Felix Salmon smackdown watch, banking-conflicts edition

March 7, 2012

Why would clients like El Paso ever hire Goldman Sachs if Goldman Sachs is always working in its own best interest rather than that of the clients? My hypothesis, yesterday, was some kind of mysterious Goldman magic. Which, admittedly, is not particularly falsifiable or compelling. So many thanks to a loyal reader, who doesn’t want to be named, for giving me some very good reasons why clients hire conflicted investment banks, especially in the M&A field. It turns out that there are good reasons why “the most conflicted bankers are often the most sought after by clients”. Take it away, loyal reader:

A few points from your post on Goldman today.

You and many other commentators seem to have some misconceptions about what exactly large, sophisticated clients such as El Paso’s board hire investment bankers to do.

Its always funny how, in the minds of pundits everywhere, those conniving and all-powerful one-percenters who sit on corporate boards become impotent and completely incapable of independent decision-making once an investment banker walks into the room.

El Paso’s directors were well aware that Goldman was conflicted and in fact displayed a healthy skepticism of Goldman’s impartiality by its decision to “exclude Goldman from tactical discussions about how to respond to Kinder Morgan from September 15, 2011 onwards”.

At the end of the day the board, not Goldman or any other advisor, made the decision of how to proceed at each major step in the process and while Goldman may have been consulted on some of these decisions (along with MS and probably 2 or more sophisticated law firms), the sophisticated directors of El Paso’s board knew full well that the decision was their’s to make and that Goldman’s advice should be taken with a grain (or block) of salt.

So contrary to your claims I would posit that Goldman’s clients do not in fact trust Goldman to provide “impartial advice in their own best interest” and that Goldman’s ability to “snow clients and get them to do whatever Goldman wants” is highly overrated (and likely non-existent).

So why do clients hire potentially conflicted investment bankers?

The tempting answer – and the one implied by your final paragraph – is that Goldman’s clients are all irrational idiots getting unwittingly screwed by a giant squid. However, it’s important to remember that pretty much every PE fund out there hires Goldman or one of its competitors to perform either buy-side (sometimes) or sell-side (nearly always) advisory work on all of their transactions. Surely, the masters of the universe running multi-billion dollar PE funds aren’t getting “snowed” by their comparatively poorer and less-well-regarded friends working on the sell-side.

When sophisticated clients (management teams, company boards, PE funds, etc) hire M&A bankers, they typically hire them for two main reasons (in addition to the legally required shams referred to as “fairness opinions”): Execution and Connections.

The execution part is obvious – M&A processes require a lot of (sometimes specialized) work that most companies are not well-staffed for since these events come around relatively rarely. While execution work represents the bulk of the person-hours devoted to a deal, the work is simple enough that if execution work were the primary value-add provided by bankers you would see much lower fees since the work itself is fairly commoditizable.

It’s the connections that bring in the big bucks for bankers. From making sure that the book lands on the desk of a potential buyer’s CEO rather than a lowly corp dev intern to massaging egos on both sides after a particularly harsh negotiation call, the value the banker provides is his/her ability to act as a conduit between the seller and potential buyers. This obviously means that the most sought-after bankers are those with the best connections to (and deepest relationships with) potential buyers. Since it’s basically impossible for a banker to develop strong relationships with a buyer without having some sort of conflict (say having formerly worked for potential buyer in a previous engagement), we shouldn’t be at all surprised that the most conflicted bankers are often the most sought after by clients.

A few personal examples:

  • Back in my private equity days our firm was looking to sell a smaller company to one of a handful of larger potential strategic buyers. Our criteria for selecting a banker basically came down to two metrics: (a) how many times had that banker worked for any of the buyers and (b) how many times had the banker sold a company to one of the buyers. We weren’t looking for impartiality and “strategic advice”, we were looking for connections and relationships – “conflicts”, you might say. It’s the job of the principal (whether a PE fund or a company’s board) to make all of the hard decisions of when to sell and for how much. The advisor is simply paid labor to help throughout the process.
  • Back in my days as an M&A banker, we had just wrapped up the sale of a mid-sized company (“Company A”) to a private equity firm when a larger firm (“Company B”) that owned a non-core subsidiary that was one of Company A’s direct competitors called us up because it wanted to sell the non-core subsidiary. The CEO of Company B hired us without the traditional “bake-off” process in part because the CEO of Company A (whom Company B’s CEO was friendly with after meeting at various industry events) had been impressed with our work. More importantly, though, CEO B knew that the PE fund that had recently purchased Company A was executing a roll-up strategy in the industry and was one of the most likely buyers of his subsidiary. At this point it’s worth mentioning that our firm’s relationship with the PE fund involved extended far beyond having recently sold Company A to them. The PE fund was one of our firm’s top relationships, and we regularly both sold companies to this PE firm and sold this PE firm’s portfolio companies to other buyers when they were ready to exit. Further, several of our firm’s MD’s, including the lead banker on the deals in question here, were LP’s in several of the PE firm’s funds, including the current fund that had bought Company A and would look to buy the subsidiary of Company B. Both CEO A and CEO B knew of our deep relationships with the PE firm before they hired us. Point being, if CEO B had tried to find a more conflicted banker to sell his subsidiary, he couldn’t have found one (and if he could have he would have hired them instead). He hired us on the spot because he knew all of our “conflicts” meant that we had the best relationships – and that’s exactly what he was buying.

It’s a well known principle of economics and game theory that “repeated game” negotiations lead to more efficient outcomes for both parties than one-off negotiations because of the reciprocity and trust built through repeated games. What clients are buying from bankers is access to this type of trust that can only be gained through repeated transactions between parties. Viewed in isolation, any one instance of “reciprocity” may look like an instance of conflicting interests – and in many cases, it might very well be. But the sophisticated clients of Goldman and other banks know that it’s exactly this reciprocity that they are buying – after all they could have easily hired the lower-priced and conflict-free banker who didn’t have any relevant tombstones in the back of his pitch deck.

Looked at from this view, it shouldn’t be at all surprising that sophisticated clients keep paying the a premium Goldman’s “strategic advisory services” when Goldman has a reputation for being the most conflicted bank on the street. These clients aren’t hiring Goldman despite its many conflicts of interest. They are hiring Goldman specifically because of these numerous conflicts and the numerous deep relationships they represent.

None of this is to excuse the Goldman MD for not revealing his holdings in Kinder or to say that Goldman is always above board with all of its clients. Nor is it to pretend that there aren’t often principal-agent issues between boards, management teams, advisors and shareholders, especially in large public companies.

But we should at least acknowledge that conflicts of interest are a core piece of an M&A banker’s value proposition to its clients and that almost all of these clients are extremely sophisticated individuals who know exactly what they’re paying for.

Update: Matt Levine has a great response.


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