Goldman Sachs Group Inc. partners Alison Mass and David Dase weren’t buying. The bankers stared skeptically at a glass of brownish liquid as a young man described a new technology for purifying even the filthiest water. The sample was safe to drink, he said, taking a sip.
More than 1,000 investment-banking colleagues, watching a video of the encounter at a daylong strategy session at the New York Hilton Midtown in March, erupted in laughter. The man with the purification pitch was an actor. Mass and Dase, who weren’t in on the joke, were doing their best to salvage a meeting that Goldman Sachs President Gary Cohn had asked each of them to take, Bloomberg Markets magazine reports in its June 2014 issue.
While the video was the latest episode in a series of hidden-camera pranks targeting partners, a broader message wasn’t hard to fathom: Goldman Sachs bankers have taken enough crap. Just a few years after the firm’s reputation was sullied by sales of shoddy, crisis-era mortgage bonds, including one that an executive at the company described in an e-mail as a “shitty deal,” the investment-banking unit is coming off one of its best years ever.
“There were concerns three years ago that clients were going to leave Goldman, but if you look since then, they’ve really been No. 1 in global M&A,” says David Konrad, Macquarie Group Ltd.’s head of U.S. bank research. “It’s been very impressive.”
Led by David M. Solomon, Richard J. Gnodde and John S. Weinberg, the investment-banking division last year generated the second-highest revenue and profit since the firm went public in 1999, trailing only 2007, when the volume of global mergers was almost twice as high.
The unit boosted revenue and market share in each of its three businesses: underwriting equity, advising on mergers and acquisitions and underwriting debt. Its share of fees from debt underwriting was the greatest since 1999, and it made about $2 billion from advisory work, 50 percent more than its closest competitor, JPMorgan Chase & Co. -- a $660 million gap, according to data compiled by Bloomberg.
The dominance was even more pronounced in the first quarter of 2014, when Goldman Sachs almost doubled the advisory revenue of every other bank and led in total investment-banking fees for the first time since the financial crisis.
The investment bankers are buoying Goldman Sachs’s results as revenue produced by traders has plunged. Chief Executive Officer Lloyd C. Blankfein, who rose through the trading business along with Cohn, is relying on Solomon, Gnodde and Weinberg to keep profitability ahead of peers, as it was last year. That will bolster his claim that his firm isn’t broken and doesn’t need a dramatic reshaping like those that transformed Morgan Stanley and UBS AG.
Blankfein, in his eighth year running the company that set Wall Street profit and pay records before the crisis, is facing questions about whether he can approach those heights again and boost shares that are off to their worst start of a year since 2008. He has said the business climate will rebound faster than anyone expects and that his investment bank is in a position to take advantage if he’s right.
“The franchise in banking has never been stronger,” Blankfein says. “The business we get in banking doesn’t just drive the investment-banking P&L. It drives the P&L of the firm. Because when you do these big transactions, they create financings, the financings create securities, the securities have to be sold in equities and fixed income, and portfolios have to be rearranged, which generates more trading.”
As the investment-banking division gains ground -- its profits trailed the trading unit’s last year by $1.4 billion, compared with a $17.5 billion spread in 2009 -- it’s also wading into businesses that have burned the firm before. Solomon, Gnodde and Weinberg are seeking to drive revenue by selling derivatives, turning customers into trading counterparties. That puts the bank’s own capital and reputation in jeopardy just a few years after Goldman Sachs was sued by regulators over the way it interacted with clients on complex deals.
A pickup in mergers and initial public offerings this year provides a chance to increase return on equity beyond last year’s 11 percent, which was down from a pre-crisis high of 33 percent. That still won’t be enough to make up for a $15 billion drop in trading profits in the past four years, says Michael Vogelzang, chief investment officer at Boston Advisors LLC, which manages $2.7 billion, including Goldman Sachs shares. The stock is down 12 percent this year, while the Standard & Poor’s 500 Financials Index is little changed.
“In order to do really well in a name like Goldman, you have to have the majority of the businesses powering ahead,” he says, listing bond dealing, commodities, high-frequency trading and the size of the firm’s balance sheet as pressing matters. “Right now, the business feels a lot weaker, because certainly the trading business is on the skids.”
The three men Blankfein is leaning on form a rare management configuration on Wall Street. Solomon, a close associate of the CEO’s, was brought in from Bear Stearns Cos. 15 years ago and rose through the financing group. Gnodde, a South African, expanded the firm’s business in Europe and Asia. Weinberg, also a vice chairman, is a son and grandson of men who ran the bank for more than half a century.
The co-heads have solidified the firm’s supremacy in leading equity offerings, such as last year’s $1.8 billion Twitter Inc. IPO, and advising on big mergers, including representing Vodafone Group Plc on the $130 billion sale of its stake in Verizon Wireless to Verizon Communications Inc. and General Electric Co. on its $16.7 billion sale of NBCUniversal LLC to Comcast Corp. They also have expanded in areas such as high-yield-bond underwriting, leveraged finance and risk-management solutions, largely derivatives and structured products to hedge against swings in prices and rates.
“We’ve figured out how to deliver a much broader array of products,” says Solomon, sitting in a sun-filled conference room overlooking the Hudson River on the 43rd floor of Goldman Sachs’s headquarters in lower Manhattan, his hands making cosine waves to describe M&A cycles. “We still have a great M&A franchise and a great equity underwriting franchise, but now we also have a great debt franchise.”
Solomon, 52, a double-black-diamond skier and a wine collector who earned the title of Mr. Gourmet 2010 from the Society of Bacchus America, has driven the expansion into debt financing. While the co-heads share responsibilities, Solomon is the primary leader of the day-to-day business, focused on efficiency and profit, according to colleagues. They say his name is on a short list of potential successors to Blankfein, the 59-year-old former commodities salesman, or to become a co-president if the firm decides to create such a position.
Gnodde, 54, concentrates on operations outside the U.S. The newest member of the trio, he became a co-head in 2011. A 6-foot-4-inch (1.9-meter) rugby fan, he spent almost a decade in Asia before moving to London as co-CEO of the firm’s international business.
He met with clients and regulators there to repair relationships amid questions about multiple roles Goldman Sachs played in such high-profile deals as the 2006 sale of BAA Plc, an operator of airports, including London’s Heathrow. The bank made an unsolicited and unsuccessful attempt to buy BAA less than two months after its merger bankers offered to help the company fend off a bid from Spain’s Grupo Ferrovial SA.
Weinberg, 57, is the guardian of the company’s culture. A Goldman Sachs lifer, he didn’t think he would follow in the footsteps of his grandfather Sidney, who ran the bank from the Great Depression until 1969, and his father, John L. Weinberg, a senior partner and chairman from 1976 to 1990. He says he changed his mind after a summer internship during business school. Now fiercely loyal to the firm -- he hasn’t sold any stock in his eight years as vice chairman, amassing equity worth $263 million as of April 21, according to company filings -- he maintains some of Goldman Sachs’s largest and most-enduring corporate relationships, including with GE and Ford Motor Co.
Some client relationships were tested after the financial crisis, when Blankfein and other Goldman Sachs executives were hauled before Congress to testify about allegedly misleading investors in the sale of collateralized debt obligations. The U.S. Securities and Exchange Commission accused the firm in 2010 of allowing hedge-fund manager John Paulson to help pick the underlying assets for a security that the bank sold to unwitting clients in 2007, even though it knew he was betting the CDO would fail. The company settled the case for $550 million without admitting or denying guilt.
The release in 2010 of two e-mails from 2007 prompted further questions about client relations. In one, Washington Mutual Inc.’s CEO compared getting advice from Goldman Sachs, which he ultimately hired, to “swimming with the sharks.” In the other, a Goldman Sachs trading executive described a mortgage security the firm sold as “one shitty deal.”
Most clients stood by the bank. Weinberg met with new accounts and old customers to deliver a simple message: Give the bank a chance to prove itself.
“I probably met with more clients over that two-year period than I’d ever done in my career,” he says, his round face, thick eyebrows and rimless glasses giving him an inquisitive look. “And I wouldn’t just meet with clients who liked us. The way I think about my role, I have to run to the trouble.”
The scars of the financial crisis are still visible, says Kathy Elsesser, co-head of the global consumer retail group.
“There’s still a measure of skepticism that exists toward Wall Street; that’s not going to change,” she says. “If there’s anything that changed post-crisis, I think more deeply, across the entire population of the division at all levels, there isn’t an assumption when you walk into any room that you’re welcome. And I think that’s actually hugely positive.”
Overcoming that skepticism may be easier with multiple leaders, a tradition at Goldman Sachs that allows them to work on deals at the same time they manage a business. The current configuration is the fourth triumvirate Weinberg has been part of during his almost 12 years at the helm of the unit.
“All of us are different in personality and background, and that adds to the strength,” Gnodde says. “If your co-heads are all identical, I don’t know what that would do for you.”
Elsesser, 47, a 23-year Goldman Sachs veteran, calls the culture “collaboratively competitive” and says it starts at the top. “David, Richard and Johnny all do have certain agendas that they think are important, that aren’t at odds with someone else’s agenda,” she says. “They just lean in certain ways. But they challenge each other.”
That they’re some of the highest-paid executives on Wall Street helps soothe any bruised egos. While Goldman doesn’t disclose Solomon and Gnodde’s compensation, Weinberg, one of 11 officers, was awarded more than $140 million in salary, bonus and long-term incentive pay during the past eight years.
The trio’s importance can be seen in the results: Last year, investment banking contributed 18 percent of the firm’s revenue, the highest portion since the financial crisis. Trading revenue has been in a steady decline since 2009, and McKinsey & Co. estimates it will remain stagnant for the next few years.
Without a large lending operation like JPMorgan’s or a brokerage like Morgan Stanley’s, Goldman Sachs’s best hope of continuing to beat competitors is to keep gaining share in investment banking as the global economy improves.
The co-heads say reported revenue at the investment bank understates its importance. The unit often generates the highest return on equity of any division, and some revenue it produces is reported in trading, more than $1 billion some years, they say. There are softer indicators of the division’s success: the number of partners -- about 140, more than in any other part of the bank -- and the recognition that comes with taking such companies as Twitter public.
“It’s a much more important business to the firm than the 15 percent to 20 percent of revenue it historically generates because it helps other parts of the business produce higher revenue,” says Devin Ryan, an analyst at JMP Group Inc. in New York. “It’s very important to trading, and it helps drive trading profits as well.”
When Goldman Sachs was a private partnership its investment bank focused on underwriting common stock and advising on mergers, acquisitions, divestitures and defense against hostile takeovers. In the past decade, armed with capital from its own IPO, it has expanded into debt and derivatives.
“It’s like we added a third leg to the stool and then a fourth leg,” Solomon says. “We had M&A and equity, and now we have debt underwriting and risk solutions. Four-legged stools are pretty solid.”
Solomon’s rise is in large part a tale of the ascendancy of debt underwriting. He was recruited to Goldman Sachs by Jon Winkelried, who became co-president before leaving in 2009, to build up a high-yield and leveraged-finance business. The offer came after he competed with and then worked alongside a Winkelried-led team to raise almost $1 billion of high-yield debt to help casino billionaire Sheldon Adelson build the Venetian resort in Las Vegas.
Solomon, who didn’t get an interview with Goldman Sachs after graduating from Hamilton College, quickly moved up to oversee all credit products at the fixed-income-trading unit, working under Blankfein and Winkelried. In 2002, with a push from then-CEO Hank Paulson, Goldman Sachs merged equity and debt underwriting into one group, naming Solomon, co-head of equity underwriting at the time, to help lead it.
Three years later, Solomon was leading the business alone when it was combined with the investment bank. Since then, it has increased lending, spurred by the growth of private-equity firms. Loans and lending commitments more than quintupled to $119.9 billion at the end of last year from $22.5 billion a decade earlier.
Once an afterthought housed in the trading unit, debt underwriting -- a risky part of the division because more of the firm’s own capital is on the line -- last year produced more revenue than advisory or equity underwriting for the first time as borrowers took advantage of record-low interest rates.
Private-equity firms offer access to hundreds of smaller companies in need of financing through just a few relationships, and no bank does more business with such clients than Goldman Sachs. It earned $2.7 billion in fees in the past three years from private-equity firms, including Blackstone Group LP and TPG Capital, according to New York research firm Freeman & Co.
That’s a group of clients other parts of Goldman Sachs often compete against and, on occasion, invest alongside, which brings its own risks. The firm was an investor and lender in the biggest buyout ever, the $48 billion 2007 acquisition of energy company TXU Corp., now known as Energy Future Holdings Corp., which filed for bankruptcy in April.
The expansion into debt underwriting has provided opportunities to profit from the firm’s risk appetite on big deals. Goldman Sachs made about $500 million arranging three bond sales in a year for Malaysia’s state investment fund, which amounted to 7.7 percent of the face value of the securities, more than five times the average fee for junk bonds, Bloomberg News reported last year.
Derivatives, the fourth leg of Solomon’s stool, generate the most controversy, even beyond the questions of suitability and transparency always present when dealing in the complex products that were at the heart of the financial crisis.
Some bankers who worked at Goldman Sachs and other Wall Street firms say their job is to remain a trusted adviser and that turning clients into counterparties by helping them to hedge risk erodes that relationship. Others, including the co-heads, say a bank can’t serve clients unless it can help with all of their potential needs.
The debate isn’t new or unique to Goldman Sachs. The co-heads of Morgan Stanley’s investment bank clashed over how hard to push risk-management products. Colm Kelleher, who came up through the underwriting and trading business and backed the expansion, won out, while merger banker Paul Taubman left the firm and now independently advises companies on deals.
At Goldman Sachs, executives have long held that the firm must manage risks and conflicts rather than avoid them. That philosophy has been embraced as the investment bank crafts derivatives deals for firms seeking to hedge against currency swings or loans to energy companies backed by oil reserves. The derivatives business, the fastest-growing segment of the division, provides more revenue some years than advisory work.
Even without such a push, Goldman Sachs bankers say, the long-term adviser model was threatened by commercial banks offering lower fees and cheap lending. It wasn’t easy to expand beyond the bank’s traditional areas of expertise, Solomon says.
“Some of this was really hard,” he says. “It was hard culturally, and a lot of people resisted. It required metrics we hadn’t used in the past, and people were resistant to that. But we figured it out.”
One of his goals since becoming co-head of the division has been to improve efficiency. That led to creating profit-and-loss statements for groups within the unit to increase accountability and relying on banker profiles that link individuals to executed deals. The segment’s profit margin was 42 percent last year, almost quadruple the 11 percent margin it posted in 2005.
Three former bankers who left the firm say the changes, particularly the more explicit tying of bankers to the annual revenue they generate, have eroded the culture of teamwork and long-term thinking that differentiated Goldman Sachs.
Solomon and other senior bankers disagree.
“I’m always amazed at the people who say this place has changed and it’s not like it used to be,” Solomon says. “Of course it’s different than it used to be. And by the way, it’s going to be different five years from now. What makes the firm great is that we change to respond to the world and to make sure we remain competitive, but our core cultural foundation remains the same.”
Goldman Sachs plans to do even more on the derivatives front. It’s urging bankers to advise companies on their risks and offer products to hedge them over time rather than just doing a one-time swap on a specific deal.
“Our bankers five years ago weren’t as risk-management literate,” says Gregg Lemkau, 45, the bank’s co-head of M&A and a former Dartmouth College soccer player. “When a banker recognizes that it’s a solution for our client to help them manage a risk, it’s a much easier thing to market.”
Executives also say the firm probably will increase its business in simple rate and currency swaps, where it previously charged more than competitors on many deals. New capital rules are forcing other banks to raise prices to where Goldman Sachs had set them, says Jim Esposito, head of financing for Europe. Those same rules are pushing some European banks to curtail high-yield lending, creating an opportunity for Goldman Sachs to expand bond underwriting in the region, he says.
Meanwhile, Goldman Sachs’s core investment-banking franchises are thriving. The firm earned more advisory fees than any other bank in each year since the financial crisis, and in 2013, it climbed back to the top spot in equity-underwriting revenue after falling to as low as fourth in 2011, according to data compiled by Bloomberg.
Even after burnishing its reputation, Goldman Sachs faces potential conflicts. The firm is committed to investing with its balance sheet, sometimes alongside and sometimes in competition with clients. While all banks have been forced by the Dodd-Frank Act’s Volcker Rule to scale back stakes in private-equity funds, the new regulation doesn’t restrict direct, long-term investments, an area in which Goldman Sachs is more active than other firms.
Bank executives point to the many occasions when customers have benefited from its ability to co-invest or take on a slug of debt. They also say they’re dealing only with sophisticated investors who know the game. Even if it would sometimes be easier to have a simpler business model, that’s not happening.
“Goldman Sachs wouldn’t be as good at everything it does if we weren’t in the businesses we’re in,” Solomon says.
For all that’s changed, Goldman Sachs bankers say the reasons for its leading market shares haven’t. The adviser on the most mergers has benefited from not undertaking any of its own, avoiding potential culture clashes. It also didn’t face the restructurings and large-scale job cuts that consumed many competitors.
“It’s a consistent, predictable place,” Gnodde says. “Externally, what we do and what’s going on in the world and where markets are and whether the cycle is up or down, things are changing all day long. But the internal environment in which we’re operating is very consistent.”
That stability and the cycle of top rankings leading to top compensation have created a bench of experienced bankers: Investment-banking partners have an average tenure of 18 years.
The experience was evident at the New York Hilton in March, at the third of three strategy sessions the co-heads held for bankers that month, the one where the prank video was shown. Much of the discussion centered on how to deliver insights to clients when so much information is available at the push of a button. Some of the bankers started their careers helping clients by copying historical stock prices out of library books. George Lee, the division’s chief information officer, urged bankers at the hotel to look beyond the technology industry to ways in which new software can transform other companies.
“My call to arms to the bankers is that these are the disruptive trends that are impacting all your clients, no matter what industry group you sit in,” Lee says.
His three bosses are counting on profiting from those disruptive trends, not succumbing to them. To do that, they’ll need to solidify gains they’ve made in debt underwriting and derivatives while avoiding risks as they wait for the old standbys of M&A and equity underwriting to pick up. The first quarter was promising, as global deals jumped 29 percent and IPOs almost doubled. Even so, the past few years have taught Goldman Sachs that staying on top isn’t a given.
“We had a very strong year in investment banking last year,” says Lemkau, the M&A co-head. “The inherent challenge in our business is that you get to celebrate that for about a minute and then you start right back at zero, wondering, ‘How the heck do we do that again?’”