It’s a question as old as Excel itself.  Or at least as old as the Vault guide.

“If investment banking is not that hard, why do you make so much money doing it?”

Sure, the hours are terrible.  And as an Analyst or Associate, you rank just barely above a primate in terms of respect.

You’re always at the mercy of the client, sacrificing to him your spouse, children (no, not literally… not yet at least) and friends.

And it’s extremely competitive, often requiring a top-notch education, stellar grades and a previous string of finance summer internships.

You need to be able to sit motionless in front of a monitor for 28 hours at a time.

All of these points are valid, and people often claim these explain why you get paid so much.  But they do not directly explain why bankers make as much money as they do (the ones at Bear Stearns excluded).

What Bankers Actually Do

First, we must understand what investment bankers actually do: pretend to be Ari Gold (from Entourage, in case you somehow don’t watch).

When I say “banker,” I don’t mean Analyst or Associate and I certainly don’t mean Models and Bottles AJ; I mean a Group Head, Managing Director, BSD type character.

Analysts would just be Lloyd.

Bankers sell companies just like Ari Gold sells Vince.  And they get paid the same way as well: commission.

So by definition, the larger item they sell, the more they get paid (well, most of the time.  Go with me here).

Investment Banking: High-Price Items, High Commissions

Imagine the average used car salesman.  If his average selling price is $15,000, he’ll have to sell a lot of cars to make a decent amount of money - or move up to higher priced cars.

A real estate agent, by contrast, might sell houses in the $500,000 to millions range.  Sure, the percentage fee is lower than what the used car salesman might get, but since the total dollar value is so much higher, it’s easier to make a lot.

Now picture the investment banker.  He sells companies for millions, hundreds of millions, billions, or even zillions of dollars.  Even with a 0.1% commission, that’s a lot of money.

And for smaller deals (e.g. under $1 billion), the commission is usually more like 1% rather than 0.1%.

High Margins Are Easy With No Expenses

Ok, but what about all those other people in financial services who work with a lot of money but don’t make a lot of money?”

So now we arrive at the second reason why investment bankers make so much money: the margins.

Sure, commercial bankers deal with a lot of money as well.  What passes through their hands every day has a lot of 000’s on the end, but the key difference is that their margins are just not as high because their commissions are lower and their expenses are higher.

You can’t exactly convince someone depositing $1 million in a bank account to give you 1%, at least not without the use of weapons.

Investment Banks: People Are The Only Expense

Banks, by contrast, have very little in the way of real expenses.  There is no Cost Of Goods Sold; there is no factory needed to make products.  All you need for an M&A deal is 4 people and an office.

Investment banks’ only ongoing, non-personnel expense is office maintenance.  Oh, and all that ink to create large stacks of pitchbooks for every meeting.

Travel?  Food and hotel expenses?  For a deal, they are charged back to the client.

And even if they weren’t, next to a multi-million dollar fee, these expenses are insignificant.

Thus, investment bankers make a lot of money because they sell things for huge amounts of money while taking a generous commission and having hardly any expenses.

What about others in finance?

Private Equity / Hedge Fund Compensation

The same principles apply to hedge fund and private equity compensation: in essence, both make a lot of money because a lot of money passes through their fingertips and they take a good chunk of it.

2%, specifically.

But there is a key difference: besides just earning a management fee on their total assets under management, private equity and hedge fund managers also earn a percentage of the returns on their investments, called the carry.

“2 and 20″ is the old phrase describing how these firms are paid: they take 2% of their capital under management and 20% of the return on investment they get.  If they invest $100 million and turn it into $200 million in a year, they would earn $20 million and distribute $80 million to their own investors (limited partners).

For funds that do extraordinarily well, the carry generates a good chunk of the wealth.

But a number of recent studies have shown that most firms actually make more money from management fees than they do from the carry, raising questions over why their investors are forking over hundreds of millions of dollars.

This Seems Too Good To Be True, How Do They Do It?

Mostly by artificially limiting the number of people who can actually break into the industry.  Wall Street is a very small place and it’s no coincidence that such a highly lucrative industry would want to remain small and highly lucrative.

Do you actually need an Ivy League education and 4.0 GPA to do a finance job?  No.

But making it really, really difficult to get an investment banking job is a good way both to limit how many people break in and raise the prestige (and pay) of the industry.

Will It Last?

These are 2 separate questions: will private equity and hedge fund managers continue to get paid so well, and will investment bankers continue to get paid so well.

In the old days, the “2″ part of the “2 and 20″ fee structure was intended to give investors a way to “keep the lights on” before any of their investments paid off.  It was never intended to generate more cash than actual returns on investments.

And indeed, in a recent survey, 57% of pension managers say this structure is “unsustainable.”

But who will be the first to accept significantly lower fees?  Raise your hand.  Yeah, that’s what I thought.

On the investment banking side, some of the fee structures (e.g. 7% for IPOs) are dated as well and some of the “products,” such as sellside M&A, are often commodities.  Clients should not be paying millions of dollars for commodity services.

Fees at these levels should not last but they likely will last because there is very little competition in the form of other banks willing to undercut and charge less.  No one wants to be the first guy in the room to make 1% on an IPO rather than the usual 7%.

If Things Were Perfect…

If the market were perfect, the high fees these firms make would come down as investors stop paying for sub-par funds and clients stop paying for commoditized banking services.

Luckily, if you’re trying to get into finance and concerned about pay cuts in the next few years, the market is not perfect and will not reach perfection in the near-future either.

So you’ll still make a lot of money.  Even if, on an hourly basis, it’s not much better than McDonald’s.

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Tags: Hedge Funds, investment banker, investment banker salaries, investment banking, Private Equity, understanding investment banking

Posted on Wednesday, March 26th, 2008 at 2:04 am.