News

Investment Dealers Digest

March 21, 2005
Cover Story

The Compensation Mirage
Avital Louria Hahn

Wall Street pay isn't what it used to be. True enough, overall investment banker compensation rose 15% to 20% last year-the best increase since the crash of 2000. But that doesn't mean that most bankers got a 20% hike.

In fact, most bankers are getting paid a lot less than they would have in the past, as eroding fees and rising costs have taken a big slice out of this once astonishingly lucrative business, IDD interviews with recruiters, compensation experts and financial industry analysts reveal. And the way things look, even if 2005 turns out to be as good a year as some expect, the average banker will get less of the pie than he would have in, say, the early 1990s.

"There is a sense out there that the bulge-bracket model is broken, that you never are going to be able to really make crazy money as a banker," says a former Bank of America banker.

Several trends are threatening pay. One is a concept that universal banks are using called "value of the platform." The argument is that the more business a bank attracts due to its own strength, such as a balance sheet or a low-cost electronic trading system, the less it needs to pay for talent, even if profits are up. And when banks do recognize the value of an individual, bidding wars for talent deplete bonus pools for everyone else.

But the biggest problem is that Wall Street is simply not as profitable as it used to be. "Margins have come in on everything in terms of the business," say Brad Hintz, a brokerage analyst at Sanford Bernstein. "There are fewer and fewer high-return businesses left on Wall Street."

To get a perspective on Wall Street's gradually declining profitability, Hintz explains that return on equity used to be about three times what it is now.

"When I got to Morgan Stanley in 1986, I was given the responsibility to represent the firm in investor relations. I was told that the policy of the firm is to generate 40% ROE," says Hintz, who had been treasurer at Morgan Stanley and later was the chief financial officer at Lehman Brothers. "By 1989, we [Morgan Stanley] were talking about 30% ROEs. By 1994, we were talking about "superior" ROEs in all points of the cycle. We were told to say that the firm would be superior to its competitors. There was no number at that point. These days, ROEs on the Street are in the high teens."

As ROE has slid, Wall Street has been putting pressure where the rest of Corporate America does-on its work force.

In fact, a typical managing director made on the high side of $1.5 million in 2004. Scroll back to IDD's pay charts for 1995, and the difference is shocking: A managing director would have made on the high side some $8 million-plus.

Not all banks are paying equally dismally, however. Last year, the best paying banks were the stand-alone investment banks, most notably Goldman Sachs and Lehman Brothers, due to strong profits and a stellar showing in M&A.

"The big money-center banks have a tradition of corporate and commercial banking," says Richard Bove, an analyst with Punk Ziegel & Co. "They struggle to pay the individual Wall Street bonuses. They don't come out of a tradition in which deal people might get more than a CEO. Goldman Sachs and Lehman and Bear don't have issues with that."

So it comes as no surprise, perhaps, that last year universal banks paid the worst. BofA's practice of giving guarantees to senior hires left many unhappy as it lowered the bonus pool for everyone else. JPMorgan, under its new cost-cutting chief executive, Jamie Dimon, stuck to strict productivity measures, leaving many disappointed.

But across Wall Street, one thing never failed: Top dealmakers got steep increases. As a favored class, they were oddly coupled with junior bankers, whose pay and ranks shrunk after the downturn. Last year, junior bankers got guarantees and pay hikes of 30% to 40% from a Street that realized the value of hard-working, lower-paid bankers in processing deals.

With the stars and juniors getting the fat, the middle had a relatively lean year. More senior than juniors but not yet bringing in deals, they got the short end of the bonus pool. At the same time, undistinguished managing directors got undistinguished pay-flat or even down. For them, as well as others stuck in a regular performer's dead end, it has not been much fun. The problem is that many of the middle, and even lower, upper ranks view their career path as blocked.

On one hand, working for a stand-alone bank can be a disadvantage, given the competitive pressure universal banks have brought. On the other hand, it is more difficult for an investment banker to "move the needle," as one banker put it.

The former BofA banker describes a vicious cycle that is eroding pay at all the bulge-bracket institutions, be they universal or stand-alone banks. Independent banks that don't have lending muscle struggle to match the universal banks, leading many bankers there to consider leaving. In fact, many bankers at brokerage firms write the former BofA banker asking for an introduction to BofA. Once at a universal bank, however, they produce a lot more revenue but get paid a smaller amount than they would have gotten in a pure investment bank, and certainly not as much as they would in a boutique, the banker says.

The real investment banking money these days is at boutiques like Greenhill & Co., Evercore Partners or Sagent Advisors, where bankers can claim credit for just about everything they bring in, he says.

"The problem with banking is, the products become so blended it's hard to tell now if it's the banker making the difference or the platform," says the former BofA banker. "So how you do compensate people?"

Stars and cogs

The practice of doling out lucrative pay to the stars and those in the niche du jour, while pinching everyone else, has been intensifying ever since the market downturn. Before the bubble, and of course during the bubble, just about everyone got paid well. In the years before the bubble-say in 1993 or 1994-bankers got paid in an ascending order that took productivity as well as seniority into account. With the crash, bankers' pay got slashed across the board. Hiring virtually halted, few MBAs came on board, and banks laid off many junior bankers. Senior dealmakers who were essential for the business got much higher pay than the rest.

As the economy and Street revenues recovered in the past few years, pay never quite recovered. Bankers waited for a really good year to finally get a lucrative package, but except for dealmakers or those in areas like fixed-income trading, it never happened. "Compensation levels have been reduced across the board in these companies," says Punk Ziegel's Bove. "At the time that the compensation levels were reduced, people were happy to have their jobs." Trouble is, he says, "as the good times returned, nobody reestablished their old compensation levels."

As the recovery took hold, banks realized they needed the junior manpower to process the deals the more senior bankers brought in. At the same time, hedge funds began to compete for the junior talent of Wall Street, forcing banks to pay up. So in 2004, juniors were not only courted outright by banks, they also got pay hikes of about 30% to 40%-even multiyear guarantees. In some cases, banks intent on hiring a junior star topped the guarantees by as much as $50,000, recruiters say.

"Associates were taken care of in a big way this year," says John Rogan, global head of financial services at Russell Reynolds. Rogan notes that the ones who got squeezed were the senior vp/director levels. "They were the forgotten group," he says. "After the revenue-producing managing directors and the execution associates were paid, there was not enough left over to take care of the middle ranks." These are the type of bankers who got cut in the layoffs and have not been hired back, recruiters say.

Over the past 18 months, however, more junior bankers have been hired. Because the mid-rung bankers earn more than juniors, but do not bring in relationships like their senior colleagues, banks found preferred to tackle deals with a small number of top producers, a large number of junior bankers-and few of the in-between types.

"As with the law firms, when you have bright junior people, they will come in on Sunday," says Les Carter, president of search firm Carter Stone. But even among junior people, banks are demanding more productivity and have learned to make do with fewer of them. "I've been telling my clients for years that they hire too many MBAs who are not productive and that they need to hire only the hungriest," says Carter. "The clients have been complaining about overhead, and that it is creating problems," he adds.

Of course, throughout the ranks, some are paid more than others. Among managing directors in various banks, the same theme emerges: Average producers got paid roughly $1 million to $1.5 million, unlike the top producers who were paid in the $4 million to $6 million range-and even more in some cases.

Indeed, the 80-20 rule is alive and well, says Peter Gonye, co-head of investment banking at Spencer Stuart. "It always begs the question: Do you need the bottom 45%? What do you lose by under compensating that peer group?"

No matter how much business has improved in the past year, that question lingers. So does the temptation to cut. "The banks have few very high-profile people producing a lot of the results," says Gonye. "You pare down three or four people and get one senior to replace them, and you gain more by doing that."

Value of the platform?

As universal banks sought to build up their investment banking business in recent years, some certainly paid up to lure talent. But now their overall tendency has been to keep pay low as they increasingly look at what bankers call the "value of the seat" or "value of the platform" as something that mitigates the importance of bankers' talent. This is a theme that threatens bankers' pay throughout the Street as independent banks are forced to lend to get the business, essentially adopting the universal banks' business model.

In this brave new world of investment banking, universal banks have been using sophisticated formulas adapted from in retail banking and that calculate risk and cost of capital and other costs associated with the platform. They then deduct these costs from investment banking revenues. So while a banker at a universal bank typically brings in more revenue than his counterpart at a traditional Wall Street firm, he will have to "share it with the house," according to the former BofA banker.

The banks make a case, and rightfully so, that the platform itself has value, and that the bank along with its balance sheet and array of products is to a large extent making the sale. No longer does the deal hinge on the banker's talent and his relationship. This way of thinking is also prevalent at some investment banks. Certainly, it has long been the model at Goldman Sachs, which is considered a platform in itself. Because the Goldman brand was always deemed more important than Goldman's individual bankers, Goldman never has been the top payer on the Street, except possibly for the partners who shared in the firm's bounty.

So far, not every bank has adopted the "value of the platform" approach, says Nick Studer, director with Mercer Oliver Wyman. But according to a survey Mercer conducted, banks are moving more in that direction.

Mercer polled HR and compensation managers at 15 leading corporate and investment banking firms 18 months ago, says Studer. It asked them the key metric they will use to determine bonus pools going forward. Some 65% plan to use a percentage of revenues or profit (i.e. little account taken for value of platform) while 35% were planning to use a percentage of profit after regulatory or risk capital charges, thereby incorporating the value of the platform.

A year later (six months ago), when asked the same question again, only 45% planned to continue to use purely financial metrics (revenue or profit), while 55% planned to use metrics that took into account additional factors, including, for many, consideration of the value of the platform.

The universal machine

That is a far cry from the clubby old world of investment banking, where bonus allocations often took place in a smoke-filled room as a department head would eyeball bankers' deals and make a decision in no small measure based on his gut feeling for what was right, says one compensation expert. Today, only the boutiques, which are private and still operate the way the business was done historically, can afford to do that.

Elsewhere, a banker's revenue feeds not only his own team but also other teams and the large financial machine that employs him. This reality is more prevalent at the universal banks, which offer the largest array of services, but it is slowly making its way into the independent investment banks as well.

When a commercial bank with a long lending relationship with a company hires an investment banker to try to sell that company equity underwriting or M&A advice, that banker will need to hit certain productivity goals to make up for the lending. In other words, if the relationship exists largely because of lending, the bank wants to collect a capital charge on the use of capital, or a "cut" from the M&A fees. That cut is charged for the value of the platform.

Punk Ziegel's Bove says that big commercial banks by their nature resist paying as much as pure investment banks. They have more products than an investment bank, not to mention their huge balance sheets. "Bank of America or Citigroup will never believe that Johnny created the business. They believe they did," he says. "Banks believe you do business with them because of who they are," he says, while brokers believe it's because of the rainmakers.

Disappointment was obvious at BofA, where bankers' pay was either flat or down, even though the bank's profits were up. BofA net income for 2004 was $49 billion, up from $38 billion in 2003. Its investment banking income was $1.95 billion, up from $1.8 billion in 2003, a 16% increase. Investment banking revenues rose much less: 8.5%, to $9.05 billion, from $8.33 billion, an indication that costs were squeezed to boost profits.

Part of the problem has to do with guarantees. BofA has been aggressively building its investment banking business for the past few years by luring senior bankers from large firms with generous pay guarantees. In fact, BofA said it would allocate another $675 million to continue to build its investment bank in the future. But in 2004, guarantees ate into the bonus pool, leaving less for those who either had none or whose guarantees expired. BofA bankers who received guarantees in prior years had disappointing paydays this year.

In addition, BofA embraces the universal bank philosophy that much of its business results from the bank's lending muscle rather than from an individual's talent. "Every bank believes that, but Bank of America believes it more than others," Bove says.

"The intellectual capital of our investment bankers adds great value to our clients and is critical to our value proposition," says Robert Ingram, a BofA spokesman.

Another place where unhappiness abounds is JPMorgan. Newly appointed CEO Jamie Dimon has been wielding his cost-cutting sword since the 2004 merger between Bank One and JPMorgan Chase. JPMorgan's net income fell to $4.5 billion, last year from $6.7 billion in 2003. The return on common equity was 6%, down from 16%. Investment banking fees rose substantially, however, to $3.5 billion from $2.9 billion. But the bank's trading revenues took a tumble, to $5.6 billion, down from $6.6 billion.

Recruiters say they are getting calls from JPMorgan bankers looking to move. Like every bank on the Street, the challenge for JPMorgan will be to balance cutting costs with protecting talent, one recruiter observes. "It will be interesting to see if Jamie Dimon can succeed in keeping compensation down enough to look good but not to lose people," he says.

Citigroup bankers were largely in a similar boat, but they had more of a warning that pay would be low, given the regulatory and legal problems that besieged the bank last year and its slight dip in profits. Its investment bank unit's earnings fell sharply, to $2.038 billion, 62% less than the $5.4 billion from 2003.

Why the top takes all

In 2004, investment banks bolstered profits by slashing costs, a trend that has been taking place since the market meltdown. By 2005, however, much of the fat had been cut, leaving banks with the challenge of finding other ways to grow their businesses and generate revenue, says Mercer Oliver Wyman's Studer.

"Growth is by far the number-one worry at this moment," he says. This conclusion came from the recent Mercer survey of financial institution CEOs, who said their number-one concern is to find ways to generate growth. The search for new growth areas means that the war for talent is here to stay, and may even accelerate, Studer says, because developing a new business means hiring senior talent, with attractive pay packages, and almost certainly guarantees. That means that the bonus pool for others automatically shrinks. The tension between the need to cut costs and market forces that dictate fat pay and guarantees will continue.

"It's not unusual for managing directors to be offered terms that include a one-year guarantee on their base compensation, and in many cases two years and even three-year guarantees," says Robert Benowitz, a partner with Rick Steiner Fell & Benowitz. "In addition, they will participate in various option and equity plans." The hiring bank will typically make them whole for any unvested equity they leave behind. Making them whole may not be a new idea, "but it's certainly in vogue," he says.

With the bonus pools finite and war for talent expensive, it is likely that banks will keep paying the lower ranks enough to keep them on board and add at the top selectively, keeping the middle lean. "It's more the A performers supported by newbies than a lot of mediocre people with five years' experience," Studer says.

"With fewer guarantees around, banks now have the flexibility to pay someone in line with their actual performance and contribution," says Richard Lipstein, managing director at Boyden Global Executive Search, "In a so-so year, they will be paid so-so."

Sharper variation in pay sends a message. "Over time, differentiation in pay has evolved to a greater degree than it had in the past," says Andrea de Cholnoky, co-head of the investment banking practice at executive search firm Spencer Stuart. "The differentiation clearly sends a message that nonperformers should be considering their options."

Universal banks know they, too, must pay or lose talent. "Some banks don't pay and end up losing the top people," says a compensation professional. "Bank of America struggled with it. It found it had to pay up for its top producers. But the average person gets less than the average at Goldman Sachs. You tend to see, top to bottom, higher performing people at Goldman."

The fee problem

One of the reasons compensation has dropped is that fees for a number of investment banking products have fallen. "There is a price war in investment banking the way there is in every other aspect of the business," says Punk Ziegel's Bove. "The universal banks are trying to penetrate the sector and are trying to do it on the commodity end and on a price basis. That tends to force fees down."

One reason investment banks have done relatively better is that they've advised on many of the large M&A deals, where there has been less fee erosion, Bove says. Still, M&A fees eroded slightly, remaining in the 1% range, depending on the deal size, according to Freeman & Co. And with more banks working as co-advisers, fees get split, as well. In addition, universal banks that both advise and lend in a merger often reduce their fees overall, adding to fee erosion.

Banks also have to do a lot of free work to keep their clients. For example, when a universal bank represents a consortium of buyout firms in an auction, in which it stands to earn both M&A and financing fees, the bank will often prepare a battery of documents only to have another bidder win. Banks eat the cost because they want repeat business from financial sponsors, says one securities attorney.

Average IPO fees fell 6% in 2004, while follow-on equities were down 6.4% and high-yield debt underwriting fees dropped 5.6% ("Shaving Fees for the Privileged Few," IDD, Feb. 28, 2005). The exception was in convertible bond underwriting, where fees rose 10.4%. Convertibles bankers were forced to introduce new structures to meet investor needs, illustrating the value of a product with a special structure versus one that is a commodity. According to recruiters, bankers with skills to design new products will be in demand.

As fees have come down, some question whether they will rebound. Bove thinks fees will recover because with interest rates rising, banks lost much of the carry trade that helped their revenue throughout the downturn. But some think not. "I don't think the fee schedule is coming back," says Alan Johnson, president of compensation consultant Johnson Associates. "What you hope is that you'll do twice the number of deals."

An increase in deal volume can be a blessing or a threat to 2005 bonuses, depending on how many new employees banks hire for the additional business, analysts say. Johnson says banks will benefit if they can keep doing business with current staff levels. He estimates that at current staffing levels, banks can do roughly 10% more business. "The key is to do more deals while keeping costs fixed," he says. "If business grows too fast, then banks need to start hiring again, which erodes profits."

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