sell an ownership interest in the company. Debt versus equity, that’s the choice. There are all kinds of arguments for why a company, the issuer, might want to choose debt over equity, or vice versa, but the fundamental differentiators are cost and risk. The debt is a less expensive means of financing for the issuer, but if the issuer screws up and has trouble paying back the debt when it comes due, then the debt holder gets to keep the company. In other words, if the issuer fucks up they lose it all.
American-style capitalism puts a high premium on broad market discipline, and this has led to the development in America of the largest and most sophisticated capital markets in the world. The investment bankers have positioned themselves squarely at the crossroads of these public capital markets. They’re the toll collectors. They make it difficult, nearly impossible in fact, to access the public markets without traveling on their parkway, and their parkway ain’t a cheap road to travel.
The investment banker is the consummate middleman. A company comes to the investment banker and says, “I need money. I need lots of money.” The banker replies, “No problem, I’ll go out and find you some money. I’ll give you most of what I find, but I’m gonna keep a little bit for myself.” The investment banker then goes out with his or her colleagues from the bank and talks to the people with the money. That means the institutional investors—the mutual funds, the pension funds, the hedge funds, and the endowments.
The investment banker goes to the institutions and tells them, “Look, I know this great company but they’re a little short on cash. They’ve got this great new product, the best you’ve ever seen, but they don’t have enough money to develop it. It’s going to be the next big thing. The guys at this company, they’re really a bunch of swell guys. If you buy some of their equity you’re gonna get rich. I promise.”
The institutional investors cut the investment banker
a check so that they can buy a piece of the deal. Sometimes they’ll buy a piece of the deal even if they don’t like it too much. They do that because they’re worried that if they don’t buy into the latest deal, then the bankers might not come back around the next time with the really big deal. No institutional investor wants to be the only one to miss out on the next big thing. The banker collects the checks, cashes them, keeps a percentage, and gives the company raising the money whatever is left over.
The size of the chunk that the investment banker keeps depends on what kind of deal is being underwritten. A banker might keep as little as 1 percent for a high-grade debt deal and as much as 7 percent for an initial public offering (IPO). Originally, the investment banker kept a bigger percentage on some deals to compensate the investment bank for taking on greater risk on those deals. It used to work like this: (1) a company would tell an investment bank that they needed to raise money (2) the investment bank would write the company a check and buy the equity or the debt directly from the company (3) the investment bank would turn around and try to find buyers for the company’s securities, and (4) the investment bank would hopefully be able to sell the securities and, in the process, get back not only all the money that they had paid the company for its securities but also something extra to compensate them for their work. The investment bank was taking on risk because they were exposed for the period of time between cutting the check to the company and selling the securities to the ultimate buyers. If the market headed south in that time period, or the investment bank hadn’t valued the securities accurately, the bank could stand to lose money. Equity is inherently more difficult to value than debt, so the investment bank got a larger fee for underwriting the equity than they did for the debt.
Things don’t generally work like that anymore. Nowadays the investment banks limit their risk by going out ahead of time and finding buyers for the company’s securities. They no longer have to hold the securities for the period of time between when they buy them and when they resell them. If the bank can’t line up enough buyers for the securities ahead of time, they tell the company, “No go, the market’s not right, we can’t do your deal.” The equity or the debt being sold effectively goes straight from the company to the ultimate buyers. The investment bank just stands in the middle peeling off its percentage for having arranged the deal. The banks have managed to cut out most of their risk, but they continue to take the same spread that they’ve always taken.
If the market for investment banking services was an efficient one, the spreads would be a lot lower than they are today. They’ve stayed high, though, because there has always been an unspoken agreement among the bankers that when it comes to underwritings they won’t compete on price. The spreads are sacrosanct. He who cuts spreads will himself become an outcast, condemned to a life of squalor among the filthiest of dogs. The investment banking community has long been an oligopoly, with only a handful of real players with the size and scale to drive through the big deals. The community of investment banks has always been small enough so that if one bank were to break ranks on the pricing issue, the others could quickly join forces and squash the offender like a june bug on the grill of an 18-wheeler. Every banker knows that the pricing issue is a slippery slope best avoided because once the price cutting begins, there’s no telling where it will end.
Until recently, there weren’t many new entrants to the underwriting business. Because an investment bank needs a certain minimum scale to operate profitably, there haven’t been many new players willing to make the necessary up-front investment. Increasingly in recent years, though, as the risk of underwriting has come down and fee spreads have stayed constant, the economic return has appeared increasingly compelling for potential entrants to the business. As this has happened, the new entrants have begun to make their appearance.
The first new competitors through the door have been the U.S. and foreign commercial banks. Increasingly, the large regional commercial banks have begun to set up securities underwriting subsidiaries and have begun to hire away investment bankers from the DLJs, Morgans, and Goldmans of the world. New investment banks have begun to pop up with an operating model based on online distribution of IPOs direct to retail investors. As the number of underwriters competing for each piece of underwriting business has proliferated, the spreads have begun to come down. With more competitors, it isn’t as easy anymore to close ranks on the offenders who dare compete on price. There’s always somebody now who’s willing to tell the other guy to fuck off. The underwriters’ world has gotten more competitive, more complicated, and less capable of being controlled. A crack has developed in the underwriting foundation and each year now, as the aggregate amount of capital raised in the public markets increases, the average spread taken in by the investment banks decreases. The fees are coming down. Slowly, right now, but they’re coming down.
One day, in the not-too-distant future, an old-school corporate executive may beckon his banker. The banker will walk in unkempt, unclean, and wearing a $99.99 poly-blend suit from the Burlington Coat Factory.
“My God!” the executive will gasp. “What happened to you? The ties, the suits, the shoes, the gold cuff links…where did it all go?”
“Away, my friend, away,” the banker will reply in a subdued voice. “The times have changed.”
The Sizzle
Don’t sell the steak; sell the sizzle. It is the sizzle that sells the steak and not the cow, although the cow is, of course, mighty important.
—Elmer Wheeler
As both the advisory side of the business and the underwriting side of the business have become increasingly competitive, the new business pitch has gained importance as the bankers’ core activity. As Rolfe and I found out, there’s not much business anymore in the banking world that can be taken for granted. Pitching became our existence.
The most telling evidence of this shift in banking activity has been the birth of what’s known as the “beauty pageant.” The beauty pageant is a head-to-head competition among a bevy of investment banks for a new piece of business. The phrase is a misnomer. Unlike the contestants in traditional beauty pageants, the bankers aren’t normally required to wear bathing suits at the pageant, but if the client asked them to, they’d come in wearing the tightest nut-hugging Speedo ever seen. In today’s ultracompetitive environment, bankers will do anything for a piece of business.
The company conducting the beauty pageant sends out word to a whole slew of banks that it’s looking to do a deal. The company sets aside a day for the pageant, and each bank gets to select the slot that they want. Just like making an appointment to get a cavity filled.
Bankers from each bank show up at the beauty pageant at their appointed time to meet with whoever is going to be running the deal from the company’s side. The bankers always travel in packs. Even a crappy little deal usually merits the presence of a managing director, a vice president, and an associate. The senior bankers like to arrive at meetings flanked by a few junior bankers, like General MacArthur with his staff in tow. They think that the strong presence will impress clients and win business.
If the pageant is for an underwriting the bankers might also bring a guy from the capital markets group to the party. The capital markets guy is a cross between a banker and a trader—he’s the illegitimate offspring. The bankers bring the capital markets guy along to show the company that everybody at the bank, not just the bankers, is going to be involved in the deal process. The capital markets guy always does the part of the pitch that focuses on the current state of the markets. It’s usually something that’s straight out of that morning’s Wall Street Journal, but if he’s a smooth talker it sounds like he’s a real expert.
The capital markets guys are a double-edged sword. They’re notorious for behaving like chronic Tourette’s syndrome sufferers by unpredictably spewing out random vulgarities and filthy jokes in the middle of the pitch. It’s the trader part of their mentality that makes them so dangerous. Sometimes the
clients appreciate the debauchery, but other times they get offended and decide never to invite the investment bank back for another beauty pageant. The senior banker always hopes that the presence of the capital markets guy will help them win the business, but then they spend the whole pitch worrying that the capital markets guy is going to say something so offensive that it makes them lose the business.
The whole idea of a pitch is to convince the client that the bank delivering the pitch is the right investment bank to lead the deal. Every bank makes the same pitch. They all go into the beauty pageant and tell the company “We’re the best. Our investment bank does all the big deals for companies in your industry. We know all the big buyers and we’re the guys. We’re the only investment bank qualified to lead manage your business.”
Although they all start out the same, every pitch turns out differently. Some go well, some don’t. Some are interesting, most aren’t. Some managing directors light up the room when they’re making the pitch. Others go over about as well as Jesse Helms at a gay pride rally.
At DLJ there were some managing directors who would make the pitch, win the business, and then wouldn’t show up again until the closing dinner. We called them the Phantoms. They didn’t need to be around while a deal was getting processed because there were hundreds of mindless vice presidents ready to do the processing for them. The Phantoms took the art of the sale to the highest order. They were able to instill so much confidence in a new client at the outset that they completely neutralized the need to hold the client’s hand along the way. Fucking amazing.
