But not Gary Cohn! Gary Cohn doesn't chase league table credit. Photographer: Chris Goodney/Bloomberg
But not Gary Cohn! Gary Cohn doesn't chase league table credit. Photographer: Chris Goodney/Bloomberg

Let's say you want to sell a lot of stock. I can offer you two ways to do that:

  1. You can publicly announce that you're selling a lot of stock, watch what that does to the stock price (try to guess!), and then sell the stock a day later at the new (lower?) price. Oh and pay me a 3 percent commission. Or
  2. You can just sell me the stock at 2 percent below the last sale price, and I'll figure out what to do with it.

Weirdly option 2 is not dominant? Companies are like, no no, I'll take the risk that my stock goes down, and pay you a hefty fee, instead of paying you a smaller fee to take all the risk. But here is a good Bloomberg News article about how option 2 -- the "block trade" or "bought deal" -- is becoming more popular, and at ever tighter pricing. The average bought deal discount so far this year is 3 percent (that is, a stock that last traded at $100 is sold to the underwriting banks at $97, for net proceeds to the seller of $97), versus a typical fee for a "marketed deal" of around 3 or 4 percent1 (that is, a stock that last traded at $100 announces a deal, drops a few points to $98, and then the seller pays $3 or so in fees for net proceeds of maybe $95).

Now this comparison is very unfair -- bought deals tend to be concentrated among bigger, better-known companies where the risk of a price drop is lower, and less time and effort are needed to market the deal -- but it's something I've always wondered about. There are a lot of places in banking where the customer pretty much gets to decide how much to pay the bank, and the bank is willing to work for a big traditional fee or for a fee determined by a hotly competitive auction or for nothing or whatever the client wants. And yet the normal option is the well-paid one.

Because of course the job of the banker is both to win the business and to maximize the revenue. So you offer a company a menu of options, including the bought deal and the fully marketed deal, and if you present it the way I did above2 then the company is like "so obviously a bought deal right?" But you don't present it that way: You use your charm and relationship and sales skills to convince them that actually the right move is for them to take all the stock-price risk and pay you more. That is what bankers are paid for. That is the skill. The banker who brings in $5 billion of marketed deals gets paid more than the one who brings in $10 billion of competitively bid bought deals.

So this is a story of banking becoming less of a relationship business -- we take care of you for years, then you pay us 4 percent to market your stock offering -- and more of a transactional business. If you don't care about your banker, you will just bid out your equity deal to whoever gives you the best price. This transactional business model often leaves banks looking like cynical hired guns, but actually seems to be mostly bad for them: If you're competing on price rather than friendship and handshakefulness, margins tend to suffer.3

What drives this shift to a transactional business model? Mostly the answer is "modern life and public corporations" -- like, what isn't becoming more transactional? -- but it's interesting to note that the growing popularity of bought deals is found "especially among private-equity firms looking to sell stakes in companies they have taken public." My toy model of the private equity business is that it is in part about arbitraging Wall Street social norms.4 Oh sure banks will enter a hypercompetitive auction for any scrap of business, but it's rude to ask them to, and it's their job to convince clients not to be rude. But if you just don't care at all about being rude, and you're not intimidated by your banker's sophistication and market experience,5 then you can pick up a lot of bargains. A big part of private equity's job is to be rude to investment bankers, so it's no wonder that it's every young banker's dream job.

But of course the banks are responsible too. Bought deals are more common, and spreads are tighter, because banks are more willing to do them, and to bid aggressively on them, than they used to be. An anecdote:

“One of our competitors bid over -- over -- the settlement price to buy a block of stock,” Goldman Sachs President Gary Cohn, 53, said at an investor conference in May, without naming Citigroup. “Didn’t seem like relative great pricing to me. Not market share I was looking to chase.”

That sounds nuts until you learn that that trade was a bought deal for a $773 million portion of KKR's stake in HCA, and that HCA bought back another chunk of that stake at the same time. So the announcement was less "a lot of stock is coming for sale" and more "there will be less stock coming for sale than you were pricing in." So the stock went up:

HCA, buoyed by a share buyback announced concurrently with the block trade, rose on each of the four days after the May 19 auction and has remained above the price Citigroup paid.

So this was a good trade for Citi.6 It was also a good trading decision: Someone at Citi looked at the facts -- a big offering, a big simultaneous buyback -- and decided to make a $773 million bet that the stock would be up, not down, in the next few days. Other traders disagreed, as they tend to do, but Citi's trader turned out to be right.

This makes some people nervous: Wasn't the Volcker Rule supposed to stop banks from risking hundreds of millions of dollars of their own capital on short-term trading decisions? No, is the answer, as it turns out; the Volcker Rule has a specific exception for underwriting corporate offerings.7 But, you know, Banks Doing Risky Stuff, etc.

But of course the risk is irreducible; it's just a question of who takes it. If you announce a stock sale, there is a risk that the stock will go down. If the stock goes down, someone loses money. The question is whether that's the bank or the client. Banks would rather put that risk on the client. (Obviously!) Clients would rather put it on the bank. Banks, driven by competitive pressure, are increasingly giving clients what they want. If your model of banking is that banks should be in the business of managing and reducing risks for real companies, then that seems like a good thing. If your model is that banks should avoid any risks, then it's a bad thing, and those risks should be put back on the real companies.8 But then what's the point of the bank?

1 The bought-deal discount is from the article; the marketed-deal fees I sort of made up, based on:

  • It's a number that seems right, at least as an advertised number, from my days as an equity capital markets banker.
  • Bloomberg's IPO function, screening NYSE and Nasdaq listed offerings of at least $100 million flagged as "Additional" or "Accelerated Bookbuild," with a "gross spread" listed (not all of them have one, which I assume means that they're block trades but can't be sure), shows 197 deals with a dollar-weighted average gross spread of 3.1 percent and an unweighted average of 4.3 percent in 2014 to date. The equivalent numbers for the last 12 months are 371 deals with an average gross spread of 2.7 percent (weighted) or 3.9 percent (unweighted).

This is a little impressionistic, and I do not particularly vouch for the science by which those deals are classified, etc.

2 And during my banking career, ha.

3 An alternative view might be that even in a relationship-driven view of banking, there are loss leaders available, and this is one of them. Basically every money-losing trade can be justified as good for getting future profitable business, either with the same client (relationship-building) or with others (marketing! league table!):

In addition to revenue brought in by a block trade, the boost to a firm’s ranking can help banks when they pitch for other deals. Block trades also provide the potential for future investment-banking business from the company as well as inventory and equity-trading business.

Honestly, I was surprised to read this article in July. You're supposed to buy league table with unprofitable bought deals at the end of the year, as the rankings approach. If you're doing bought deals in the first half, that means you're serious about it as a business model.

4 So the recruiting model: Banks traditionally are happy to see their young analysts go to important clients. So the private equity firms say "OK, we'll take all of them, immediately, thanks." And the banks sort of mutter that that wasn't really what they'd had in mind.

5 Or moved to pity by his servility and desperation. Whatever works.

6 Or, I mean, not a terrible trade. HCA opened a few cents below Citi's price on the next day, though it rose through the day; if Citi got out of most of it before the open -- as is customary -- it was probably at a more or less zero profit/loss.

7 See section 4(a) of the rule, which exempts "underwriting activities."

8 Or, OK, fine, mostly private equity firms.

To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this article: Zara Kessler at zkessler@bloomberg.net.