Wall Street Compensation: A Flexible Model for a Changing World
Overview
Well, it’s that time of year again. For the bitching and moaning, both within and without Wall Street firms (but mostly without this year given the magnitude of Wall Street bonus pools, with the possible exception of some unhappy folks at firms like Credit Suisse, JP Morgan and Morgan Stanley). And Andrew Ross Sorkin’s piece titled “Goldman’s Season to Reward and Shock” in today’s New York Times was simply the icing on the cake for me. There are so many articles and posts on the topic of excessive bonuses that it is almost nauseating. But my take on this phenomenon is somewhat different.
My thesis - Wall Street firms have morphed into two distinct businesses with two distinct cultures: proprietary trading a/k/a hedge funds that absorb risk, and client-facing advisory/capital raising and asset gathering businesses. And it is only through understanding this structural shift - the ever-increasing emphasis on proprietary trading - that Wall Street compensation can be properly assessed.
My punch line - current Wall Street compensation is both appropriate and necessary, even in light of the stunning absolute numbers. And notwithstanding Mr. Sorkin’s contention, stock price performance does matter, and the way he feels Goldman’s compensation expense should be adjusted downward shows a distinct lack of understanding of the competitive landscape and the pressures of managing a firm that is, in essence, a microcosm of global society (i.e., with the “superrich” garnering the lions share of the spoils, with the sea of others sharing in a disproportionately small percentage of the total compensation pie). Just as issues of social equity exist in the non-Wall Street world they exist in the Wall Street world as well, and though some might say “Who the hell cares about a bunch of rich, spoiled a**holes,” the fact is that the Wall Street community plays an essential role in the capital formation, risk absorbtion and asset allocation process, and not just at the highest levels of these firms. So people should care, and should take the time to understand what is really going on here.
The Wall Street Firm - a new organization for a new world
Without getting all historical, the bottom line is that the way Wall Street firms make money has changed - a lot - over the past thirty years. The proportion of money being made from trading has skyrocketed relative to advisory and underwriting services, and this is reflective of both the needs of the global capital markets and the opportunities for making money that present themselves. And as this transformation of the Wall Street firm has taken hold, it has put them in direct competition with one of their largest and most profitable client segments - alternative asset managers, principally hedge funds and private equity funds. And not just in competition for investment assets and deals, but for talent. And this is the point of my post. For ease of discussion, I will focus on Wall Street traders vs. hedge fund managers and leave the Wall Street Financial Sponsor/Private Equity fund discussion for another day, though the issues are similar.
Wall Street Traders vs. Hedge Fund Managers - different organizations, different jobs
The differences between Wall Street trading businesses and hedge funds are several-fold, including:
The Wall Street trader P&L begins each year at zero. This is distinctly different than hedge funds which have an embedded management fee that is pretty secure, especially in light of lengthening lock-up periods, stiffer gating provisions, etc. This means that the Wall Street trader needs to re-invent themselves each year. This is hard.
The Wall Street trader generally doesn’t have the ability to invest in their own strategy on a tax-deferred basis, so gets taxed currently at ordinary income rates which is extremely inefficient. Hedge fund managers, conversely, generally have tax-efficient offshore structures that facilitate tax-deferred compounding of their capital, which can mean enormous incremental wealth for them as compared to their Wall Street counterparts. This is not a trifling matter.
The Wall Street trader is playing with house money, which can faciliate more aggressive and confident risk-taking. The hedge fund manager, on the other hand, is playing with a mix of client money and their own money, which, over time, can become very significant, and can lead to greater risk aversion once a manager achieves a certain level of wealth. The Wall Street trader is unburdened by this dynamic, as the discipline of beginning at zero each year means that legacy gains and accumulated wealth mean absolutely nothing in the coming year.
The Wall Street trader has neither their name on the door nor equity in the business. This differs markedly from the hedge fund manager that has broken away, started their own firm and built their own business. While the Wall Street trader doesn’t have to deal with operational/infrastructure irritation of running his/her own business or raising capital, the ego and economic damage of not having one’s own gig is pretty significant, especially as one rises to the top of the prop trading pecking order.
So what does this all mean? It means that investors, analysts and critics shouldn’t look at headline bonus numbers and say “What the hell?!? $100 million for a trader at Goldman? What is going on here?” Because that is dumb and myopic. What they should look at is the economic value the trader has created, the perceived benefits the trader gets from being in-house (like infrastructure support - is the trader a geek that hates human beings, would be a horrible business manager and basically wants to be left alone to make money, or are they personable, a business-builder and a true risk to start their own fund?) and how much risk the trader has needed to generate their level of returns.
Pretty standard stuff, right? And to be clear, Wall Street traders neither get management fees nor the level of payouts reserved for hedge fund managers. Depending upon level, experience and one’s “deal,” trader payouts generally range from, say 8% to 15% of P&L, with 10%-12% likely the fat part of the distribution. This is clearly no 20%-25% of profits and includes no management fee, either. And no tax-efficient compounding of capital. And no equity in the business. And having to report to someone. And having to deal with some measure of politics. And on and on. So, to be clear, working at a big Wall Street firm isn’t a cakewalk. There is brain damage involved, to be sure.
So that $100 million payday could easily have been double or more, on an after-tax basis, had this individual worked at a hedge fund. So now, Mr. Sorkin, is this looking like a really crappy deal for shareholders now? Really unfair, huh? I would contend that the best Wall Street traders are a virtual bargain, and the reason Goldman’s stock has run up so much (even in light of its 10x P/E) is because investors know they are getting a bargain. And the fact you can’t see it is because you aren’t thinking about it the right way. You need to look at comparables on a tax-equivalent basis, and then factor in non-monetary issues like the lousy and painful aspects of working at a Wall Street firm versus being Eric Mindich or Dinakar Singh, otherwise you are truly comparing apples and oranges. No, check that, apples and basketballs.
And after nearly 20 years on Wall Street, and running a team with many of these super-traders who have subsequently moved on to run their own successful shops, there is no doubt that even super-high Wall Street payouts are frequently not enough to keep the best from seeking greener pastures. So to the extent you’ve got these super-traders and have a chance to keep them, PAY THEM. Because they’re cheap by the only yardsticks that matter - risk-adjusted returns and comparisions with their principal alternative source of employment - hedge funds. Mr. Sorkin’s contention that Goldman’s comp levels should be compared to those of Bear Stearns, Lehman’s or any other Wall Street firm again is ludicrous and not the point. Because Goldman’s star trader’s employment alternatives aren’t Bear and Lehman - they’re Och-Ziff, SAC, and starting their own shops. And trying to compare overall talent pools is certainly beyond his ken or anyone else’s. So let’s focus our energies on the things we can empirically study - like risk and performance.
So What About the Others? - working in obscurity yet creating value
So many people also seemed to be stunned at the average compensation per employee at Goldman, some $623k. The NYT story also went on to describe the lavish holiday parties, etc. I mean who really cares? Ok for selling newspapers and filling column inches but, at its core, completely irrelevant. Good for Goldman that they paid out that much. Clearly these numbers are heavily skewed by the fact that a handful of people likely took home several billion of the $16 billion+ that got doled out across the firm. But hey, it is likely that lots of assistants, associates and VPs got payouts quite unlike any other they’ve seen during their tenure at Goldman. And Goldman has not historically been known as a firm that paid well except for those at its highest ranks. This was the carrot that was held out to the junior staff, that if they could only work hard enough and generate enough value to make Partner (or PMD in today’s public comany parlance) then they’d be on the gravy train after, say, 10-12 years of killing themselves. So now some of these people get to share in the booty of an historic year.
You know what this does? Builds bonds. Builds loyalty. Builds esprit de corps. Makes non-PMDs and super-traders feel like they are being recognized for the hard work they put in, the hard work that sometimes enables the superrich to make their money. And this is what I spoke of previously about Goldman and Wall Street firms, in general, of being a microcosm of society. There are a handful of Bill Gates’ and Warren Buffetts’, and a whole lot of others plugging away who are key to the operation and its functioning. So if Bill and Warren keep on raking in mega-bucks while the others keep collecting nickels, eventually people will get disenchanted, pissed off, and maybe leave for places like Bear and Lehman. Because those places are their alternative work situations. So what Goldman did, in my opinion, is both enlightened and fair. And smart. Shareholders should praise Lloyd et al. Because they had a golden opportunity to do the right thing and cement the already strong bonds between senior management and the rest of the highly-productive organization - and they did. Smart, f&cking smart.
Conclusion
I am not a philosopher, I am a pragmatist. I believe that Wall Street and its denizens serve a vital function for the global economy and society at-large. Given this mind-set, my work experience and understanding of the transformation of Wall Street from a largely client-driven business to a heavily trading-driven business, I view the Wall Street compensation culture and Goldman’s in particular as being reasonable, appropriate - and necessary. And pieces like Mr. Sorkin’s do not, in my opinion, shine any new light on the issue as they fail to acknowledge how the world has changed, and how the dollars generated by and paid out by Wall Street firms reflect value created, risks taken and the competitive landscape. Bravo, Goldman. Congratulations on a stellar 2006 and best wishes for a lights-out 2007.
