Money Stuff: Goldman’s CEO Wants to Get Paid

I sometimes talk to students at colleges or business schools, and a question that one often gets asked in that circumstance is “what should I do with my life?” The venues being what they are, the way that question comes out of a student’s mouth is often “should I go into private equity?” I don’t know! Nothing in this newsletter is ever career advice. But my heuristic is that, if everyone in your graduating class is trying to get on a clearly defined and rigidly structured career track that leads to the same place, then succeeding on that track is a good safe prestigious well-paying thing to do, but maybe, you know, the peak is at least in sight? The way you make a lot of money in finance is by spotting market inefficiencies that no one else has seen; everybody kind of knows about private equity now.

More broadly, you could ask the question: “Is private equity a structurally lucrative sort of business, or did the relatively recent discovery of private equity turn a bunch of people into billionaires?” I wrote last month about KKR & Co.’s partial shift from doing traditional leveraged buyouts to making “strategic” acquisitions of companies that they planned to hold for the long term, and I suggested that this shift — along with the broader trend of private equity managers getting into private credit and becoming more general “alternative asset managers” — might have something to do with the business model reaching maturity. I wrote:

The original private equity founders were in a scrappy business of picking low-hanging fruit; now they run huge institutions and a lot of that low-hanging fruit is gone. Every top business school graduate wants to work for them, and every institutional allocator wants to give them money, because of the generational profits they made with the essential insight of “companies could be much more levered,” but that insight is not as lucrative now as it was when they made all that money.

Those founders are still around: George Roberts and Henry Kravis, the R and a K in KKR, are co-chairmen of the firm, though the co-chief executive officers are from a younger generation. This is generally true at the biggest alternative asset managers: The founders are around somewhere, and the people who were young whippersnappers when the firm was a scrappy upstart are now running the place.

Those people are rich: The founders are often billionaires, and the next-generation executives often get paid vastly more than people who work in older and more established financial businesses. We also talked last month about John Waldron, the No. 2 guy at Goldman Sachs Group Inc., who was “approached by Apollo Global Management about a senior job offering life-changing money, even when set against the $30mn he earned the preceding year.” I am sure that Marcus Goldman and Samuel Sachs did great out of founding Goldman Sachs, but they died in 1904 and 1935. A lot of subsequent heads of Goldman Sachs have also done great; Lloyd Blankfein, the immediate past CEO, is a billionaire. But being a good professional executive and steward of a 150-year-old institution shouldn’t be as lucrative as founding your own huge institution, or even taking over that institution after getting in near the beginning. Some portion of the money that the big alts managers get paid is a sort of amortization of the compensation they earned for taking the risk of getting into a whole new sort of finance when the clearly defined and rigidly structured career track led elsewhere.

One way to put this to my college audiences would be: If you had joined a private equity firm as a first-year associate in 1985, in hindsight that had a pretty high likelihood of making you extremely wealthy. You were jumping into an inefficient market, and the opportunities to correct the inefficiencies were large. If you join a private equity firm as a first-year associate in, let’s see, 2027 — graduate college this spring, work your two years in banking and then move to private equity with everyone else — that just seems like a very, very efficient market.

How should this make executives at big investment banks feel? One possible answer is: Great, because the banks can more easily compete for talent with the big alternatives managers, because joining an institutional alternatives manager at this point is not the golden ticket that it was 20 years ago. On the other hand, if you are an executive at a big investment bank, your paycheck is much lower than the paycheck of a similar executive at a big alts manager, who did get that golden ticket.

Anyway how much should David Solomon get paid? Bloomberg’s Todd Gillespie reports:

As Goldman Sachs Group Inc. asks shareholders this week to back $160 million in special bonuses for its top two executives, the hope is that investors will agree that the firm is far more than a storied investment bank.

The retention packages for Chief Executive Officer David Solomon and President John Waldron give the latter more reason to stick around to run the place — but Goldman’s justifications go beyond that. It says their compensation needs to reflect their status as the heads of a private-markets giant.

“The board considered the unique competitive threats for talent that Goldman Sachs faces, including from alternative management firms and others beyond the traditional banking sector,” the firm said when announcing the bonuses and a new carried-interest program in January. After all, it noted, Goldman is “a top 5 alternative asset manager.” …

At the heart of the spat is the blurring line between diversified investment banks and alternative investment firms — known as “alts” — in the era of burgeoning private markets. Both sides are expanding beyond their traditional roles, with banks gathering more money from wealthy and institutional investors to invest privately in companies, while alts are scaling up lending. 

In recent years, the firm has increasingly pitched itself as a competitor to the likes of Blackstone Inc., KKR & Co. and Apollo Global Management Inc., which carry higher market valuations and give non-founding leaders a shot at billionaire status. But ahead of Goldman’s vote, several influential voices have lined up against rewarding its own top brass in a similar fashion.

One way to think about this is “alts managers are more lucrative than investment banks, therefore they pay their executives more, and so Goldman is positioning itself as an alts manager because (1) that is true, (2) it is good for shareholder value and (3) it is good for executive pay.” But another way to think about it is something like “the people running Blackstone and KKR and Apollo mostly got in pretty early on building new institutions, and are getting paid for that, but that can’t last forever.”

In the US, generally, short-term capital gains are taxed at a higher rate than long-term capital gains. (“Long-term” mostly means “more than a year.”) If you buy a stock and sell it in a week, your profits are taxed at ordinary income rates, say 37%. If you buy a stock and sell it in two years, your profits are taxed at lower capital gains rates, say 20%. If you are in a business of frequently buying and selling stocks, you will generally pay 37% taxes on your profits. [1]

If you are doing that business over a long term, though, you might want to do better. You might have a thought process like: “I am going to buy some stocks today. Tomorrow I will sell them and buy different stocks, and the day after that I’ll do it again, for years and years. At the end of, say, two years, I will hopefully have a profit from all that trading. But that is a long-term profit, isn’t it? I shouldn’t have to pay short-term capital gains taxes on my interim profits, my daily trading profits along the way. I should just pay long-term capital gains taxes on the overall profits on my portfolio over the long term.”

This thought process is not particularly correct, but it is tempting. How might you achieve it? Conceptually the answer is:

1. You create a box. The box will hold your stock portfolio, and will buy and sell stocks every day.
2. You don’t own the stocks: The box owns the stocks. You control the box’s trading, but the trading takes place in the box, not in your account.
3. You just own shares in the box, which you hold consistently for years.
4. At the end of, say, two years, you sell your shares in the box, hopefully at a profit (because the box has made money by trading stocks).
5. Your profits on the shares of the box are long-term capital gains, because you held the box for two years.

Again this doesn’t feel quite correct, but it is the right direction. There are two obvious problems. One is that the box is trading stocks every day, so it should have to pay short-term capital gains taxes. But you can find solutions to that. Perhaps the box is a nonprofit, or a foreign entity, and doesn’t have to pay taxes. More realistically, the box can be owned by a bank or securities dealer: Professional securities dealers normally pay ordinary income taxes on all of their mark-to-market trading gains and losses, short- or long-term. The bank can write you a derivative giving you the gains or losses on the box. Then the bank has profits (from the box’s trading) and offsetting losses (from the derivative giving you the box’s profits), so it doesn’t owe any taxes. The box’s short-term gains have been converted into your long-term gains.

The other problem is that this is too cute and, if you do it, the Internal Revenue Service will say that it doesn’t work and that actually you own the box and are responsible for its short-term gains. You can work on that too. One promising approach is for the bank to write you a derivative giving you, not all the gains and losses on the box, but just the gains. (A “call option” on the box, rather than a “swap” or “forward.”) This makes you look less like an owner of the box and more like a genuine derivatives counterparty.

Why would the bank do this? One answer is “you pay the bank a premium for the call option,” but there is a better and more conceptually satisfying answer. This answer is: Giving you a call option on a box full of securities that you select is a lot like giving you a loan against that box of securities, which is a business that the bank is in anyway. If you are a hedge fund and want to buy $100 of securities, you can probably do that with $15 of your own money and $85 you borrow from your bank. [2]  If the securities go up to $120, you will pay back the loan and keep $35 for yourself; if the securities go down to $80, you won’t pay back the loan and your $15 will be gone. Roughly speaking that is like paying $15 for a call option on the securities struck at $85. [3] But if the bank gives you an $85 loan against a $100 basket of securities that you own and trade every day, you will have short-term capital gains on that basket. If the bank owns those securities (and trades them every day at your instructions), and writes you a two-year call option on them, then perhaps you will have only long-term capital gains on the option.

That’s the idea. Does it work? Well. No. Some very smart people tried it! We have talked about it a couple of times before, because the most famous attempt was made by Renaissance Technologies Inc., which trades stocks frequently and prefers not to pay taxes. [4]  Rather than trade stocks that it owned, Renaissance would buy long-term “basket options” from its prime brokers; the options referenced a basket of stocks that Renaissance could and did change frequently. The benefits here are (1) lower long-term capital gains taxes and also (2) US bank regulation limits how much Renaissance could borrow from its banks to buy stocks, but doesn’t limit the leverage Renaissance could get from options. 

The IRS didn’t like this, though, and challenged it; ultimately Renaissance settled and its investors had to pay billions of dollars in taxes.

But another hedge fund, George Weiss Associates, also did these trades, and the IRS also challenged them, and GWA fought the IRS. Last week the US Tax Court ruled in favor of the IRS. Here is the opinion. Here is how it describes the trades:

GWA invested hundreds of millions of dollars in STFIs [“specially tailored financial instruments”] that it characterized as “call options.” GWA initially invested in this type of product with Royal Bank of Canada (RBC) and later with Deutsche Bank. These products lacked many (or most) features of standard call options. And the products GWA purchased from Deutsche Bank included stop-loss features or “barriers” that significantly reduced, if they did not entirely eliminate, the risks that buyers and sellers of call options typically face.

The putative “call options” had long terms, with expiration dates ranging from 5 to 12 years into the future. The asset underlying each “option” was a basket of securities that included hundreds or thousands of different stocks (“basket securities”), which could vary from day to day (or hour to hour). The basket securities were nominally owned by the bank. But GWA was entitled to trade the basket securities as it wished, subject to very minor constraints. And it traded them with great gusto, employing the same long/short strategies that its affiliates deployed in their other portfolios.

If GWA’s investment strategy was successful, its annual trading profits would increase the value of the securities in the underlying basket. But if GWA did not exercise its “option” on the basket securities until maturity, the accumulated trading profits could escape taxation for many years, and would ultimately be taxed, not at ordinary income rates, but at more favorable long-term capital gain rates. And because the basket securities were not held in a prime brokerage account titled to GWA, regulatory limits on leverage would not apply.

For instance:

Beginning in 1998 Deutsche Bank developed a Managed Account Product Structure, or “MAPS,” which was marketed by GPF [Deutsche’s Global Prime Finance division]. It characterized MAPS as involving “barrier call options,” to which we refer as Barrier Contracts. GPF marketed this product to hedge fund customers as an “amortizing call option [that] provides delta-1 exposure to [an] underlying reference portfolio” of securities. A customer’s “delta-1 exposure” to the reference basket ensured that changes in the value of the basket securities would be reflected dollar for dollar in the value of the “option.”

“Delta-1” means that, for every dollar that the value of the underlying basket increased, the value of the “option” would also increase by a dollar. That’s not usually true of call options, but it is true if you own the stocks yourself. The MAPS description goes on:

The customer would be required to pay a “premium” when purchasing the “barrier call option.” The “premium” would purportedly be priced according to the investment strategy used to manage the basket securities, including the volatility and liquidity of the assets. In practice, the “premium” was almost always 10% of the “notional amount,” i.e., the amount of cash Deutsch Bank made available to the customer for investment in the securities basket.

The customer could choose the initial composition of the securities portfolio, and Deutsche Bank’s London branch would purchase those securities and place them (at least notionally) into the basket. Although the securities were titled to Deutsche Bank, the customer could appoint the investment advisor, who would direct all trading activity in the account. At the termination of the contract, the customer would be entitled to receive a cash settlement amount corresponding to the gains that had accumulated in the basket.

The Barrier Contract had a knockout feature such that, if the value of the basket fell below a specified barrier, the contract would be terminated and the securities would be liquidated. But Deutsche Bank built in a fail-safe mechanism that kicked in before that point was reached. If the value of the portfolio fell to a level that approached the knockout barrier, Deutsche Bank could demand payment of an “additional premium.” The demand for “additional premium” resembled an anticipatory margin call in a traditional prime brokerage account.

If the customer declined to supply additional premium, Deutsche Bank could immediately terminate the contract and the securities would be liquidated to cash. These features were designed to ensure that the Barrier Contract would be terminated, and the underlying assets converted to cash, before investment losses in the reference basket exceeded the “premium” paid by the customer. Deutsche Bank was thus insulated from downside risk on the investment portfolio.

That is: Normally if you put up $15 and borrow $85 to buy $100 worth of stocks, and the stocks go down to $90, your bank will call you and ask you for more money. Normally if you buy a call option on some stocks, and the stocks go down, the option seller won’t call you to ask you for more money: The whole point of an option is that you can’t lose more than your premium. These trades were much more like margin loans than they were like options, but they were called options.

The tax court didn’t buy it:

We conclude that the Barrier Contracts were not options in substance because they lacked the essential economic and legal characteristics of genuine options. When the self-serving labels are stripped away, the true substance of the arrangements is clear. GWA held and traded the basket securities through a prime brokerage account, and Deutsche Bank financed GWA’s investment in those securities by extending a margin loan at 10-to-1 leverage, with the putative “premium” serving as collateral for that loan.

In particular, GWA generally got its full premium back in upside cases (in my example numbers, it would pay $15 for an “option” on $100 worth of stock, struck at $85, so if the stock went up to $101 it would get back $16), and “the pricing of the Barrier Contracts exhibited none of the risk characteristics that inform the pricing of true options.” Also the options “had a term of 12+ years,” which is pretty abnormal for a real option, and the dividends on the underlying stocks were passed through to GWA. Basically GWA’s prime brokers had none of the risks of owning the stocks; they just held onto the stocks for GWA. [5]  So effectively GWA owned the stocks, and bought and sold them frequently, and had short-term gains. The box was a neat idea, but it didn’t work.

Two models you might have are:

1. Retail brokerages compete to attract the most sophisticated retail investor customers, because … I honestly don’t even have a “because” here? Because sophisticated retail customers are more fun to deal with? Because they are less likely to lose all their money and sue? Because they are more likely to make money, and retail brokerages measure their success by how much money their customers make? Because the retail brokerages use customer flow to predict stock prices, and the most sophisticated customers are the most predictive? [6]  Perhaps you have other suggestions.
2. Retail brokerages compete to attract the most addicted retail day traders, because, you know. Because a core business of a retail brokerage is to take the other side of its customers’ trades (or more commonly to get paid by a market maker that wants to take the other side of the customers’ trades [7] ), and the more the customer (1) trades and in particular (2) trades risky high-margin things like options or crypto, the more money the brokerage makes.

Just two models you might have. Anyway:

Morgan Stanley, whose E*Trade business just posted its highest-volume trading days in years, is ramping up efforts to reach the most-active day traders with a new platform.

“Power E*Trade Pro” allows traders to customize as many as 120 tools across six screens on a desktop application separate from the firm’s current web and mobile products. The offering, announced Monday, is in a pilot period and set for a full launch in June.

“Our sophisticated trader population is a hugely important group of folks for us,” Jed Finn, Morgan Stanley’s head of wealth management, said in an interview. “We took the most sophisticated active traders in the industry and we said, what do you need to take your game to the next level?”

The word that jumped out to me there is “game,” which is perhaps unfair but here we are. “Six screens,” also. And for that matter “Power” and “Pro,” which I guess are normal enough words in this context, but I was amused to find both of them in the name. I should launch Power Money*Stuff Pro, which is just this newsletter but on all six of your screens. 

One thing that I like about crypto is that many crypto projects make explicit things that are latent or obscured in real financial markets. For instance here is a crypto project called Gambler’s Coin, which is a token that allows you to make negative-sum all-in random bets with your money until you lose it all. From the description:

If you send exactly 0.0003 Gambler’s Coin to another person, you automatically wager your entire Gambler’s Coin balance against theirs.

Wagers require no counterparty consent, meaning you might be targeted for a wager whenever you hold Gambler’s Coin. In any wager, win odds are based on your balance and your opponent’s balance.

So if your opponent has twice as much Gambler’s Coin as you have, she has a 2-in-3 chance of winning, and you have a 1-in-3 chance; resolution uses a random number generator. There is a small fee to do a bet, so the bets are all slightly negative-sum for everyone. Why would you do this? I mean! If I said to you “sports gambling and single-stock options trading are also ways to do negative-sum bets resolved using random number generators,” you would probably protest, and technically you would be correct, but come on. [8]  Those are big businesses. Surely the distilled explicit version should be … you know, an amusing art project. Probably not a big business but who knows.

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