16 September 2013
This is not my beautiful house; this is not my beautiful wife –
Images and Illusions of Investment Banking
Investment banking, and investment bankers, has taken a huge beating over the past few years. In fact, the phrase investment banker is pretty toxic and has expanded to encompass, effectively, anyone or anything who are just ‘bad’.
This was curious to me. I have been a banker for over thirty years. Even though I have low levels of self-knowledge, it has never occurred to me that I am inherently evil or even marginally nasty. But who knows?
So this evening I would like to deconstruct the true meaning of the term and get to the heart of the matter – my thesis here is that investment banking is an incredibly interesting and satisfying undertaking, it adds value to the people paying the fees, and properly defined, has never been a destructive force. We will see how the industry has changed, and where we are now. I thought I might illustrate this via a path through my own career, together with a few rules and observations along the way.
So – the first rule – know what you are looking for. This is pretty helpful. In my very first job interview at the small liberal arts college in New England I attended, two bright and aggressive women asked me the key question – “so, David, why First Boston?” I replied that I was quite interested in commercial banking, and that I very much liked the city of Boston. They informed me that First Boston was in fact an investment bank located in New York, and the meeting became shorter.
So I learned the first thing about banks – investment banks are not commercial banks.
At that point, I had to take whatever I could – it was The Irving Trust, a bank so poorly managed it eventually was acquired in the only hostile takeover ever of a large bank in the US. But at least I was in the game. I figured out pretty quickly that, in those old days, there were two sorts of firms serving companies – commercial banks, which used their own and depositors capital to make loans and the like, and investment banks, who did deals in the markets.
Now Europe was always a bit different, with banks playing a more integrated role and generally much smaller equity markets, but in the US, investment and commercial banking activities were strictly separated by legislation dating back to the 1930’s. This offers an excellent opportunity to define – strictly – what is an investment bank. I would define the following activities as investment banking in nature:
What does that mean?
Advisory-led means that your clients find value in the advice and knowledge you give them, whether on the corporate or markets side, and that you somehow get paid for this. Examples are M&A, structuring securities offerings and writing research on corporations. This is your leading source of value-add and differentiation.
Agency-based means you are undertaking markets activities – dealing in securities, raising capital in the markets by placing new issues for corporates – as an agent, i.e. you are matching buyers and sellers without taking a position or using cash capital to actually buy and hold debt and equity securities.
And markets-centric means just that – activities centred around the public and private capital markets for debt and equity.
Most importantly, investment banks were NOT principals – they did not commit or lend long-term capital to clients, and they did not generally take medium or long-term trading positions, especially in illiquid parts of the market.
My next career step was to get closer to the capital markets, which I did via joining a large Japanese bank to start its bond finance business – still not a pure investment bank, but involved in the securities markets nonetheless. However, crucially, I failed to notice that I WAS NOT JAPANESE. This was a career-limiter in 1984. It took me four years to make this discovery.
Clearly I needed more education, so I decided to procure an MBA. There, I learned about Universal Banks, a kind of magical enterprise that combined the best of all these things into one institution. Actually, this was a time when boundaries were beginning to blur – Bankers Trust, GS, JPM – people were talking about Universal Banks.
I stumbled on this fact while interviewing with one of the major investment banks. I asked a very senior partner the question – given the convergence in the business, how do you deal with the inherent conflict between your clients and your firm, as a principal, and what do clients think about that?
What he thought was that clearly I was not bright enough to work there. Once again, your star interviewer was kicked onto the street, unemployed, but probably with the FBI instructed to investigate my un-American views. I then joined a smallish firm that financed growth companies and participated in the heyday of traditional investment banking – taking companies public such as Microsoft, Starbucks and America Online. I learned a lot about operating under the traditional definition of investment banking – it was all knowledge-based activities in the markets.
But the seeds of change were in the air – First Boston, now owned partly by Credit Suisse, had invented two new types of debt securities – the high-yield or junk bond, which replaced and expanded bank lending, and the synthetic debt security, which institutionalized the funding of things such as mortgages and auto loans by selling bonds collateralized by pools of these assets. This was all very creative, and since everybody in the business immediately copied and improved these innovations, a large new market arose in these types of securities. Ultimately these new markets offered businesses a more inexpensive source of debt financing and made houses cheaper to buy.
This kicked off a debt-issuance revolution that completely changed the landscape. Investment bankers needed to know how to access those markets for clients, and have the businesses to do this, which typically required more capital than we had at the time as small players. There was also money to be made by investing side by side with clients on buyouts.
A lot of the mainstream equity capital raising and M&A advice was still dominated by smaller or privately-held firms. So the great consolidation wave began, and, by the end of 2001, virtually every pure investment bank of note had been acquired by a commercial bank.
The commercial banks increasingly took huge balance sheet bets on risky and illiquid assets they did not understand, while the investment banks fashioned ever-more-exotic securities to sell to them (and others).
PJ O’Rourke once said that “giving money and power to government is like giving whiskey and car keys to teenage boys”, and so it was with the bankers. The few remaining larger investment banks started looking a lot more like wholesale commercial banks, with one crucial difference - they did not fund themselves via deposits, but via the market. Commercial banks did not know how to manage risks in fast-moving markets businesses, and also generally the acquired investment bankers ended up running them anyway in a reverse takeover, with a risk appetite to match. This did not end well.
Where does that bring us, in terms of the current state of the investment banking industry? Several things have changed significantly:
Global capabilities are an absolute requirement. One must have the ability to offer clients access to the optimal market for their capital needs. We have seen a great deal of cross-border capital raising – possibly the most interesting recent example is our IPO of Manchester United in the US. Football is not a huge sport in America, but investors have a deep understanding of sports franchising and global brand marketing, which is the economic driver behind the company.
The role of capital has changed massively. Investment banks need much higher levels of capital to effect transactions and make markets. Most corporate finance activity now requires investment banks to underwrite large debt and equity components for subsequent securitization and issuance into the markets.
Regulators have reasserted their authority, and are key or even dominant players in the industry. Regulations such as Dodd-Frank or the Volcker Rule take us back to a previous era of regulation.
I believe, however, that the original definition of investment banking holds, in terms of role and behaviour.
The key driver is knowledge and advice based on that knowledge. Everything still flows from that.
True investment banks are still primarily agents. The goal is to raise capital for clients in the capital markets. While the role and importance of capital to facilitate that has changed dramatically, still the notion of not being a principal applies, more strongly than ever. No one – clients, regulators, shareholders – wants investment banks taking long-term, illiquid positions that tie up balance sheet and create conflicts with clients.
The advisory-led businesses – M&A, equity capital markets, and the corporate bond market - are in great shape and continuing to grow. Clients need and want advice on how to build and finance their companies in today’s competitive business environment. They want their advisors to be unequivocally on their side of the table, with no conflicts, but they need them to be of sufficient scale to be able to help with capital needs and deliver global perspectives and execution. Investors need to know you are making markets fairly, you do not have positions you are trading against them and that you have the financial wherewithal to trade in size if necessary.
Personally, I was there for all this. My firm got bought (twice) and I ended up enjoying my time at one of the fabled universal banks, being a bit of everything to everybody. Then I remembered what I actually like to do which is to raise money for growth companies. For the past six years, I have been working for Jefferies, which fits the above definition to a Tee, to do just that.
Being in a board-room, advising a client on how to finance the business, or grow it strategically, remains one of the most interesting things to do in business, and in life. Getting these deals done is challenging, tension-filled and ultimately very fulfilling. On the other hand, you cannot be in the seat if your first priority is to recover £500m that your organization has lent the client – it is just a conflict. In similar fashion, you cannot trade with pension funds, mutual funds and other investors if your overriding concern is how to dump all the toxic waste you have accumulated on your own balance sheet – that is a conflict too. And certainly manufacturing your own product is filled with moral hazard.
Ask yourself one simple question - who stands to gain or lose most from a trade? If it is you, then look out.
Thank you for your attention and I hope you found these random thoughts useful, or at least interesting.