The Business Of

Banking | Goldman Sachs | How Do They Make Money?

Morning All!

So yesterday, we started our new series on The Business Of Banking and we briefly touched on what Goldman Sachs does in their investment banking and market making segments. Today, we’re going deeper and asking the question - how does Goldman Sachs actually make money from these services?

And to help us answer that question, let’s first take a look at where Goldman’s revenue comes from…

As we can see, over the last 5 years, Goldman’s revenues have been dominated by three main areas; (i) market making, (ii) investment banking and (iii) investment management. And market making is actually first! Which absolutely shocked me - I thought investment banking would’ve been the largest revenue contributor.

But anyway, let’s kick off with investment banking because that’s what they’re most known for. Yesterday, we said investment banking was made up of 3 main divisions - M&A, ECM and DCM. So, without further ado, let’s dive into M&A…! Oh, a heads up - today’s newsletter is a little longer… but I hope worth it!

Investment Banking - M&A: The GOAT Of Mergers

Okay, so yesterday we highlighted one example where Goldman Sachs advised Microsoft on their $69bn acquisition of Activision Blizzard. But what do Goldman’s M&A team actually advise Microsoft on? Well, the main things the M&A team will do are valuation, deal structuring, negotiation and due diligence. Which I know, is all finance jargon - so let’s try and understand those terms!

So, valuation would be working out WHAT to pay for that target business. And deal structuring would be figuring out HOW to pay for that business. In our example, Goldman Sach’s M&A team would have helped Microsoft figure out what to pay ($69bn) and how to pay for it (all in cash). Throughout the acquisition process, there will be loads of terms and conditions that need to be agreed on and so Goldman’s bankers will be helping with negotiating those too. And then in terms of due diligence, this is when Goldman’s team will check if there are any major legal issues at Activision which could hurt Microsoft post-acquisition.

Alrighty, so we know what Goldman Sach’s M&A team are doing. But here’s a question - how do Goldman actually make money themselves from all of this? Well, the answer is fees. To help us understand, let’s look at our example.

Microsoft’s acquisition of Activision was a $69bn acquisition. How much will Goldman Sachs have charged for their help on this deal? Well, we don’t know the exact figure for this precise deal. But on average, in 2022, Goldman charged an advisory fee of 0.35% of every deal. Now, I know 0.35% looks tiny. But what’s 0.35% of $69bn? $242m! Which isn’t too bad, considering Goldman do multiple acquisitions a year! The chart below shows us that the total value of completed M&A deals Goldman advised on was ~$1.3 trillion in 2022.

And so what’s Goldman’s revenue from M&A advisory in 2022? 0.35% (advisory fee) x $1.3 trillion (total value of deals advised on) = $4.7 billion! Incredible! But the question I have is – how does Goldman Sachs rank vs other banks in their M&A advisory offerings?

Well, the answer is pretty darn well! The chart below shows us that Goldman has hardly left the number 1 position over the last decade. With Morgan Stanley briefly taking the #1 spot only in 2016.

However, whilst the chart makes 2016 look like a one-off… we may see Goldman Sachs lose their crown again this year! For the first half of 2023, the investment bank that advised on the highest value of deals was JP Morgan, with Goldman coming in second place!

Investment Banking - ECM: Where Did All The IPOs Go?

Okay, so that’s M&A. Now, let’s turn our attention to ECM. Yesterday, we highlighted the example of Arm’s IPO – where Goldman was the underwriter for the deal. But what does being the underwriter really mean? And what does Goldman’s ECM team actually do when it comes to helping Arm IPO?

Well, first, let’s remember that Arm are doing this IPO to raise cash, by selling shares. And it’s Goldman’s job to help them sell those shares! So Goldman will do several marketing events including roadshows, to present the investment opportunity in Arm to asset management companies, hedge funds and other potential buyers of the IPO shares. Once Goldman hears feedback from the events and gets an idea for the demand in Arm’s shares, they can then start determining the ‘correct’ price for the IPO shares. If there’s high demand for a company’s shares, the investment bank can price the IPO shares at a pretty high valuation… which is what happened with Arm!

The third main thing that Goldman’s ECM team will do in IPOs is underwriting. Now, what’s underwriting all about? Well, underwriting is all about taking risk away from the client. When a company IPOs, they’re selling shares in their company, but there’s a risk that they may not find investors to buy all the shares they’re offering. This is where investment banks step in and heroically say ‘Hey, we’ll buy the shares from you, so you get your cash. And then we’ll be responsible for allocating those shares to investors’.

So, ECM teams tend to take on more risk than M&A teams. And this higher risk shows up in the fees they charge their customers. We saw in the earlier section that Goldman’s M&A unit charges only 0.35%/deal on average. But the ECM division charges nearly 8x as much, with 2022’s average fee rate at 2.6%! Let’s focus on the Arm IPO which raised $4.9bn for the company. What’s 2.6% of $4.9bn? $123m – not too shabby! However, it’s not always rainbows and good times. Because as we can see in the chart below, ECM revenues really struggled in 2022… like, really struggled!

And why was that? Well, because the IPO market was ice cold. With interest rates on the rise and stock markets uncertain (well unless your name is Nvidia!), lots of companies decided not to IPO in 2022. The amount of equity offerings fell to just $33bn, a huge drop from $140bn in 2021. And the average fee rate also fell from 3.6% in 2021 to 2.6% in 2022.

However, whilst Goldman felt the effects last year, they weren’t the only ones. As we can see from the chart below, Goldman was still #2 when it comes to the value of the ECM deals they assisted on.

I should add that whilst IPOs are a big part of ECM, the other major part is follow ons. Now, we don’t have time to really dive into follow ons, but for those interested, I’d recommend checking out this article which is fairly simple to follow!

Investment Banking - DCM: Like ECM, But Cheaper!

Okay, so the last part of the Investment Banking division. We’re on to Debt Capital Markets (DCM). And yesterday, we highlighted the example of Amgen raising a monster debt offering of $24 billion. But again, let’s ask ourselves, what do investment banks like Goldman really do in these situations?

Well, this section’s going to be a bit shorter because it’s very similar to what Goldman does with ECM! They do roadshows and marketing events to get potential investors interested in buying the debt. They then price Amgen’s debt based on the kind of demand they’re seeing from investors. And then finally, they’ll underwrite the debt offering. Taking on the risk from their client - the company issuing the debt.

However, there is one major difference between the DCM and ECM divisions. And that’s to do with the fees they charge. Despite doing very similar functions, Goldman charged only 0.81% for their DCM services. But as we saw earlier, they charged 2.6% for the ECM services. So what’s going on here? Why is the fee rate much lower in the DCM market?

Well, there’s 2 main reasons. One, there are often more debt offerings than equity offerings in a year, and when there’s higher supply of something (debt offerings) in a market, usually the price (fee rate) will come down. And the second reason is that debt offerings require a lot less time from investment banks. These offerings may last days rather than the months an IPO offering process could take.

As we can see from the chart above, DCM revenues didn’t escape the tougher macro conditions in 2022. With revenues falling from $3.5bn in 2021 to $1.8bn in 2022.

And similar to what we’ve seen earlier, the chart below shows us that the reason behind this fall in revenues was due to (i) a falling fee rate and (ii) a falling value of debt offerings that they helped on.

So, how do Goldman rank vs competitors when it comes to debt capital markets? Well, would you believe it, Goldman Sachs aren’t the kings of this division! As we can see below, JP Morgan sit on top of the tree and Goldman had to make do with 4th in 2022. Not even in the medals!

Market Making: It’s All About The Spread

Alrighty, so we’ve had a pretty deep dive into investment banking. But let’s now talk about Goldman’s other main division - their biggest in terms of revenue - market making. We said yesterday that one of the main functions of market makers is to provide liquidity and make trading easier for investors. Like when Michael Burry (in the Big Short) wanted to buy credit default swaps in 2008, Goldman Sachs basically created that market for him which allowed him to trade and make money.

But for those of us who aren’t trading sums like Michael Burry, let’s make this a bit more practical for our circumstances! What happens when a retail investor like us places a trade on Hargreaves Lansdown (HL) or another trading app? Does HL use market makers? And the answer is yes! Let’s say I want to buy £1,000 worth of Tesla shares. When I click BUY on my HL app, HL will almost instantly ask ~30 market makers for their prices - the price they’re willing to sell Tesla shares at. And HL will then give me the best price (lowest price) for those Tesla shares.

Hargreaves is happy because they’re able to deliver me the shares I wanted. I’m happy because I got the lowest price for those Tesla shares. And the market maker is happy because… we’ll get there in a moment! Now, a company like Goldman Sachs focuses less on individuals like me trading small amounts. And focuses much more on larger institutions trading millions.

So, let’s say a big fund at Ninety One thinks Tesla shares are going to go down and wants to sell the shares. Who can they dump their shares on? The market maker – Goldman! But hold on, if these smart investors at Ninety One think the shares are going down, and then Goldman buys the shares, surely Goldman now has the risk, right? Because the Tesla shares may go down and Goldman loses money. So, the question is – why on Earth are Goldman buying the Tesla shares from Ninety One? Is it because they’re good Samaritans who just want to make trading easier for investors? Obviously not! The reason is because Goldman are hoping to make a spread on these trades.

Okay, so what is a spread? Well, the spread is the difference between the price at which Goldman will buy the shares and the price at which they’ll sell. The graphic above helps us understand. For Tesla’s shares, that are quoted at ~$260. Goldman may say to Ninety One, okay, we’ll buy the shares from you at $259.98. But then Goldman will look to sell those shares as quickly as possible (in a matter of milliseconds) to another party (e.g. Schroders) at a slightly higher price (e.g. $260.02).

And this is how market makers make money! Now, making revenue of $0.04 on a trade may seem like nothing. But remember, that’s $0.04 on every Tesla share bought and sold. How many Tesla shares are traded on average in a single day? 115 million! Now, Goldman won’t be responsible for most of those trades. There’s other huge market makers like Citadel, Optiver and Jane Street. But as the chart below shows, Goldman’s market making division doesn’t do too badly…

… it brings in $18.6 billion in revenue! Now, that $18.6 billion is made up of billions of trades. And the way you can simply think about Goldman’s market making revenues is ‘total number of trades x average spread’. It’s a little bit like Netflix’s revenues - ‘total number of subscribers x average subscription price’. Or Airbnb’s revenues - ‘total booking value x take rate’. Simple!

A Strong, But Cyclical Ride

Okay, so let’s wrap up. We’ve had the time to look at Goldman’s two biggest revenue generating segments - investment banking and market making. But we didn’t even get a chance to touch on investment management and net interest income! But not to worry, investment management, we’ve covered previously on TBO with The Business Of Ninety One - feel free to check that out. And net interest income, we’ll cover next week on The Business Of Barclays!

In the chart below, we can see how Goldman’s total revenues have progressed over the last two decades. We can see that in some years, revenue growth is up above 20%. But in plenty of years, revenue growth is negative. Why is this? Well, the reason is because Goldman Sachs is in a very cyclical business.

As we said earlier, investment banking revenues are very dependent on the economic environment. When things are uncertain, companies are less likely to IPO or do M&A and hence there’s less fees for Goldman and other investment banks. And even with marketing making, an uncertain economy may lead to more cautious investors. Less trades being executed. And hence less revenue for market makers!

Now, this cyclical element isn’t ideal for any business, and Goldman is no different. In recent years, the bank has wanted to move into more stable business lines. And as we’ll see on Thursday, this is something they did with their retail banking venture, Marcus… with limited success!

24th Oct 2023

Nigel Jacob CFA