How Analysts' Pay Packets Got So Fat

It has been a frustrating 15 months for Daniel Peris, an analyst at Argus Research Corp. in New York. His efforts to cover AOL Time Warner Inc. (AOL ) have hit one brick wall after another. Unlike analysts at big-name investment banks, Peris was one of the few bearish voices on the stock for much of last year. He has been yelled at by AOL's investor-relations reps for spouting off in the press, he has been granted scant contact with senior management, and his calls seeking basic information are returned by low-level employees--often weeks later. "I'm sitting here in obscurity," he says. His consolation: Clients who followed his advice did better than those who followed more bullish calls.

What sets Peris apart from peers is that he works for an independent research firm that doesn't trade or do investment banking. And that means he has also missed out on the big bucks raked in by most other high-tech analysts. While AOL admits it gives priority to bigger firms, the company says it returns all analysts' calls, regardless of banking ties. Since the mid-'90s, those ties earned many Wall Street analysts fat paychecks by helping investment bankers win lucrative business, such as underwriting or merger deals. "The analysts who brought in deals drove huge changes in research compensation," says Joan Zimmerman, partner at New York's Rhodes Associates, an executive search firm.

Salaries for Wall Street's researchers skyrocketed with the surging stock market. Fueled primarily by the tech and initial-public-offering boom, equity analysts' pay jumped fourfold in a decade--and with it, all pretense that research was being written to benefit the investor. Because analysts' pay is tied so closely to the banking business, the Chinese Walls intended to keep them apart crumbled. "Technology drove a higher percentage of investment banking revenues, and [pay packages] started going up at a much faster pace as well," says C. David Bushley, a financial-services consultant at Buck Consultants Inc.

Senior analysts had no trouble pulling in a million in 2000, the blowout year. Those with a decade of experience tripled that by contributing heavily to the deal flow. A few hotshots at each firm earned anywhere from $12 million to $24 million. Even neophytes easily earned six-figure paychecks.

So how exactly are Wall Street analysts compensated? Increasingly, by yearend bonuses. A fixed portion of income is related strictly to old-school research duties, but the more that analysts are in fee-generating businesses, the higher their take-home pay. "The sales part of analysts' jobs became huge," says compensation consultant Alan Johnson of Johnson Associates Inc.

Wall Street denies there's any direct link between pay and deals. "There isn't anything you can track in a statistical, quantifiable way," says Lehman Brothers Inc. (LEH ) spokesman William Ahearn. Goldman, Sachs & Co. (GS ) and Merrill Lynch & Co. (MER ) also insist they have never paid analysts directly for generating investment banking business. "Their compensation is based on the overall profitability of the firm," says Merrill spokeswoman Susan McCabe. "They've never done a deal and gotten a check."

True, it's a bit more subtle than that. New York State Attorney General Eliot Spitzer found that in the fall of 2000, Merrill Lynch asked its analysts to tally up all the investment banking deals on which they had helped. In an Oct. 13 memo from Merrill's Equity Research Director Deepak Raj, the company was "once again surveying...contributions to investment banking during the year." Superstar Internet Analyst Henry Blodget replied, listing his team's involvement in generating about $115 million in revenue from 52 deals, including an IPO pitch for Blodget's compensation jumped from $3 million in 1999 to $12 million in 2001. He resigned in December, citing a "lifestyle change."

Attorney Jacob J. Zamansky, who has already sued two investment banks on behalf of investors, says he has seen employment contracts for analysts that promised specific compensation related to the volume of investment banking deals they pulled in. Specifically, he says, he saw confidential contracts that promised a $2 million bonus to analysts if they brought in $30 million in banking fees, and others that promised 3% to 7% of investment banking revenue. Banks such as Credit Suisse First Boston, PaineWebber, before merging with UBS, and Donaldson, Lufkin & Jenrette have paid analysts up to 2% of the banking fees generated at the peak of the market. The idea was an incentive to produce sales and to lure talent from the competition.

The banks insist that analysts' pay is based on complex formulas. Part hinges on the accuracy of analysts' stock recommendations and earnings estimates, part depends on "votes" about their value from investors. Sometimes they'll earn a premium if the sector they cover is viewed as key to the firm, or if they cover the largest industries. Analysts are graded for how much access they have to top brass at companies, and for getting inside scoops.

It's very different from the old days when analysts' compensation was linked to the trading commissions their stock picks generated. That world changed for good when the fixed-commission system was swept away in 1975, forcing banks to find other ways of bankrolling expensive research staffs. Now, compensation experts are scratching their heads over how regulators could sever the ties between deals and analysts' pay. It's not as if the two sides of the bank would stop talking to each other, points out Michael I. Franzino, senior practice managing partner at headhunters Heidrick & Struggles: "Is the head of investment banking going to go over to equities research and say, `We need a little help here'? Yes."

Franzino may be right. Research departments once generated enough money to pay for their own bonuses. They earned it from investors willing to pay for objective info. Now that the advice is "free," investors are getting exactly what they pay for.

By Mara Der Hovanesian, with Louis Lavelle and Tom Lowry in New York

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