Wall Street Needs More Skin in the Game - Partnerships were one way of aligning the interests of money managers and investors

Wall Street Needs More Skin in the Game. By PETER WEINBERG
Partnerships were one way of aligning the interests of money managers and investors.
WSJ, Oct 01, 2009

The debate about bonuses and Wall Street pay rages on, and for good reason. Compensation is a complex issue that is essential to managing systemic risk. The asymmetrical structure of pay packages—a "heads I win, tails I win less" approach—was wrong. But overly prescriptive government intervention to solve the problem poses its own challenges and might not help us get the incentives right, either. So what can we do?

Prior to 1970, the New York Stock Exchange had a rule prohibiting brokerage firms from being publicly traded companies. There was a genius to this rule. It aligned the interest of the partners of old Wall Street with that of the securities markets themselves. Today, all the large firms are publicly traded. This has given these firms needed permanent capital, but has also served to distort incentives.

We can't snap our fingers and turn public financial institutions back into private partnerships, but we can realign interests by restructuring executive pay.

The only private partnership I can talk about authoritatively is the one in which I was a partner from 1992 to 1999, when the firm went public: Goldman Sachs. Partners there owned the equity of the firm. When elected a partner, you were required to make a cash investment into the firm that was large enough to be material to your net worth. Each partner had a percentage ownership of the earnings every year, but the earnings would remain in the firm. A partner's annual cash compensation amounted only to a small salary and a modest cash return on his or her capital account. A partner was not allowed to withdraw any capital from the firm until retirement, at which time typically 75%-80% of one's net worth was still in the firm. Even then, a retired ("limited") partner could only withdraw his or her capital over a three-year period. Finally, and perhaps most importantly, all partners had personal liability for the exposure of the firm, right down to their homes and cars.

The focus on risk was intense, and wealth creation was more like a career bonus rather than a series of annual bonuses. Other private Wall Street firms had similar pay structures.

Here are two ideas that could help us replicate the discipline instilled by the old pay packages of private partnerships:

First, institute what is called a "10/20/30/40" plan. Under such a plan, junior employees would receive regular competitive pay, but senior employees would be paid as follows: 10% of annual compensation in cash now; 20% of annual compensation in cash later; 30% of annual compensation in stock now (with a required holding period); and 40% of annual compensation in stock later.

"Now" means paid immediately at the end of a compensation period. "Later" means after a period during which a cycle can be evaluated. During that evaluation, the firm's compensation committee would perform a "look back" in which it can adjust the award or leave it at a predetermined level. This function should not be used to micromanage past bonuses but simply to make sure success in a specific year was still viewed to be success in hindsight.

Second, create a "Skin in the Game" plan. When an executive or a senior employee manages a trading or asset-management business which can be measured by its own profit and loss statement, those executives or employees should invest a significant amount of their own capital in that business or fund. The compensation committee of the company's board would determine who qualifies for this plan and the definition of a material commitment.

What would these two plans achieve? The first would back-end wealth creation to ensure that through-the-cycle compensation was linked to through-the-cycle value creation. The second would increase stock ownership and personal financial commitment to better align the pocketbooks of Wall Street with the pocketbooks of financial markets and our economy.

Beyond more prudent capital requirements, regulators and politicians likely won't gain much if they are too prescriptive. Writing new rules could spark a cat-and-mouse game that would not benefit anyone. If the private sector can align its incentives and risk management with the interests of the global marketplace, we will all be pulling in the same direction. That has worked before.

Mr. Weinberg is a founding partner of Perella Weinberg Partners, an advisory and asset-management firm based in New York and London.