How IBD Makes (or Loses) Money and Why that Matters to You

Inspired by @CompBanker" 's post on "The Truth Behind PE Compensation."

Many junior IBD bankers are often asked to participate in "business planning" for their department. This is usually pitched as an activity with "great exposure to senior bankers" when more experienced junior bankers realize it's often a high risk (pissing off senior bankers), low reward (thankless) job.

However, for those who are voluntold to do the analysis, it can be a very enlightening experience. This information can often be used to justify the shrinking or expanding coverage universes, promotions, hirings and firings at any level. This post is intended to shed some light on some of the key learnings you can find out through the analysis.

For this analysis, let's talk only about historical and backward-looking metrics (deals that have closed and the bank gets paid). There are different types and levels of revenue (Revenue to Street, Revenue to Bank, Revenue to IBD). There are different models for how revenue credit is shared.

Broadly speaking, there are two categories of [Thomson qualified - league table credit] banking revenue 1. Advisory Services (M&A) and 2. Capital Markets Products (debt and equity issuances, DCM / Lev. Fin. and ECM).

1. How Banks Make Money on M&A

First, let's look at M&A which is the simplest model. Assume your bank works on, announces and closes a $1.0 billion transaction and that the fee is 1% of TV or $10 million. Keep in mind different M&A products (sell side advisory, buy side advisory, fairness opinions, activism defense, restructuring, divestitures, etc.) all have different fee structures associated so this can vary wildly.

The next biggest question is how does credit get split
- How much credit does the IBD coverage team get for sourcing the deal? (Is the company a house account, is the bank a relationship lender, how critical was the coverage MD in winning the business vs. the bank's brand)
- Did the Industry Team do the execution? (Did M&A have to dedicate resources)

Things banks will look at when doing an analysis on M&A revenue:
- M&A fees paid in the space to the street and how much is your bank capturing (market share)
- M&A fees this particular client paying and how much is your bank capturing (share of wallet)
- Top fee paying clients
- M&A fees generated per headcount by bank (efficiency benchmarking)

This type of analysis can potentially highlight if your bank is missing deals (deals announced in your space where you have a relationship, but were not hired as adviser) and if you are punching within your weight class (how you stack up against competitors).

2. Capital Markets Products

This is where it gets a little more interesting. Let's look at a $100 million bought equity deal. Mechanics for leveraged finance products are similar: selling paper at an attractive and well thought out rate (priced right) and potentially taking some principal risk. Last trade was $10.40 per share. Offering price is $10 per share (~4% discount for 10 million shares). Underwriting fee is $0.50 per share (net proceeds to the company is $9.50 per share).

Total Fees Paid by Client = Revenue to Street = 10 million shares x $0.50 per share = 5 million bucks
(Also equal to Gross Proceeds less Net Proceeds to client)

How Product Deals Lose Money
If the banks/syndicate are unable to fill the order (order is not over-subscribed) they may have to do a clean up trade (eventually, sell the stock below the offer price). This is dangerous as banks can lose a lot of money very quickly. This is why we go to committees to get approval for these deals.

Example:
For the above deal metrics, assume the deal is not well received, and banks can't get enough interest at $10 and have to sell at $9. The banks are committed to giving the client net proceeds of $95 million ($9.50 x 10 million shares). However, they can only sell the shares for $90 million, so the banks don't get their fee and also lose $5 million (spread among the syndicate).

Banks avoid losing money like the plague. Sometimes banks will price very aggressively for league table credit or to develop a relationship with the client, potentially having very tight returns or even losses. A bad deal where the bank is "holding inventory" (has unsold stock) is terrible. If the share price continues to move against them, the bank will continue to lose money. The company stock usually experiences an overhang because the market knows there is a chunk of stock that didn't clear at the offer price (which usually becomes the de facto price ceiling). If anyone says banking is becoming commoditized, you'll often hear: "Good execution is not a commodity." This is usually what people are referring to when referring to capital markets execution.

How Product Deals Make Money
Let's assume everything goes according to plan. How much money does your bank make? On aggregate, the gross proceeds are $100 million. The syndicate gives net proceeds of $95 million to the client and retains $5 million in profit (Revenue to Street).

Let's assume your bank has 20% economics. That means they are responsible for selling 20% of the $100 million of equity or $20 million. They will also collect 20% of the underwriting fee or $1 million (let's exclude additional fees paid to book runners to keep it simple).

Revenue to Bank = Economics x Revenue to Street = $1 million

For business planning, banks will often look at the same questions as the M&A questions above.

However, where this product differs from M&A is how the Revenue to Bank is divided and credited to IBD. Let's look at the underwriting fee.

The underwriting fee is divided up within the bank to give incentive to the coverage bankers to originate deals. But you also have to incentivize ECM/S&T on execution. A portion (let's say 40% for simplicity) is sales commission/incentive. So of the $1 million Revenue to Bank:

Revenue to IBD = Revenue to Bank - Sales Incentive = $1 million x (100% - Sales Incentive of 40%) = $0.6 million

Other Considerations
This is top line analysis only. A more fulsome P&L analysis will also include expenses: legal fees, flights to clients, entertainment/closing dinners, your nightly dinners and cab rides, etc. some of which gets billed back to the client.

Anyone else have to do this exercise at their bank? Any insights?