Inside The Money Machine
lt would be a "match made in heaven," declared Travelers Group Chief Executive Sanford I. Weill. The genial king of Wall Street takeovers was not talking about Salomon Inc., the firm Travelers agreed to buy in mid-September, but Goldman, Sachs & Co. Several months before the Salomon deal, Weill had met with Jon S. Corzine, Goldman's low-key chief executive, about a possible buyout of Goldman. To Weill, Goldman was the best investment bank on Wall Street, so why not start at the top? For half an hour at Weill's lower Manhattan office, Corzine heard Weill out over coffee. Then, Corzine politely told Weill that Goldman was doing just fine on its own, thank you.
Spectacular is more like it. During the week of Dec. 15, Goldman is expected to report more than $3 billion in pretax profits for the 12 months ending Nov. 30, an all-time record. In mergers and acquisitions, the Street's most prestigious business, Goldman is No.1 in the world by a significant margin, according to Securities Data Co. As an investor, Goldman has scored four home runs. It took public or sold for handsome profits pieces of its stakes in AMF Bowling, the largest bowling-alley owner; Cadillac Fairview, a Canadian real estate giant; Westin Hotels & Resorts; and Polo/Ralph Lauren. In an interview in his office at the firm's unpretentious lower Manhattan headquarters, Corzine says: "I couldn't be happier." Not surprisingly, Goldman partners will see their capital accounts increase this year by an estimated $3 million to $25 million.
Much of the credit for Goldman's stellar results goes to this year's bull market. But Corzine deserves kudos as well for getting the Wall Street institution founded by Marcus Goldman in 1869 back on track. Corzine, 50, took the helm in September, 1994, when Goldman had been derailed by huge trading losses and bad management decisions. Corzine and Goldman President Henry M. Paulson Jr. quickly refocused the firm on client relationships, installed risk controls, and tightened the management structure.
But beneath Goldman's success lies a festering issue that could jeopardize both its independence and its future: the firm's vaunted but anachronistic private partnership structure, which is both a blessing and a curse. It's the source of Goldman's phenomenal success. Yet it also puts the firm at a competitive disadvantage because of its lack of access to public financing. That problem is being highlighted by the sweeping industrywide consolidation in financial services--most recently, the Dec. 8 merger of Union Bank of Switzerland and Swiss Bank Corp. The combined bank will have $26 billion in equity (table, page 90).
Goldman, by contrast, has only $6 billion in equity at yearend. Archrival Morgan Stanley, Dean Witter, Discover & Co. has $12 billion in permanent capital and can use its stock to make acquisitions. "Goldman's unique capital structure means it is better equipped than its peers to benefit from business opportunities," says Les Muranyi at Moody's Investors Services. "However, it could be a hindrance in buying or merging with a larger entity."
Another concern is whether Goldman's capital structure is strong enough to weather a prolonged market downturn. Trading losses or legal settlements come directly out of the partners' pockets. If Merrill Lynch & Co., for example, took a big hit, its stock price would plummet, but its capital would not be affected. "Goldman's capital structure is inappropriate. You have to have permanent equity," says one competitor. "Goldman would never allow a client to have that capital structure."
The firm got a frightening taste of its own handiwork in 1994. Some 36 partners fled, including the firm's leader, Stephen Friedman, taking a sizable chunk of Goldman's capital with them. "When the animals are well-fed, the jungle is quiet," says one leading M&A adviser. But "there will be a time when brokerages have a bad quarter. Then, they will say: `Why should we bear all the risk? Why not let the public?"'
SPLIT SENTIMENT? The public ownership issue, which has been considered regularly since 1969, has caused a serious split within the partnership. Competitors say older partners favor going public, largely because they could cash out to a windfall. Younger partners oppose the move, since they own fewer shares in the firm and thus have less to gain. When the issue was last on the table, in January, 1996, competitors say Corzine and most of the six-man executive committee favored public ownership but were held hostage by the younger partners.
Whatever his private view, Corzine says the issue was never put to a vote. He says the overwhelming sentiment at the firm is to remain private and that the issue won't be on the agenda in 1998. Goldman is far better off private, Corzine says. It has the management flexibility that comes with not answering to public shareholders or worrying about quarterly earnings reports. It also allows Goldman to attract and retain the best people, he says. This gives the firm a lower turnover rate, institutional stability, and an aggressive, "we're going to win," team-oriented culture. "We have something unique, and it's a competitive weapon," says Paulson.
Corzine and Paulson insist Goldman doesn't have to get bigger simply because everyone else is. The firm doesn't need a retail broker or a credit-card company, they say. It wants to grow in asset management but believes it can build a stronger presence through internal growth, not large acquisitions. Further, Corzine believes Goldman can come up with creative financial solutions to do whatever it wants. "I find it a bunch of malarkey that we couldn't make an acquisition," he says. "We can figure out a lot of ways to do a lot of different things if we so choose." Adds executive committee member John A. Thain: "Size alone is not a competitive advantage." Thain and John L. Thornton are expected to be Goldman's next co-chief executives.
Goldman has already strengthened its capital structure. In 1995, new restrictions were adopted that require retiring managing directors, as they're now called, to leave their capital with the firm longer. "If we thought we couldn't withstand a cyclic downturn at least as well as our public competitors, we'd be public," says Paulson. "This isn't the 11th Commandment around here: `Thou shalt be private."'
STAND AND DELIVER. One reason the partnership issue looms so prominently is that it is integrally connected to how Goldman makes so much money. Simply put, the firm's 190 partners, as owners, have their own money on the line. Unlike virtually all top execs of public companies, Goldman partners have 80% or more of their assets tied up in the firm. This makes for a disciplined, intense, profit-oriented organization. "Everything all of us have worked for all of our lives is in this place," says Robert J. Katz, Goldman's general counsel.
Michael P. Mortara, co-head of fixed income, has a vivid recollection of his first monthly partnership meeting after he joined in 1987 from Salomon Brothers. John Weinberg, then Goldman's co-chief, called on the partner with the best results and the one with the worst. Mortara recalls the partner in risk arbitrage getting up in front of the group to explain why he had lost $20 million that month. "Weinberg felt that the people who owned the firm deserved an explanation of how the firm was doing," says Mortara.
This owner mentality goes beyond the partners. It infuses the entire firm because the thousands of nonpartners are motivated by the hope of becoming partners. That, in turn, binds the firm together; everyone knows they can each make the most money if they work as a team. "They are clearly the most closely knit tribe on Wall Street," says one consultant.
Right now, Goldman is expanding rapidly, especially overseas. "Every market they enter, they dominate, if they decide to dominate," says one M&A adviser. Becoming a regional powerhouse in Asia is another goal. "We did not come here to finish second," says Philip D. Murphy, president, Goldman Sachs Asia.
Goldman's single most profitable business in 1997 is the mergers-and-acquisitions division. Its success is a testament to the firm's internal cohesiveness. Instead of fighting about who should carve up a particular client fee, bankers and traders and analysts share information and mobilize the global resources of the organization. "We work with each other better around the world, across borders, with research, with different divisions," says Goldman Managing Director Peter Weinberg, John Weinberg's nephew. "One of the reasons we do it is that this is an economic partnership."
Take Imperial Chemical Industries PLC, the big British chemical company. When Charles Miller Smith took over as chief executive in 1995, he wanted to redirect the company from its basic chemicals operations into higher-margin businesses that would still make use of ICI's existing sales force. Goldman and McKinsey & Co. identified Unilever PLC's specialty-chemical business as a target. In May, 1997, when Unilever decided to sell the business, ICI had only seven days to come up with the $8 billion price. That's huge for ICI, since its market capitalization is just $8.4 billion. So, together with SBC Warburg and HSBC Holdings, Goldman put its own balance sheet on the line with an $8 billion bridge loan. Goldman later led a $1.25 billion bond and $8.5 billion bank refinancing for ICI, two of Britain's largest transactions ever. Then, Goldman shored up ICI's finances by selling off two basic chemical businesses for more than $5 billion.
To do this complex deal, Goldman fielded three partners--investment banker Thornton, chemical industry banker Howard Schiller, and, on the equity trading side, Michael Evans--plus many teams to handle various aspects of the transactions. "Goldman was at the heart of our whole thinking and delivery process," says Miller. "We could not have made the changes we did without an enormous amount of assistance. They provided it."
Collaboration is also key to Goldman's equity and fixed-income divisions, the firm's next-most-profitable businesses. Last spring, in a deal that few if any other firms could have managed, Goldman completed a $2 billion block of British Petroleum Co. stock in 12 hours, one of the largest block trades ever. After the close of business in London on May 14, Goldman got a call from advisers to the Kuwait Investment Authority asking for a bid. Goldman had pursued the deal for several years, but only had an hour to decide if it wanted to risk $2 billion to bid for the stock. An hour and a half later, Goldman bought the shares. Then, the firm mobilized hundreds of professionals to sell them. Before the London markets opened the next morning, the stock was sold to 500 institutional and individual investors--and Goldman pocketed $15 million.
Another very profitable business for Goldman is principal investing, which it does on a far bigger scale, especially overseas, than most competitors. It has invested $4 billion for clients in companies, including $1 billion of its own money. The firm has investments in 92 companies, about half in the U.S. and a quarter each in Europe and Asia. It has stakes in Executive Jet, Rollerblade, and Kinko's. Goldman earns about 30% annual returns on its own money, with an overhead of just 50 employees worldwide. Besides management fees on $3 billion, the 92 companies collectively are Goldman's single biggest client, since their transactions generate banking and underwriting fees.
One home run was Polo. Ralph Lauren had been a client since the late 1980s, when he was introduced to Robert E. Rubin, then co-head of Goldman and now Treasury Secretary. Rubin became Lauren's investment banker. In 1994, when Polo's business was soft, Goldman invested $135 million for 28% of the company. This year, Goldman underwrote Polo's public offering. All told, Goldman stands to clear $600 million.
LANDED GENTRY. Goldman has also made a lot of money by getting into the booming real estate markets early. Since the early 1990s, it has become one of the largest and most aggressive investors in real estate in the world. Of the $5.5 billion it has invested for clients in its Whitehall and other real estate funds, it has about $1 billion of its own money at stake. After a nasty but successful fight with ex-client Samuel Zell, Whitehall gained a 50% stake in Rockefeller Center. In France, Whitehall has bought more than $1 billion in property assets from French banks, making it by far the biggest buyer of French bank properties.
But becoming such a big principal investor is a risky business. First, there is a greater risk of losing money. But the bigger risk is hurting its reputation as a firm whose first business principle is: "Our client's interests always come first." In several cases in the early 1990s, Goldman got burned when it made investments at odds with the interests of its clients. Today, the firm says it has a very active "conflict management system" and that it regularly walks away from deals that will harm a client. But some clients discern a shift away from serving customers toward serving Goldman. "They are still the preeminent firm. But Goldman has changed from long-term greedy to short-term greedy," says the chief financial officer of a major U.S. company.
Being "long-term greedy" is Goldman's motto. It means the firm is willing to be a long-term investor. For example, in Europe, it lost money for years before it turned a profit. It started spending to build up in London in the mid-1980s when it saw a vacuum there for aggressive, U.S.-style corporate finance. Goldman and Morgan Stanley have created a new European financial order, much to the chagrin of local firms. In Germany, Goldman is the biggest and most aggressive M&A house, leading the rankings year after year. Goldman made its name there in 1996 by winning the $11 billion mandate to take Deutsche Telekom public. Getting the nod took years of cultivation. "Our people made minimum wage," says limited partner David M. Silfen. "But it got us the stamp of approval at the highest government levels."
Goldman's ability to mobilize people for difficult projects stems from the large amount of time it spends recruiting, evaluating, and managing people. The firm has an elaborate annual review process that results in a binder the size of a small phone book that is used to critique employee performance. The firm also puts considerable effort into determining what each person should be paid. The goal is to create a deep bench of well-trained employees, ready to seamlessly replace whomever retires. Says one former Goldman employee: "The leader isn't important. It's the organization of the ant hill."
Perhaps. But Jon Corzine has emerged as a powerful figure. In many ways, he is an atypical chief for Goldman, which historically has been a German-Jewish firm. Corzine is a Methodist whose father was a wheat farmer and whose mother was an elementary school teacher. He was born in a farmhouse in Willy's Station, a southern Illinois hamlet of 50 people. Married to the girl he sat next to in kindergarten, Corzine went to the University of Illinois and then joined the Marine Corps reserves. After getting an MBA from the University of Chicago, he worked at two Midwestern banks and joined Goldman in 1975. He lives with his wife and three children in suburban New Jersey and recently built a house in the Hamptons.
In a culture of high-powered intensity, with Type A personalities such as predecessors Friedman and Rubin, Corzine is a man of modesty and warmth who immediately puts people at ease. A protege of Rubin, he is also known for staying calm under pressure. Corzine began as a government bond trader and rose to run the entire fixed-income unit, a key profit center. His reputation sprang from making a lot of money as a savvy trader on behalf of the firm.
A Clinton Democrat, Corzine is a hands-on leader who walks the trading floor and meets with clients. His management style is to work hard to develop a consensus and then implement the group's decision. He is scrupulously careful about treating Paulson as his partner rather than his subordinate. A natural politician, Corzine pushed to broaden the partnership by adding a category of extended managing directors who are not equity owners. "Jon has a burning desire to be fair," says executive-committee member Roy Zuckerberg.
Corzine has also stressed volunteer activities "for the soul of the firm." One effort was attended by almost 90% of the firm's full-time workforce. In October, some 9,000 employees turned out at locations around the world to do everything from hammering nails on low-income housing projects to teaching in New York City classrooms.
For all of his political agility, Corzine faces a formidable challenge in trying to resolve the firm's capital issues. Goldman's capital structure is so complicated that many Goldman managing directors don't understand it. And, notes one competitor, the firm is about as interested in talking to outsiders about it as it is in "showing you their underwear."
OUTSIDERS' CUT. Right now, the partner-managing directors own 100% of the firm and are the only ones who can vote. The partners also get the biggest share of the firm's profits: 76%. But to satisfy the need for new capital, Goldman has had to recruit outside capital, which reduces the partners' share in the firm's earnings. Attracting new capital to fund its growth has been expensive. In 1986, 1992, and 1994, Goldman raised $1.3 billion from Sumitomo Bank Ltd. and Bishops Estate in exchange for about 20% of the firm's profits or losses. Goldman raised an additional $755 million from institutional investors, mainly insurance companies, which receive a flat interest rate. The result: The firm will pay an estimated $500 million-plus this year to nonpartner equity holders.
Whatever Corzine feels privately about going public, undoubtedly Corzine's biggest fear is losing control of a proud company that plays such a large role in his and his colleagues' identities. Whatever Goldman does, it will undoubtedly attempt to maintain that control. "I see no reason to turn over our franchise--our reason to be--to a larger organization," says Corzine. "We have to be able to control the cultural character of the place." Which is why Corzine told Weill--and will undoubtedly tell any other suitors--they are doing just fine on their own, thank you.