"No one can suck margin out of a deal faster than a banker."
This is typically said—with a wry smile—after a few cocktails.
Often by the bankers themselves.
It's an inside joke, of a kind, couched in banker speak. But the point is clear: Bankers are compensated handsomely for the deals they facilitate.
In London, that compensation is currently under fire, as Anita Raghavan reports in a New York Times DealBookpost today.
Here is the crux of the story: A recent report shows that securities underwriting fees in London have risen, on average, over thirty percent in the last seven years—from an average of 2.6 percent in 2003, to an average of 3.4 percent in 2010.
Fees on some British deals in 2010 were as high as 4 percent.
About ten years ago, after criticism from a similar report, fees were down to about 2 percent.
The cost explosion from the early years of this decade to the present represents a staggering 50 percent jump in fees.
The latest report was produced by an organization representing investors—and the language the report has inspired is intense. One investor, who appears to be affiliated with the group that issued the report, called the fees 'immoral'.
But the issues involved, not surprisingly, are complicated. To quote the article:
"The council’s findings touch on a tricky subject. Underwriting—where an investment bank buys shares from a company at a pre-determined price, taking on the risk that it may not be able to distribute the shares to investors at the price it paid or a higher level—is a seamless process when markets are functioning smoothly and there is a little volatility. "
In defense of their fees, bankers typically set forth two principal arguments:
First, that accessing the capital markets is a complicated proposition.
If done incorrectly, the financial consequences for the firms issuing the securities can be disastrous. The skills that a banker brings to the table—namely, an understanding of the structure and pricing of securities—is critical to the firms they represent, because an optimized capital structure is absolutely essential to the financial health of the firm.
Also, there are competitive market forces in play that constrain the fees that bankers can charge.
Before an IPO, for example, investment banks compete in something called a 'beauty pageant', where bankers bring detailed pitch books and make the case for why they should represent a firm during its offering.
If you don't like the fees your old I-bank is charging, you're free to take a walk across the street and hire a competitor to represent you during your underwriting. The CFO's of public corporations, after all, should be sophisticated enough to analyze the mathematical minutiae presented to them, and make good data driven choices. (Who do you think we're trying to kid? CFO's of are the most 'overbanked' people on the planet.)
In response to the counterargument—that all I-banks charge outlandish fees—the banker might shrug.
If the competitive marketplace prices his skills at a premium—because those skills are both valuable and rare—so be it.
Professional athletes are lavishly compensated for the same reasons.
The second point relates directly to the excerpt I quoted above from the DealBook piece: Namely, risk.
In the United States, equity IPO's are done in two ways: as "Best Efforts" offerings or as "Firm Commitments".
The two are very different.
In a Best Efforts offering, the I-Bank acts as an agent of the firm it's taking public.
The bank pledges to make their "best effort" to sell the securities they are bringing to market for their client. But they do not pledge to buy any of the shares themselves.
On the other hand, during a firm commitment offering, the I-Bank pledges, under contract, to buy a fixed number of shares—no matter what.
It's the second type of offering—where banks take a risk position—that the DealBook quote is likely referring to.
(For example, the article references banks "taking on the risk that it may not be able to distribute the shares". In the U.S., that would only be the case in a Firm Commitment offering.)
In a Best Efforts offering, the first argument for banker compensation—that it's an important and necessary skill, priced by market forces—still holds.
But the risk position argument is only valid in Firm Commitment offerings.
And this is a subject about which bankers are truly passionate.
Bankers can—and often do—argue their case forcefully.
Typically, their argument goes something like this:
"Look, if I'm taking a risk position in a security I deserve to be compensated for that risk. I'm not just bringing my valuable professional skills to the table—helping my clients to access the capital markets efficiently, and to strike the best deal with their investors. I stand to take a loss if I screw up the deal. Personally.
And if I don't do my homework, and I set the price at the wrong level, I've got big problems. I've either left money on the table—or worse, I've lost money. For myself and for the bank. And banks don't like losses. When you talk about my fees, you're only looking at the deals I made money on. This isn't an exact science—and bankers do lose money. I'm taking on real risk here. Don't I deserve to participate in the upside of a deal I've shepherded when it goes well? Particularly since I stand to suffer a loss if it goes badly.
The only way the marketplace works efficiently is when my compensation is tied to the success of a deal. The system works—because I've got serious skin in the game."
I present both arguments without comment or editorializing.
But I will say this: The extent to which you buy either of those arguments likely determines the degree to which you are sympathetic to the 'immoral fees' position presented in the report.
And remember, "Britain’s biggest investors," whose interests are represented by the report, are the guys on the other side of the trade.
Post Script: The following quote from the DealBook article is worth remarking upon: "Typically, gross underwriting fees were 10 times as much as the total reward for executive directors in the year that the rights issue took place, the council said in its report." Like so many other stories on Wall Street, and in The City in London, the narrative seems driven by competition. When the handsome fees paid to executive directors are dwarfed—in this case, by a stunning order of magnitude—in relation to the fees paid to investment bankers, the directors won't be happy. In finance, as in life itself, everything is relative.
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