“Don’t ask the barber whether you need a haircut.”That little nugget was buried in Warren E. Buffett’s annual letter to Berkshire Hathaway shareholders published over the weekend. It was his thinly veiled dig at Wall Street bankers and the perverse incentive system for corporate “advice” on mergers and acquisitions — namely that bankers are paid only if a deal is completed. (Bankers typically earn nothing if a deal is abandoned or collapses, giving them little reason to recommend against pursuing a transaction.)
It was a timely note from Mr. Buffett — Monday ushered in more than $50 billion worth of merger announcements — and it resurrected an age-old debate on Wall Street about how bankers are compensated for their counsel to corporate boards.
And it’s an issue that resonates far beyond Wall Street. Just think of all the other parts of life where people offer only encouraging words — “You should do this!” — because that’s the only way they get paid (real estate agents, stock brokers, the list goes on).
And Mr. Buffett has trained his sociologist’s eye on this phenomenon more broadly, too. In his 1989 letter to shareholders, he famously wrote about the “institutional imperative,” which describes, among other things, how an entire organization can rise up to help a boss justify some deal he’s inclined to do, regardless of its merit.
It’s nice to think some things can change, but the deal incentive for bankers probably isn’t one of them.
“You shouldn’t earn a lot less by keeping your client from doing something stupid, but that’s the way it is,” Felix Rohatyn, the financier and elder statesman of Wall Street, told me. “The majority of fees are conditional.”
Mr. Buffett’s letter made a bold suggestion that isn’t sitting well with the establishment.
“When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion,” he wrote. “Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through.”
Of course, acquirers often hire more than one banker to advise a board, to act as a check on the other. But all too often, both banks are given the incentive to recommend the deal.
Since 2008 in the United States, in 131 of the 230 deals that were worth over $1 billion, the acquirer hired more than one bank, and in some cases more than five. Those banks were paid an estimated $3.3 billion for advisory services, according to Thomson Reuters and Freeman Consulting.
The problem, as Mr. Buffett explained when I called him on Monday, is that the system is skewed. Companies are willing to pay advisers a supersize fee when they do a deal because then it is merely a rounding error, a tip on a lavish, celebratory meal.
It would be hard to justify a big payment if there were no deal, so the system has evolved into an all-or-nothing game. Banks are willing to play it, because the rewards are so high, and they are not shy about offering attaboys and go-get-em’s to help make it happen.
When Berkshire recently acquired Burlington Northern, Goldman Sachs and Evercore Partners — which advised Burlington — were paid almost $50 million for what equated to only a couple of weeks of work.
Mr. Buffett, of course, did not use an investment banker.
“If we need advice for a deal, we probably shouldn’t be doing it,” he said with his trademark chuckle. He told a story about how First Boston (now Credit Suisse) tried to gin up interest in the mid-1980s for Scott Fetzer, a hodgepodge of small businesses based in Cleveland. It called on 30 firms to help make a sale, but failed to find a buyer.
Mr. Buffett then called Scott Fetzer’s chief executive himself and negotiated the deal face to face. Just as they were about to sign the deal, a banker for First Boston said that the bank was still entitled to a $2 million fee. The banker asked Mr. Buffett’s partner, Charlie Munger, whether he’d like to read the firm’s analysis of Scott Fetzer. Mr. Munger replied, “I’ll pay $2 million not to read it.”
That’s not to say that Mr. Buffett won’t ever pay investment bankers. “If someone brings me a deal, I’m more than willing to pay them,” he said, referring to his favorite banker, Byron Trott, a former managing director at Goldman Sachs, who helped broker deals including Berkshire’s investment in the $23 billion Mars-Wrigley merger and its acquisition of Marmon Holdings. However, Mr. Buffett insists that typically, “I don’t think we’ve ever paid for advice.”
Mr. Buffett’s biggest gripe is not just that bankers are given improper incentives, but he thinks their advice is suspect, especially when valuing stock-for-stock deals.
He had some experience this past year with such deals when Berkshire bought Burlington (he issued 80,932 Class A shares and 20 million B shares). He was also uncharacteristically vocal with his criticism of Kraft for paying $19.6 billion for Cadbury, much of it in stock (he’s a big Kraft shareholder).
He thinks that too much attention is paid to the value of the company that may be acquired, and not enough attention is focused on the value of the stock that the acquirer is shelling out.
“In more than 50 years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given,” he wrote in his letter.
“Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy. The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the current market price, why in the world should we ‘sell’ a significant part of the company at that same inadequate price by issuing our stock in a merger?”
Despite hearing from some of Wall Street’s biggest names about Mr. Buffett’s critique of their profession on Monday, most were circumspect in their reply.
“As usual, Mr. Buffett has an interesting point,” said Joseph Perella, one of the deans of the deal business and the co-founder of Perella Weinberg. He said he was happy to report that some clients had begun paying flat quarterly fees for advice, regardless of whether his firm recommended for or against a deal. However, he acknowledged, “most clients aren’t doing that.”
When I invited Mr. Rohatyn to critique Mr. Buffett’s view of his profession, he replied, as so many in the business did: “Warren is Warren,” is all he would say.
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I will once again be in Omaha for Berkshire Hathaway’s annual meeting on May 1 asking questions of Mr. Buffett and Mr. Munger. If you have questions for either gentleman, please send them to arsorkin@nytimes.com. (Let me know if I can identify you by name if I ask your question. Also, please tell me if you’re a Berkshire shareholder.)
By ANDREW ROSS SORKIN
8 Comments
- Luckily for I Bankers most companies are run by frightened people too afraid to miss out!
— emil - When I was an investment banker I could not help but wonder how there appeared to be no consequences for giving bad advice. If an M&A deal worked, the bankers took the credit for making it happen. If it did not, the fault was surely due to bad execution by the management.
I think that with a bit of refinement, especially in relation to the design of incentives, Warren Buffet’s idea might be just what the industry needs. It would force bankers to do some critical thinking about the merits and demerits of a potential deal rather than justifying the highest possible valuation.
— Ayitey Parkes - Warren Buffett applies then extends the first lesson of an MBA program: each project has pluses and minuses, and organizational leaders need to understand both.
Buffet sensibly formalizes this maxim by bringing competing views to the table.
Lincoln applied the same thought in politics (“Team of Rivals”), and Buffett extends it to commerce.
Why are we not surprised?
Thomas Kowall, PhD
Professor Emeritus, Strategy and Communication
International MBA Program
ENPC, Paris
— Thomas Kowall - Your column today is right on point. The practice of “success fees” in M&A transactions makes little sense for the client. Even lawyers acknowledge that “success fees” for lawyers would taint their judgement though there is little doubt their charges in completed transactions are much greater than in those that do not.
In any event, your column brings to mind one of my few opportunities as a lawyer in a relatively small town for close contact with Wall Street investment bankers.
In the ’80s, I was engaged to represent a small NYSE-listed company with strong need of both cash and management expertise. Ideally, it would receive an equity investment from a company in the same industry that could also augment the management capabilities of the client. While a viable prospect (Company A) was soon identified, the board knew it should solicit competing offers to gain needed perspective. A big name Wall Street banking firm was engaged. The banker would get a typical percentage fee if a deal were concluded with the prospects produced by it plus a fixed fee for a fairness opinion. For obvious reasons, the banker had to bring in someone other than Company A to get its percentage fee. A number of unpromising prospects were brought in by the banker. It was finally concluded that my client would go forward with Company A.
As the parties converged the night before negotiations with Company A, the bankers took me aside and said they had concluded that, based on the outstanding offer from Company A (terms they had known all along), they would be unable to deliver the highly-important fairness opinion unless they were engaged to conduct the negotiations with Company A. This would have entitled the banker to a transaction fee of several hundred thousand dollars. I, being inexperienced in dealings with big-time bankers, was shocked to learn that our banker could, after all, behave like a nefarious real estate broker might back home. The bankers did, however, dress a good deal better. After huddling with my clients, I advised the bankers we could not accede to their request and the bankers said they would therefore return to New York that night.
At the negotiations the following day, a deal was reached with Company A, along the lines of its original offer. But we needed the fairness opinion. I called our banker in New York, related the terms of the deal we had negotiated and asked if it would provide the fairness opinion. I can’t say I was surprised to learn the banker would provide it.
A few weeks later, it having been determined by all parties that my client needed substantially more capital than had originally been anticipated, a second agreement with Company A was reached at a per share price that was more favorable than that in the original transaction. I called the investment banker and asked if a fairness opinion for that transaction could also be given (for the same fee as for the first one). No problem.
— Chuck Wellborn - them that have get. ALWAYS.
— bill kennedy - This method is as old as the hills: real estate advisors get paid upon completion of successful transaction only. Of course there is the cost of research for valuation aka appraisal. Appraisal takes into account the three methods. In the case of 2008 and 2009 there is more under the baize, which the Board of Directors and the Executive Committee should have the wisdom to add to the analysis. If the deal sours, fire the company leaders or be glad it didn’t go through.
— J Atkins - what’s his gripe ?
didn’t he sell his soul to bankers to help fund the Burlington Santa-Fe and countless other “deals”
— Joe - I was involved in an LBO and was amazed at the banker’s swarming around the honey pot. There is a certain arrogance they posses that makes them with a straight face ask for their fees. It is a lawyer’s arrogance that comes from traveling in circles others maybe travel once. If you’ve done more than one LBO or merger, it becomes apparent it is mostly a show.
— mbi
Investment is both an science and arts.
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