Authors: Steven G. Mandis
What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences (12 page)
Pressures Intensify
Following consolidation, the financial services industry became intensely competitive, and Goldman now faced competition for scarce resources not only from other banks but also from insurance companies, investment advisers, mutual funds, hedge funds, and private equity firms.
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To gain market share, commercial banks aggressively offered highly competitive pricing for services, resulting in additional pressures for Goldman. Commercial banking competitors also had access to cheaper financing, and they could take a longer-term view in pricing assets and loans on their balance sheets than could those who remained strictly investment banks. That’s because investment banking firms must mark to market or use fair-value accounting (which means that the fair value of an asset is based on the current market price), compared with commercial banks, which can use historical cost accounting for assets held for investment.
Some Goldman partners often privately complained about this advantage, in addition to accusing the commercial banks of illegally tying lending to investment banking business. Goldman faced increasing pressure to retain market share by committing more capital to important clients and conducting transactions on terms that often didn’t offer returns commensurate with the risks or didn’t meet Goldman’s internal return hurdles. Moreover, consolidation significantly increased the capital base and geographic reach of some of its competitors. It wasn’t only Goldman’s US competitors; foreign banks were buying US banks (Deutsche Bank bought Bankers Trust/Alex Brown, UBS bought Warburg and Dillon Read, etc.). Goldman also faced competition from the advent of electronic execution and alternative trading systems, lowering commissions. It also faced disintermediation by hedge funds, alternative asset management companies, and other unregulated firms in providing or raising capital.
Goldman also began facing stiff competition in attracting and retaining employees. “We live in a competitive environment,” said David Viniar during his tenure. “We still have people leaving for multiyear offers away from us, some from our competitors, some from other industry participants.”
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Goldman’s client base also began to change. Its traditional banking clients were corporations, which were typically relationship oriented. In the early 1990s, there weren’t many private equity firms. For example, in 1992, when I started, I worked on the sale of one of a company’s divisions to a private equity firm. We must have contacted fewer than a dozen private equity firms, because there were not many of them around. Nor were there many large hedge funds. Later in the 1990s, however, private equity firms and hedge funds began to boom. Generally, these firms were much more transactional and generated large fees in the short term compared with Goldman’s traditional corporate clients or “buy and hold” mutual funds. People at hedge funds tended to be more transaction oriented than relationship oriented. Similarly, private equity firms tend to be transactional; buying and selling companies and taking them public are shorter-term transactions than traditional corporate client business. Goldman executives decided to focus on this growing industry and even started a group in the mid- to late 1990s to cater to this client base.
Reflecting on the shift, a Goldman partner I spoke with said that perhaps Goldman’s emphasis on doing the right thing was too extreme to be practical in the competitive business environment and that an emphasis on more transaction-oriented clients, like private equity firms, was needed in banking. He felt that too many Goldman people were focused on maintain unproductive client relationships and were being rewarded simply for their internal Goldman relationships or caretaking historically loyal Goldman clients and contributions to recruiting and mentoring.
Because private equity firms and hedge funds valued and treated Goldman differently than did traditional corporate clients, Goldman’s approach to clients began to change. The private equity firms valued any investment bank that could get them the inside track on deals and could provide the best financing terms (including guaranteed or bridge financing, which puts the investment bank at risk if it can’t sell or distribute the loan to other lenders or investors). Many of the private equity firms felt they already had people (many of them former bankers) who were smarter and more skilled than those in the banks in the kinds of deals the firms were doing. In an interview, one private equity client described most investment bankers who maintained a relationship with his firm as “order takers.”
Hedge funds also changed the landscape. Unlike many traditional mutual funds, which had a “buy and hold” mentality, many hedge funds went in and out of securities with high frequency. They typically borrowed money from investment banks to buy securities, and they shorted securities. All of these activities generate significant fees, and so Goldman organized groups to focus on these growing clients and their special needs.
I remember working on a special project to analyze Goldman’s top fee-paying clients, and I was shocked by how many were hedge funds. They, along with private equity firms, quickly became the largest fee payers on Wall Street. The hedge funds were sharp and sophisticated. In trading, there is an inherent tension between buyer and seller. Because of the sophistication of the hedge funds, they also typically viewed Wall Street firms as “places of execution” that provided liquidity and securities. They valued “the edge”—receiving special access to decision makers who gave them a competitive advantage, or to traders who were willing to take the risk and provide them with liquidity, better execution, or a better balance sheet and who offered low-cost, easy financing terms so that the hedge funds could leverage their investments and improve their returns. The private equity funds and hedge funds generally treated Goldman more like a necessary counterparty than a trusted adviser for the long term. Most of these funds were under intense pressure to produce short-term results and did not value long-term relationships in the same way that many corporate clients did.
As Goldman grew its proprietary investing activities and became a more active competitor to its investing clients, some hedge funds and private equity firms suggested that Goldman was introducing too many conflicts of interest into its operations—as when Goldman had the Water Street Fund in the late 1980s and early 1990s—causing mistrust. They felt Goldman had access to proprietary information from clients and had the potential to use it to Goldman’s advantage. According to most of my interviewees, these accusations began in the mid-1990s and accelerated as the hedge fund and private equity industry became more competitive and added players, and at the same time Goldman dedicated increasing amounts of capital to these competing activities.
Many hedge funds came and went, gaining a few years’ worth of great returns and growth and then hitting a rough patch or falling out of style and shrinking as investors fled. Hedge fund traders also tended to move around. So there was not the same traditional long-term relationship mentality with hedge funds as with corporate relationships. But even corporations changed in this regard in the 1990s as pressure for performance increased on corporate boards and CEOs. Boards came under pressure to replace underperforming CEOs, a trend that continued in the 2000s. The average tenure of a CEO has consistently declined.
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So relationships with corporate CEOs were also becoming short-term propositions.
Technological Pressures
Technological innovation was another source of significant pressure on Goldman and the whole banking sector. New technology has added transparency to financial markets, as with electronic trading, while also making them less transparent, as with the design of increasingly complex investment products, such as the mortgage securities behind the 2008 crisis. Generally, more transparency in markets and electronic execution hurts investment banks’ profitability, and the hit on profits drives banks to seek greater scale and a higher volume of transactions to offset the losses. This is happening today, for example, with the sale of treasury notes. More than 20 percent of the $538 billion of treasury notes auctioned this year have been awarded to bidders who bypassed the traditional dealers at the banks by using a website to place their orders.
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That’s almost twice the amount as in 2011 and up from 5.6 percent in 2009. This direct-bidding system has eaten into the profits of government bond traders at investment banks. Typically, low-transparency/high-complexity products have the highest margins. So it’s understandable that banks focus on developing and selling complex products, especially to offset the negative impact of transparency from technology.
Technological pressure contributed to the change in Goldman’s culture in various ways. For one thing, technological changes increased the emphasis on trading, both within Goldman and generally. Traditionally in investment banking, information was exchanged primarily by word of mouth—in person or over the phone in the context of long-standing relationships. It was a labor-intensive, human capital–intensive business, as well as an apprenticeship business, more art than science. In
Information Markets
, William Wilhelm Jr., a professor of management, and Joseph Downing, an investment banker, point to technological pressures as being so powerful that they were key reasons that Goldman went public. Information technology provides a lower cost, more reliable way of disseminating, aggregating, storing, and analyzing information, and it has diminished the role of long-standing relationships and human capital in banking. In response, Goldman began to put less emphasis on selecting its human capital, and on mentoring, training, and developing the culture to support the maintenance of relationships.
Ironically, the technological advances have also put a higher premium on star players. According to one part of Wilhelm and Downing’s theory, there are a few exceptional “human capitalists” or “stars” who have an ability to transcend technology and utilize their skills and talents to build relationships to bring in the kind of money that technology-driven trading does. And these stars require outsized compensation. The way this affected Goldman was that its relatively tight bands for compensation for people at the same level started to widen, and the partners decided that exceptions in hiring, compensating, and promoting “stars” must be made, further impacting Goldman’s culture.
Technological innovation also required greater specialization by employees at the firm. People needed to be specialists in order to add more value to clients. This also created more silos—and the conditions of structural secrecy, where information isn’t completely shared or understood by all of the appropriate people.
More Than the IPO
Too much emphasis has been placed purely on the IPO as the force of change at Goldman; as this analysis shows, the change began well in advance of the IPO. John Whitehead had pointed to issues related to Goldman’s earlier growth as his motivation for writing down the business principles. The pressure to grow was there at the time the principles were written—organizational drift was already in motion—and the principles were intended as one way to manage or constrain the change. In fact, the agreement of the partners to finally go public after resisting for so long was one of the products of the cultural changes that preceded the IPO.
Some may object to the argument that competitive and external pressures to grow were behind the change at Goldman as overly simplistic. The truth is indeed more complex. For one thing, the increased complexity in management and systems that often accompanies growth must be factored in as well.
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Charles Perrow notes that institutional complexity prevents people from understanding the consequences of their behavior.
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Certainly, complex systems pose greater control challenges than do simple ones. And the faster an organization grows, the more the pressures and reactions to them compound and become interconnected, leading to increasing complexity and difficulty in seeing change.
In addition to accelerating certain changes, Goldman’s structural change into a public company initiated a cascade of significant changes to other aspects of the organization. Now it had a board of directors that included independent directors (people from outside Goldman); a new partnership compensation program, with voting rights, as spelled out in the shareholder agreement (to help replicate some elements of the partnership); additional layers of processes, controls, and management needed by a public company; new compensation processes and consideration (stock in addition to cash) and more.
But there were also pressures from within to grow revenues. During my interviews with partners, one of the recurring themes was the need for Goldman to “increase the size of the pie.” This means that revenues, and consequently the firm, had to expand for the firm to be successful in recruiting and retaining talented people. If the pie stayed the same size, then as more people became partners, each partner would keep getting a smaller slice of the financial rewards, making partnership less attractive. In this way, the external competition for people, combined with financial incentives, pressured the firm to increase revenues—not only to stay competitive but also to shore up the partners’ wealth. As we’ll explore in more detail in the next chapter, the acceptance of a number of changes in practices at the firm that deviated from the traditional values, and the normalization of that deviance—or what could be described as rationalization that they weren’t really deviations from the original meaning of the principles—were also crucial in the process of continuing drift.
Chapter 5
Signs of Organizational Drift
I
N THEIR FIRST LETTER TO SHAREHOLDERS IN THE 1999 ANNUAL
report, the top Goldman executives wrote, “As we begin the new century, we know that our success will depend on how well we change and manage the firm’s rapid growth. That requires a willingness to abandon old practices and discover new and innovative ways of conducting business. Everything is subject to change—everything but the values we live by and stand for: teamwork, putting clients’ interests first, integrity, entrepreneurship and excellence.”
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Changes were happening, and the partners seemed to be making it clear that they wanted any changes carefully managed to maintain Goldman’s core values. But as the firm encountered decision-making dilemmas related to change and growth, managers found it difficult both to acknowledge what was happening and to confront the conflicting needs and desires that underlay the issues. The Goldman partners I interviewed, even some of those who initially said there had been no change in culture, conceded that some changes had occurred, but they described them as “one-offs” or “special circumstances,” and others said the industry was growing and changing so quickly and becoming so complex that they hadn’t seen the changes clearly.
It is important to understand certain unique mechanisms at Goldman that formerly had helped slow the pace of change. The pressures on these mechanisms provide a lens into the firm’s policies and business practices and how they evolved.
Constrained Capital
One inescapable reality of a private partnership is that capital is somewhat constrained by its being contributed by the individual partners—and there are, after all, only so many partners. This constraint acts as a check on growth. A second factor is the personal liability of the partners, which requires the maintenance of large capital reserves to cover potential losses as well as the adoption of business practices that help the firm avoid large regulatory fines or lawsuits.
For most of Goldman’s history, these capital constraints provided a measure of self-regulation that not only limited growth but also helped maintain cultural stability and led the firm to emphasize client relationships. John Whitehead observed that “limited capital forces an investment banking firm to be careful in deciding what kinds of business it should be involved in and to what extent.”
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With restricted capital, the firm had to emphasize client-oriented businesses, rather than trading, because they required less capital and often entailed relatively less risk. That is one of the reasons why the M&A department was highly valued.
Whether or not the lack of capital was a drawback is debatable, and it was debated by the partners at the time. Not only did Whitehead believe that capital constraints forced the firm to make better decisions, but also many competitors thought Goldman was at no disadvantage. As one commented, “I wish I could find a business where Goldman is capital-constrained.”
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But the stark fact was that in 1998, Goldman had roughly half the capital base of Morgan Stanley or Merrill Lynch—this, after having twice the capital base of Morgan Stanley in 1986. The increasing pressure for growth led the partners to seek outside capital in order to remain competitive, even though acknowledged Goldman culture carriers voiced concerns, fearing the impact on the firm of outside investors’ goals as well as the impact that more capital would have on the firm’s business mix, tolerance for risk, culture, and management.
Another key loosening of the constraints on organizational change came from the changes in liability for losses, the dangers of which many partners were also well aware of.
Partners’ Liability
Earlier investments—the $500 million private equity investment of Sumitomo Bank in 1986, and the $250 million private investment made four years later by the Kamehameha Schools/Bishop Estate, had loosened the constraints on growth, but they had not relieved partners of personal liability. But first with the transition to LLC and then with an IPO, they would be freed from this liability, which a number feared would lead to a stronger appetite for growth and risk and would quicken change. They had already seen evidence of greater risk-taking even before the IPO.
In my interviews, many of the partners pointed to their personal liability as having been a constraining factor on “doing stupid things.” Some pointed to the risk Goldman took in bailing out the hedge fund Long-Term Capital Management (LTCM) in 1998 as an early case of taking on more risk than the firm had traditionally been comfortable with. LTCM was a speculative hedge fund that used a lot of leverage and faced failure that year. As LTCM teetered, Wall Street feared that its failure could have a ripple effect and cause catastrophic losses throughout the financial system. Unable to raise more money on its own, LTCM had its back against the wall.
Goldman, AIG, and Warren Buffett’s Berkshire Hathaway offered to buy out the fund’s partners for $250 million, provide capital of $3.75 billion, and operate LTCM within Goldman’s own trading division. The situation was so serious and the pressures on LTCM were so intense that the offer was made with a one-hour deadline. But at the beginning of the year, LTCM had $4.7 billion in equity, so its partners regarded the offer as stunningly low. They did not accept Buffett’s offer within the required one-hour deadline, and the deal was off. Ultimately, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid widespread financial collapse. Goldman and the rest of the top-tier creditors each contributed $300 million.
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For some Goldman partners, getting involved in the bailout subjected their personal capital in the firm to too much risk. The investment banking partners, in particular, according to my interviews, generally were not happy about the potential risks to their personal capital and were worried about Corzine’s aggressiveness in pursuing the deal. To some of them, that the firm went ahead was a sign of both the pressures and the changes.
As the risk rose—when the firm grew and invested its own money more aggressively—it subsequently changed the way the partners interacted with the firm.
The IPO Debate
Even though many Goldman partners now say that the culture hasn’t changed, at the time the IPO was decided, some of the partners were quite vocal about their concerns about cultural change. In fact, when people at Goldman—not only partners but also employees—discussed among themselves the idea of the firm going public, most of the concerns they expressed were about how Goldman’s culture might change rather than about financial or personal repercussions. Partners talked about their responsibilities as stewards to leave the next generation a stronger business with smarter people than the one they had inherited. In discussions, most IPO opponents expressed the concern that going public could “destroy what makes Goldman Sachs Goldman Sachs.”
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A contemporary report described the process of debating and then postponing the IPO as “a wrenching experience that has bruised the firm.”
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It created tensions between the firm’s active general partners and retired limited partners, between Goldman’s investment bankers and traders, and between Corzine and Paulson.
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The discussion was personal, because people had to consider their own self-interest as well as the interests of the firm.
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Partners screamed and cried during one meeting in what one observer described as a “cathartic experience.”
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Conflict arose between new partners and those who had been at the firm longer and had a much greater stake in the firm and were about to retire. Partners with longer tenure, whose Goldman equity and percentage had gained greatly in value and now would get multiples of their book value, had a greater personal financial incentive to favor an IPO.
Some partners were rumored to believe they should be compensated, through the IPO, for staying in 1994, turning the firm around, and taking the risk when others left. But John L. Weinberg said, “I always felt there was a terrific risk and still do, that when you start going that way [an IPO] you are going to have one group of partners who are going to take what has been worked on for 127 years and get that two-for-one or three-for-one. Any of us who are partners at the time when you do that don’t deserve it. We let people in at book value, they should go out at book value.”
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While I was at Goldman, one partner privately told me that he felt terrible that an IPO would make him worth more money than the management committee partner who had helped build the firm and helped get him promoted to partner. He estimated that this man, who had worked at the firm for more than twenty years and retired before the IPO, was worth an estimated $20–$40 million, compared with newer partners like him, some of whom had worked at the firm for less than ten years and would be worth more than $50 million.
Understandably, dissatisfaction was greatest among the retired limited partners, and tension between them and the general partners (essentially, Goldman’s controlling owners) became heated. As the IPO was originally structured, limited partners would have received a 25 percent premium over the book value of their equity, whereas general partners would have seen premiums of nearly 300 percent.
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Whitehead predicted a major problem if this inequity were not resolved. Issues related to fairness and compensation were also raised by nonpartners because of Goldman’s long-standing policy of not paying high salaries to the “all-important junior executives—the ones who do the grunt work—holding out instead the brass ring of partnership and its potential for eight-figure incomes.”
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Divisions also arose between the investment bankers and the traders. While in general, investment banking partners, especially the relatively new partners, did not support the IPO because of concerns about culture change and increased risk taking, most trading-oriented partners supported it, in part, because with the additional capital they could grow their businesses larger and faster.
One investment banking partner who did support the IPO explained to me that he did so because of concerns about capital risk and liability that outweighed those about change to the culture. All his wealth from working at Goldman for more than twenty years was tied up in the firm, and the IPO offered a way to get it out. Getting out at a multiple of book value was greatly beneficial and probably sold him on the IPO, he explained (sheepishly admitting some self-interest), but he had also been genuinely worried about the risk involved in the LTCM deal and he feared massive trading losses. He felt that Corzine was willing to take bigger risks than he was, and he was worried that the big traders—many of whom he didn’t know well and some of whom were not partners—were risking lots of partners’ money. It spooked him. But the firm needed to grow, he said, to continue to be the best place to work, to attract the best people, and to survive. He rationalized the IPO as a necessary compromise that was a result of pressures and changes.
Key Signs of Organizational Drift
One sign of organizational drift is a change in policies and business practices associated with a firm’s principles. Even before the IPO, Goldman began embracing opportunities it had once shunned out of concern for preserving its reputation for ethical conduct and to reduce conflicting interests.
When firms get into new businesses in which they lack expertise or that are at odds with the values and principles that made them successful, they become vulnerable to veering off course, adding incremental risk—financial and reputational. The pursuit of maximizing opportunities can lead to rationalizing the drift. Previous decisions made to protect the firm start to be considered too conservative or out of date. Even the fundamental business model may be challenged. Goldman was not exempt from this process. Once again, I’m not judging or evaluating the changes; I’m simply pointing them out.
Representing Hostile Raiders
Goldman had made its reputation in banking by defending companies in hostile raids or unsolicited takeovers, when a company bids for a target company despite the wishes of the target’s board and management, typically when the board decides it is not in the best interests of the shareholders for the company to be sold at the price offered. A “hostile” bidder makes its offer “public,” taking it directly to shareholders—implying that the board of directors and management are not acting in the best interests of the shareholders and are trying to hold on to their jobs. To the target’s board and management teams, the bankers who work against the takeover to protect them and shareholders are viewed very positively. A 1982
Wall Street Journal
headline captured this positive image: “The Pacifist: Goldman Sachs Avoids Bitter Takeover Fights but Leads in Mergers.” The accompanying article praised Goldman’s policy of not representing corporate raiders in hostile deals, although it included the few obligatory criticisms from competitors.
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Goldman had made a strategic decision not to represent companies initiating hostile bids, the only large investment banking firm to do so.
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When questioned about the wisdom of this policy, Whitehead responded, “We have to dissuade them from going forward with this and explain to them why our experience showed that it would be unlikely that this unfriendly tender offer would turn out to be successful for them a few years later.”
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As a result, CEOs were more comfortable revealing confidential information to Goldman than to other firms, because they trusted Goldman not to use the information in representing hostile raiders against them.
This policy lost Goldman some business and restricted the profits and growth of the M&A department, but it was a sound business decision that contributed to the positive public perception of the company. It was long-term greedy, calculated to make the most money for the firm over the long term, and Goldman may well have ultimately made more money because of it. Many clients actually paid Goldman an annual retainer to be on call in case of a hostile bid. Although the policy was not strictly about integrity, it had the effect of reinforcing Goldman’s reputation for integrity among clients and the public. Even a Morgan Stanley banker once said clients viewed Goldman as “less mercenary and more trustworthy than Morgan Stanley.”
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Most partners told me they felt the policy reinforced the image and culture of Goldman.
In the late 1990s, this policy was challenged, as many huge hostile deals were announced by Goldman clients and coveted potential clients. A series of internal meetings was held to discuss changing the policy. I participated in some of them.
At one meeting, the people in the room were evenly divided. I was with the group that advocated against representing hostile raiders, whether they were blue chip corporations or individuals financed by junk bonds. We felt that doing so would cause us to lose both our credibility with clients and our perceived moral high ground. We reminded the group of Goldman’s advertising slogan, “Who do you want in your corner?” and observed that Whitehead had also resisted serious challenges to the policy. John L. Weinberg had supported the policy, too, even though one of his largest clients had requested Goldman represent it in a hostile raid.
Those arguing in favor of representing hostile raiders claimed that very good clients of the firm were asking for our help. By working with them, we could try to reduce the “hostility,” implying that other advisers would not have as much tactical or moral sway with clients. They also said that they feared clients would not hire us to advise them on buy-side transactions because we weren’t willing to advise them on a hostile approach.
We countered that in the past, Goldman had stepped aside and other firms had stepped in, to which the others replied that this was disruptive and did not serve the client well. We pointed out that in these very large deals, it was not unusual to have co-advisers anyway, so we would simply recuse ourselves, and the client would not have to get someone up to speed from scratch.
In the end, senior partners decided that Goldman would work on hostile raids “rarely and reluctantly.” We developed a series of questions, essentially a test, to determine whether we would advise a hostile raider. At the same time, we did get a minor victory in that there seemed to be a gentleman’s agreement not to do it in the United States, where Goldman’s market share and association with the policy were particularly strong. In hindsight, this compromise is a clear case of an incremental shift, and the compromise provisions imply that at least subconsciously we were aware that there could be adverse consequences of this change in policy.
The manner of the arguments also reflected a drift from the Goldman principles. Never did anyone say in the meetings that the policy should be changed to maximize opportunities for growth, market share, profits, or a potential IPO. Instead, people argued the need to stick with clients, make clients happy, add “another tool in the tool chest” to help clients. Ironically (or paradoxically), these arguments invoke the first business principle of keeping our clients’ interests first. But for the first time I began to hear the rationalization, “If we don’t, someone else will,” and the rationale was not dismissed outright. “This time is different,” people asserted; the world had changed and was more competitive than when the two Johns ran the firm.
One could certainly argue that the real reason for making the change was that Goldman needed to maximize revenue growth opportunities in anticipation of an eventual IPO. Goldman already had the lion’s share of the raid defense business, so the only way to acquire a greater M&A market share was by tapping the other side of the equation. But the decision cannot be attributed solely to the looming IPO. The trigger was that there also had been an explosion of large, hostile transactions. One concern was surely that hostile M&A deals were very large, and if Goldman were not involved, its leading M&A market position could be threatened.
I later found out that Goldman’s co-leaders at the time disagreed about changing the policy. What surprised me was that Paulson supported the change and Corzine did not. It was later reported in the press that Paulson thought the “no hostiles” tradition was costing Goldman huge fees it could have received from “advising large, ambitious, serial-aggressor corporations on takeovers,” whereas Corzine was concerned about the damage to Goldman’s image as “corporate management’s most reliable friend.”
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The firm’s entry into this aspect of investment banking was incremental and started outside its core US market in the mid- to late 1990s with hostile acquisitions of non-US companies, outside the United States, by other non-US companies.
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The first announced hostile M&A deal for which Goldman advised in North America was in 1999, and that was in Canada.
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To many of the Goldman partners I interviewed (who acknowledged change), in hindsight, there could hardly have been a more dramatic business policy decision to signal that the Goldman culture was changing.
Renewed Involvement in Asset Management
Goldman had steered clear of asset management since the Great Depression. In 1928 the firm created Goldman Sachs Trading Corporation (GTSC) as an investment trust, which worked much like modern mutual funds: the trust bought and managed a portfolio of securities, some of them speculative, and shares were sold to the public. According to one author, “It was essentially a trust which used debt to buy other companies, which used more debt to buy still more companies—in other words, a ticking time bomb of debt.”
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GTSC itself bought many shares of the trusts it managed. The idea was that Goldman would profit enormously from the original underwriting fee, from the appreciation of shares Goldman held in the trust, and from investment banking and securities trading on behalf of companies whose stock was held by the trust. By 1928, with only $20 million in partnership capital and either sole or joint control over funds worth $500 million, this created a devastating level of exposure on the eve of the October 1929 stock market crash. John Kenneth Galbraith used phrases such as “gargantuan insanity” and “madness … on a heroic scale” to describe GTSC’s strategy.
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When the crash came, GTSC shares fell from their high of $326 to less than $2 per share. The ensuing debacle and damage to Goldman’s reputation, leadership, and clients caused Goldman to stay away from the asset management business.
This attitude changed in the late 1980s, when, lured by the consistent profits its competitors were earning in asset management, Goldman established Goldman Sachs Asset Management (GSAM) to serve institutional and individual investors worldwide.
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Goldman struggled to determine whether it should manage money for high-net-worth individuals or institutions, in the end doing both. According to the interviews, there was strong sentiment from many partners that Goldman should not be perceived as competing with clients, but one of the key rationales was that Goldman’s competitors were doing it.
Beginning in the mid-1990s, GSAM experienced explosive growth, and Goldman now points out that it is one of the largest asset managers in the world, and yet many of the largest asset managers are still Goldman’s clients.
GSAM became a strategic priority, in part, because it was not as capital intensive as proprietary trading and it offered consistent fees, which were a percentage of assets under management. When Goldman went public, establishing the asset management business proved to have been a wise strategic decision for this reason. Institutional investors buying the stocks of investment banks, and research analysts covering investment banks, liked the consistency of earnings and gave a higher valuation to the earnings from asset management divisions than to trading earnings.
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The growth of asset management, and the strategic opportunities and strategy of the business, are cited in most research reports regarding Goldman’s IPO. GSAM also is mentioned as one of the key areas of potential growth in Goldman’s IPO prospectus.
The changes in Goldman’s business mix in the 1990s, before the IPO, were not lost on the financial press: “Goldman intends to build up its asset management business … If it does not, it cannot expect to be valued as highly as Merrill and Morgan Stanley in the grim as well as the great times of the cyclical securities industry.”
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However, some of GSAM’s funds have consistently underperformed Goldman’s proprietary traders, an outcome that has led some investors to suggest that the best investors and traders at Goldman went into proprietary trading to manage Goldman’s money and not that of clients—claiming that this is a classic example of Goldman putting its interests ahead of its clients’. Such criticism is not entirely fair, because Goldman partners’ personally invest in the funds, as well as often coinvesting the firm’s capital with clients’ money, and the funds have specific mandates. But on the other hand, Goldman is receiving valuable recurring revenue fees from the outside investors in the funds so the risks and rewards are not exactly the same as those for outside clients.
Advising Companies in the Gambling Industry
Goldman had also traditionally declined to do business with companies involved in the gambling industry, for reputational reasons. The firm changed this policy in 2000. Its first foray was to represent Mirage Resorts and Steve Wynn. Mirage was sold to MGM Grand Inc. for $6.6 billion ($21 a share) in June 2000. Although the gambling industry was starting to be regarded as increasingly professional and mainstream, one could argue that Goldman made this change simply because it saw a huge financial opportunity. To raise its profile in the industry and in junk bonds, Goldman hosted a lavish conference in Las Vegas, with entertainment by Cirque du Soleil and Jay Leno, which was attended by eight hundred people.
As William Cohan wrote in
Money and Power
, “One portfolio manager who attended the three-day conference said that it was something he expected from [Donaldson, Lufkin & Jenrette], not Goldman. Marc Rowland, CFO of oil and gas producer Chesapeake Energy of Oklahoma City, had previously issued $730 million in junk bonds through Bear Stearns. Rowland remarked that prior to the conference, he never would have thought of approaching Goldman to handle junk bonds.”
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Of course, one could also argue that Goldman was shrewdly capitalizing on a market opportunity and that it was true that the industry’s reputation had changed.
Partners I interviewed pointed to two key examples of pushing the client envelope in terms of the questionable nature of clients taken on. Interestingly, they were both outside the US market. One was London’s Robert Maxwell, whom Goldman acquired at the very end of John L. Weinberg’s watch, when it was still trying to establish itself in London—and well before the IPO. The other recent example was Libya. In early 2008, Libya’s sovereign-wealth fund controlled by Col. Moammar Gadhafi gave $1.3 billion to Goldman to sink into a currency bet and other complicated trades. At one time, the investments lost 98 percent of their value. Also, according to reports, afterward Goldman had to arrange for security to protect its employees dealing with Libya. Many current and former partners questioned the firm’s dealing with a client like Libya—even though the United States had lifted sanctions in 2004—where employees would need security protection. Retired and current partners felt that Maxwell and Libya being clients showed a deviation from the standards of the 1980s, and were due in part to the pressure to grow.
