The days when Wall Street banks could blithely hand out half their revenue in compensation to their staff without a murmur from shareholders have come to an end.
In an era of leaner times and tighter regulation, big mutual funds and pensions are growing more vocal in pushing executives at investment banks to rein in pay and bonuses and consider more staff cuts. Investors worry that bank employees are getting too big a piece of a shrinking pie, leaving shareholders a much smaller slice.
So far, much of the jousting is taking place behind closed doors. But the debate over whether investment banks should keep devoting roughly 50 percent of revenue to employee compensation is starting to enter the public realm through proxy battles and as more large shareholders speak out on the issue.
"Sometimes executives are being rewarded immensely for just sitting in their chairs, just coming into work every day," said Aeisha Mastagni, an investment officer at California State Teachers' Retirement System, which manages $154 billion in assets. "There is a need to conform to truly performance-based compensation."
Wall Street pay was not a big concern to investors when investment banks were highly profitable and shareholders were reaping benefits too, Mastagni and other investors said. But large shareholders are becoming more vocal because earnings no longer justify compensation at pre-financial crisis levels.
Last year, Morgan Stanley executives came under fire during some investor meetings, according to one person who attended those meetings but was not allowed to discuss them.
At one meeting, he said, "furious" representatives from mutual funds who were among the bank's 10 biggest investors sharply questioned executives, including the chief financial officer and head of investor relations, asking why Morgan Stanley could not cut compensation to about 30 percent of revenues.
Wesley McDade, a spokesperson for Morgan Stanley, which has paid out 51 percent of revenue for compensation the past two years, did not initially offer a comment on the matter.
But later on Thursday, Morgan Stanley Chief Executive James Gorman told the Financial Times that the bank was planning to consider lowering pay and bonuses in its next round of cost-cutting.
"There's way too much capacity and compensation is way too high," Gorman was quoted as saying.
Gorman told the paper that traditionally Wall Street kept compensation ratios flat when revenues went up but increased the ratio when times were bad, arguing they needed to retain people.
"That's a classic Wall Street case of ‘Heads I win; tails, you lose'. The current Wall Street management is a little tougher-minded about that and shareholders are certainly tougher-minded," he told the paper.
When asked about Gorman's comments, McDade, the bank spokesman, said he did not dispute the Financial Times story.
Jeff Harte, an equity research analyst at boutique investment bank Sandler O'Neill, who often organizes meetings between investment bank executives and investors, said compensation has been "a theme in management meetings."
"Investors are saying, 'We're past the crisis; you guys still have low returns'," Harte added. "At what point do you admit that this is the new normal?"
Mastagni said some large Wall Street banks, such as Goldman Sachs Group Inc and JPMorgan Chase & Co, have begun reaching out to shareholders to explain their rationale for compensation decisions. She said the outreach is welcome but CalSTRS is looking for banks to act more decisively on pay.
"I'm not sure that we could agree with the fact that 50 percent of the revenue should be going to the employee base," said Mastagni. "That's just very difficult for us to come to grips with."
With tougher talk from big shareholders, the balance of power may be shifting from bank employees who use capital to the asset managers who supply it. The longer banks suffer from weak earnings, the harder it will be to ignore shareholders on pay.
Bank executives have been delaying big changes to staff levels or compensation for as long as possible, hoping economic growth will pick up and trading volume will rise.
Wall Street banks say they are worried that if they slash compensation, top talent may flee for hedge funds and private equity firms. If they cut staff, it can be more expensive to add workers again when markets improve. Also, layoffs can actually boost near-term compensation costs because of severance.
But investors say the problems keeping profits down may be more permanent than banks acknowledge. In addition to the weak economy and low trading volumes, new regulations and higher capital requirements have cut into returns in fixed income and equity trading.
Trouble in trading is one of the biggest factors behind depressed bank earnings. It was a big reason Goldman Sachs earned just $4.4 billion last year, a 60 percent decline from fiscal 2007.
Those earnings represented a 6.6 percent return on common equity - a measure of how effectively the bank wrings profit from its balance sheet by comparing net income to common equity. Investment banks have historically aimed for more than 15 percent.
"People are starting to get the idea that investment banks right now aren't run for the investors — they're run for the bankers," said Ralph Cole, a portfolio manager at Ferguson Wellman Capital Management, which manages $3.2 billion.
PRESSURE IS ON
Compensation is the biggest expense for most investment banks, so cutting pay is a logical way to boost returns.
But for Goldman to have earned a 15 percent return on equity last year, it would have had to pay just 15 percent of its revenue to employees — far less than the 42 percent it did pay.
Wall Street executives contend that cutting pay to even 30 percent of revenue would cause a massive flight of talent and evaporate profits, hurting shareholders even more.
But many investors have little patience with these arguments. If employees cannot generate high enough returns for their banks, their pay should be cut, multiple hedge fund, mutual fund and pension fund investors told Reuters.
Some shareholders have taken dramatic steps.
Nelson Peltz's Trian Fund Management LP acquired a 5 percent stake in investment bank Lazard Ltd this year, then pushed management to slash compensation, a demand the bank is heeding. Lazard has one of Wall Street's highest compensation-to-revenues ratios, typically paying employees more than 60 percent of revenue.
Jefferies Inc shares have dropped nearly 12 percent since executives were grilled about compensation on an earnings call last month. Since 2009, the investment bank has spent a lot of money luring bankers and traders from larger rivals with big pay packages that are guaranteed for years, making it difficult for Jefferies to cut expenses. It paid out almost 60 percent of revenue to employees last quarter.
At Citigroup Inc, shareholders voted against CEO Vikram Pandit's pay package at an annual meeting in April. But the vote was nonbinding and his compensation did not change. Citigroup has been the only big bank to face such a rebuke under a new say-on-pay rule.
Some banks have conceded that times have changed. Deutsche Bank AG last month said it was cutting bonuses, axing jobs, and spending less of its revenue on pay.
"The payout ratio, it's got to go down," said the bank's co-Chief Executive Anshu Jain about the level of bonuses. "Employees must make their contribution."
(This story was corrected to fix spelling of names: Nelson Peltz's Trian Fund Management in paragraph 30 )