Percentage Pricing - the Key to Investment Banking

Of course, traditionally, the key to investment banking has been OPM - Other People's Money. That vital insight was conveyed to me when I was in a Fellowship at Yale, and two of my classmates, Steve and Fernando, were seniors interested in business. One day they came bubbling back from a class to let me in on the secret. Someone from Wall Street had come up to lecture to them and told them about OPM. Yes, they were bubbling, chortling. Such a key they had had introduced to them! There was also a bit of wonder about it - my God, can you do this?!

A variation of this is the observation of some, convincingly, that the major step to perdition in Wall Street has been the abandonment of partnerships in favor of public ownership. This has meant that risks incurred are not to one's own money, but public money. Before, partners had to question themselves severely about the risk they took. They were using OPM, but they were also injecting their own.

But it strikes me that in addition to OPM, a key element is what I call Percentage Pricing. This term simply means that, if you are an investment banker doing a deal, you price your participation not by your hours, but as a percentage of the total deal. Large deals in the billions - and all I want is one-half of one percent. Isn't that what they do? And what is the justification? Probably just that a very small percentage, and you're a CEO, what do you care?

In economics, I imagine this issue comes under "setting prices." I remember what the Russians asked in the 1990's when the Americans were trying to help them set up their new economy. They got the structure, that was pretty easy. But they kept asking the Americans: "But how do you set prices?" The Americans didn't really have an answer. There is plenty of literature on how prices adjust in a free market, but it involves costs, and costs involve prices themselves. It's one thing to go from an equilibrium; it's another to set up the equilibrium to begin with.

So, in investment banking, if you want to do a deal, you need to figure how much you will pay the investment bankers. This comes from what they have charged in the past, so you can figure on that. If they have competition for their time and effort, the same expectation of fees holds - depending on what they have gotten before.

It's similar to CEO pay - abroad, it's far less than in America. Does this mean their CEO's are worse? That's doubtful. It's just tradition and expectations.

So, back to Russia - I would love to know how it worked out, and where they got their inspiration of where to start out. In the end, it's probably who's got the cajones to set the price he wants and stick by it.

It reminds me of ecology. You might think that given a certain percentage of various species in a set environment, that the eventual equilibrium of how many of each species gets established in the environment would be constant. X percentage of this animal, y percentage of that. But that's not the case at all. It's widely variable, but in each case, once an equilibrium is established, that's where it sticks. One case can have X percentage of species A, and the second case, with identical start point, will come out with Y percentage for species A, and X and Y are very different.

I see the same thing in medical care. In the USA, specialties rule - the specialists get paid a lot. the primary care docs don't get so much at all, despite the fact that it is widely recognized that the best systems have primary care as the base, and in this country we are becoming very deficient in primary care docs. Abroad, primary care docs can earn more than the specialists. Specialties like orthopedics have very dominant personalities populating their ranks; these assertive people make a lot of money, because they demand it. No other reason I can think of.

It is no coincidence that the culture of investment banking is one of very dominant personalities. They simply set the price at what they can get - as percentages of the deal, even though what they do has really no connection at all with the underlying worth of the businesses involved. These guys have balls, and balls brings money.

C'est la vie.

Budd Shenkin