Monday, May 30, 2011


The only easy day was yesterday
The mind must always be in the state of "flowing," for when it stops anywhere that means the flow is interrupted and it is this interruption that is injurious to the well-being of the mind. In the case of the swordsman, it means death. When the swordsman stands against his opponent, he is not to think of the opponent, nor of himself, nor of his enemy's sword movements. He just stands there with his sword which, forgetful of all technique, is ready only to follow the dictates of the subconscious. The man has effaced himself as the wielder of the sword. When he strikes, it is not the man but the sword in the hand of the man's subconscious that strikes.

— Takuan Sōhō, The Unfettered Mind

There is a tradition within Bushidō, the ancient Japanese way of the samurai, which states that a warrior must always be prepared for death; in fact, that a true warrior should always act in combat as if he is already dead. Only in this way does he have a chance of attaining mushin no shin, mind without mind, without which he cannot hope for success.

On this Memorial Day, I would ask each of you to reflect on this thought—forged in a culture and society in which combat was usually conducted at close range, with edged weapons, between combatants who could normally see each other's eyes—in the context of modern, mechanized warfare. Where death or incapacitation is more likely to come

  • without warning
  • from a distance
  • from an unseen opponent
  • in the form of splintered, searing metal which shatters limbs and tears flesh.

Then ask yourself who is more courageous: a professional warrior, raised from birth in a tradition of service and self-abnegation, facing a known opponent at arms length, or an 18-year old Specialist, fresh off the boat from America, driving a Humvee through the IED-riddled streets of Ramadi.

Then, please, do me a favor: Say a prayer of thanks, and protection, for all our young men and women in harm's way. They deserve it.

Happy Memorial Day.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sunday, May 29, 2011

Pebbles in the Stream

Miyamoto Musashi, Kobokumeigekizu
Above all else, the mentat must be a generalist, not a specialist. It is wise to have decisions of great moment monitored by generalists. Experts and specialists lead you quickly into chaos. They are a source of useless nit-picking, the ferocious quibble over a comma. The mentat-generalist, on the other hand, should bring to decision-making a healthy common sense. He must not cut himself off from the broad sweep of what is happening in his universe. He must remain capable of saying: "There's no real mystery about this at the moment. This is what we want now. It may prove wrong later, but we'll correct that when we come to it." The mentat-generalist must understand that anything which we can identify as our universe is merely a part of larger phenomena. But the expert looks backward; he looks into the narrow standards of his own specialty. The generalist looks outward; he looks for living principles, knowing full well that such principles change, that they develop. It is to the characteristics of change itself that the mentat-generalist must look. There can be no permanent catalogue of such change, no handbook or manual. You must look at it with as few preconceptions as possible, asking yourself: "Now what is this thing doing?" 1

We can still remember the golden days before Heisenberg, who showed humans the walls enclosing our predestined arguments. The lives within me find this amusing. Knowledge, you see, has no uses without purpose, but purpose is what builds enclosing walls. 2

Think you of the fact that a deaf person cannot hear. Then, what deafness may we not all possess? What senses do we lack that we cannot see and cannot hear another world all around us? 3

I have said: "Blow out the lamp! Day is here!" And you keep saying: "Give me a lamp so I can find the day." 4

* * *

You should never be in the company of anyone with whom you would not want to die. 5

1 The Mentat Handbook, Children of Dune.
2 Leto Atreides II, His Voice, Children of Dune.
3 The Orange Catholic Bible, Dune.
4 Bijaz to Hayt, Dune Messiah.
5 Ancient Fremen saying, God Emperor of Dune.

© 2011 The Epicurean Dealmaker. All rights reserved.

Thursday, May 26, 2011

Hail Mary, Full of Grace

This is not an income statement
Life is like an analogy.

— Aaron Allston

I am a fan of the carefully chosen analogy, O Dearly Beloved. Perhaps you have noticed this. Analogies can be persuasive rhetorical devices, both illuminating and clarifying difficult topics by drawing attention to their similarity to situations and things with which we are more familiar. Using an analogy can reveal aspects of the subject in question which would otherwise be difficult to perceive. A well-chosen analogy can make the reader say, "Why, yes, of course. Why didn't I see that? How clever."

But analogies can be dangerous, too. In particular, analogies can encourage an over-facile equation of things which are fundamentally dissimilar based upon a few, selected characteristics they share in common. This can lead an author and reader to draw unsupported conclusions, or to extend the analogy to other aspects of the subject to which it does not truly apply. Carried too far, an unsupported or overextended analogy can conceal more than it reveals, or beg the more interesting questions at hand in favor of cheap and easy parallelism. Carried to an extreme, a faulty or weak analogy can even suggest an incorrect interpretation of events, or counterproductive behavior.

Analogies are like spices: a judicious application can enhance and bring out the flavor of a dish; too much can overwhelm it and even change its character entirely. Sriracha, anyone?

* * *

So, for example, I am innately suspicious of the most common analogies which businessmen (almost always men, natch) use to characterize business: war and sport. While certain characteristics of these phenomena have obvious parallels in the world of business—high-stakes competition against determined opponents, a focus on developing and maintaining strategic and tactical advantage, and the importance of disciplined and coordinated teamwork, for example—there is a great deal of business which is not at all like either sport or war. In particular, no-one usually dies in business, and standard business methods do not normally include the destruction by attrition of an opponent's personnel and matériel through the overwhelming application of violent force. This is a—if not the—key definitional characteristic of the aims and methods of war. Without this core quality, business is nothing like war, except in the most superficial aspects listed above.1

By the same token, businesses compete in a far more fluid and undefined competitive space than do sports teams. There are no regularly scheduled games, championships, or league rankings in the world of business. Competition among businesses is not governed by a rigid, highly codified system of rules, overseen and enforced in real time by independent officials who can intervene with absolute authority. Business competitions rarely result in easy to understand outcomes: Coke, 23; Pepsi, 21. Finally, unlike sport, business is not at its core an entertainment, or play. It is deadly serious, and it involves almost all of us as direct participants and competitors. Employees are not fans. While sports fans can have a lot of emotional capital at stake (and money, too, if they wager), they do not lose their jobs, get laid off, or suffer pay cuts if their favorite team loses the playoffs. In its form and essence, sport is simple, clean, and relatively static. Business is nothing of the kind.2

* * *

Hence, you may understand why I am less than enthusiastic about a recent article written by Roger Martin, the Dean of the Rotman School of Management, which appeared in the Harvard Business Review. In it, Professor Martin draws an extended—if not exhaustive—analogy between the behavior of business executives and American football quarterbacks. His basic complaint, if I read him aright, is that, unlike quarterbacks who play to accomplish real results (i.e., winning), public company CEOs run their businesses to satisfy market expectations. That is, they manage to their company's stock price, not to its real financial and operating results.

Here is what Mr. Martin has to say:

CEOs routinely go to the microphones to apologize or make excuses for missing the analysts' consensus earnings estimates — even if their real results are substantially up. And executives routinely take extreme and risky actions at the end of fiscal periods in order to juice results to hit those consensus earnings estimates.

Why is it that what is inconceivable in football is standard in business? The answer is that compensation is largely based in the expectations market in business and is strictly based in the real market in football. CEOs have a large portion of their compensation based on the performance of their company in the stock market, so CEOs spend their time shaping and responding to expectations. Quarterbacks have no part of their compensation based on the performance of their team against the point spread, so they focus completely on winning games.

Football has figured this out a lot better than has business. Football focuses its key players on the real game; business focuses its key players on the expectations game. Football gets 100% useful activity from its key players; business has them engaging plenty of their time in non-value-adding activities, like talking to analysts. It is time business learned a few things from football.

Perhaps Mr. Martin has been addled by enthusiasm for his analogy, but I think this is pretty silly advice. For one thing, quarterbacks and football players get paid for "real" results (winning football games and championships, for example) because those results are so well-defined and easy to measure. Did the Steelers beat the Bengals last night or not? That's a simple yes or no answer. Did the Steelers win the Super Bowl or not? Ditto. On the other hand, how do you measure success in business? Is it that net income increased by 15% year over year, or revenue by 10%? Is it that your company gained three points of market share, or reduced its outstanding debt by 10% with free cash flow?

Sports teams and fans track lots of statistics over the course of a season, but let's face it: the only thing that matters at the end of the day is whether they win or lose. Football teams and quarterbacks can put up better statistics than anyone else in the league, but if they don't win games, it just doesn't matter. Football is simple: over the course of a season each team in the league competes against all the others, and the playoffs and championship determine—by definition—the "best" football team of the season. There is no equivalent in the world of business. The metrics of success in business are far more multiform, variable, and relative: revenue growth, income growth, operating margins, free cash flow, market share, etc. You cannot point to a company's results at the end of a fiscal year and definitively declare that it "won" or "lost." Even if it outperformed its entire history in terms of growth, margins, and profitability, that does not mean it outperformed its competitors. There is no commonly accepted measure of absolute success in business.

Therefore, while it is relatively easy to track and incentivize football players based on whether they won or lost, and how often, it is quite tricky to pick one or two easily measured metrics to determine compensation for business executives. It makes no sense to pay a CEO solely based on operating or financial results, because that ignores industry conditions and relative performance, among other things. Why pay a CEO an incentive bonus if net income increased by 15% on his or her watch, but net income at the company's closest competitors increased by 20% or more? Why pay him or her for increasing sales if sales across the entire industry rose due to exogenous factors outside any executive's control?

There is, however, one universal metric in business—at least for publicly traded companies—which can be easily tracked and measured: a firm's stock price. Since this stock price presumably embodies the real-time, summary judgment of investors about both industry conditions and a company's individual prospects, it can act as a reasonably reliable proxy for the performance of the company and, hence (again presumably), its executives. That is why you see so many companies tie a significant portion of their executives' compensation to their stock price. Now, because a company's stock price incorporates factors external to its own performance—most notably investors' perceptions of the company's absolute and relative success—you will see corporate executives devote a great deal of time and attention to persuading investors of their case, to satisfying investor expectations, and to generally managing to the share price in addition to delivering actual results.

* * *

But—and this is crucial—this makes all the sense in the world. Why? Because management's incentives are aligned with those of their company's investors. They want to see the share price to go up, just like investors do. In fact, for both investors and management, a rising stock price is "winning." Just like quarterbacks and their teammates get paid to win games, win playoffs, and win championships, corporate executives get paid to boost their company's stock price, because that's what their owners (employers) want them to do. Football players are incentivized to win because it makes the franchise earn more money, it gratifies the team owners' egos, and because to the best of my knowledge the NFL takes a very dim view of owners and players betting against their own teams. Corporate managers are paid at least partially in stock and options because investors want them incentivized to raise the stock price, so the investors who own the company can make money.

Now, can excessive focus on raising the stock price distract management's attention from running the business and delivering the operating and financial results over which they have real control? Sure. Does an effort to drive the share price occasionally encourage managers to engage in counterproductive and dangerous games like managing earnings and creative accounting? Of course. But no incentive system is foolproof, and no incentive system is immune from being gamed for someone's advantage.

Perhaps in his obvious enthusiasm for the apparent purity and nobility of American football, Mr. Martin has forgotten that sport is vulnerable to the very same distortions and bad behavior that he chastises in business. There is a very old set of bad, distorting, and counterproductive behaviors which afflict and undermine any sport which is focused on winning. It is called cheating.

* * *

So, in contrast to Mr. Martin's recommendation, I would posit another. There is something important which business can teach the followers and encomiasts of sport: never underestimate the incentive, opportunity, and temptation for human beings playing high-stakes games to cut corners.

That is called human nature.

1 If you remain unconvinced, indulge me with a little thought experiment: what do you think the competition between implacable soda pop rivals Coke and Pepsi would look like if they could bomb each other's plants, machine gun each other's employees, and assassinate each other's leaders? Yeah. See the difference?
2 Before the sports mad take up pen and cudgel, let me explain. Sport operates with far fewer degrees of freedom than does business. The rules, structure, and forms of acceptable behavior are limited and highly codified, by definition. That's what makes it sport. I say this not to take anything away from the skill, beauty, and excitement which well-played sport entails. It's just that sports participants channel their energy, skill, and determination into extremely limited and well-defined channels. In contrast, business is much more like a barroom brawl.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sunday, May 22, 2011

Dan, You Pompous Ass

Ya gotta show a little leg, babyFrequent visitors to this site know to discount my more fearsome moods and expostulations as simple proof of passionate engagement with my various subjects. Nevertheless, I am always pleased to receive constructive criticism when and where appropriate. Therefore, it is with gratitude that I acknowledge a pair of interlocutors who observed helpfully yesterday that I failed to directly address one of the principal charges which Joe Nocera leveled in his ill-considered jeremiad on the LinkedIn IPO. I can only excuse myself by noting that I must have gotten caught up in demolishing the silly accusations of Mr. Nocera's partners in disinformation.

For your convenience, I will repeat the core of his argument here:
[I]n reality, LinkedIn was scammed by its bankers.

The fact that the stock more than doubled on its first day of trading — something the investment bankers, with their fingers on the pulse of the market, absolutely must have known would happen — means that hundreds of millions of additional dollars that should have gone to LinkedIn wound up in the hands of investors that Morgan Stanley and Merrill Lynch wanted to do favors for. Most of those investors, I guarantee, sold the stock during the morning run-up. It’s the easiest money you can make on Wall Street.

As Eric Tilenius, the general manager of Zynga, wrote on Facebook: "A huge opening-day pop is not a sign of a successful I.P.O., but rather a massively mispriced one. Bankers are rewarding their friends and themselves instead of doing their fiduciary duty to their clients."

Now, I think I rather conclusively eviscerated the notion that LinkedIn's underwriters "absolutely" knew the stock would more than double on the day of pricing in my previous post. They had no idea, other than LNKD was a hot IPO; therefore, all bets were off. Furthermore, even if they strongly suspected something like that would happen, there was very little they could do to forestall it, if LinkedIn's executives and current shareholders did not want to offer substantially more shares.

So Nocera's remaining allegation—echoed by Zynga's GM—is that the underwriters took advantage of the expected pop in the company's shares to hand risk-free trading profits to their friends and best customers. There are two answers to this accusation, one based on the facts of how investment banks allocate shares in IPOs and another based in common business practice. I will address them both in turn.

* * *

First, lets examine the facts, as they are known in the reality-based community.

Once a company launches the investor marketing phase of an initial public offering—consisting of management trotting around to dozens of one-on-one management presentations and rubber chicken lunches in front of hundreds of institutional investors—its underwriters commence a direct outreach program to these very same investors. As the actual offering date approaches, a more intense program commences known as bookbuilding, in which the investment banks survey the buy-side investors as to their appetite for the stock, including preferred number of shares and price limits, if any. The twofold objective is to build a book of indicative orders that exceeds the anticipated size of the offering—to create conditions for a sustained level of demand support after the stock opens for trading—and to build this book with investors who do not have hard limits on the price they are willing to pay.

Now, every underwriter worth its fees will do its damnedest to build what we call a high quality book of orders. In other words, we want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket. These are the type of investors virtually all of our issuer clients want: investors, not traders; buy-and-hold accounts, not fast money hedge funds. Of course, the stronger the demand for the deal, the more selective underwriters can be in our allocations. The stronger the overall demand, the more likely it is that we can exclude buy side accounts who traditionally flip on the offering from the deal entirely. And believe you me, we know exactly who the fast money accounts and IPO flippers are. We track every deal, and we keep records.

The other material point to relate is that virtually every investment bank makes this process as transparent as possible to its issuer clients. As we approach the pricing date, underwriters hold calls with company management and selling shareholder representatives every day—and often several times a day—to relay investor feedback and update the status of the order book, including requested allocation sizes, limit orders, etc. While it is saying too much to assert every company has a detailed grasp of its IPO order book prior to pricing, it is almost never the case that the sellers are surprised in any material way by its final makeup.

Unfortunately, hot IPOs can disrupt underwriters' and issuers' carefully laid plans to build stable, supportive, long-term investor bases. Even buy-and-hold investors with the best intentions can yield to the temptation to flip their shares when an IPO doubles in price on the first day. We underwriters can look sternly at them, and ostentatiously put a black mark next to their names in our offering records, but it's hard for us not to understand the compulsion they feel. It also makes it harder for committed investors to add to their positions, as many of them prefer to let the stock settle down to a dull roar before they commit more funds to the investment.

But that, as they say, is a champagne problem to have. Most companies are so delighted with a strong IPO performance that they don't mind having a few more hedge funds and fast money accounts in their shareholder base for a while. After all, those guys' money is just as green as Warren Buffett's.

* * *

Second, I find it absolutely ludicrous that kibbitzers feel compelled to criticize investment banks for passing around favors in our gift and treating friends of the firm well. For one thing, investment banks by their very nature straddle both the buy- and the sell-side of markets. We have corporate clients and their inside shareholders who sell stock and institutional investor clients who buy it. Yes, we serve two client bases with potentially competing interests, but that is the very reason we are able to underwrite securities in the first place. We are middlemen, and it is the essence of what we do all day to balance the competing interests of our clients for the benefit of all. All our clients are fully aware of this.

For another, what business of any kind does not treat some clients better than others on occasion? Do you really think a midsize manufacturer gets the same attention and economic terms from Microsoft that General Electric does? Do you really think it is not in the very nature of business to trade favors for increased business, for better terms, for new business? Of course investment banks horse trade with certain buy-side investors; of course we give certain accounts bigger than normal allocations in IPOs; of course we give a hedge fund we owe a favor to access to a hot IPO. By the same token, we earn a lot of favor ourselves for giving accounts access to such hot IPOs. The horse trading goes both ways. And because we owe an obligation to underwrite a successful offering for our issuing clients, all the competing pressures from the institutional securities side of our house are generally and pretty successfully kept in check.

This—for those among you who might be unfamiliar with it—is commonly known as business.

* * *

Frankly, I have always suspected that the stentorious outrage about special favors and secret deals investment banks allegedly dispense on IPOs really boils down to simple envy. Nine times out of ten, I suspect the person whinging is just pissed off he did not get shares in a hot IPO himself. There is a name for such people in my business: retail flippers. And we never allocate shares in hot offerings to them if we can possibly help it.

© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, May 21, 2011

Jane, You Ignorant Slut

xkcd: Duty Calls
GOD DAMN IT. I thought Joe Nocera was smart. Then I read horseshit like this:
[I]n reality, LinkedIn was scammed by its bankers.

The fact that the stock more than doubled on its first day of trading — something the investment bankers, with their fingers on the pulse of the market, absolutely must have known would happen — means that hundreds of millions of additional dollars that should have gone to LinkedIn wound up in the hands of investors that Morgan Stanley and Merrill Lynch wanted to do favors for. Most of those investors, I guarantee, sold the stock during the morning run-up. It’s the easiest money you can make on Wall Street.

As Eric Tilenius, the general manager of Zynga, wrote on Facebook: "A huge opening-day pop is not a sign of a successful I.P.O., but rather a massively mispriced one. Bankers are rewarding their friends and themselves instead of doing their fiduciary duty to their clients."

With this appalling emission, Nocera joins the ranks of the table-pounding, idiotic commentators—including Henry Blodget, Jim Cramer, and, apparently, the financial markets expert in charge of underwriting tomatoes and cabbages over at Farmville, Eric Tilenius—who have tripped all over themselves to draw the exactly wrong conclusions about this week's 110% pricing day gain in LinkedIn's IPO.

In fact, Nocera cites Henry Blodget approvingly for one of the stupidest analogies about initial public offerings ever conceived:

But over at the Business Insider blog, Henry Blodget — who knows a thing or two about bad behavior on Wall Street — had the perfect analogy for what the banks had done to LinkedIn.

Suppose, he wrote, your trusted real estate agent persuaded you to sell your house for $1 million. Then, the next day, the same agent sold the same house for the new owner for $2 million. "How would you feel if your agent did that?" he asked. That, he concluded, is what Merrill and Morgan did to LinkedIn.

Jesus. The mind just fucking boggles.

* * *

Where to begin? Such a target-rich environment.

I know, let's start with The Stupidest Analogy About IPOs Ever Conceived. Blodget asks how you would feel if your real estate broker sold your house one day for $1 million to someone (a friend of his, presumably) who turned around and sold it the next day for $2 million. You'd be pissed, right, and feel betrayed? Of course you would. That would be a big problem.

But let me posit another scenario. Let's say that you didn't want to sell your entire house and move out. Instead, you want to raise some money for kitchen remodeling. Being a clever, innovative sort, you decide to do so by selling a small portion of the equity in your house (you own it debt free) to a bunch of strangers for $50,000. Your broker tells you he thinks he can sell that based on an estimated valuation of your house at $1 million, which means you need to sell 5% of your equity. You say great, he sells it for you, and the next day a whole other bunch of strangers are trading the shares you sold for $100,000.

Is this a big problem? Well, if you and your broker knew that demand for a tiny sliver of your home equity would be so strong, you could have raised $50,000 by selling a smaller portion, say 2.5 or 3%. After all, you don't need more than fifty grand to remodel your kitchen (it's a nice kitchen), and, what with interest rates so low, you sure didn't want to put any extra in the bank. But your broker was adamant that you needed to sell at least that much because, if you sold less, those shares wouldn't trade easily enough, and it would have been hard to drum up enough interest to sell them in the first place, perhaps even for any price.

More to the point, do you really care? You got your money, you still own 95% of the equity in your house, and you feel pretty happy that the home you built over many years with your bare hands seems to be worth $2 million. Especially since you paid less than $30,000 for it in the first place. You know that if you want to sell your house tomorrow, or any additional portion of it, you have a pretty good chance of getting close to $2 million for it. Your broker shrugs apologetically, you pat him reassuringly, and you both walk off to the kitchen remodeling store arm-in-arm whistling. Fifty grand foregone seems like a pretty small price to pay to find out the true value of your home, no?

So, using Henry's house sale analogy, and correcting it to reflect the facts of the LinkedIn IPO, the underwriters' behavior doesn't seem quite so damning after all, does it?


Like I said: The Stupidest Analogy About IPOs Ever Conceived.

* * *

Next, let's turn to Mr. Cramer, another supposedly intelligent man, who ranted on air that LinkedIn's IPO was "outrageous" and "preposterous" and, apparently, should have been prevented by regulators. His major criticism seems to be that the deal was too small. By selling only 8.3% of the company's shares in the offering (pre-shoe), Cramer claims that the company and its underwriters created a buying frenzy for LinkedIn shares through sheer scarcity.

But this is ludicrous. First of all, it's not at all clear that the company needed the money it did raise in the first place. Pre-IPO, LinkedIn was debt-free, had over $100 million in cash on its balance sheet, and hadn't invested much more than $50 million in cash in its business in any one year since inception, most of which it funded from operations. The declared use of proceeds is typical content-free legalese [emphasis added]:

The principal purposes of this offering are to increase our capitalization and financial flexibility, increase our visibility in the marketplace and create a public market for our Class A common stock. As of the date of this prospectus, we cannot specify with certainty all of the particular uses for the net proceeds to us of this offering. However, we currently intend to use the net proceeds to us from this offering primarily for general corporate purposes, including working capital, sales and marketing activities, general and administrative matters and capital expenditures. We may also use a portion of the net proceeds for the acquisition of, or investment in, technologies, solutions or businesses that complement our business, although we have no present commitments or agreements to enter into any acquisitions or investments. Based on our current cash and cash equivalents balance together with cash generated from operations, we do not expect that we will have to utilize any of the net proceeds to us of this offering to fund our operations during the next 12 months. We will have broad discretion over the uses of the net proceeds in this offering. Pending these uses, we intend to invest the net proceeds from this offering in short-term, investment-grade interest-bearing securities such as money market funds, certificates of deposit, commercial paper and guaranteed obligations of the U.S. government.

Like many maturing internet companies, LinkedIn is basically self-funding. Unless its executives go hog wild and start buying other companies with cash—Zynga, anyone?—I expect we'll see close to $300 million still on its balance sheet a year from now. Earning 30 basis points in short-term Treasuries. What would Cramer have the company do with more cash, buy back its own shares? Oops.

The only other source of shares would be current shareholders, but it's patently obvious almost no-one wanted to sell a substantial portion of their holdings on the IPO. Only relatively small holders Goldman Sachs, McGraw Hill, and SVB Financial sold their entire positions, for reasons best known to themselves. The fact that insiders were unwilling sellers can be deduced from the structure of the overallotment option (or "green shoe"), which is the 15% extra shares the underwriters have a right to sell in the face of strong demand. If sold, those shares will come from the company.

No, unless Messrs. Wiener and Hoffman have something surprising up their sleeves, I think we can assume that they did this IPO for the very reason they disclose in plain English:

The principal purposes of this offering are to ... increase our visibility in the marketplace and create a public market for our Class A common stock.

They did it to go public, which means, in this case, that current shareholders will be able to sell their shares in future offerings. They are priming the pump for bigger paydays in the future. Believe you me, I can guarantee the underwriters were begging company executives and big shareholders to increase the size of the offering, especially after they began to see the strength of demand. After all, the investment banks get paid 7% of the offering proceeds; the bigger the offering, the more money they make.

Viewed this way, the approximately 50% haircut the company and its current shareholders took on the offering was the price they paid to establish a public trading market for their shares. It was indeed a steep price—several hundred million dollars—but I doubt many of the newly minted billionaires and multimillionaires are too bent out of shape about it.

* * *

Finally, I would like to turn to the issue of valuation. People like Henry Blodget, Eric Tilenius, and uncountable others have been raving on and on about how the LinkedIn IPO was seriously "mispriced." To a person, they blame the investment banks which underwrote the deal, accusing them, at best, of near-criminal idiocy and, at worst, of criminally fleecing their issuing client and its shareholders. But this is just stupid.

Before they ever approach the market, investment banks do a lot of work evaluating new issuers to come up with a price which they think the company will be worth once it is trading normally in the marketplace. They do this based not only on the company's own historical and projected financial results but also on the trading multiples and profiles of comparable companies already public. Once they determine an estimated normalized value, they apply a standard 15% discount to the shares offered in the IPO. The purpose of this is to try to ensure that new investors have a positive investment experience with the IPO, and there is enough intrinsic value left for shares to trade up going forward. This is especially important if the company and/or its existing shareholders intend to sell shares in the future. Giving new investors in an IPO some value for free is the price of being able to do successful follow-on offers in the future.

Now, you can see that this exercise is an art, not a science. Investment bank IPO pricing is the epitome of (very) highly educated guessing. We often get it wrong, but, on average, IPO pricing is normally pretty accurate. After all, it's our job, and we do it well. The picture gets complicated, however, when the company in question, like LinkedIn, does not have any comparable peers among listed public companies. Our guesses become much less educated and much more finger-in-the-air type things. There is no cure for this but to go to market and see what investors themselves tell you they are willing to pay.

But once we go to market, the issuer and the investment banks essentially hand the steering wheel over to investors. We pitch, and wheedle, and cajole, and praise the company to the skies, but it is investors who set the price, initially in individual conversations with the underwriters' salespeople—where they indicate the number of shares, if any, they want to get in the offering and any price sensitivities or limits they may have—next when the banks set the final price for the offering, and finally—and, by definition, definitively—when they bid up the price in the aftermarket after the shares are released for trading.

Let me make this perfectly clear: Investment banks do not set the ultimate price for IPOs; the market does.

And sometimes, as in the case at hand, you get what we call in the trade a "hot IPO." Investors work themselves into a buying frenzy, the offering becomes massively oversubscribed (e.g., orders for 10 or more shares for every one being offered), and the valuation gets out of control. Underwriters have a limited ability to respond to these conditions, which typically emerge during the pre-IPO marketing or "bookbuilding" process, including revising estimated pricing up, like LinkedIn's banks did (+30%), and increasing the number of shares offered. But eventually you just have to release the issue into the marketplace and let the market decide what the company is really worth.

That is when you see grizzled investment bankers, veterans of thousands of IPOs, sit back at their trading terminals and laugh in disbelief. I'll let you in on a little secret: Morgan Stanley and Bank of America Merrill Lynch think people who bought LinkedIn shares at $90 or more are nuts. Three days ago, they never would have imagined it could go so high so fast. (Give them a few days, of course, and a few pitches to other currently private social networking companies contemplating IPOs, and they will change their tune. They will say a $10 billion valuation for LinkedIn makes all the sense in the world and, yes, we can get you the same or better valuation for your gem of a company. We have short memories when it comes to money-making opportunities.) LinkedIn's price performance guarantees that future social networking IPOs will come at stratospheric initial valuations, too. Why? Because it is our newest and best comparable, of course. Duh.

* * *

So say what you will about hot IPOs causing bubbles, no-one directly involved in the LinkedIn offering—the company, the selling shareholders, the underwriters, or the initial investors—is remotely unhappy with what happened. I guarantee you the clients were guiding the process and making decisions every step of the way. The underwriters simply told them what was possible, took the company to market, and got out of the way.

As far as people who bought LinkedIn shares above the offering price, well, all I can say is good luck. No-one held a gun to your head and, for all I know, you may have made a stellar investment. Nobody can be sure that LinkedIn shares won't continue to rise from here. (Of course the converse is true, too.) I seem to recall a certain former Wall Street research analyst making a name for himself with what seemed like an outrageous prediction that would reach $400 per share during the prior internet bubble. If I remember correctly, I think he was proved right. One thing investment bankers learn early is never to underestimate the ability of the market to confound you.

But let's hear no more ignorant twaddle about "scamming," or dereliction of fiduciary duty, or bankers just being in it for themselves. It's just wrong, and it's based on an appalling misunderstanding of how and why IPOs get done by people who should definitely know better. It's just not that hard to understand.

And if the backchat doesn't stop, I may just have to get nasty. I won't like it, but that's something else I'm really good at, too.

DISCLAIMER: I was not involved in the LinkedIn IPO, and I have no position, direct or otherwise, in LNKD shares. My analysis is speculative, based upon my own knowledge of the industry, extensive experience underwriting IPOs, and general common sense. I make no representations that my description of what happened really did happen that way, but it's pretty damn likely to be true. Never, ever take anything I say here as investing advice. If you do, I will hunt you down and kill you.

1 My analogy is approximately correct, based on the information disclosed in LinkedIn's IPO prospectus: the company sold a 5.1% stake consisting of 4.8 million newly-issued shares to investors (selling shareholders, like Goldman Sachs, sold the rest). The original shareholders' basis in the company was $120 million, or 2.8% of the original IPO valuation at $45 per share (p. 38). I ignore for these purposes whether the underwriters will exercise their overallotment option (the "green shoe"), which they most certainly will. Those additional 1.2 million shares will come from the company, too.

© 2011 The Epicurean Dealmaker. All rights reserved.

Tuesday, May 17, 2011

Pixels Don't Breathe

Willem de Kooning, Easter Monday, 1956 - Click to view larger
As usual with de Kooning, the handling is wet-in-wet—high-keyed color worked with lots of white paint, which keeps things lively and advancing. There are screechy yellows, electric blues, boudoir pinks, and—as painter friends assure me—two of the most ungovernable hues in the painter's kit: alizarin crimson and thallo green. These are dyelike synthetic pigments, transparent like nail polish and viciously intense. They affect other colors the way garbage cans kicked downstairs would affect chamber music. They give the Dutchman no great difficulty.

— Peter Schjeldahl, The Hydrogen Jukebox 1

Here's a fun project for you, children.

One fine, convenient day, close your laptop, shut down your monitor, mute your smartphone and slip it into a pocket, and go visit an art museum. Once inside, skip the bookstore, shun the gift shop, and eschew any special exhibitions of Blockbuster Anything or Super Duper Famous Artist retrospectives. Instead, find the painting galleries in the permanent collection and wander around until you find a nice piece that particularly interests you—preferably one with a bench commodiously arranged before it—and sit down. Just exactly what kind, vintage, or style of painting is entirely up to you. For what it is worth, for my purposes I prefer an abstract painting, but this choice is an entirely personal matter and does not impinge upon the value or effectiveness of the exercise. By choosing an abstract piece, I am not distracted by the narrative behind it, the physical beauty or attractiveness of the painter's subject(s), or the verisimilitude of his or her representation. But again, the choice is yours.

Now, here's the exercise: look at the painting. Just look at it. Look at it long and hard: 10, 15, 20 minutes at least. Stand up and go look at it up close. Back up and look at it from a distance. Look at it with squinted eyes, with eyes wide open, with a sideways glance. Try to take in the entire painting at one time (this is harder than it looks). Go up close to look carefully at individual passages or details to see how the paint has been applied. Is it smooth? Is is scumbled? Is it cracked or glazed with varnish? How does the surface of the painting—shiny, fleshy, or rough—work with the colors of the paint and the light of the room to create the images you see from a distance? Can you guess how the artist painted that particular passage? Try to understand why the light falls on it just so in that one intriguing corner.

If you are doing this right, you will need to take frequent breaks. Looking this intensely at anything is hard work. Use these breaks however you like: looking at other museumgoers (always interesting sport), glancing at other paintings, reading a snippet of catalogue, taking a brief stroll around the gallery. But always return to the painting. Try to look at it afresh each time, and try to see something new, or something you missed, or something you thought you saw before but now realize you missed entirely.

Go up and read the label, if you want, just to give yourself some context, but try not to let the label tell you what to think about the painting. Make up your own mind. Do you like it? Do you dislike it? Why? Are there particular parts or passages that you like or dislike? Why? Try to answer these questions for yourself, but if you cannot, do not get frustrated. Instead, examine your feelings and impressions about the painting. Try to decide what you think about it. After all, the painting is there for you. It will wait.

* * *

There is much, much more you could do, but I think you get the idea by now. The point is to experience an object in real time—in the flesh, as it were—unmediated by the lacquered page of a book or the reflections on a computer screen. An object which has been created out of canvas, and wood, and paint, and whatever else the artist chose to incorporate for the express purpose of being looked at in itself, as an object: here and now.

Given how much of my personal and professional life is conducted or mediated through the sterile arrangement and rearrangement of glowing pixels on a screen, I find an occasional such exercise to be a refreshing and even reinvigorating way to reconnect with the physical world. You could accomplish the same thing by contemplating a tangerine, or your belly button, I suppose, but I personally tend to find fine art more intrinsically interesting. Plus, there's the advantage that staring for 20 minutes at a painting in a museum will garner you fewer incredulous stares (although not none) than doing the same thing with a piece of fruit in a farmer's market.

For someone who likes and looks at art a lot, primarily on the printed page but increasingly online, I never fail to be amazed by the sheer physicality and scale of good paintings in real life. I remember being astonished years ago when I first encountered historical paintings by Rubens in a European museum: they were so damn big. Scale is integral to the experience of an art object, and that is something completely missing from photographic representations in whatever medium. As is the physicality of the medium itself. You simply cannot appreciate the sheer weight, texture, and fleshiness of the surface of a de Kooning painting—or the way its surface and scale can draw you in until you swear you begin to see it breathe—until you have stood before the actual object.

* * *

I am sure I could draw parallels between my little exercise and others you could perform to pierce the electronic veil before your eyes and reconnect with the world-as-it-is, but I will leave that project for you to contemplate.

After all, like most artists, I do not wish to dictate. I prefer to suggest.

1 "Willem de Kooning." Berkeley, California: 1991, p. 133.

PHOTO CREDIT: Willem de Kooning, Easter Monday, 1956. Photograph by Renzo Dionigi, here. This is a very good, high resolution photograph of the de Kooning piece hanging in the Metropolitan Museum of Art in New York City. The color balance is a little too yellow, but this is a common problem in such shots.

© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, May 14, 2011

Put Down Your Pitchforks

Nobody ever wrote legislation standing on an orange crate in the parkThis opinion piece by BusinessWeek columnist and author Roger Lowenstein deserves not only the broadest possible exposure which can be afforded it, but also to be read by everyone and their brother carrying a pitchfork and torch towards the ramparts of Wall Street. There was a protest on Wall Street earlier this week wherein many of the demonstrators carried placards emblazoned with the slogan "Make the Banks Pay." If those people are truly interested in educating themselves about the sources of the financial crisis and perhaps even preventing another one in the future, they would have been far better served spending fifteen minutes reading this, instead of chanting slogans at a bunch of straw men.
The financial crisis was accompanied by fraud, on the part of mortgage applicants as well as banks. It was caused, more nearly, by a speculative bubble in mortgages, in which bankers, applicants, investors, and regulators were all blind to risk. More broadly, the crash was the result of a tendency in our financial culture, especially after a period of buoyancy, to push leverage and risk-taking to the extreme.

Mortgage fraud exacerbated the bubble—as did, among other factors, lax monetary policy, failure by Congress and successive administrations to rein in Fannie Mae (FNMA) and Freddie Mac (FMCC), and weak financial regulation, itself a product of the discredited but entrenched thesis that markets are efficient and self-policing. At the banks, overconfidence in "risk management" methods (which were mostly worthless) and ill-considered compensation practices were serious contributing causes.

As this list suggests, the meltdown was multi-causal. That explanation will be unsatisfying to armchair prosecutors, but it has the virtue of answering to the complex nature of the bubble. To prosecute white-collar crime is right and proper, and a necessary aspect of deterrence. But trials are meant to deter crime—not to deter home foreclosures or economic downturns. And to look for criminality as the supposed source of the crisis is to misread its origins badly.

But screaming "criminal," "bankster," and the like is far more satisfying—not to mention lucrative—to filmmakers like Charles Ferguson and polemicists like Matt Taibbi, who, after all, have tickets and magazines to sell. It also resonates nicely with the average American, who feels victimized by impersonal forces beyond his or her control or understanding. But it does nothing to help those Americans or their elected officials either understand or address the issues at hand.

As Lowenstein writes, the financial crisis resulted from the confluence of many different forces, which fell upon a system the checks and balances of which appear in retrospect to have been very badly designed and managed. But these flaws were evident before the fact to anyone who cared to look. They were hiding in plain sight. Nevertheless, almost everybody—bankers, regulators, politicians, ratings agencies, everyday financial consumers—decided to look the other way, because it suited our financial interest to do so. The pernicious fact about financial bubbles is that everyone has an incentive to prolong them, and almost everyone who participates in them profits from them, at least until the bubble pops and the last ones in are left holding a very smelly bag.

Writing about the ratings agencies, whose entire business model was designed to facilitate, support, and encourage the bubble, Lowenstein makes a point which applies generally to the entire crisis:

To call [this kind of behavior] criminal is to call the culture criminal, which is a point of rhetoric, not law.

Later, he states that

it's worth remembering that in the American legal system, people who merely act badly or unwisely do not do time. And people who contribute to a financial collapse aren't guilty of a crime absent specific violations that make them so.

The statutes which would have rendered the behavior most culpable for the financial crisis criminal—greed, stupidity, arrogance, willful recklessness—were not on the books in 2007 and 2008. Therefore, the people who committed those acts did not commit crimes. Period, end of story.

* * *

Now, if we want to reexamine our financial system in a measured, rational, determined way in order to actually fix the damn thing, let's do so. If we want to criminalize or enjoin certain types of behavior—formerly legal—which we now consider dangerous to the public weal, fine. That is what societies do. I am all for it, in fact.

But's let put a lid on the rabble rousers jumping up and down screaming "Criminals!" at the top of their lungs. They are nothing but a distraction to the proper focus and task at hand, and the energy and anger which they are stirring up among the public is getting frittered away in purchases of movie tickets, magazines, and overheated exposés of the crisis, not to mention increasingly unhinged and disconnected comments on blog posts and news articles.

Fixing the sources of the financial crisis will be long, hard, complicated work. Let's stop dicking around and get started.

© 2011 The Epicurean Dealmaker. All rights reserved.

Eight Reasons Not to Hire an M&A Advisor. And One Reason to Do So

Everyone can use a little professional advice every now and thenIt's always fun to read reactions in the press and blogosphere to big M&A deals. So much of what passes for informed opinion is ignorant twaddle, tendentious, misinformed bullshit, or thinly-veiled axe-grinding. Even people who actually know how the M&A sausage factory works can rapidly overshoot their skis if they start to speculate on dynamics which took place behind closed doors and over the phone over the course of the months or even years that a typical large transaction takes to close.

But your Humble Correspondent was struck by one fact which emerged from the brouhaha surrounding Microsoft's recently announced purchase of Skype: Microsoft did not use an advisor in the deal. It occurred to me that some among my Dedicated Readership might be interested in my unbiased opinion as to whether this was a good idea, and, to boot, whether I think that doing without an advisor on a large M&A deal is ever advisable. So, notwithstanding the paradox of a professional advisor giving advice on the advisability of professional advice, I thought I would share with you lovely people what I perceive to be the pros and cons of the matter.

Somewhat surprisingly, I have found it easier to itemize reasons why it makes sense to not hire an investment bank to advise on an M&A deal. (Never let it be said I am not subtle in advancing my own interests.) So, without further ado, here they are:

* * *


1) You are a serial acquirer or dealmaker. This deal is not your first rodeo. In fact, it is simply one in a long series of deals. Your firm is an M&A machine, with experienced deal professionals, established procedures, disciplined processes, and the full support and backing of your firm's senior decisionmakers. Your firm's M&A strategy is crystal clear. You have done enough deals to have seen—if not it all—at least a hell of a lot. You have spent time, energy, and money on deals which never closed, where you were outbid, which you withdrew from. You know how and why the previous deals you did do succeeded or failed, and you can document this exhaustively. Your dealmaking system is so well-oiled that you can execute transactions in your sleep, but you don't, because you make it a practice to learn something new from every process. You may have more deal professionals working for you that most investment banks. You are Cisco Systems or General Electric.

Companies like this conduct mergers and acquisitions just like any other business line, and they get very good at it. Like many things, practice in M&A makes perfect—or at least really, really good—in part because every deal is different, and experience counts for a lot. There is another group of potential clients who do deals for a living, too: private equity firms, or "financial sponsors." Like experienced corporates, PE firms normally do not need help with tactical issues like process, negotiation, or valuation where investment banks commonly add value. With rare exceptions, when clients like these hire investment banks as advisors, they are really just renting our balance sheet to help finance the deal. Most of them won't even meet an M&A banker like me during the process, because they just don't need what I'm selling.

(Which is fine with me, by the way, because I really don't like most of those assholes anyway.)

2) Your target is not a big, unusual, or risky deal. The company you are acquiring is small relative to your own firm, it is in a business line you understand well, and integrating it into your own business should present no difficulties. In other words, the deal you are contemplating is not a bet-the-company transaction, or one that will dramatically transform your firm's current operations and future prospects.

3) The seller and/or its advisor is a sophisticated and experienced deal-doer. You might think that having a skilled counterparty across the negotiating table would necessitate bringing your own hired gun to the party, and normally you would be right. But often an unsophisticated counterparty can create a nightmare of a process, simply because they don't know how to behave or even how one goes about executing an M&A deal. Having an experienced M&A advisor at your side can ameliorate such situations by gently steering the doofuses you are dealing with onto the right path and running interference for their most egregious misbehavior before it ever interrupts your peaceful slumber. Never underestimate how clueless and irrational the members of a family-owned business can become when they decide to sell their company.

4) You want ideas as to which companies to buy and why. No. No, no, no, no, NO. If you are a Chief Executive Officer of a company who wants me to tell you which companies in your industry you should buy and why, you don't need an investment banker; you need a new job. And your Board of Directors needs a new CEO. Are you fucking kidding me? That is your day job, buddy; you're supposed to know this shit better than anyone. We investment bankers don't tell you Who and Why; we tell you How and When. That's our value add.

Now, if you have decided for whatever reason to diversify into a business line or industry with which you have little familiarity—or you are a private equity firm which wants to invest in an unfamiliar sector—it might make sense to hire someone like me to hold your pee-pee for you while you figure out how to urinate. But this is and should be a relatively rare occurrence in M&A. The throes of a hotly contested acquisition should not be the place where you decide what you want to be when you grow up.

5) You know you are the "natural buyer" of the property in question. In other words, you understand the competitive M&A landscape extremely well, and you do not reasonably anticipate being surprised by another bidder coming out of left field to gum up the process or beat you with a topping bid. This condition is pretty rare, however, especially in hot industries or when M&A is very active. You might think that a participant in a particular industry should know the strategic intentions and capabilities of its direct competitors well, but normally you would be wrong. Competitors do not talk to each other directly about strategy because—wait for it—they are competitors. On the other hand, it is the job and practice of any good investment banker not only to develop an informed opinion about how each significant competitor in a space thinks about strategy but also to have done so by talking directly with them, frequently if possible. This is simply not practical for most corporations. Investment bankers are normally far better informed about the strategic landscape of an industry than any one of its participants. This is a critical component of the network knowledge which investment bankers bring to the table for their clients.

6) You need someone to tell you when to stop bidding. If you need an advisor to tell you when to walk away from a deal—because it has become too expensive or the value you expected is no longer there—you do not need an investment banker, my friend; you need a testicle transplant. Investment bankers are trained, incentivized, and paid to close deals. If you're not completely sure that you want to close a transaction, don't hire an investment banker, because we will use all the honey-tongued blandishments at our disposal to persuade you, your counterparty, and anyone else who will listen that this deal here is a really, really good deal, and you should close directly. Ninety-eight percent of the time, we only get paid when a deal closes. How do you think that affects our ability to pull you aside and whisper in your ear that you should let this particular opportunity go?

Never forget, my friend: you are the ultimate decisionmaker in a deal. If you can't say no, you shouldn't expect to hire it done, either.

7.) You are supremely confident this will be an entirely "friendly" deal. In other words, you know the seller/buyer well, you judge that your interests are well-aligned, and you anticipate that your negotiating positions will not be that far apart. This means that, if all goes well, you will not find yourself at 3:00 am in some dingy conference room in Wichita, Kansas, screaming obscenities at your erstwhile friend and golfing buddy of 30 years because he will not budge from his demands for 18 months severance in case of termination without cause, whereas you only want to give 12. Good luck.

M&A deals are high stress affairs, because they are time-pressured, overrun by multiple third parties and advisors (e.g., lawyers) with multiple conflicting (yet eminently sensible) interests and demands, and put a great deal at stake. Even the strongest and oldest of friendships and business relationships can become frayed beyond repair in the negotiating room. That is often why otherwise sophisticated and competent dealdoers in their own right hire third party advisors to do their mud wrestling for them. That way, the investment bankers and lawyers can scream at each other as proxies for the principals, while the principals can walk away arm-in-arm after the fact with no hard feelings. Do not underestimate the value of this, especially if you intend to live and work with the person(s) you have negotiated against so hard for several years after the fact.

8.) You want some sort of guarantee that this deal will work out. Sorry, buddy. Investment bankers are agents. You hire us to help you do a deal. Whether that deal is a good one, or works out for you and your shareholders in the end, is your responsibility. We don't integrate your acquisition, we don't run your merged company, and we don't devise your business plan or operational strategy. All that stuff is your responsibility, and that is the stuff—in addition to exogenous factors like the general performance of the economy and your industry which are largely out of anyone's control, plus a healthy dose of sheer luck—which determines whether your acquisition or divestiture will turn out to be a good deal in the end. The terms of the deal you struck—price among them—are relatively minor factors in the ultimate success or failure of an acquisition.2

M&A is simply an accelerated, concentrated version of investment in your business by other means. It is capital expenditure. It's your plan. We investment bankers are just there to help you execute it. If it doesn't work out, don't blame the bat.

On the other hand, there is...

* * *


1.) At least one of reasons 1, 2, 3, 5, or 7 listed above is not true.

Any questions?

* * *

In conclusion, I will let you clever readers decide which, if any, of these conditions Microsoft violated when it chose to go solo on Skype. Heck, this could even become a parlor game.

1 NOTE: These recommendations and remarks pertain primarily to the decision whether a client should hire a "buy-side" advisor to help him or her acquire another company. "Sell-side" advisory is an entirely different kettle of fish, in which an advisor runs a process for a client who wishes to sell an asset or business. The arguments against using a sell-side advisor are much fewer and weaker. As a matter of fact, most clients do tend to use sell-side advisors when they transact, and the percentage of deals with sell-side advisors is much higher than those with buy-side advisors. (Skype used sell-side advisors when it sold to Microsoft.) If you people are really, really nice to me, perhaps one day I will elaborate further on this.
2 Please, please, please don't talk to me about whether or not a deal is "fair" to shareholders. I have eviscerated that legalistic canard quite definitively in the past.

UPDATE: This post is a replacement for the original item posted earlier in the week which vanished into the ether. (Just in case you were keeping track.) The folks at have been permanently removed from my Christmas card list. Fuckers.

© 2011 The Epicurean Dealmaker. All rights reserved.

Friday, May 6, 2011


What a silly, maladapted little creature!
Delay is natural to a writer. He is like a surfer—he bides his time, waits for the perfect wave on which to ride in. Delay is instinctive with him. He waits for the surge (of emotion? of strength? of courage?) that will carry him along. I have no warm-up exercises, other than to take an occasional drink. I am apt to let something simmer for a while in my mind before trying to put it into words. I walk around, straightening pictures on the wall, rugs on the floor—as though not until everything in the world was lined up and perfectly true could anybody reasonably expect me to set a word down on paper.

— E.B. White, "The Art of the Essay" (Interview), The Paris Review1

Me, I tend to walk in circles, like a predator circling its prey, or a burglar casing a building. The metaphors and the methods differ, but the purpose is the same: it is not procrastination, but rather preparation. Each of us has his or her own little rituals and techniques to concentrate the mind.

The drinking sounds about right, however.

1 The Paris Review Interviews, IV. New York: 2009, p. 138.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sunday, May 1, 2011

Twilight of the Übermenschen

Are you shooting at me?
This is the true joy in life, the being used for a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the being a force of Nature instead of a feverish selfish little clod of ailments and grievances complaining that the world will not devote itself to making you happy.


Beware of the pursuit of the Superhuman: it leads to an indiscriminate contempt for the Human.

— George Bernard Shaw, Man and Superman

* * *

Steven Davidoff opens a recent piece at The New York Times DealBook blog with the following words:

Reputation is dead on Wall Street.

This is powerful language. What does he mean?

Well, for one thing he means that the reputations of individual investment banks are no longer coterminous with the reputations of their executives and employees. He ascribes this to the tremendous growth in scale and complexity of financial markets over the past three decades:

Today’s Wall Street is not the Wall Street of 1907 when J.P. Morgan single-handedly used his reputation and wallet to stem a running financial panic.

Until the 1980s,... Wall Street was made up of traditional partnerships. These were small groups of investment bankers who represented companies in offering and selling securities and occasionally acquisitions. These bankers put their individual reputations on the line, because there were so few of them. Morgan Stanley, for example, had only 31 partners in 1970 and fewer than 1,000 employees.

But this began to change in the 1980s. Trading markets became much more sophisticated, and trading and brokerage became the investment banks’ primary business. This is a technology game. The better the technology, the better the trading and brokerage operation. Individuals became less important.

The growth of more complex capital markets and a global economy also created much larger financial institutions. Morgan Stanley now has more than 62,000 employees. These banks could use their assets and position to compete in the market for finance and trading. Again, individuals were less important as size dominated. A client now trades or does business with a bank based on its positions or ability to make a market or loan. The executive at the bank executing the transaction is unimportant.

In one respect, this is true. Lazard is no longer Felix Rohatyn. Goldman Sachs is no longer Sidney Weinberg. The First Boston Corporation is no longer Bruce Wasserstein and Joseph Perella. But this is old news. All those investment banks (or their successors) have become institutions in the sense that no one larger-than-life personality defines its image, its reputation, or its capabilities.

Professor Davidoff also points out the inverse: that an individual's reputation is no longer irrevocably tied to that of his or her current or previous employers. Both of these observations make intuitive sense. The tremendous scale of large global investment banks normally renders one individual too small and insignificant to make much of a difference. Rarely does a customer deal with one person when they transact with an investment bank nowadays; there are teams and teams of faced and faceless individuals who do a client's bidding. Even in the case of senior executives, who arguably should make a difference and presumably direct and/or set the tone of their firm's operations, the organization is too large and diverse to imbue most individual transactions with significant impact on those executives' reputation. Most customers nowadays are smart enough not to lay the blame for every botched JP Morgan mortgage at Jamie Dimon's feet.

In fact, investment banks have followed the lead of the rest of Corporate America and become brands. This is simply a natural evolution of the economy, in which people no longer purchase goods and services based on the local, individual reputation of a merchant known directly to them. Brands separate reputation from individuals and make it portable across geography, time, and whoever happens to be preparing your Jamba Juice across the counter. Some investment banks—notably Goldman Sachs in the 1980s and 90s—used to make a concerted effort to sublimate individual bankers' reputations and even identities to that of the mothership. Others cultivated the star culture, to greater or lesser success. But now, even a well-educated insider would be hard pressed to identify a material number of individual superstars on Wall Street. Every bank has become a brand first. In my business nowadays, the name on your business card that matters most is not yours; it's the name of your employer.

* * *

But the Professor's description of investment banking is incomplete. If superior technology and gobs of capital were all it took to compete, my industry would have been taken over years ago by the lumbering behemoths of commercial banking. They have always been bigger than investment banks, have much more capital, and have plenty of money to spend on technology and plenty of experience automating financial transactions. And yet the past few decades are littered with examples of huge commercial banks—mostly foreigners—spending lavishly to buy their way into investment banking, only to trip over their own genitals and transfer billions of shareholder euros or yen into the pockets of footloose investment bankers (and thence to their wives, mistresses, and Maserati dealers). Where investment banks and commercial banks have successfully merged, it has almost always been the case that the investment bankers came out on top.

Furthermore, if automation and capital were the only factors which mattered, we should expect to see much more price competition among investment banks than we do. For, as I have mentioned in these pages many times, virtually everything investment banks do is highly commodified. There is almost no transaction, product, or service that Goldman Sachs can deliver to their customers which Morgan Stanley, JP Morgan, or any number of competitors all over the globe cannot deliver that is indistinguishable in terms of perceived quality and actual price. This is particularly true in the areas which Professor Davidoff focuses on for his examples: capital markets lending, underwriting, and trading. We can't even distinguish our product offerings by flavor, like Coke and Pepsi can.

Finally, Professor Davidoff's image of global investment banks as well-funded, highly automated factories staffed by faceless automatons fails to answer a nagging question: Why do investment bankers make so much money? If labor is so interchangeable and replaceable, how come 50% or more of revenues in my industry has historically gone and continues to go toward compensation? If we bankers are so meaningless to our customers, how are we able to skim so much cream off the top? Do not forget that the average Goldman Sachs employee makes roughly ten times the median income of a family of four in this country. And there are plenty of clerks, washroom attendants, and janitors in that average. The average investment banking professional—supposed faceless cog in a vast financial factory—brings home pay which would make the average pasha blush.

If superior technology and vast capital were all that mattered, the Gucci-clad wage slaves would not be bringing home so much of the bacon. If something else wasn't at work, investment bankers who sell non-proprietary, commodified financial services like leveraged loans, equity underwriting, and, yes, even mergers & acquisitions advice would get paid like glorified bank tellers; that is, like corporate lending officers. The only ones who would make any serious money in such a firm would be the topmost executives and the shareholders, just like most of the rest of Corporate America.

Why isn't that the case? Because Professor Davidoff has missed the key, defining feature of investment banking which differentiates it from other financial activities, which provides the "value add" that our customers are so willing to pay so much for, and which explains why labor captures so much of the firm's value. He has missed the fact that investment banks are not factories.

Investment banks are networks.

* * *

I have made this point many times before.

Notwithstanding what they like to tell you, investment bankers don't really sell "ideas." They sell connection, and access, and they are successful to the very extent they can maintain themselves in the flow of market information. Investment banks derive their market power and importance by maintaining dense and robust information networks across the numerous markets they participate in. This makes them better traders, better investors, and better advisors.

When our clients ask us to underwrite a debt or equity offering, they want access to our network of contacts among buy side investors and our network knowledge of the capital markets. When counterparties trade financial instruments like securities and derivatives with us, they want access to the breadth and depth of our trading network and the capital of our trading counterparties and our own proprietary books. When a client asks us to advise them on a merger or acquisition, they want access to our network of potential buyers and sellers and our network knowledge of the M&A markets in their industry. Networks are absolutely central to the power and value which investment banks bring to their clientele. It's what we're selling.

And networks lie at the nexus of the conundrum we have been considering. For having a differentiated network in a particular area can enable a bank to distinguish itself from its competitors. While any bank can underwrite an initial public offering, a bank which develops a reputation for being the best at, say, health care IPOs can attract new business and maintain market leadership in that area. The peculiar power of networks is well known: they derive their power and effectiveness from their completeness, breadth, and depth. And these features make it easier to attract new connections into the network to make it stronger. Network strength builds upon itself.

The other particular feature of networks is that they consist of interconnections made among nodes. A moment's thought will convince you that, in the case of networks comprised of constantly changing information and personal relationships, the nodes of an investment banking network are its people. Investment bankers are powerful—and get paid a lot of money—because they are custodians of their firm's power: its networks. You simply cannot automate the most interesting market knowledge or access to external aggregations of people and capital which are constantly forming and reforming, much less the personal relationships and insights which most of these are based on. Furthermore, that knowledge is portable. If a banker ups and leaves, he or she takes his or her network of contacts, knowledge, and relationships with him or her, usually to a competitor.

This is the source of the peculiar tension between individual investment bankers and the "platforms" from which they operate. Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.

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So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.

One last thing is worthy of note. The network of relationships and market knowledge which each investment banker carries is a local one; that is, it is limited in scope and power to the industries or markets he or she participates in. My knowledge of M&A, capital markets, and the participants and dynamics of Industry X is valuable to my clients in that industry, but it is largely meaningless to a proprietary trader on my firm's govvie desk or a structured products banker packaging and selling mortgage derivatives, much less to their clients or customers. This has always been true. What has changed is that banks have gotten so big, global, and interconnected that the network of any individual employee—no matter how prominent—has become incrementally less important to the overall picture.

Which is only to say that, were he to work at a big global investment bank today, living legend and networker extraordinaire Felix Rohatyn would probably be just another schmuck with a corner office.

Of course, he'd probably be paid a lot more, too.

© 2011 The Epicurean Dealmaker. All rights reserved.