Wall Street's Lone Ranger

In a world of megabanks, can CEO Hank Paulson keep Goldman Sachs independent?

Near the New York Stock Exchange, on the 30th floor of Goldman Sachs Group Inc.'s (GS ) headquarters at 85 Broad Street, portraits of former senior partners in gilded frames line the hallway leading to the executive suite. The paintings mark the 133-year-old legacy of a banking empire with $15.8 billion in revenues, whose undisputed dominance of initial public offerings and mergers and acquisitions has long made it the envy of global finance. In stark contrast, the office of Chairman and CEO Henry M. "Hank" Paulson Jr. is bare of the trappings of money, power, and history. Instead, Paulson has hung photos of wild animals, some of them once-endangered and now-plentiful predatory birds.

His photos aren't just ornamental. Conservation--particularly of raptors, a group that includes eagles and falcons--has been a passion of this jeweler's son since his boyhood in the Chicago suburbs. His hobby is an apt metaphor for the battle that Paulson, 55, now faces. Although Goldman is a rapacious competitor in the financial world, it may become an endangered species in its own right--one of the last holdouts against the wave of consolidation that is rolling over Wall Street and changing the way it operates.

Megasize financial supermarkets offering commercial, retail, and investment banking--plus insurance, brokerage, and money-management services--threaten to crush the likes of Goldman. Their balance sheets dwarf Goldman's. The largest, Sanford I. Weill's giant Citigroup (C ), has $1 trillion in assets, more than triple Goldman's $312 billion, while J.P. Morgan Chase & Co. (JPM ) has double that amount (table). By offering companies a wide range of services, including cheap loans, the behemoths have been attracting profitable investment banking business their way. That's how Citi's Salomon Smith Barney unit clawed its way to become the leading issuer of corporate debt and equity and to hoist itself up the list of top M&A dealmakers.

Paulson refuses to follow the pack. He scorns the very idea that Goldman should seek out a merger partner so that it can lend big. "We don't need to buy a [commercial] bank," he says. "If we wanted to reduce our return on equity by 50% through lending, we could do it ourselves." Instead, he is determined that Goldman will remain a pure-play investment bank.

The core of Paulson's strategy is simple: "We want to be the premier global investment-bank, securities, and investment-management firm," he says. "We want to have a disproportionate share of the business of the most important clients in the most important markets." To achieve that, Paulson believes Goldman must gain a lock on providing financial advice to marquee corporations, government authorities, and superrich individuals in the world's major economies--the U.S., Germany, Britain, Japan, and China. At the same time, the firm wants to add market share in the most profitable securities businesses: mergers, IPOs, equities, and commodities trading, high-yield offerings, and complex financial instruments called derivatives. To do that, Paulson has made targeted acquisitions in these fields to give Goldman greater depth, not breadth.

It's a high-risk gamble that could easily fail. Paulson figures he has roughly a year before he could be facing even larger rivals. "This is a transition year," he says. "It's a difficult year." His game plan relies heavily on a snapback in the markets and economy, both of which could be slow to rebound and weaker than expected. IPOs are still a trickle--only four have been completed in the U.S. since Enron Corp. filed for bankruptcy on Dec. 2--while mergers are down 42%. Although he has snared some of the biggest deals going, from Tyco International's (TYC ) $10 billion breakup plan to Hewlett-Packard Co.'s (HWP ) proposed $25 billion merger with Compaq Computer Corp. (CPQ ), there isn't enough business to sustain Goldman for long. Furthermore, the Enron debacle has soured companies and investors on the sort of bravura financial engineering at which Goldman excels.

For Paulson, the price of failure would be high: Goldman could be gobbled up by one of the megabanks he thinks he can outfox. With a market cap of just $39 billion, vs. Citigroup's $216 billion and J.P. Morgan's $56 billion, Goldman looks like a tasty morsel to predators.

Part of the problem rests squarely with Paulson. Until he cut 3,000 employees in mid-2001, Paulson had spent lavishly on expensive talent and acquisitions at the peak of the market. After Goldman went public in 1999, he behaved as if Goldman were invincible. By mid-2001, Goldman's staff had tripled, to a peak of 25,000, as Paulson added high-priced specialists in everything from M&A and IPOs to investment advice for the superwealthy, junk bonds, and equity trading. And once he had publicly traded shares at his disposal, he went on a buying binge costing well over $7 billion--the first time Goldman had ever made major acquisitions in its then-130-year history. Since July, 1999, it has taken over a specialist share trader, an online investment bank, an options trading outfit, and two market makers. The biggest, costing $6.5 billion, was Spear, Leeds & Kellogg, which trades on all listed U.S. exchanges and over-the-counter markets.

Indeed, this year threatens to be one of Goldman's darkest. Salomon Smith Barney analysts, the most pessimistic, expect it to report first-quarter earnings as low as 88 cents per share in March, down 37% from the same quarter in 2001. That's far worse than most analysts' preliminary forecasts for Goldman's main rivals--drops of 27% at Merrill Lynch & Co. (MER ) and 22% at Morgan Stanley Dean Witter & Co. (MWD )--and the 11% rise in profits expected from Citigroup. "It's going to be an ugly year," says James F. Mitchell, securities industry analyst at Putnam Lovell Securities Inc. "If mergers and other capital-markets activities stay at these low levels, worst-case scenario, Goldman could post even worse net earnings in 2002 than in 2001 [which were down 24.7% from 2000]."

But at the same time, Goldman has managed to escape many of the woes now afflicting most of its rivals. The megabanks are reaping a bitter harvest from profligate loans made to snare investment banking deals. Their losses on bad loans to hundreds of struggling companies--from telecom upstarts to retail store chains--are now surpassing any profits they made on the deals.

Several were also involved in both lending to Enron and setting up, and investing in, its now-notorious off-balance-sheet partnerships. J.P. Morgan Chase alone took an $807 million charge in the fourth quarter for losses on lending to Enron and Argentina. The same goes for Credit Suisse First Boston, which expects to announce in March a $1 billion net loss in the same quarter. "The one-stop shopping malls on Wall Street, the J.P. Morgan Chases and the Citigroups, are going to be discredited," says Charles W. Peabody of New York investment advisers Ventana Capital. "In setting up those partnerships, the more they put their balance sheets at risk. Goldman was unwilling to do that, and I think they'll be a healthier institution in the endgame."

That's why many financial mavens give Paulson a reasonable shot at winning out in Goldman's make-or-break year. Its stock has risen 28% since its May, 1999, IPO. Meanwhile, an index of its rivals' stock prices has fallen 7.6% over the same period. Goldman produced record net earnings of $3 billion on $16.5 billion in revenues in 2000--a profit margin of more than 18%. Even in a bear market, Goldman's stock proved more resistant than most, sinking 7.5% in 2001, vs. a 12.5% fall in the Russell Financial Services Index. "When the market comes screaming back, there's going to be prestige in companies saying that Goldman is their lead bank. Others won't have the same cachet," says financial-services analyst E. Reilly Tierney of New York's Fox-Pitt, Kelton Inc.

As his rivals reel, Paulson needs to prove to investors, clients, and his own people that his go-it-alone strategy is on the mark. The toughest sell may be Goldman employees, who own 55% of the company. His top executives have kept the faith. But some in the lower ranks now believe that Goldman may eventually be forced to buy a commercial bank or be taken over by one to stay in the game. "If [Goldman's employees] feel that preservation of their wealth requires affiliation [with a commercial bank], I don't think they'd hesitate to do it, and I think they'd move very quickly," says financial services analyst Guy Moszkowski of Salomon Smith Barney Holdings Inc.

Already, there are rumblings of discontent among employees, from the ranks of managing director on down, as Paulson switches his focus to pruning costs. Now, say Goldman insiders, the firm is preparing another hefty round of layoffs. Many who survived last year's cuts were bitter because they were asked to accept options instead of cash as a large part of their 2001 bonus. Making matters worse is the so-called partnership compensation pool that Goldman created when it went public in 1999 to protect the status of the firm's upper echelon. The effect has been to create three classes of employees: the old-guard partners, the veterans who never made partner, and a legion of newbies, the 40% of staff who have been on board for two years or less. Some of the newer arrivals were angry that they had to take larger pay cuts than members of the pool at the start of this year. Paulson doesn't have much sympathy for the disgruntled. "We try very hard to be fair. But if people don't like what they got paid, they don't have to work here," he says.

Some are getting the message loud and clear. On Feb. 11, three Goldman sales and trading executives left for Morgan Stanley. That in itself was quite a change. "Five or six years ago, we didn't think of hiring anyone from Goldman. It didn't happen," says one rival banker. Meantime, co-head of investment banking Steven M. "Mac" Heller, a 20-year veteran, is about to retire. Other managing directors who have been hanging on until this May, when they will be able to sell the shares they received in Goldman's IPO, will probably follow him out the door. Since going public, Goldman has lost 6 of its 22 management committee members. But losing even one top exec can prove critical. After head of research Steve Einhorn left in 1998, Goldman's research slipped from No. 2 to No. 7 in the closely watched Institutional Investor rankings. Moreover, 7 of the 13 female partners at the time of the IPO have quit. "My biggest concern as a shareholder is that Goldman will suffer from a brain drain," says a former Goldman insider. Based on what employees have told them, Goldman brass insists there won't be a mass exodus.

It's up to Paulson to prove them right. A lanky and athletic six-footer, he's a complicated man who alternately terrifies and inspires employees. He's capable of poking fun at himself over his inability to operate computers. (His secretary has to print out his e-mails.) But some employees avoid riding in elevators with him rather than face his probing questions, though they can't escape the voice mails he regularly leaves at 2 a.m. He expects his employees to work as hard as he does: He makes 360 visits a year to executives at top companies.

Even in leisure moments, he can be unrelenting. He is so driven that he gets visibly upset when he fails to catch a marlin on vacation in the Florida Keys. "Hank has never been satisfied to lose--ever," says personal friend and client Walt Minnick, chairman and CEO of SummerWinds Garden Centers in Boise, Idaho. As a football linebacker at Dartmouth College, Paulson offset his comparatively slight build with such ferocity that he was nicknamed "The Hammer." He emerged as a major player at Goldman in 1994 after he was yanked from the Chicago office to New York as COO, charged with slashing costs 25%. He managed to do that, but still remained very much in the shadow of Jon Corzine, his co-CEO and now a U.S. Senator from New Jersey. Until, that is, Goldman postponed its 1998 IPO after the stock market faltered following Russia's financial meltdown. Paulson leapt in as the enforcer--and with the help of his now co-presidents, John A. Thain, 46, and John L. Thornton, 48, dumped Corzine, completed the offering, and made himself and the other 220 partners each an average of $100 million richer.

Now the trio run Goldman as a team. Unlike other Wall Street houses, where power struggles are common and very public, the three are considered so close and complementary that employees refer to them in one breath as "Hank, John, and John." While Paulson came up through the ranks as an investment banker, Thain "the Humane" is a trader at heart and makes more operational decisions. Thornton is the group's strategist, who built up the firm's European operations with Thain. The three tag-team decisions on most major transactions, sometimes from different corners of the globe in a typical daily blitz of 50 voicemails. Anything O.K.'d by one is considered approved by all. Occasionally they disagree. If that happens, they may take hours or even days to hammer out a decision in their tight circle. "If we don't agree, we lock ourselves in a room until we come to an agreement," says Thain.

Whether in unison or as individuals, they will have to ensure that employees execute flawlessly. Paulson's nightmare is that an employee may feel too pressured and make a mistake--and put the firm's reputation on the line. "In this tough economic environment, people can do stupid things," he says. Early in his career, Paulson saw close-up how damaging mistakes could be. One of his first jobs was as an aide to John Ehrlichman in President Richard Nixon's White House. In 1973, when he thought the President was lying, Paulson quit, recalls SummerWind's Minnick, who also worked in the White House at the time. "He was very troubled," says Minnick.

Until three years ago, Goldman groomed its bankers for leadership roles through informal apprenticeships. But with thousands of employees spread around the planet after the hiring splurge, that's no longer possible. So, Goldman is drafting a succession plan that extends down to its division heads. It has also hired management gurus to figure out how its top three officers can best reach their people. One result: Paulson, Thornton, and Thain teach managing directors in a leadership program called Pine Street. "We want people to act as though they've been here for 10 years when they've been here for two," says Lloyd C. Blankfein, a managing director.

So concerned is Paulson that his ambitious strategy might be torpedoed by a screwup that he's at pains to remind staffers of incidents that put the firm in jeopardy. In December, he walked all the managing directors through a litany of past blunders. They included angering Japanese regulators with careless recordkeeping, annoying the Singapore government by advising on a hostile bid where such practices are usually taboo, and advising dot-coms with questionable business plans. Since January, all Goldman employees have been taking refresher courses on everything from the so-called Chinese walls that separate investment bankers from research analysts to appropriate ways to manage risk. On Feb. 19, Goldman announced that it will make its research department independent from its equities division and banned analysts from owning stocks in industries they cover.

The moves are timely. Rivals are eager to spread the word that even the world's No. 1 adviser can mess up. Though it has so far escaped being directly tainted by the Enron scandal, Goldman is receiving flak over its handling of Tyco's breakup and HP's proposed merger with Compaq. Tyco and HP say they are satisfied with Goldman's work. HP CEO Carleton S. Fiorina told BusinessWeek: "They prepared us for the negative market reaction" that initially greeted the Compaq deal. But that hasn't silenced competitors. Some bad-mouth Goldman, which stands to make $33 million for advising HP, for not heading off a proxy fight by forcing HP management to seek the O.K. of the Hewlett and Packard families and foundations. Says one rival banker: "This deal has been a comedy of errors. It's amateur hour."

That may be no more than sour grapes as Goldman steals market share from rivals. By sticking to what Goldman does best, Paulson has cut a huge swath in Germany and Japan. The firm swept to first place as a merger adviser in Japan last year, handling 46% of the deals, worth $30.4 billion, vs. $15.9 billion for Morgan Stanley and $11.5 billion for Merrill Lynch. In Germany, where thousands of private companies are looking to go public, Goldman has bested both Deutsche Bank and Dresdner Bank to become that country's top adviser on mergers and equity offerings. Indeed, Goldman has developed such a stronghold after adding such big-name clients as DaimlerChrysler (DCX ) and Deutsche Telekom (DT ) to its roster that local investment banking competitors are having to offer discounts to win back business. "They tend to be arrogant, which Germans don't like," says a rival U.S. banker. "But there is no denying that so far, they have done comparatively well here. We consider them our chief competitor, alongside Deutsche."

Paulson's tactic of deepening Goldman's expertise is starting to pay off in U.S. equities trading, too. Through acquisitions, Goldman has patched together critical mass in everything from self-directed electronic trades to processing and clearing services. In two years, Goldman has gone from making markets in 500 stocks to 6,000. And with the ability to clear its own trades after it bought Spear Leeds, it is now handling transactions and back-office work for more than 600 investment managers with $100 billion in hedge-fund assets, up from nothing two years ago.

That may sound like grunt work, but Paulson argues it will help Goldman to grab more underwriting deals. His reasoning: Companies want the highest prices when they issue equity, so they will flock to the best-informed firm. "The more knowledge we have on what is really going on in the capital markets--the market's pulse--the more insight we can provide investor and issuer clients," says Robert K. Steel, Goldman's head of equities.

Likewise, Goldman's investment management business may be about to pay off. Years in the building, it now spans the globe and offers clients a wide variety of products ranging from fixed income to hedge funds. Division co-head Peter S. Krauss believes he can deliver 40% profit from asset management. While other divisions are cutting staff, Krauss has been training 200 brokers to add to a 500-strong force catering to superwealthy individuals with $20 million or more to invest.

All this positioning should have a big payoff when the economic recovery finally kicks in and mergers and IPOs pick up. And if the rebound is as synchronized around the world as the downturn was, Goldman will benefit more richly than rivals without its heft in Europe and Asia. "Look at what's happening around the world," says Paulson. "The forces of globalization. Restructuring. Open trade. Pension reform. Goldman Sachs operates at the sweet spot of capitalism."

For Paulson, the big test is now. It won't take long--no more than an economic cycle--to figure out whether Goldman survives intact. Already, his biggest competitors are on the prowl. Citigroup's Weill and Morgan Stanley CEO Philip J. Purcell are sniffing out new acquisitions, while J.P. Morgan Chase or HSBC are eyeing Merrill Lynch. If Paulson's strategy works out, Goldman will remain rich and independent. If not, his firm stands to become just another aisle in a financial supermarket.

By Emily Thornton in New York, with David Fairlamb in Frankfurt, Mara Der Hovanesian and Marcia Vickers in New York, Peter Burrows in San Mateo, Calif., and Brian Bremner in Tokyo

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