Interview With Ilana Weinstein: Investment Banks' Glum Future

Includes: DIA, GS, QQQ, SPY
by: Harlan Levy

Ilana Weinstein founded The IDW Group, a high-end executive search firm in 2003, which provides top talent for the investment banks, hedge funds, sophisticated asset managers and family offices. Previously she was an analyst at Goldman Sachs, then got an MBA from Harvard and joined the Boston Consulting Group.

Harlan Levy: What does the landscape across Wall Street look like for hedge funds and investment banks?

Ilana Weinstein: We obviously had a difficult year in 2008. 2009 came back in a big way. For many investment banks it was their best year in fixed-income trading, and compensation was good again. Since 2009 the beginnings of regulation and everything that that means have started to take effect. Banks can't grow at the same rate. They can't use leverage to juice up equity, and they really can't engage in all of the high-margin, ultra-complex new products that we had up through 2008. The appetite for that went away with the crisis. All of these highly structured complex products are now dirty words down in Washington.

In 2010 we saw revenue go down across equities and fixed income. As a result, compensation fell across sales and trading by about 20 percent, and then again in 2011 it was the exact same story with compensation hit even harder. Life at the investment banks has become more difficult. They've seen lower levels of client activity, decreased trading volume - and this is all ongoing - market volatility, sovereign risk, political uncertainty across the globe that's not abating any time soon, and of course we have the new regulatory environment and how that will affect the banks, which we're still working through. Dodd-Frank and the Volcker rule and Basel III have not yet been fully implemented.

So, many of the high-return businesses, such as proprietary trading and others will no longer be possible or economical. Banks can't use leverage the way they once did, and many of the fixed income businesses won't make sense in terms of the amount of capital that must be held against those assets. So, risky, balance-sheet-intensive businesses, which drove a lot of the revenue in fixed income, are in shrinkage mode.

H.L.: How do the third-quarter results look?

I.W.: This year's Q3 numbers at the banks are interesting, because even though they were pretty good for the first time in a long time, the reality is that a lot of the revenue was driven by risky assets on balance sheets that simply reflated. For example, net revenue at Goldman Sachs (NYSE:GS) this quarter went from $3.5 billion in revenue to $8.5 billion - and there should be confetti thrown from the windows - but most of it came from things like private equity, from their stake in the Industrial and Commercial Bank of China, from holdings of bonds and loans - not franchise sales and trading businesses. Rather, it was their investing effort, so this source of revenue may not be sustainable. Dodd-Frank is looming, and there's a question of whether the banks will be able to have these investing businesses as a driver of revenue, given the oncoming regulation.

If a lot of that goes away, what does that do to the sell side in terms of return on equity? The days of ROE of 32 percent, which Goldman had back in 2007, are gone. It's difficult to generate that kind of ROE without leverage. Back then ROE across the top 13 investment banks was 20 percent, and now it's looking more like 7 percent.

If we're trying to drive that up, and the revenue coming out of the trading desks isn't there, then you really need to look at head count and compensation as the levers to push up ROE. If you look at the landscape of the investment banks' sales and trading desks, it's still in shrinkage mode, either because of businesses that are no longer economical or even allowed because of the oncoming regulation, and on top of that headcount across the board is too high.

H.L.: What's happening with hedge funds?

I.W.: Hedge funds have more of a transparent, pay-for-performance type of construct. Performance year-to-date has been "OK" for most hedge funds. For most it hasn't been stellar. Most hedge funds are up in the high single digits, not like the S&P 500, up 14 percent year-to-date. It's not terrible in that they're not losing money. But if you're investing in a hedge fund you're going to have less liquidity, and you're paying fees, and there's an argument that you should be outperforming the S&P.

Most of the money is going to the bigger funds, because institutional investors care about the fund having real infrastructure: across compliance, technology, risk management, back-office, etc. They want to see something that feels safe (particularly after 2008) and not just five guys sitting in a room investing. And definitionally, it is the bigger funds that can afford to create the kind of infrastructure that will resonate with institutional investors.

Interestingly, the bigger funds don't necessarily have the better returns, because it's harder to move the needle with more capital, but there's a feeling amongst large clients that if you're parking your money with a well-developed $20 billion fund that's been around a long time, it just feels safer than with a start-up even if the returns aren't as high.

H.L.: So do hedge funds have a secure future?

I.W.: I don't think there is any danger of them going away. As long as they continue to outperform over time, that's what investors care about.

H.L.: Does a college senior graduating in the top of his or her class at a top school view investment banking as a dream job?

I.L.: The future of how the investment banks will grow is in question. Trading volume has been down, and client activity has been low, as people are afraid to do things given how volatile the market has been. Also, the cost base is so high right now. You have the regulatory burden and all the costs associated with that. You have technology costs. Base salaries are higher. Legal reserves are sky-high because of all the lawsuits that banks are dealing with so it's a lot more expensive to compete in these markets from a cost perspective. You've got top-down pressure on revenue and bottom-up pressure on costs so the banks are getting squeezed at both ends.

The glory days of legendary bonuses are gone. Back in the 1980s and '90s and leading up to 2008, getting a bonus of $40 million or even more could happen. But we are regulating away prop trading and not allowing for the kind of high leverage strategies that lead to those paydays. And I don't think they are coming back any time soon.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.