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?”
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.
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?
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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