Why Investment Banks Make So Much Money
It’s a question as old as Excel itself.
“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’re respected just slightly more than a primate.
You’re always at the mercy of the client, sacrificing your spouse, children, friends, and social life in the process.
It’s extremely competitive, requiring a top-notch education, stellar grades and previous finance summer internships.
And you need to sit motionless in front of a monitor for 28 hours at a time.
All of these points are valid – but they do not directly explain why bankers make as much money as they do.
What Bankers Actually Do
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.
You know, Ari Gold.
Bankers sell companies just like Ari Gold sells movie stars. And they get paid the same way as well: commission.
Just like movie agents, the higher the price, the more investment bankers can earn in commissions.
Ari Gold Wannabes
Think about a used car salesman: they’re paid a commission based on the profit earned on the cars they sell.
So let’s say they sell a car for $15,000, of which only $500 is profit – they might earn around $100 (20%) from that.
Not bad, but they’re going to have to sell a lot of cars to make bank.
Now think about another variation of Ari Gold: real estate agents. They’re selling much higher-priced items, ranging from hundreds of thousands of dollars to millions of dollars or even more than that.
They might only make 5% or 6% on that, but 5% of $1 million is $50,000. Not bad for one sale.
But now picture the investment banker: he sells companies for millions, hundreds of millions, or even billions of dollars.
Deals worth less than $1 billion might come with a 1% commission, while deals worth more than that will scale down to around 0.1%.
But even 0.1% of $50 billion is… $50 million.
So that’s part 1 of why investment bankers make so much money: high-priced items with high commissions.
Other Financiers
But if you just stopped there, you might think that commercial bankers and wealth management guys would make bank as well: they manage billions and also earn commissions on their funds.
However, those commissions are lower than what bankers get and they have significantly higher expenses as well.
Expenses – What Expenses?
So now we arrive at the second reason why investment bankers make so much money: the margins.
Think about all the expenses that a commercial bank might have: you have to pay for all those physical branch offices, ATMs, tellers, checkbooks…
And you can’t exactly charge someone a 1% fee on $1 million just for depositing it in a checking account.
People Are Not An Asset, But They Are An Expense
Banks, by contrast, have almost no real expenses.
All you need to advise a company on a deal is a small office and 3-4 bankers – no factories, no manufacturing costs, no hordes of employee salaries to pay.
They do have to pay for office maintenance and other fees, but they’re tiny next to the expense profiles of “real” businesses.
Travel? Food and hotel expenses? On a deal, the client pays for those.
And even if the client didn’t pay, these expenses are nothing next to multi-million dollar fees.
Investment bankers make a lot of money because they sell companies for huge amounts of money while earning a generous commission and spending hardly anything in the process.
And what do they do with that generous commission?
Traditionally they have paid out 50-60% of revenue to employees in the form of salaries and bonuses: and that’s why investment bankers make so much.
Private Equity & Hedge Funds
The same principles apply to hedge fund and private equity compensation: both make a lot of money because a lot of money passes through their fingertips and they take a good chunk of it without spending much.
Private equity firms and hedge funds earn money from a management fee – what they charge to cover expenses and “manage” funds – and carry – a percentage of their return on investment.
The typical management fee at these funds is 2% – so at a $10 billion fund, you could earn $200 million just for sitting around and “managing” the money.
The carry is dependent on performance: funds typically charge 20% on their returns. So if they invest $100 million and turn it into $200 million, they would earn $20 million and then distribute $80 million to their own investors.
“2 and 20″ is the term used for this structure.
A few funds perform extraordinarily well and make most of their money from the carry – but plenty of under-performing funds actually earn more from the management fees.
Wait, But Shouldn’t the Markets Be Efficient?
If you’ve studied economics, you might be wondering how these types of business models with high marginal profits can last.
Shouldn’t the markets be efficient and force fees, salaries, and bonuses down?
Nope.
Applying economic theory to this scenario is problematic because you can’t quantify reputation and relationships, both of which are essential to advising companies.
It can take 10-20 years to become a trusted advisor to companies – so yes, marginal expenses are low and profits are high, but the barriers to entry are extremely high as well.
Will It Last?
Let’s look at private equity firms and hedge funds first.
In the old days, the “2″ part of the “2 and 20″ fee structure allowed investors to “keep the lights on” before they exited any of their investments.
It was never intended to generate more profit than the firm’s actual investments.
And most investors in hedge funds and private equity firms would say that they’re greatly over-paying for these management fees.
But who will be the first to propose lower fees?
As long as the investing process requires skilled individuals with years of experience, fees are unlikely to come down.
The only way this will happen in the future is if computerized investing takes over – but while that has happened on the flow trading and prop trading side, it’s not viable to let computers run $50 billion deals.
On the investment banking side, there’s even more of a case to be made for lower fees: in a lot of cases, bankers simply don’t add that much value.
It seems ridiculous that banks can often charge 7% on IPOs and 1% on M&A deals given that they take on little risk most of the time.
But once again, we come back to the same problem as above: who will be the first to undercut everyone else?
And that’s why the fee structure will continue: no one wants to accept lower fees if they don’t have to, and the high barriers to entry prevent disruption.
If The Market Were Efficient…
If the market were 100% efficient, fees would come down, firms with sub-par performance would go out of business, and companies would stop paying high prices for commodity services.
But the market is not efficient and bankers are creatures of habit, which means that high pay will continue into the future.
So if you’re breaking into investment banking right now, there’s no need to worry: 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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great post that provides an explanation to peers on what bankers do. keep it up!
hello, i am a senior student working on a research paper
and i was wondering if this is an accurate site.
if i could recieve an answer as soon as possible, that would be great!
Hilary: That depends on your definition of “accurate.” :) This is a blog and it is all my opinion, based on my own experiences. It is NOT a research paper backed up with tons of facts or anything so I would recommend against citing it in any paper you write. :)
Compensation for careers in finance will likely come down significantly after this latest financial meltdown. The market has adjusted.
True, but compensation levels will remain above those of most other fields. For PE/hedge funds in particular, there’s no way you can compete with 2% management fees on $20B under management if you make money by selling services or even high-end products.
in your example, you said that iBankers make so much because they sell companies for millions to zillions of dollars @ .1% profit.
if a company is sold at, let’s say, $50B so .1% of that is $50M…
how is it split? does the iBanker get that whole $50M? or x% goes to the analysts, associates, vps, mds of the group?
does it benefit only the group that sealed the deal?
how many groups are there in an investment company?
how many people are there in a group? what are their functions/positions?
thanks so much!!
It all goes “to the bank.” The $50M itself is not actually split among the group – at the end of the year, the group’s revenue total is taken into account for bonus calculations but pay is not directly proportional, except at the higher levels.
So even if an Analyst didn’t close any deals, he will still get paid the same as other Analysts… but higher than that, and the difference can be significant. In 2002-2003, some VPs made more than MDs if the MD did not close any deals.
Groups at a bank really varies by bank, but maybe around 10-20 main ones at a large bank? People in a group again really varies by bank and group but at minimum there is 1 set of Analyst-Associate-VP-MD and usually multiple people within each of those categories… so one group might have 20 Analysts, 10 Associates, 5 VPs, and 3 MDs (for example).
Dude, bankers used people money for their own expences, and now they want bailout money to spend even more.Forget about plans, investments.Is plain and simple, they waisted huge sums of money.
I agree there are out there some smart bankers, but most bankers cannot justify their income.I mean just buying a crapy bussiness doesnt mean you get rich.That bussiness must work.I believe that despite the fact that the general population is poor, very poor(they cannot afford a reasonable house,education,car,etc) the dept their local comunity is HUGE.There are a lot of money missing.Who waisted all these money.Well the answer is obvious.The sad part is all these money were spend building golden pools filled with shampain.History is repeating itself.If there is no head, then pitty for the body.All the latest “progress” was just thin air.What can be done?Stop waisting money on stupid things, cause it wont help.Invest more in research and education, and try to live a more honest life.
Interesting post, but there is one item on which you are completely incorrect. Anyone can get into investing banking. It is in limited. You can start your own firm. Yes if you want a job at one of the big investment banks, that’s hard to come by, but that holds true in any profession. Stop complaining, if you think this is easy work and easy money start your own company and watch the dollars roll in.
“But once again, we come back to the same problem as above: who will be the first to undercut everyone else?”
I’m an investment banker in Southeast Asia. As one of the largest IHs in the country, we experience many of the other firms trying to undercut fees in order to gain relationships with our preexisting clients. Of course, we don’t want to lose mandates to other firms so we tend to match these undercut fees once the other investment houses dive. So my thoughts are, to answer your question, “whoever isn’t closing as many deals as you are”.
As the investment banking climate in the US is obviously very different than it was back in ’07, do you see the same thing happening there at present? IHs undercutting each other?
You don’t see undercutting as much in developed markets – it’s more in places like SE Asia where the market is fragmented and up-and-coming. Even with the recession, banks don’t do that quite as much in the US because often times only the top 2-3 places will even have access to executive at F500 companies.
if someone enters the investment banking industry (i.e. M&A), is there a statistic as to how much an average investment banker earns over the course of his/her life? I’m not talking about the top performers but an average M&A or Capital Markets Banker? What is his net worth, say at the age of 45?
If someone has a business generating $300k a year after tax, would you suggest that they pursue the family business or do you reckon they could do substantially better as an I-Banker? I know I sound greedy, but I hope you see that when one thinks about life (having you own family, etc) money does come into play.
Thanks!
I don’t know of any statistic like that – my guess is that net worth numbers are far lower than you’d expect. Here are the numbers for top business schools:
http://www.businessweek.com/interactive_reports/mba_pay_the_haul_of_lifetime.html
If you make $300K after-tax, personally I would not get started in i-banking at all – to match that as a banker you’d have to get to the mid-levels (VP) at least and even as an MD you may not make much more after-tax, so it’s not really worth it.
Hi M&I,
Thanks a lot for your response! I got a 2:2 from LSE so I thought if I didnt get into IBD, life could be very difficult but you’ve really reassured me.
I have an acquaintance who works at Nomura (DCM) and he mentioned that associates can make over GBP 150k a year. He mentioned that VP’s make over $1m a year and his MD can make $10m in a decent year. Do you think thats a real exaggeration?
Thanks as always!
Dan
That is an exaggeration – VPs rarely make over $1M and MDs usually make in the low millions. Group heads and higher-level executives might make over $10M. But no way you would get to that level without 20+ or so years of experience.
Thanks M&I,
This leads to yet another question (forgive me for trying your patience). What percentage of associates who enter an organisation actually make it to the MD level? Also, Im assuming you mentioned those finances before tax? Lastly, $1M before tax is still higher than $300k after tax right so (monetarily speaking) wouldnt being a banker make more sense than running a family business?
Very few make it to the MD level, maybe 5% or less. $1M before tax is still more than $300K after tax, but consider the hourly rate: 80-100 hours per week in banking vs. much less in your own business (hopefully anyway). If you’re already making $300K money stops being the most important criterion after a point.