Why Goldman Always Wins

What do investment bankers, wedding planners, funeral directors, and movie-trailer voice-over artists have in common? High fees for high-stakes, once-in-a-lifetime deals.

By Megan McArdle

In the summer of 2000, David Poor, a direct descendant of a founder of Standard & Poor’s, flew me to his family’s Nantucket home on a private jet.

I am sure he will not remember having done so. At the time, he was the head of Merrill Lynch’s technology investment-banking group, and I was a summer associate serving out my internship in his department. The only time I got more than a glimpse of him was during that Nantucket weekend, when we larval M.B.A.s tried to impress the boss with the panache with which we donned ugly chintz sundresses or crisp new Nantucket Reds. Bunked at his mother’s “cottage” with the few other women in the group, I spent the weekend gingerly sipping gin-and-tonics and trying to fade into the couch.

Weeks after this WASPish ordeal, I remained puzzled by it. Why were David Poor, and presumably Merrill Lynch, spending so much money on us? We were all fine Americans, I am sure, and attended top business schools. But that summer, and every summer, tens of thousands of young M.B.A.s would have slaved away happily in Merrill Lynch’s beige corridors without being wined and dined. If Merrill had lost a few of us to JP Morgan or Goldman Sachs, we could have been effortlessly replaced. Yet the company was not only treating us to trips and fancy dinners, but also paying us $25,000 for 10 weeks of work.

I use the word work somewhat loosely. My summer-associate class had been flown in for orientation the previous spring, only to spend the day in the lobby of the training room, watching the NASDAQ plunge 300 points. By the time we reported for duty in mid-June, the tech-heavy index had lost about 1,300 points from its March peak of 5,132. Before the crash, eager recruiters had told us that Merrill Lynch’s bankers would be okay no matter what; in the bull market, they had done initial public offerings, or IPOs, and in a bear market, they would do mergers and acquisitions and stock repurchases instead. This prognosis turned out to be as delusional as the Pets.com prospectus. The office was a well-upholstered tomb. We spent most of our days—and nights—performing a kind of kabuki, pretending to do work for bosses who must have known that they had no work for us to do. Yet still the dinners, the trips, and the lavish paychecks continued.

Why? The question was resolved for me during an August cocktail hour at P. J. Clarke’s, the financial district’s version of a meat market. There another associate pointed out, a trifle owlishly, the explanation: “Seven percent.”

That was where a new analysis had pegged the average “gross spread,” or fees, on an IPO, which was the only kind of live deal I had worked that summer. To be sure, Merrill Lynch was splitting those fees with other banks. But when offerings ran into the hundreds of millions of dollars, as they easily did, a few percent was a lot of money. Sure, a competent bookkeeper or legal secretary could have done most of our work. But in the banks’ fees, our salaries were a rounding error.

Still, why not compete down our salaries, if they could? I’m sure that if David Poor and his fellow managers had hired M.B.A.s from Georgetown and Notre Dame instead of Harvard and Chicago, they could have found something to do with the money saved.

These days, that question seems more pertinent, and more mysterious, than ever. With laid-off bankers flooding the job market, you would think that salaries in finance at long last would come down. But even a coven of angry Congress members seems to have had only a limited effect on what the financial industry is willing to pay its employees. Hearings and diatribes have succeeded merely in forcing firms to pay more compensation as salaries rather than as bonuses—as if the main issue with lavish paydays at bailed-out banks were the timing of the checks.

To understand why banker pay seems so persistently outlandish, consider another industry that skims off the top of a vast well of cash: the business of making movie trailers.

Unless you’re deaf, or have been living in an ashram for the past four decades, you’ve heard the voice of Don LaFontaine, known in the trailer industry as “the voice of God.” LaFontaine’s gravelly baritone popularized the phrase In a world where … and seduced us into movie after movie, from Dr. Strangelove to The Simpsons Movie. When he died last year, at the age of 68, one obituary reported that at his peak, LaFontaine was making $30 million a year voicing trailers and commercials.

That’s quite a wage, especially when you break it down to an hourly rate. Over a long career, LaFontaine voiced more than 5,000 trailers and hundreds of thousands of commercial spots. But top voice-over artists frequently work out of their homes and record the spots, which usually run about two minutes, in no more than five takes. It’s one thing to pay Tom Cruise $25 million per movie; he makes perhaps one movie a year, to which he brings his built-in fan base. But no guy asks a date if she’d like to go see the new Don LaFontaine trailer.

Nonetheless, trailers have grown into a nearly $100 million industry, whose companies continue to give work to a coterie of well-paid veterans, rather than bidding jobs out to the legions of starving actors haunting the streets of L.A. And if you look at the economics of the movie industry, this behavior starts to make sense.

Don LaFontaine’s 40-year career began as the old Hollywood studio system breathed its last. The forces that killed the studio cartel also smashed the monopoly of the National Screen Service, which had produced virtually every movie trailer for more than 40 years. In its wake, independent firms began competing for the lucrative business, gradually supplanting those stilted spots you see on Turner Classic Movies, where Bob Hope appears on the screen to tell you how great his next picture is.

Over the years, changes in the movie business conspired to make trailers and television ads more and more important. First TV, then VHS, and finally DVD reduced the number of times people went to see a movie in a theater. As a small child, I saw Star Wars something like 17 times on its first run. But I’m hard-pressed to name a single movie I’ve seen twice in theaters since graduating from college.

Star Wars grossed $1.5 million the first weekend it opened, in late May of 1977, and peaked at $7.7 million the first weekend of September. By early December, it was still earning more than a million a week. These days, it would already have been out on DVD by then.

Because of piracy and a highly competitive DVD market, films no longer have much time to build an audience. They need to roar out of the gate, rake in piles of money for a few weeks, and then retire to finish out the modern movie life cycle of international releases, cable premieres, and DVD box sets. So the ads and trailers need to drive novelty-hungry teenagers, the movie industry’s ripest target audience, out to the theaters in droves. Heavy investment in top-notch promotion may be why people like me call trailers their favorite part of the movies. Even when studios don’t make a profit at the domestic box office—as happens all too frequently—big box office helps to sell the movie in foreign markets.

When a studio spends tens of millions of dollars producing a film, and further tens of millions advertising it, cheaping out on a voice-over makes no sense. You could pay a Don LaFontaine successor $300,000 a spot and still eat up just a tiny percentage of the film’s overall budget. A bad voice-over would cost you far more than you could hope to save. When you have only one chance to get it right, you tend to open up your wallet and pray. So one-shot deals are very, very expensive—a logic that prevails with weddings, funerals, and college diplomas.

That same logic explains why clients have been willing to pay investment banks lavish fees to do IPOs—and secondary offerings, and bond underwriting, and M&A, and advisory work. The mystery of investment-banking fees is often framed as a matter of banks rooking naive managers, or managers selling out their shareholders in return for a space on Merrill Lynch’s private jet. But the venture capitalists behind many of the IPOs aren’t neophytes at the mercy of big-city bankers; both they and the firm’s managers depend on a strong IPO, and a liquid aftermarket, to allow them to get some of their money back out of the company. If they’re tolerating such large fees, there must be a reason.

When the boutique firm WR Hambrecht + Co persuaded Google to use an auction process for its 2004 IPO, there was a lot of talk about the end of traditional investment banking. Five years later, however, firms like Goldman Sachs are as dominant as ever, and auctions are rare. Google could rely on its own brand to sell the stock and create a deep secondary market in which its employees could exercise their stock options. But most companies need a little more help. Although Goldman Sachs may not be a bargain, if you’re undertaking a one-shot deal, you may want to pay more to hear the one thing a hungry upstart can’t tell you: that the company knows how to handle an offering of size and complexity, because it’s done so a bunch of times before.

Of course, underwriting IPOs isn’t the only place where financial firms, or financial workers, make their money. But the logic of the one-shot deal applies to the payment of traders and many others. A moment of reckoning will come when the deal either goes well, or does not; that moment is very hard to anticipate; and if things go wrong, they can be very hard to fix. In those cases, even weak signals of ability—like, say, an M.B.A. from a top school—command huge premiums.

I didn’t get a permanent offer from Merrill Lynch at the end of the summer; both the firm and I recognized early on that I had no inner investment banker struggling to get out. (Even in one-shot deals, a weak signal gets you only so far.) Most of my classmates who did, toiled for a year or two and then were laid off, or they left for a job that would allow them to occasionally see the sun.

But the ones who stayed in the financial industry have earned ever-huger sums, helping to fuel another congressional obsession: America’s rising income inequality. A growing body of evidence suggests that our grossly inflated financial sector accounts for a substantial portion of the widening gap between rich and poor over the past two decades. Even for someone as basically libertarian as I am, that’s troubling. Financial markets are an extremely valuable contributor to the economy. But they are not so valuable that they should have soaked up most of the income growth of the past few decades.

As this article went to press, Goldman Sachs had just announced record profits, and rumors abounded of another banner year for banker pay. How much longer can this go on? Every time another banker bonus is announced, Congress screams, and its staffers look for some quasi-legal way of capping financial salaries. But a recent paper by the economists Thomas Philippon and Ariell Reshef suggests that when deregulation allows for a complex financial sector, particularly in the arenas of IPOs and credit risk, the wages of financial workers will remain severely inflated relative to workers in the rest of the economy.

Is it worth tamping down complexity and risk to limit banker pay? Right now, the answer seems obvious. But the tech and credit bubbles created as well as destroyed: assuming that we manage to skirt an outright depression, we won’t necessarily be better off in five or 10 years if we try to chase all the excess returns out of the financial sector.

Unfortunately, regulation itself is a one-shot deal—we won’t know until long afterward whether we’ve done it right. Maybe Uncle Sam should spend less time worrying about banker pay, and more time wooing prospective regulators with fancy trips on private jets.

This article available online at:

http://www.theatlantic.com/magazine/archive/2009/10/why-goldman-always-wins/307653/