Investment banking is going through its most severe dislocation since the Great Depression. The economic turmoil during the 1930s led to the Glass-Steagall Act, which separated investment banks from commercial banks and also introduced new regulations to protect the monetary system.
Congress repealed much of Glass-Steagall in 1999. And now, a decade later, it’s all but inevitable that Washington will re-regulate the financial sector – not just investment banks, but commercial banks as well as other unregulated pools of capital such as hedge funds.
I believe that the investment banking industry must accept and embrace re-regulation while adjusting its business model.
Investment banking used to be a customer facilitation business that served its client base. Investment banks were private partnerships that were very attuned to the risks they were taking. They were relationship-based – not transaction-based – entities; and they took a long-term approach to the business. That meant aligning themselves, through culture and fee structure, with their clients’ best interests. Doing the right thing for clients was the operating principle.
What Went Wrong?
As investment banks decided to go public, beginning in the early 1980’s, several things happened:
- They used public shareholder capital to enter business lines that had a very high risk profile
- They abandoned their relationship approach and became transaction focused because of quarterly earnings pressures
- They began competing against their clients when it came to trading activities and traditional investment banking activities such as M&A
The overall take-away: Fueled by public shareholder funding, investment banks essentially became hedge funds and PE/VC funds, and their core investment banking activities were relegated to secondary business lines. Even more damaging, investment banks employed increasing leverage and generated billions of dollars of revenue from non-traditional investment banking activities during the bull market of 1985-2007. To keep pace with income from these new lines of business, investment banking fees had to increase. So bankers focused on near-term transactions, and jettisoned the long-term perspective as well as client relationships, in order to achieve this goal.
I believe that the current dislocation requires investment banks to rethink this value proposition and respond accordingly. My view is that investment banking must return to what it was before the going-public era. And the new model has to be a customer-focused investment bank that exists to serve its clients.
Adjusting Fee Structures
Becoming a customer-focused investment bank in 2009 will require firms to re-assess their fee structures.
For many years, the investment banking industry rode the wave of tradition. Seven percent IPO pricing and M&A deals priced at a percentage of the transaction value have been the norm. In addition, firms became fixated on all-or-nothing fees. The obsession was with multi-million-dollar fee income; minimum fees became standard and were rarely less than seven figures. For the most part, investment banks haven’t been willing to adjust their fee schedule to accommodate engagements that don’t fit the minimum fee structure.
There are many client engagements where a percentage priced approach with a minimum fee is truly appropriate. Especially when there is a significant risk that a deal won’t happen and the investment bank stands to come away empty-handed. Or when an investment bank is providing a full suite of M&A services during an engagement.
But there are also many situations where clients don’t need full service investment banking. A deal may already be in process, for example, and the client only needs a specific offering from its investment bank – perhaps valuation work, maybe structuring and negotiation, or possibly diligence services.
Fairness opinions have already started to unbundle for legal and regulatory reasons; but it’s clear that in many customer situations the best way to move forward is to also unbundle the other services that an investment bank provides and price them on a flat-fee basis. In this way, the investment bank aligns its interests with those of its clients.
From my perspective, re-calibrating the investment banking industry’s fee structure is one of the best ways to make sure that clients are well served as we move ahead in the era of re-regulation. This adjustment is significant, but it must take place – and the sooner the better for all parties concerned.
Michael Butler is Chairman and CEO of Cascadia Capital, LLC, a Seattle-based national investment banking firm that serves sustainable industries and technology and middle-market companies. Read his past peHUB blog posts.