The Capital Cycle Podcast - Investment Bankers and the Capital Cycle

Episode Date: December 20, 2024

A look back at how the investment banking species has evolved into its modern day form of alternative investment manager. The story is told through the career of Stanley Churn, Marathon’s satirical archetype of an investment banker.Presented by Edward Chancellor with Charles Carter, Portfolio Manager EuropeFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

this is Edward Chancellor with another episode of the Capital Cycle podcast. I have with me Charles Carter, who is a portfolio manager in European Equities and Marathon Asset Management. This podcast is going to be slightly different from the ones we've done before because we're going to talk about the role of investment banking and how to view investment banking from a capital cycle investment perspective. Once a year, Charles, you write a light-hearted, fictional piece about a made-up investment banker type called Stanley Chern. And that appears in the December of every year. You and I started our careers in finance together in what was then known as merchant banking, now investment banking in the corporate finance department. I remember you telling me tales of how the bank's partners would urge corporate clients to escalate their bidding, regardless, let us say, of whether this was in the true interest of shareholders. Bankers, you often told me, are only interested in fee generation.

Yes. Well, Eddie, I think that period in the late 1980s, there was a change afoot. There had been some more kind of relationship-oriented bankers, but then the American investor, banks arrived and the whole industry became much more transactional and fee-driven. There was a senior partner in the French affiliate of the firm that we were working at who used to go around apparently saying the deal price was the price that hurts our clients, which I remember struck me at the time as quite weird. Not in the interests of the clients. So later you moved from the sell side to the buy side of marathon.

And since then, you've had further grounds for thinking that the investment banker is rarely, if ever, on the investors side. I arrived here in 1998, and that was really at the start of this, you know, very excessive TMT bubble. You can spell what TMT means? Well, Telecom media and technology. And, you know, there were lots of M&A deals, but particularly a lot of really quite terrible. IPOs that took place, which destroyed lots of value for the shareholders of those investing in the IPOs or, you know, the shareholders in the acquiring firms. And so shareholders really lost out and bankers made vast fortunes. Marathon's capital cycle approach is particularly wary of corporations

being captured by investment bankers. Yeah, I think the capital cycle approach, you know, always makes one very wary of capital flowing into hot sectors. But of course, it's the opposite for investment bankers. And they really egg the whole process on. And company management teams can be sucked in to all the hype that's whipped up by investment bankers and media during these bubble phases. Sometimes it seems that the bankers have got their hands on the controls. I think Vodafone in that period was one example. When it made a lot of... a large acquisition of management. Yeah, it was on a sort of roll-up strategy acquiring lots of different firms, lots of

firms around the world. And it was a sort of, you know, great fee feast for the investment bankers. And you somehow felt that, you know, they were almost taking control of the company. And then you had cases where that really did happen, where some tired old European conglomerates got hold of an investment banker to be the CEO. And then, you know, you got the sort of the deal flows. I think Vivendi was a classic. And that was run by a French banker, Jean-Marie Messier.

Yes. Who destroyed, let us say, a great deal of shareholder value during his tenure. Another Napoleon of Finance. So in our first collection of global investment reviews, capital account, there was a notorious example of how bankers in the 1990s exploited conflicts of interest between the investment banking and their brokerage research arms. I know that things have changed over the past 25 years, but can you explain to listeners how the game works,

or at least how it used to work? That phrase actually came out of a headhunter's memo, which I was inadvertently sent. I was applying, well, looking for a job before I came to marathon, and this was an investment bank with a tech franchise looking to hire analysts. Not just 80, the top tech franchise. It was the top one. They wanted analysts to come and work for them to sort of puff up the IPOs.

And in this meeting note, which I received, it sort of spelled out what they were looking for. And it was clear that it wasn't really analytical integrity. I think there was a phrase, you know, we didn't want people who were prissy about their independence. And that the money was made in the business from IPOs. At that time, I think you made 7% of the value of the IPO. in fee and that the analyst salaries were 50% paid by the corporate finance side. And I think it ended up by saying, you know, we really want people who need the money. It says expensive tastes, children of private school, that sort of thing, you remember.

Yeah. So the fictional figure of Stanley Turner, who invented the financier investment banker, appeared in the second marathon book Capital Returns relating to the fictional firm of General Chocolate in December 2003, which comes in the form of the letter from the CEO of General Chocolate, a promotional firm held bent on growth. And Stanius mentioned there as the head of sales of Greedspin partners. Tell us what was going on. General Chocolate was this just a fictional company and it was this idea of a sort of long-term family-oriented firm in the chocolate business where they suddenly had got an investment banker in charge, a CEO who they got from

greed spin, which was this fictional investment bank. And of course, that then results in a sort of disastrous series of acquisitions. And this later piece where Stanley Churn first appeared, that was about this kind of rehabilitation phase after the collapse. And Stanley Churn was really just a sort of amalgam, a kind of personality type of that kind of alpha male. And they weren't mostly male investment bankers. it was really just trying to sort of, you know, mob that up a bit, but also trying to make our clients aware that this was a problem for the industry. So a couple of years after that, the first appearance of Chern, Stanley's left Greensman and working in a private equity outfit, the you call Rearview Capital. To add value in private equity, he writes, just add debt.

Stanley salivates at the fees extracted by private equity. This was penned during in the great buyout boom prior to the global financial crisis. There was a trend, I think, in the industry because the fees in investment banking were kind of drying up. And then there was this bright new horizon that opened up in private equity. And I think Charlie Munger was quite early on this, pointing out that private equity in a way was a sort of branch of investment banking, you know, the deals, the fees, the short-termism, and the kind of personality types. And the methodology, the working practices were so, I think, you know, there's an obsession with E. V-Ebit DAR as a metric, huge spreadsheets that

would be produced to describe companies. And then there's sort of torturing of junior analysts. You have to stay up all night working on these enormous spreadsheets. So that sort of commonality, I think, you could see between the two areas. And I think so Munga also like to talk about what he called the Krupier's take, the fees extracted by Wall Street on the unlawful. underlying investments, the underlying investments can only deliver a certain return from the fundamentals of their business activities. A Munger would point out that what Wall Street did was add layer after layer after layer of these so-called groupier stake. And I suppose this era, the early 2000s, was a combination of hedge funds, which we're not going to talk about now with

their two and 20, and private equity fees plus investment banking fees, loaded on to assets that were traded in the public markets with much lower overall fees. By December 2008, Tannes moved on in the aftermath of Lehman's bankruptcy. He's working for a sovereign well-funded advisor. As the era of massive fiscal deficits, zero rates and quantitative easing opens up, churn anticipates extracting even more fees. I think, again, that was sort of topical at that time. So after things started to fall apart, there was this period where a number of sovereign wealth funds, particularly from the Middle East, were sort of gulled into making poor investments in these collapsing financial firms, fee generation game, which didn't end well for the investors.

By 2010, Chern has fled to China, the great post-crisis prospect for investment bankers. that didn't work out well for investors in Chinese shares, did it? There's another capital cycle story here. Yeah, I mean, that's a whole story. And in fact, I mean, there's a chapter in capital returns called China Syndrome, which describes a lot of the sort of shenanigans that were at foot at that time. Yes, and in terms of conflict of interest, the Chinese state sold, if you remember, shares in their big four banks to the Wallstrands. banks at the time of their recapitalization of the early 2000s.

And then it was about this time, if you remember, that the federal government became concerned that Wall Street was employing too many Chinese princelings, the sons of leading politicians, as well as actually employing people who were members of the Chinese Communist Party. So there's asked in an interview about his favorite pastimes, Chern replies at one point, point, I shoot sheep. That's based on a true investment banking story, isn't it? I was a very junior, this merchant bank, and there was a meeting we had with an investment banker who worked for a Swiss financier. We were looking at a sort of UK takeover target

for them, and I think there was some small talk at the end about, you know, what this chat was doing over the holiday. And he said he was off to Canada or somewhere, and he was planning to go off sheep shooting, which, you know, struck me, struck me. at a time as pretty odd. But investment banking pastime. Churn is enthusiastic about the rise of passive investment, claiming that equity's exposure is now all about beta, while the private investment delivers so-called alpha.

You take a different view that the move towards indexation is creating market inefficiencies that can be exploited by active managers. Yeah, I mean, I think passive is there, and it drives momentum. So a share goes up, you buy more of it, and it goes up. It's a self-fulfilling kind of mechanism. And we've got to the point now... Charlie, you probably ought to explain that this is because of the flows into passive.

Yeah. So, you know, if you think that passive is probably, people say it's 60% now of the assets in the US, up from 30% 12 years ago or something like that. And then it's an even larger proportion of the... flows coming in. Those flows, I think, have this tendency to exacerbate mispricing. David Einhorn has been quite good on this. He's written recently about precisely how that works, the mechanism. And I think if you think of two identical companies with the same future in terms of their cash flows, and therefore, in theory, the same valuation, if one of them gets slightly

higher valuation than the other, that's a higher market cap. And that then means that more of the passive flows have to go into it and lessen to the other one. And the other one that then looks undervalued may be bought by an active investor, people like us, on the basis that it's undervalued. But if that process continues of the rising overvaluation and an increasing undervaluation, then you get to the situation where the active manager gets sacked and the assets probably get put back into passive. So the whole thing becomes a kind of doomsday machine. And in that kind of environment, the active managers who do do well tend to be those who buy the kind of larger, more overvalued stock. So that adds to the whole momentum process. And this in a way reminds me slightly what was happening during the tech.com bubble of the late 1990s,

where if you remember, the value fund managers were being sacked. and that capital was then transferred into the growth fund managers. And there were people like Tony Dye, who was head of Phillips and Drew, which was then a big UK fund manager, who was a value guy, who was sacked right towards the end of the bubble. My old boss Jeremy Grantham value manager, he lost half his assets during that period. And Marathon, if you remember, from bitter experience, was also having quite a hard time. So in those days, it wasn't indexation, but it was closeted.

indexation with fund managers tracking the benchmark. Now it's more direct indexation, but the same impact and the same sort of bifurcation of values in the market. And there was this thing at that time where if you had a high tracking error, because you didn't own a lot of these larger cap stocks, which marathon did. Then clients would complain and say, you're taking too much risk, which of course turned out to be precisely the opposite of the reality that the risk was all in these large cap, overvalued at a time telecom stocks and other TNT stocks in Europe. And the Vendys and the Vodafone,

so we talked about earlier, whose share prices collapsed. I think Vodafone was something like 15% of the UK stock market, wasn't it in 99? Possibly. Yeah, I think it was something like 7% of the European market at its peak. Yeah, and I remember you were saying to me, the most important decision we have to make is whether we own Nokia, the Finnish telecoms equipment company, which has since dwindled into nothing. Back to Stanley Churn, he's now into

private credit. I know this is not your field, Charles, but you have your concerns about that. I mean, I think just from the outside, you observe the sort of personality types that, you know, have gone from investment banking to private equity. And now you see that. them into the world of private credit as a high source of fees, potentially, you know, originating loans and then funding them. And it just strikes me that it's got some of those elements of sort of regulatory arbitrage as well as, you know, tax arbitrage. What Charles means by that is that after the global financial crisis was a great thicket of banking regulation that made it easier for people to lend outside of the banking system.

So the private credit was a natural upshot of that great regulation. So this shift towards more private equity, which is probably largely done since interest rates rise have risen. And private credit inevitably raises mungers' croupier's take, doesn't it? Yeah, I think Morgan Stanley have this estimate that I think half of all fees in the investment industry will go to the so-called alternative managers in 2024, and that was 28% back in 2003. And then Bain have got a projection that value of private assets will, in the not too distant future, will exceed public assets at around $60 trillion. And in the private credit world, notoriously opays. and complex, there are potential debt problems lurking, you think. I mean, you can see data now for some of these business development companies, BDCs,

where more than 20% of their net investment income is coming from so-called pick income or payment-in-kind income, which is a kind of IOU, which in the banking world would set off the alarm and you know you had to write down the loan. It's called a non-performing loan. but it's somehow treated differently in the world of private credit, which also I think, you know, should set off alarm bells. Yes, because payment in kind loans or pick loans, they proliferated in the last decade when interest rates were very low. And there was a general deterioration of credit standards. If you remember, the proliferation of so-called covenant-like loans and so forth.

And the payment in kind loan is typical poor credit. issued late in a credit cycle that sooner or later, at least historically, has come back to bite. There are other problems, aren't there, that private equity is having trouble realizing its investment. But the industry has been finding ways around this problem. But as ever, there are conflicts of interest to consider. I mean, you hear stories the heads of some of these endowment, college endowments complaining that they're not getting any checks from private equity. And actually the reverse, they're being asked to stump up money for the funds according to the agreements that they've signed. And, you know, there's been a bit of innovation

in terms of continuation funds and these of GP secondaries means of transferring assets, which feels a lot like sort of putting off the evil day and, you know, elements of denial around the investments and then the sort of upcoming refinancing, which is going to take place. And of course, you and I talked about this back in 2008. We expected there to be a sort of great day of reckoning for private equity, but they got bailed out by the low interest rate policy. And you and I felt that they were probably the least deserving beneficiaries of that period of central bank, large yes. And actually, Charles, the same problem is occurring in venture capital too, whether lack of realisations from VC investments and continuing calls.

And I think sort of if one takes this whole conversation together, Stanley Chen is a way of expressing quite serious views about the level of fees extracted by the finance industry from investors. and a continuing appeal to investors to remember that actually active management in the public markets is a relatively cost-effective way of extracting returns for investors. I think that's a fair sum. Yeah, and I think to go on from what I was saying earlier, the passive juggernaut, if you like, has created an undervaluation in the small and mid-cap arena.

So companies that aren't either in the index or are undervalued and then go through this Einhorn process of becoming more and more undervalued. And that's a great opportunity for active managers or indeed for private equity, which has, you know, vast amounts of dry powder to invest. And maybe that will be where they choose to invest it. Thank you very much, Charles. Enjoyed this conversation. And no doubt, Stanley,

and will continue to return in future. Thank you, Edward. Thank you for your time today. I hope you will listen to the next edition of the capital cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.