Not long after the U.S. Treasury Department’s pay czar ended his oversight of Citigroup’s compensation practices, the bank hired a new head of global energy investment banking. Citi, which nearly went under in 2008 and was partly owned by the U.S. government until last December, lured Stephen Trauber away from rival UBS. It dug deep into the kitty to get him. Trauber reportedly will be paid $9 million a year (all currency in U.S. dollars).
You are no doubt appalled. Yeah, me too, I guess. But moral outrage, unlike i-banking, is easy. Let’s consider a less demotic proposition: that Trauber’s compensation, and that of some of his peers, is perfectly rational. It just might be, if you believe in the Economic Theory of Superstars.
Three decades ago, University of Chicago economist Sherwin Rosen set out to solve the riddle of why some people are paid so much more than the rest of us. He looked at the industry with the most extreme inequalities: the entertainment business. There are millions of starving artists in the world, like the singer at your local pub who can barely make rent. Yet Lady Gaga made an estimated $62 million last year. How come?
In Rosen’s groundbreaking 1981 paper, “The economics of superstars,” he explained why Lady Gaga doesn’t have to be 5,000 times better than the local musician in order to earn 5,000 times more. He pointed to two factors: “imperfect substitution,” which is our willingness to pay a lot more for that which is only a bit better, and “joint consumption technologies,” which allow a popular musician’s work to be purchased simultaneously by millions. Either one can lead to high pay. Together, they spell superpay.
Imperfect substitution is easy to understand. “Lesser talent,” said Rosen, “is often a poor substitute for greater talent.” Three mediocre singers won’t satisfy an audience as much as one excellent singer. A major corporation facing a major lawsuit will likely hire the best lawyer; a lawyer who is 10% less competent can’t compensate by working 10% more, or charging 10% less. As a result, said Rosen, “the demand for the better sellers increases more than proportionately.”
Trauber is one of those better sellers. A classic i-banker, he helps energy companies do deals, especially mergers and acquisitions. He and his team at UBS have done 115 oil and gas deals over the past five years, worth $167 billion (according to Bloomberg). Other bankers brought in little or no business, and washed out of the profession. One of Trauber’s last big transactions was the $11-billion sale of Smith International Inc. to Schlumberger Ltd. His UBS team advised Smith and collected a fee of $29.3 million.
Did Smith get its money’s worth? The deal closed, and the company sold for a premium of 37.5% over its pre-deal share price, compared to an average premium of 26% in other recent oil and gas deals, according to Dealogic. The excess premium was worth about $1 billion to Smith shareholders. If Trauber was responsible for even a fraction of that—something that’s hard to prove, or disprove—he earned his fee.
Yet i-bankers like Trauber aren’t really full-fledged Rosen superstars. Unlike Lady Gaga and other star entertainers, Trauber does piecework. Each M&A is a one-off. Lady Gaga, in contrast, is software. She can earn a theoretically infinite amount of money from just one recording session: The resulting song can be purchased by millions of consumers worldwide. Or, as Rosen put it, in something close to English, “when the joint consumption technology and imperfect substitution features of preferences are combined, the possibility for talented persons to command both very large markets and very large incomes is apparent.”
Which financiers are superstars? Hedge fund managers. They’re pulling down Lady Gaga coin, and then some. They pool the money of many investors, because it’s not much more time-consuming to manage billions than millions: That’s joint consumption technology. And in a demonstration of imperfect substitution, they also charge much higher annual fees than mutual funds. The standard for hedge funds is “two and 20”—2% of assets under management, plus 20% of returns. Result: In 2009, the 25 highest-paid fund managers earned a total of $25.3 billion.
One mogul, James Simons of Renaissance Technologies, has made more than $1 billion a year for the last half-decade by managing a huge pool and pushing imperfect substitution to the max: Renaissance’s standard fee isn’t two and 20, but five and 44.
Do hedge fund managers deserve their paycheques? Do i-bankers? In a moral sense, surely not. They planted no crops, educated no children, built no homes and saved no lives. Then again, neither did Lady Gaga. And the free market assigns compensation not on moral merit, but on supply and demand. As long as there are chart-topping songs, there will be chart-topping bankers. Ye have the poor always with you, said Jesus. And the superstar rich, said Rosen.