The key to understanding investment banking fees lies in the engagement letter signed between the investment bank and the client company. As detailed in the Wall Street Journal article, the engagement letter typically includes conditions that the client will hire the investment bank for future transactions and pay fees based on deal value. For cryptocurrency startup Circle, signing an engagement letter with boutique bank FT Partners entitled the bank to an estimated $800 million fee after Circle’s valuation doubled. The fee dispute highlights how engagement letters can result in advisory fees far beyond norms. This article will analyze how engagement letters shape investment banking compensation.
Engagement letter terms empower investment banks to claim higher fees
The Circle case demonstrates how engagement letters allow investment banks like FT Partners to secure uncapped fees. By including clauses that fees will increase with transaction value and that the bank has a right to future deals, FT Partners positioned itself to earn over 5 times the typical M&A fee. The open-ended nature of such terms facilitates disproportionate paydays when deal valuations rise. Yet clients agree because they are eager to close time-sensitive transactions or lack sophistication to negotiate engagement letters.
Percent-of-proceeds fees reward investment banks for increasing valuations
Another key provision benefiting investment banks is basing fees on a percentage of transaction value instead of fixed dollar amounts. This gives banks an incentive to increase valuations to earn higher payouts. In Circle’s case, FT Partners was contractually entitled to 9% of the purchase price. So when Circle’s value doubled from $4.5 billion to $9 billion, so did FT’s estimated $400 million fee. Percentage fees thus magnify banks’ upside while capping client risk, contributing to some staggering advisory fees.
Engagement letters establish investment banking rights upfront
By signing broad engagement letters, clients also effectively pre-commit to using the same bank for potentially higher-value future deals. So winning an early mandate via an engagement letter allows banks to locked in roles advising on later, larger transactions. Had Circle not disputed the terms, FT Partners would have advisory rights over any future Circle transactions. Locking in future roles lets investment banks build relationships and accumulate fees.
Renegotiating investment banking engagement letters is challenging
For clients like Circle realizing that they face exorbitant fees down the line, challenging engagement letter terms is an uphill battle. Investment banks craft agreements that courts often uphold as binding contracts even if fees appear excessive. And clients rely on banks to execute time-sensitive deals, limiting their leverage. This makes trying to change terms mid-stream difficult despite surprising fee totals. Hence for clients, understanding engagement letter implications at signing is crucial.
In summary, investment banking engagement letters contain value-based fees and advisory rights over future transactions that empower banks like FT Partners to claim extraordinary payouts. For clients, engagement letter terms that seem harmless initially can result in disproportionate fees that are tough to dispute later absent renegotiation at signing.