Read an Excerpt
From Utility to Casino: The Morphing of Wall Street
Alan “Ace” Greenberg’s ﬁrm may have collapsed underneath him, but even in the darkest days of 2008, the eighty-one-year-old investment banker’s legendary chutzpah was visible on Bloomberg’s business television network. “There’s no more Wall Street,” Green-berg, the former CEO of Bear Stearns, declared, adding that it had vanished “forever” in the rubble.1
It’s fashionable on Wall Street today to talk wistfully—or in a tone of reverential awe—about investment banking as it was practiced during what is now seen as a kind of golden era. Greenberg’s comments, though more hyperbolic than most, are one example.
The changes over the course of 2008 were so dramatic that Green-berg believed the Wall Street he helped forge no longer existed in any kind of recognizable fashion. Some nostalgic Wall Streeters view the investment banking landscape of the 1960s, ’70s, and early ’80s as a kind of utopia: investment banking as its purest, before the 1987 stock market crash, the collapse of the junk bond market, and Gordon Gekko made Wall Street seem slightly reckless and disreputable. To others, Greenberg among them, the golden era is the more recent past, when investment banks such as Bear Stearns saw their revenues and proﬁts soar as they catered to the emerging powers on the Street, hedge funds and giant buyout funds, and watched their bonus payments and personal wealth climb even more rapidly.
The balance of power has certainly shifted on Wall Street, and new products, players, and technologies have transformed it. But Greenberg’s comments were directed at the collapse of speciﬁ c institutions: the shotgun wedding of his own ﬁrm with JPMorgan Chase, the bankruptcy ﬁling of Lehman Brothers, and, the same weekend, the ﬂight of Merrill Lynch into the arms of Bank of America. Greenberg most likely knew about the behind-the-scenes wheeling and dealing orchestrated by Ben Bernanke and Hank Paulson that involved every conceivable combination of every Wall Street ﬁrm with every one of its rivals ( J.P. Morgan and Morgan Stanley? Goldman Sachs and Citigroup?). The desperate rush to save the ﬁnancial system from utter collapse had resulted in the kinds of merger negotiations—however short-lived—that would have seemed laughable only weeks earlier. To Greenberg, still reeling at the collapse of his own ﬁrm (which had, after all, survived even the 1929 market crash and the Great Depression), that must indeed have felt like the end of Wall Street.
Wall Street, however, is more than just a set of institutions with big brand names, however old and venerable. At its heart, it is a set of functions, and those functions remained intact even in the midst of the crisis. Two days before Greenberg delivered his epitaph for Wall Street, a small Santa Barbara company, RightScale, raised $13 million in venture capital backing from a group of investors led by Silicon Valley’s Benchmark Capital.2 RightScale’s secret? It was in the right business—cloud computing, a way for customers to reduce their IT development costs by using Internet-hosted services—at the right time. Despite the dramatic headlines focusing the world’s attention on the plunge in the stock market and the deep freeze that hit the credit markets, parts of Wall Street’s core business were still functioning, albeit in a more muted fashion. In the ﬁnal three months of 2008, venture capital ﬁrms invested $5.4 billion in 818 different deals, bringing the total for the year to $28.3 billion. That was down a bit from 2007, when venture ﬁrms—partnerships that have made fortunes backing companies such as Amazon.com and Google and lost smaller amounts backing stinkers such as Pets.com—put $30.9 billion to work. But it’s still more than they invested in any year from 2002 through 2006.3 By the ﬁrst anniversary of the collapse of Lehman Brothers, even the high- risk world of junk bonds was back in business. The sign? Beazer Homes, one of the worst-hit home- building companies in the entire industry, was battling not only the collapse in the real estate market but also a federal fraud investigation. Yet Wall Street found enough investors willing to close their eyes to those risks and invest $250 million in junk bonds issued by the company to help replenish its coffers.4
What Does Wall Street Do, and Why Does It Exist?
The reason for the Wall Street bailout—the explanation for Hank Paulson being desperate enough to literally drop to one knee in front of Nancy Pelosi in the White House and plead for her help passing the initial $700 billion rescue package—is that Wall Street’s functions are essential to the economy. According to reports that were leaked to the media almost immediately, Paulson begged Pelosi not to “blow it up” (referring both to the bailout package and the ﬁ nancial system itself ) by withdrawing the Democratic Party’s support for the rescue effort. “I didn’t know you were Catholic,” Pelosi quipped, referring to Paulson’s kneeling before her, in an effort to lighten the atmosphere before blaming the Republicans for the gridlock.5
By saving some of Wall Street’s institutions—those viewed as the strongest or the most important to the system—the architects of the bailout and many of the subsequent reform packages hoped to preserve intact the system that enables capital to ﬂow more or less smoothly through the economy the way power ﬂows through the electrical grid or water through a municipality’s water and sewer system. Regardless of what Main Street was thinking—and communicating to their members of Congress—Wall Street isn’t incidental to what happens in the rest of the economy. Without Wall Street to perform its ﬁ nancial grid functions, it would prove almost impossible to raise capital to repair bridges, ﬁnance new companies such as RightScale, and keep others—such as Beazer Homes—aﬂ oat.
What we tend to think of as Wall Street—the stock market, the investment banks, and the newer entities such as hedge funds—is really only the visible tip of a much larger iceberg that is the entire ﬁnancial system. Collectively, these institutions help ensure that capital continues to move throughout the rest of the “money grid.” Sometimes they do this by providing a market for participants to undertake basic buy or sell transactions; on other occasions, they negotiate or devise solutions to more complicated capital- related questions, such as helping a company go public or sell debt (a process known as underwriting) or working with it to establish and achieve the best price possible in a merger negotiation.
That intermediary function is alive and well, most visibly at the New York Stock Exchange, which occupies not only the epicenter of Wall Street at the corner of Broad and Wall Streets but the heart of its role as a ﬁnancial utility. On its sprawling trading ﬂ oor, traders go about their business in much the same way their earliest pre decessors did in the naves of Amsterdam churches, executing the purchases of blocks of shares for their clients, who these days could include an individual trying to sell 100 shares of General Electric or Microsoft inherited from a grandparent or a mutual fund manager trying to reduce his holdings in Amazon.com in order to buy a stake in Alibaba.com, a Chinese counterpart. Exchanges trading stocks, futures, and options contracts as well as commodities remain one of the most heavily regulated parts of Wall Street because of the essential role they play in a large, geographically scattered, and diverse community.
Not convinced of the value of Wall Street’s functions and processes? Imagine you are a retiree in your seventies, living off your investment portfolio. The wisdom of your decision to invest in Microsoft in the mid-1980s has become clear; now you’re counting on being able to sell some of that stock at its current market value in order to cover your living expenses for the next six months. Wall Street’s processes make that relatively simple—all you have to do is place an order to sell the stock at the market price with your broker or custodian (say, Charles Schwab) and ask for the money to be transferred to your bank account when the trade is settled in three days’ time.
Now, imagine that there was no Wall Street. For starters, you’d have a hard time establishing a fair price for that stake in Microsoft without the stock market, with its countless numbers of buyers and sellers meeting in cyberspace to decide each minute of the day what value they ascribe to Microsoft’s shares and thus what price they are willing to pay for your stock. Even if you thought you knew what your shares were worth, how would you ﬁnd a buyer and persuade her that your analysis is right? Would you go door-to-door in Miami or Los Angeles? Put up an ad on Craigslist? (In Vietnam’s over-thecounter market, that is exactly what happens; you then arrange to meet the buyer on a street corner to swap the shares for cash.) And if you found a buyer, could you be certain that you would be paid in full and on time, so that you could pay your own mortgage and purchase your groceries?
Money has existed for millennia, ever since people recognized that barter was an inadequate method of exchange. The stock exchange, just a few centuries old, was the next logical step as society’s ﬁnancial needs became more complex. The ﬁrst exchanges were established in wealthy trading cities such as Hamburg, Antwerp, and Amsterdam. Here, by the early sixteenth century, there was a signiﬁ cant concentration of wealth in the hands of merchants and noblemen, all of whom had an interest in putting it to work in new and different kinds of enterprises in the hope of diversifying and making still more money. These communities traditionally were also home to cutting-edge commercial enterprises, ranging from new technologies such as printing to global trading ventures to the East Indies.
Investors willing to back these enterprises—most of which could take years to pay off—needed a secondary market: a place where people who were interested in buying or selling shares in ventures could meet each other or ﬁnd an intermediary to help them with that transaction. For a while, Amsterdam’s church naves served that purpose, along with the open-air wharves on Warmoesstraat near the city’s old church, or Oude Kerk. The ﬁrst formal stock exchange in Amsterdam opened its doors in 1610; between noon and 2:00 p.m. each business day, members were expected to show up and buy and sell on behalf of the general public—in other words, to provide liquidity to the secondary market.6 By 1688, the Amsterdam exchange already looked a lot like the trading ﬂoor of the New York Stock Exchange in its twentieth-century heyday; seventeenth-century stock jobber Joseph de la Vega, in his dissertation on the ﬁ nancial markets of the time, entitled Confusión de Confusiones, famously described the scene as one in which “handshakes are followed by shouting, insults, impudence, pushing and shoving.” (Perhaps it was this familiar atmosphere that led so many former professional football players to pursue second careers in the trading pits of the Chicago Board of Trade and the Chicago Mercantile Exchange.)
There probably has never been a time when people didn’t complain about how the ﬁnancial system worked—or failed to work. Nevertheless, the United States, as Alexander Hamilton, the country’s ﬁrst Treasury secretary, realized, would need a smoothly functioning ﬁ nancial system as part of its struggle to emerge as a viable nationstate.7 Hamilton’s initiatives included creating the country’s ﬁrst national or central bank, the First Bank of the United States, to replace myriad institutions within each of the thirteen original colonies, each of which had its own monetary policy and issued its own currency. Hamilton’s goal was ﬁnancial order and transparency, necessary if the new country was going to be able to repay its war debt and ﬁ nance its growth by investing in new industries.
Wall Street, the narrow thoroughfare in lower Manhattan that owed its name to its former role as the northern border of the sixteenth- century Dutch colony of New Amsterdam, beneﬁted from many of Hamilton’s efforts to create the infrastructure of a national ﬁ nancial system and emerged as the heart of the new country’s ﬁ nancial markets. It was here merchants chose to hang out on street corners to swap their ownership interests of government debt or the handful of start-up companies, such as canal construction ventures, that would form the core of the United States’ new economy. (If you wanted to trade in the bonds newly issued by Alexander Hamilton’s ﬂ edgling Treasury Department, you’d have to know which lamppost on Wall Street to stand under.) Eventually, the introduction of New York state regulations banning curbside haggling as a “pernicious” practice drove these early Wall Streeters indoors. Some two dozen dealers gathered under a buttonwood tree to sign a pact that served as the foundation of the New York Stock Exchange. First housed informally in a Wall Street coffee house, the exchange moved to a room at 40 Wall Street in 1817, paying $200 a month in rent, before relocating to the quarters it now occupies, just across Wall Street from Federal Hall. Today, the original Buttonwood Agreement, a tiny sheet of yellowing paper, is on display at the Museum of American Finance a few doors away at 48 Wall Street, the building that once housed the Bank of New York, also founded by Hamilton himself.
“You know, if Hamilton came back to life, I don’t think he’d be all that surprised at the way the ﬁnancial system has evolved,” says Dick Sylla, the Henry Kaufman Professor of the History of Financial Institutions and Markets at New York University. A silver-haired, slightly built man, Sylla appears unrufﬂed by the dramatic changes that have taken place on Wall Street, smiling wryly at a display at the museum featuring Citigroup’s now-reviled leaders—Robert Rubin, Sandy Weill, and Charles Prince. But then, for him as for Hamilton (about whom he is writing a book), America’s ﬁnancial system was never about a single institution, however large. “It’s all about the functions that the various institutions perform, rather than what names they go by or where their headquarters happen to be,” Sylla explains. “Hamilton knew that there would be bubbles and periods of chaos. But if over the long run the system as a whole performs its function of allocating capital and allowing us as investors to diversify our portfolio, to not put all our eggs in one basket, it is doing what he wanted it to do.”
The Nature of the Money Grid: The Intermediary
Wall Street, in its totality, involves more than what happens on the ﬂoor of the New York Stock Exchange or within the walls of any single investment banking institution. It has become a labyrinth of many different groups and institutions, all of which have one thing in common: they make the whole money grid work more smoothly and more efﬁciently. Many of them work hundreds or thousands of miles away from Wall Street itself. In Tacoma, Washington, Russell Investments devises stock indexes widely used by mutual funds and other big investors; in Kansas City, a ﬁrm called TradeBot uses computer-generated models to exploit tiny differences in the price of different types of securities and trades—in only milliseconds—on that information, making markets more liquid; Chicago’s options exchanges make it possible for investors to bet not on the direction of a stock’s price but on the rate and magnitude of change in that stock price and the time frame in which the change will occur.
All of these players perform functions that link the “buy side,” those who have capital and want to invest it proﬁtably, and the “sell side,” those entities in need of capital. “At its heart, when it is doing what it does best, Wall Street is a superb gatekeeper, making matches between investors and businesses, governments, or anyone else who needs to ﬁnance something,” explains Mike Heffernan*, a former Morgan Stanley banker. The sell-side client could be a regional bank trying to resell portions of some of the loans it has made, a credit card company looking for an investment bank to package up its receivables into asset-backed securities for resale, a town in Indiana trying to ﬁnd an underwriter for the municipal bonds it must sell in order to ﬁnance new hospitals and schools, or a company trying to raise capital for expansion or to acquire a rival.
The sell side wants to get as much capital on the most favorable terms possible from the buy side—investors who range in size and importance from individuals to mutual fund conglomerates such as Fidelity, and include hedge funds, private equity funds, foundations, college endowments, pension funds, venture capital partnerships, and ultrawealthy individual investors such as Microsoft cofounder Paul Allen or ﬁnancier George Soros. In a perfect world, the sell side would love free money—with no interest payable, no speciﬁ c term for repayment, and no promises about increasing the value of the investment. It is the myriad institutions that collectively make up Wall Street that—in exchange for a fee—bring together the two parties and negotiate a compromise: the terms on which the buy side is willing to invest some of its capital and the sell side is willing to agree to in order to get its hands on that capital. Banks have been fulﬁ lling that kind of function in more limited ways for centuries: the Bank of Venice issued government bonds back in 1157 to ﬁnance its war with the Byzantine empire in Constantinople, and by 1347, as the Medicis rose to power in Florence, there were no fewer than eighty banks making loans and doing business in that city-state; a few years later, the Florentine authorities started a special credit fund that would give interest-free loans to distressed condottieri, or soldiers of fortune.8
But as the sums got larger and the members of interested parties on the buy side (investors) and sell side (individuals or entities in need of capital) expanded in size and number and their needs became more complex, the process of bringing them together got tougher, and Wall Street–like intermediary institutions arose to facilitate the procedure. If you were a former condottiere who had lost an arm ﬁghting for Florence against its neighbor and rival city-state Pisa in the fourteenth century, you knew which bank to approach for your interest-free loan. But what about ﬁnancing a decade-long voyage to Southeast Asia in hopes of ﬁnding the mysterious Spice Islands and returning with a king’s ransom in the shape of black pepper, cinnamon, and nutmeg in the sixteenth century, or funding the development of the latest gene-based cancer therapies in the twenty- ﬁrst century? Both require the right kind of buy-side backer, or else the sell-side entity (the merchant adventurer or biotech engineer) would squander weeks or months it could ill afford trying to raise the capital it needed on its own. And it was only logical that these go- betweens—the investment banks and their pre decessors, who made it their business to be familiar enough with all the deep- pocketed members of the buy side to quickly route the different investment opportunities to those they believed would have the most interest and the right risk appetite—should pocket a fee for that knowledge as well as for their skill in negotiating the terms of any investment.
Wall Street exists to help investors and those in need of capital ﬁnd their way through the ﬁnancing maze. Investment bankers still not only link the two sides but also help them sort out what terms are fair for the kind of capital being sought. Wall Streeters weigh in on the relative merits of different kinds of capital as well, advising corporate chief ﬁ nancial ofﬁcers when it will be cheaper in the long run to issue debt on which the company will have to pay interest periodically, or when it might be a better idea to sell a stake in itself to investors in a stock deal. If they opt to issue corporate bonds, what kind of debt do investors want to buy, and what interest rate will the buy side demand in exchange for capital? Without the processes that Wall Street collectively oversees, it’s hard to see how that vital function in our economy would be ﬁlled. The U.S. Treasury could still issue bonds and sell them directly to citizens, and municipalities might be able to raise at least some of the money they need selling muni bonds to their own citizens. But the latter, at least, won’t raise all the capital they could at the cheapest possible price without an intermediary to help them identify the maximum number of interested investors.
If we were still back in the early 1900s, the prospect of the collapse of the investment banking system wouldn’t be quite as apocalyptic as it is today, at least as long as enough of the commercial banks remained in business. That’s because well into the 1920s, corporate ﬁnance was largely a matter of bank loans—if you could persuade your local bank manager that your business idea was sound and that you were a good credit risk, then he would lend you what you needed to get going and perhaps introduce you to some other folks who would invest in the ﬂ edgling company.
The earliest backers of auto pioneers Henry Ford and William “Billy” Durant (who founded both General Motors and Chevrolet) were local businessmen willing to risk some of their own money on two of the ambitious pioneers trying to build and sell the new horseless carriages. Durant even orchestrated a bidding war between Flint and Jackson, two midsized Michigan towns, to decide which would become the corporate headquarters of Buick, the company that would later become General Motors. Flint won the battle (along with the future tax revenue and jobs for its citizens) when its four banks and several carriage and wagon businesses, along with hundreds of other corporations and civic boosters, put up nearly $1 million in cash in exchange for stock in the ﬂedgling company, more than double what Jackson’s citizens were able to offer.9
Financing these entrepreneurs was both risky and nerve-racking: two-thirds of the more than ﬁve hundred car companies launched between 1900 and 1908 had either collapsed or changed their business within a few years.10 Once a bank or a backer had committed its capital to a speciﬁc venture, there were few exit strategies—the stock wasn’t publicly traded. This early version of the money grid was unsophisticated and underdeveloped. Even Durant— far easier to work with than the mercurial Ford, and a former stock trader to boot— couldn’t penetrate Wall Street’s establishment and get the money grid working for the beneﬁt of his company. Discussing the possibility of forming a trust made up of the biggest automakers to design and build a car for the mass market with J. P. Morgan’s minions, Durant couldn’t persuade the great man himself of the virtues of the automobile. Much as he loved the idea of an oligopoly, Morgan seemed to love his horse-drawn carriage still more, dismissing automobiles as toys for the rackety younger generation and Durant as an “unstable visionary.”11 Durant was no more enamored of Morgan. “If you think it is an easy matter to get money from New York capitalists to ﬁnance a motor car proposition in Michigan, you have another guess coming,” he wrote bitterly to his lawyer. Ultimately, Durant relied on local ﬁnancing to get his new venture, General Motors, off the ground. Henry Ford managed to steer clear of Wall Street until the end of his life, relying on a steady ﬂow of loans from banks such as Old Colony Trust Co.
Today’s money grid is altogether a far more sophisticated and effective entity, having expanded geographically and evolved functionally. Wall Street is no longer a small clutch of giant investment banks, but includes a large and diverse network of venture capital funds whose speciﬁc function is to underwrite risky start-ups of the kind that Ford and Durant sought ﬁnancing for a century ago and that a new generation of automotive industry entrepreneurs are trying to launch today. “This is what we exist to do,” says Dick Kramlich of New Enterprise Associates, one of the venture industry’s veterans. “Until the postwar period, and even for a while after that, if you wanted to start something completely new, your personal network needed to include people who had money or who could vouch for you to the bank. Now all you need is a great business plan that you can get in front of one of us. We’ve become part of the bigger, broader Wall Street system.”
Indeed, during the Internet boom in the 1990s, Sand Hill Road, the long and winding thoroughfare that connects downtown Palo Alto, California, with the campus of Stanford University and other parts of Silicon Valley, became a kind of Wall Street west as the venture capital funds that set up shop there became more important to both the economy and the ﬁnancial markets, ﬁ nancing start-up companies and generating big paydays for their own backers when some of those—eBay, Amazon.com, Netscape, and Google, to name a few—hit it big. Of course, just as many of the ships that sixteenth- century merchants ﬁ nanced in their voyages to the Spice Islands of Indonesia ended up dashed to pieces against the rocks on the coast of Africa, so many of the start-ups that today’s venture capitalists back never live up to expectations or go belly-up. But the winners have been frequent enough that venture capital investors willing to wait ﬁve, six, or even ten years for their bet to pay off in their little corner of Wall Street can make just as much money as top-ﬂ ight investment bankers or superstar hedge fund managers in theirs.
At the height of the dot-com boom in 1999, commercial real estate on Sand Hill Road was more expensive to rent than anywhere else in the world (including Manhattan and London’s West End), reﬂecting the triple-digit returns some venture funds were earning.
That bubble popped in 2000, making it possible once again to ﬁ nd affordable ofﬁce space in Silicon Valley. But the venture capital community continues to scour the landscape for the next “new new thing.” To many VCs, one of the most exciting of these is green technology, with businesses built around environmentally friendly twists on the pioneering products of a century ago, such as new kinds of batteries and power generation technologies along with— yes, you guessed it— new kinds of automobiles. Detroit’s executives might have had to grovel for a share of bailout funds after their ﬁnancial prospects became so bleak that Wall Street east couldn’t do anything to help. But on Wall Street west, some of Sand Hill Road’s venture investors were eagerly backing companies such as Tesla Motors, founded by Elon Musk, the millionaire creator of electronic payments system PayPal.
“A few years ago, this was the lunatic fringe of the venture capital industry,” explains Ira Ehrenpreis, a general partner at Technology Partners, one of Tesla’s ﬁnancial backers. Today, he estimates, as much as $17 of every $100 that venture funds collectively invest goes into clean-technology companies as a category, while half of all the capital Technology Partners raises is allocated to the industry. Ehrenpreis waxes rhapsodic about Tesla’s ﬁrst car, the $109,000 Roadster, of which 1,200 were on order by the end of 2008; 937 had been sold by December 2009. “It makes a Prius look like a gas-guzzling hog and drives like a Ferrari!” he exults. A couple dozen of the brightly colored sports cars, which can travel 236 miles on a single charge, can sometimes be spotted whizzing silently along Silicon Valley’s highways and streets, Musk’s among them. The Roadster, says Ehrenpreis, shattered the belief that going green meant abandoning style; the next step is to take the concept to the mass market, rolling out a more affordable Tesla sedan by 2011, and to raise capital for that through an initial public offering (IPO) of stock in the company.
Kleiner Perkins Cauﬁeld & Byers is one of Silicon Valley’s most venerable venture ﬁrms; it has invested in most of the technology industry’s landmark deals, now runs a $100 million “iFund” jointly with Apple in addition to its other portfolios, and has the same status in the venture capital universe that Goldman Sachs does on Wall Street east. But despite the motto on its website—“In Search of the Next Big Idea”—the ﬁrm passed up the chance to invest in Tesla. “All-electric cars probably aren’t practical for a long time,” argues Ray Lane, a partner at Kleiner Perkins and former president of Oracle Corp., the world’s second-largest software company.
But Lane’s resistance to the idea of investing in a next-generation kind of auto company didn’t last long. Kleiner Perkins is now backing a more hybrid, less purist company, Fisker Automotive, launched by a designer who brieﬂy worked for Tesla. “The Fisker cars are what I call a ‘no-compromise’ vehicle—beautiful and with a price point as well as features that will compare to a BMW,” boasts Lane, who has a gray Fisker prototype in his garage at home that can run for ﬁfty miles per battery charge. “To back these electric vehicle companies, you have to be as entrepreneurial within the venture world as the entrepreneur is within the corporate world—in other words, very, very willing to embrace risk.” But, he quickly adds, Fisker will build some seven thousand electric vehicles in 2010. “GM can’t seem to produce one.”
By being able to reconceive itself and its role to include venture capital, Wall Street has proven itself, in the long run, more entrepreneurial than the Detroit-based automakers. It’s not just venture capitalists that have spotted the potential of this new breed of auto-maker, however. Even with only a few dozen vehicles on the road, the ﬂedgling green technology banking teams from Goldman Sachs, Morgan Stanley, Credit Suisse, and others were already making the trek to San Jose to check out Tesla and its rivals. So what if they are still guzzling capital faster than an SUV or Hummer can guzzle gasoline? Wall Street today doesn’t need to be persuaded that it needs to be present from the very beginning if it is to capture all the business—and proﬁts—it can. Sure enough, early in 2010, Tesla Motors ﬁled to go public, with Goldman Sachs selected to lead four blue-chip underwriters.
How the Financing Life Cycle Works
There may be no better example of Wall Street’s raison d’être than the role that venture capital—itself part of the money grid—plays in making entrepreneurial dreams a reality.
The same week that Lehman Brothers collapsed, the major ﬁ gures of the venture capital community assembled at Microsoft’s campus in Mountain View, California, a stone’s throw from Sand Hill Road. The occasion was the National Venture Capital Association’s thirty- ﬁfth anniversary. They listened to pre sentations by three carefully selected venture-backed companies: Tengion, a ﬁ rm developing biotechnology to build new human organs from cells; Digital Signal Corp., which is honing 3-D facial recognition software that can be installed anywhere from airports to shopping malls; and Tesla Motors. Formalities over, the crowd escaped gratefully to the reception room to quaff Napa Valley wines and buzz excitedly about the meltdown under way on Wall Street east. One of the most visible of those present was former star technology banker Frank Quattrone, who had spent the 1990s steering one promising technology company after another through the ﬁnancing pro cess, from the ﬁrst capital infusions to the initial public offering (collecting hefty fees for his ﬁ rms, which included Morgan Stanley and Credit Suisse, along the way). He became the banker most closely associated with the dot-com boom, but years after it burst, he was back helping start-up technology companies raise capital.
That eve ning he was talking up his new quasi- banking venture Qatalyst, and debating the impact the turmoil on Wall Street proper would have on start-up businesses in Silicon Valley and his own ﬁrm’s prospects. “He was very interested, feeling that this might pave the way for a revival of the old West Coast boutique investment bank, like the Four Horse men,” said one venture investor who was on the receiving end of his pitch that eve ning.
The Four Horse men were four small to midsized investment banks—Hambrecht & Quist, Montgomery Securities, Robertson Stephens, and Alex. Brown—that individually and collectively carved out both a niche and a reputation for themselves as the go-to guys for entrepreneurs in need of ﬁnance, venture capitalists hoping to take their portfolio companies to the next level, and investors hoping to get in on the ground ﬂoor of the next great business idea. “We didn’t go into this wanting to be Goldman Sachs; we knew we’d end up as a marginal player trying to compete with them on ground that they owned, and that would be dangerous,” recalls Bill Hambrecht, who founded the ﬁrm that bore his name and who now runs another boutique, W. R. Hambrecht & Co. “More than many of those larger East Coast ﬁrms, our model was very straightforward—we were there to help those companies move up the ladder to the next stage in their ﬁnancial life cycle.”
In 1981, the rest of the investment banking universe woke up to what was happening on the West Coast. “In a sixty-day period, we underwrote [the initial public offerings of stock in] Genentech, People’s Express, and Apple,” recalls Hambrecht. “I think we had sixty people in the ﬁrm; we made about $50 million that year and it changed everything.” Hambrecht had attended college with the late Dick Fisher, then chairman of Morgan Stanley, who recognized what was brewing before the rest of the big Wall Street institutions. “He called me, then came to visit me, and told me, ‘Okay, I want in on this business.’ I asked him what companies interested him, and he mentioned Apple and a few others—he and his team had done their work and identiﬁed the best companies, not the biggest ones.” Hambrecht & Quist would go on to co-manage multiple deals with Morgan Stanley, helping each other earn hundreds of millions of dollars more in fees for both ﬁ rms before Fisher retired and Hambrecht & Quist’s partners decided to sell their ﬁrm to Chase Manhattan in 1999, at the peak of the dot-com market.
The names of the institutions that help Silicon Valley’s most promising companies move from one stage of development to the next by providing capital directly or introducing the company to potential backers are likely to continue to change, but the pro cess itself remains intact. The earlier it is in a company’s life cycle, the more informal that pro cess is, as was the case with Google, now a corporate behemoth. One of the company’s earliest supporters was David Cheriton, a Stanford professor who knew its founders, Sergey Brin and Larry Page. Cheriton also knew Andreas “Andy” Bechtolsheim, the cofounder of Sun Microsystems, and introduced him to the two would- be entrepreneurs at a gathering at his Palo Alto home. Bechtolsheim wrote Brin and Page a check for $100,000 on the spot even though the company hadn’t yet been formed. He followed that with another $100,000 when the ﬁrst formal venture ﬁnancing round occurred the next month.12 (One ﬁrm that passed on Google was Bessemer Venture Partners; offered the chance to meet the “Google guys, ” tinkering in the garage of a friend’s home, David Cowan asked if there was a way out of the house that would enable him to bypass the garage.)
In the space of those few weeks, the Google guys had rounded up another $760,000 in start-up funding after Bechtolsheim introduced them to John Doerr, one of Sun’s earliest investors and at the time the lead investor at Kleiner Perkins. Where Doerr went, others eagerly followed: the imprimatur of Kleiner Perkins was as valuable as that of Good House keeping or Goldman Sachs. Doerr roped in Jeff Bezos (he had also provided start-up funding for Bezos’s Amazon .com), who in turn brought along Amazon colleague Ram Shriram; all invested in the ﬂedgling company long before it was clear that Google was going to become, well, Google. At the time, it was just another speculative “angel” investment, one of scores that each of these individuals undertook between 1998 and 2000. But by the time the IPO had been sold and Google’s stock was trading on the public market, Bechtolsheim’s $200,000 was worth $300 million or so.
A typical venture ﬁrm, such as Kleiner Perkins, raises and provides capital at the earliest stages of the ﬁnancing life cycle. That capital comes from other buy-side players, such as college endowments, pension funds, and very wealthy individuals whom the general partners know and trust, often successful entrepreneurs such as Bechtolsheim and Bezos. Venture funds make most of their money from their share of the proﬁts of their funds (usually 20 percent) but also collect a fee from their investor base in exchange for their services bringing together those investors with bleeding-edge investment ideas at their earliest (and most potentially proﬁtable) stage of development. Without venture funds and their vast networks, how would Verizon’s pension fund know that two bright young Stanford students were about to put together a company that within a decade would dominate the technology landscape? And how would Brin and Page have navigated the Wall Street labyrinth in search of ﬁ nancing at such an early stage, while still working out of a friend’s garage?
The next stage in the ﬁnancing life cycle for venture-backed companies such as Google is something that will allow those early backers to realize the value of their investment. People such as Doerr and Bechtolsheim, like everyone else on the buy side, don’t want to keep their capital tied up in the same companies indeﬁnitely; at some stage they want it back, along with a healthy return, in order to put it to work somewhere else and repeat the pro cess. In other words, they want liq uidity, just as any of those sixteenth-century merchants wanted to be able to sell part of his stake in the East Indian trading vessel long before it returned home with its hold stuffed with nutmeg, cinnamon, and silks so that he could provide his daughters with dowries.
By the time Google was ready to go public in the spring of 2004, its team didn’t need any help from Bechtolsheim or Doerr in ﬁ nding an investment bank willing to serve as an intermediary between Google and its future stockholders. Every investment bank in the United States, as well as an array of foreign competitors, wanted a piece of the action. Unlike all the dot-coms that had crashed and burned just months earlier, this technology company could point to real revenues, not just an ambitious business plan. It was a jewel, and every bonus- starved banker wanted a place on the list of underwriters—preferably as lead underwriter or, even better, the book runner, the guy in charge of deciding which equally excited mutual fund managers, brokers, and individual investors would win a few Google shares at the IPO price and who would get to pocket the bulk of the underwriting fee in compensation for all the aggravation. This would be a multibillion- dollar offering, and in a typical IPO, the underwriters collectively could pocket as much as 7 percent of the proceeds as their fee.
Every banking team in the world began to chase the deal, and they all took it very seriously indeed. Morgan Stanley opened up a Silicon Valley war room, complete with a team of top bankers and analysts preparing pitch books and rehearsing answers to questions they expected to get from Lise Buyer, then Google’s chief ﬁ nancial ofﬁ cer, and the other Google execs who would select the winners. “It was just like a presidential election campaign,” recalls Hambrecht. Two weeks before the “bake-off ” was scheduled to take place at the Palo Alto ofﬁces of Google’s law ﬁrm, Wilson, Sonsini, Goodrich, & Rosati, pitting the ﬁnalists against each other, Morgan Stanley’s team hired the key analyst that Hambrecht had assigned to prepare his own ﬁrm’s pitch for the deal. “They wanted to ﬁnd out what we were doing,” Hambrecht says, shrugging. “All’s fair in love and war.”
And this was war, make no mistake about it. On a Saturday afternoon in early April, the ﬁnalists were scheduled to appear, one at a time, to make the ﬁnal pitch to Google executives and board members, each explaining (with the aid of thick pitch books stuffed full of charts, diagrams, and other propaganda) why they were the only guys for the job. The Google folks knew what they were in for. Buyer had helped prepare pitch books herself in a previous life as a top technology analyst. Aware of the other tricks that Wall Streeters liked to play, she instructed the top bankers to stay home, decreeing that only the middle- ranking people who would actually do the grunt work on the deal should show up. (Few abided by that rule.) She also told them to be creative. “We wanted to be sure we’d be working with bankers who got our corporate culture, so I guess we kind of opened the door to a lot of the silliness that followed,” she said.
One banking team brought beer, apparently assuming that a freewheeling culture was synonymous with the liberal consumption of alcohol. Another tried to design a PowerPoint pitch incorporating Google’s own search engine, which would spit out the ﬁ rm’s name when asked, “What is the best bank to underwrite Google’s IPO?” (The technical challenge proved impossible, and the banking team resorted to a paper version of the same pitch.) Citigroup’s technology bankers designed laminated place mats that spelled out the bank’s achievements and creative strategies for marketing Google to the public, using Google-like design elements and layout. The place mats probably came in useful for the pièce de résistance. The banking team from Goldman Sachs, taking to heart Buyer’s quip that, “given that we’re all here on a Saturday afternoon, you can damn well bring me dessert,” and learning through their own research that Brin and Page loved chocolate, ordered up a big chocolate cake, emblazoned with the Google logo, to bring to the pitch meeting. Stunts like that have been known to work, as Lisa Carnoy, who is now global capital markets co-head at Bank of America, knows from her days co- managing the same group at Merrill Lynch & Co. Pulling together a pitch book for the investment bank’s pre sentation to Lululemon, a yoga clothing retailer seeking to go public, Carnoy included details of the favorite yoga positions of each member of the banking team in hopes of showing just how much the bankers understood their potential client’s business. “They got a kick out of that and we got the deal,” she recalled.
Winning an IPO is one matter; completing it to the satisfaction of all parties is something else altogether. However crucial the role played by Wall Street in bringing together and reconciling the competing interests of the buy side and the sell side, there is usually one group that feels it has given up too much in the pro cess. A typical IPO investor, for instance, wants the largest allocation possible of a hot new issue. Many of those investors are also investment bank clients; they execute buy and sell orders and generate trading fees for Wall Street institutions year- round and aren’t shy about telling the investment banks what they expect them to deliver in return. Fidelity, back in the days when it routed more than half of its immense trading activity through Wall Street trading desks, routinely threatened to “cut the wire” and trade with a particular investment bank’s rivals if it didn’t get an allocation twice that of its nearest competitor for an enticing IPO. The investment bank usually obliged.13
To make the buy side happy, the new stock should be priced at a level that will allow it to rise in value—preferably by 20 percent or more—in the days immediately following the IPO. That gives any mutual fund manager the chance to sell some of his shares at a quick proﬁt—and can mean a big boost in trading revenues for the investment bank as trading volume in the newly public stock shoots higher. When Netscape went public in 1995 at $28 a share, it posted its ﬁrst trade at $71. Those watching the electronic screens were convinced it was a typographical error or that they were hallucinating. An entrepreneur watching that kind of drama, however, is well aware that he may have just lost millions of dollars of new capital for his company and is left wondering whether Wall Street has just ripped him off. “Everyone was angry about that, and very vocal about” what they viewed as giving up that much in potential proceeds, says Buyer.
Google tried to ensure that it would capture as much of the proceeds as possible for itself and its backers. In fact, while the deal itself turned out to be messier and less proﬁtable than anyone had hoped, it did at least leave all three parties—the buy side, the investment bankers, and the company itself— feeling equally dissatisﬁ ed. Morgan Stanley and Credit Suisse were told they had won the coveted co-lead- underwriting spots but that they would have to use Hambrecht’s new method of capital matchmaking, a kind of auction that forces would- be buyers to bid against each other for the stock, disclosing the maximum price they will pay. That approach was anathema to both bankers and the buy side: it not only involves a much smaller fee for the underwriters (about 2 percent of the proceeds rather than the traditional 6 percent or 7 percent) but also in theory eliminates the possibility of a ﬁrst-day pop in the price of the newly public company of the kind that investors cherish but that issuers such as Google had learned to loathe. Hambrecht’s new ﬁrm, W. R. Hambrecht & Co., which had devised the auction methodology, won a co- manager slot due solely to Brin and Page’s fascination with the auction idea rather than his four- page stapled pitch, which Buyer rated the worst she’d ever seen.
For their part, potential buyers were disgruntled at being asked to relinquish their traditional instant proﬁt. Hambrecht remained unfazed. The auction pro cess, he says, “means that Wall Street is really fulﬁlling its role as the intermediary because the proceeds are going to the company, not as instant, nearly risk-free returns to the bankers or investors who’ve owned the stock less than seventy-two hours.” The rock- bottom fee took a toll on the pro cess, banking analysts would later argue. Merrill Lynch walked away from the underwriting syndicate outright, unwilling to do all the work for what it saw as a measly return. The remaining underwriters later confessed to being reluctant to battle as ferociously as they might have done to combat buyer apathy, given the low fees. Buyers lowballed the deal, responding to the pro cess and the deteriorating climate for technology stocks. Google had to settle for a price of $85 a share, instead of the $135 it had hoped to make from the deal.
The Troubled Heart of Wall Street
The process of underwriting an IPO or raising other kinds of capital for companies such as Google and providing exit strategies for their venture backers remains one of the core “utility” functions of Wall Street’s big investment banks. “It’s really not all that different today from the way it was back in the 1960s, when I wrote my ﬁrst-ever case study about the IPO pro cess,” says Samuel Hayes, professor emeritus at Harvard Business School. Only the names of the issuers and the underwriters are different, while the dollar amounts are larger. But as the Google transaction illustrates, the relationships between Wall Street institutions and the two groups on either end of the capital exchange transaction that develop when a company goes public or otherwise raises new debt or equity capital aren’t always smooth and straightforward. On the sell side, corporate clients such as Google don’t always feel that their investment bankers are looking out for their best interests. Meanwhile, parts of the buy side—the investors— are just as skeptical.
The ﬁrst part of the problem—the increasingly bumpy relationship between the investment bank and its corporate clients—Hayes attributes to changes on Wall Street itself. The mergers that have taken place over the last twenty years—all of the Four Horse men were absorbed by national institutions, most of which in turn became part of still more massive ﬁnancial behemoths—mean that doing the kind of smaller deal that is characteristic of what most companies need in the earliest days of their existence isn’t cost-effective. Venture capital investors are well aware of this trend, and it worries them. “Unless I have another potential Google, these guys don’t want to know,” says one Silicon Valley venture capitalist bitterly. “They want the sure thing, the big deal that is going to be able to make a visible difference to their own proﬁts at the end of the quarter. They are more interested in that than in building relationships with corporate clients that might generate a stream of fees over the years. They have betrayed our trust.” He points to Goldman Sachs, which shuttered its Sand Hill Road outpost (in a building it had shared with archrival Morgan Stanley) a few years after the tech bubble burst. “They’ll ﬂ y people in for things they consider important, but there aren’t as many people competing to serve this space, which means that all the companies that we are starting to fund today are going to have a much harder time in the later stages of their corporate lives when it comes to getting ﬁ nancing.”
This venture investor predicts that a greater number of venture-backed companies will wither on the vine, unable to get ﬁ nancing simply because of their size relative to that of the investment banks. That, he argues, may not augur well for the future of both entrepreneurial energy and Wall Street. Will some prospective entrepreneurs be deterred or some promising companies derailed? And what happens if Wall Street turns its back on its core function of helping promising businesses realize that promise by accessing capital? “We play our role; we want Wall Street to play theirs.”
For now, at least, the venture industry is keeping its part of the tacit bargain and continuing to invest billions of dollars a year in start-up companies. Despite the market chaos, venture funds still want to back the companies that they believe have the potential to become next-generation versions of Genentech, Google, or Amazon. These days those companies will range from start-ups offering innovative ideas on managing power grids more efﬁciently to businesses based on new medical devices. But by 2009, the signals were becoming more mixed. Wall Street’s recent aversion to doing what it saw as small-scale underwriting deals had remained, and had been exacerbated by the general chaos as banks focused on their own internal restructuring. That forced some venture companies to direct as much as 40 percent of their investment funds in 2009 toward existing, relatively mature companies still languishing in their portfolios and unable to ﬁnd an exit.14 In a normal year, says Jim Feuille, a general partner at Crosslink Capital, his venture capital ﬁ rm invests in eight or nine new businesses. By late October 2009, they had selected only three new companies in which to invest, in order to preserve enough capital to be able to continue supporting those older businesses. The National Venture Capital Association reported that the same trend was being seen across the industry: by the third quarter of 2009 only 13 percent of all venture capital investment dollars were directed to ﬁrst-time companies, the lowest percentage on record. Venture capital analysts such as Tracy Lefteroff at PriceWaterhouseCoopers began to fret that if this trend continued, it could create a “hole” in the pipeline of companies going public, doing a disservice to parties at both ends of the money grid.
This kind of breakdown in the relationship between Wall Street, as represented by investment bankers, and its corporate clients isn’t conﬁned to Silicon Valley—nor, as I’ll explain later in the book, is the breakdown restricted to one part of the money grid. The relationship between Wall Street and its partners on both the buy and sell sides has been under threat for more than a decade, as Wall Street drifted further and further away from its core utility function and those clients generated a decreasing proportion of its revenues and proﬁ ts.
From Gatekeeper to Casino Croupier?
Harvard Business School’s Sam Hayes has studied the breakdown in the relationship between Wall Street and its corporate clients in real time. Hayes knows whereof he speaks. He holds the Jacob H. Schiff Chair in Investment Banking as a professor emeritus and has studied Wall Street from the perspective of a scholar (he has published seven books and countless research papers and other articles about various aspects of Wall Street), a con sultant (to the Justice Department, the Treasury Department, and the Securities and Exchange Commission, as well as many businesses), and even a participant (he chairs the investment committee at his alma mater and is a former chairman of the Eaton Vance family of mutual funds, making him a member of the buy side, while his role as a member of the advisory board of brokerage ﬁ rm Edward Jones puts him on the sell side). When in 1970 he began scrutinizing the way Wall Street worked, it was performing its intermediary function adeptly; the relationships with clients, he says, were true long-term ties of importance to both parties. When a CEO wanted to sell bonds, raise new capital through a stock issue, or mull over other strategic issues, he’d pick up the phone and call his banker. That banker would be the same person, or at least someone at the same ﬁrm, year after year.
But Hayes soon began to detect signs that those relationships were crumbling, as they came under siege from both sides throughout the 1970s. A new breed of CEOs and chief ﬁ nancial ofﬁ cers with MBA degrees felt better equipped to pit one Wall Street ﬁ rm against another in search of a way to cut ﬁnancing costs. Wall Street ﬁ rms were quite eager to poach their rivals’ investment banking clients, adding fuel to the ﬁre. To both groups, this breakdown seemed logical and even beneﬁcial—why shouldn’t corporations shop around for the best deal and investment banks compete to offer that deal? By 1978, Institutional Investor magazine had stopped publishing the annual “Who’s with Whom” list documenting which ﬁ rms “banked” which corporate clients. “Clients didn’t like being labeled as ‘belonging’ to Kuhn Loeb,” Hayes recalls.
The turning point came a year later when IBM wanted to add Salomon Brothers as a co–lead underwriter to a bond sale it was planning. When the company informed its traditional bankers at Morgan Stanley of its wish to include Salomon because of the latter’s growing importance in the bond markets, Morgan Stanley refused to share the spotlight. (At the time, Morgan Stanley, in an attempt to emphasize how exclusive it was in the clients it accepted, even insisted on using a special typeface in the newspaper “tombstone” ads announcing deals it had done.) Instead of backing away from the idea, as Morgan bankers had expected, IBM awarded the whole deal to Salomon Brothers, shutting out Morgan Stanley altogether. It wasn’t until 1984, when Morgan Stanley agreed to share the lead underwriting role for Apple with Hambrecht & Quist, that the blue-chip New York ﬁ rm conceded that it would have to relinquish part of the limelight on occasion in order to participate at all in the deals it wanted to do.
If IBM’s decision to put its foot down was the turning point in the relationship between Wall Street and the sell side, the tipping point in ties between the Street and its buy-side clients came in 1995, when Netscape went public with the assistance of several leading investment banks. The transaction certainly was part of Wall Street’s core function—the underwriters were raising money for a corporate client—but the company in question had a far riskier and less established business model than those that bankers were accustomed to introducing to the buy side. With Netscape, says Lou Gelman*, a former Morgan Stanley banker involved in the IPO, Wall Street was asking its buy-side clients to adopt a completely different approach to investing. Netscape wasn’t earning a proﬁt, and its business model was untested, relying on the then- new phenomenon of the Internet. “Until Netscape came along, Wall Street used to say a company had to have two years of operating proﬁts in order to go public,” Gelman says. But Morgan Stanley badly wanted a piece of what promised to be a very hot IPO. “Suddenly our top guys were tossing their own rules out the window in order to get this business.”
Above all, the Netscape IPO opened the door to speculation as an investment strategy. It was now in Wall Street’s ﬁ nancial interest to encourage its buy-side clients to toss away their concerns about investing in a relatively risky business. “We went from being a gatekeeper to [being] a croupier,” says Gelman. Until that time, he argues, Wall Street had served its buy-side clients by helping them preserve and protect their wealth. Now the ethos seemed to have changed; Wall Street was becoming a casino, a place where people could create wealth rapidly by speculating. “It was with the Netscape IPO that the conviction we have today—that it’s actually possible to get rich in a day by owning the right stock—took root,” Gelman says. “It’s corrupting.”
Not only that, but for several years it was also exciting and dramatic; that drama would help swell Wall Street’s own coffers as hundreds of Internet companies followed Netscape’s lead and paid their 7 percent underwriting fee to go public. It all followed the success of the Netscape underwriting team, which, after overseeing the pro duction of an IPO prospectus containing twenty-plus pages of risk factors, took the ﬂ edgling Internet company’s management team on the road to drum up buying interest. The target stock price crept slowly higher, to $12 per share and onward, as public awareness grew during that “road show.” The battle to acquire stock in the deal ended up bringing Wall Street and Silicon Valley to Main Street’s attention; both captured the imagination of ordinary investors who until then had never had a brokerage account. One caller to Netscape’s headquarters asked what the IPO signiﬁed. “Essentially that means our company will be trading a certain number of shares on the stock market, which will raise capital so we can expand our business,” the operator informed him. “What’s the stock market?” the caller inquired. Another caller had heard people talking about the deal in the grocery store and wanted more information. A third threatened to report Netscape to the San Jose police for “insider trading” when he wasn’t allotted shares at the IPO price of $28 apiece. It’s not surprising he was unhappy: the stock soared as high as $75 in its ﬁrst trading day, before closing at $58 a share.
The external exuberance wasn’t always matched inside Morgan Stanley itself, even after the deal turned into a runaway success story. “Some of us pushed back, but the argument came down to the reputation of our franchise against the potential revenue,” says Gelman today. “Were we going to be the ﬁrm that doesn’t do early-stage IPOs, when this is what the public wants to buy? No one, it turned out, was willing to walk away and leave that to our rivals.” By the time the dot-com bubble was fully inﬂated, Gelman was convinced that the capital- raising pro cess had undergone a fundamental change. “We weren’t there to provide companies with the best long-term sources of capital to grow with; we were doing this to help our investor clients get richer faster.” In his view, Wall Street had abandoned both of its core constituencies in pursuit of its own self-interest.
That approach gained momentum as the years passed, and extended into a variety of products, including higher- risk corporate bonds and collateralized debt obligations (CDOs), the bundles of mortgages (including those issued to subprime borrowers) that had been repackaged in the form of marketable securities. Caveat emptor, Wall Street declared—buyer beware. “Eighteen or twenty years ago, when someone [on Wall Street] showed us a bad product, we went crazy; we’d tell them, ‘Don’t ever show us that again,’ ” recalls Scott Amero, a portfolio manager at BlackRock, a major buy-side asset management ﬁrm. “At ﬁrst we took the time to explain why something was a bad product, why it was risky or poorly designed.” But eventually Amero found it impossible to provide that kind of detailed feedback: either the relationships weren’t strong enough to permit it or the banker wasn’t in a position to do anything about BlackRock’s concerns, especially since there were other willing buyers. All Amero could do was go on a buyer’s strike. In 2009, Larry Fink, one of BlackRock’s founders and its chairman and CEO, gave voice to his fury with Wall Street for abandoning its traditional role as gatekeeper that took care to funnel only valid and viable products to the buy side. In the past, Fink told the Financial Times, ﬁ rms such as BlackRock “relied on Wall Street to be the safety guards to the capital markets,” winnowing out the poor-quality deals. Now, he added angrily, it seemed as if it was up to his ﬁrm and other buy-side institutions to protect the integrity of the parts of the market.15
The Core Function Becomes a Sideshow
The IPO market may be one of the best examples of Wall Street’s core function at work, funneling capital from those who have it to those who need it. But Wall Street saw underwriting IPOs as less and less attractive with each year that passed. Most transactions were far smaller than either Netscape or Google, and the amount of work the investment bank had to do in order to drum up investor interest in a previously unknown company could be time-consuming. When that company planned to raise only $15 million or so, the fees were small. But being willing to work on an IPO was what a bank had to do in an era where relationships alone were not enough to win business. Some, such as Morgan Stanley’s Dick Fisher, realized that technology companies weren’t going to generate a lot of banking fees in the future. They didn’t need much new equity after an IPO, typically, and almost never raised debt capital, since they didn’t have the kind of ﬁxed assets that bond buyers like to see. Unless the company decided to make acquisitions, the IPO fee might be the only banking revenue the underwriter ever earned. “Fisher told me he knew [companies such as Adobe and Apple] weren’t going to be good investment banking clients,” says Hambrecht. “He was right; Adobe had a $10 million IPO and then never raised another dime on Wall Street.”
But Fisher’s ultimate goal was to capture a different kind of business and a more secure stream of fee income for Morgan Stanley: he wanted to woo the newly wealthy executives as clients for Morgan Stanley’s private banking team. “Sure enough, Morgan Stanley ended up managing about 90 percent of the wealth created in the Apple IPO, while Goldman Sachs did the same for their Microsoft millionaires,” says Hambrecht. And when the $4.4 billion initial public offering of stock in UPS closed in November 1990, Morgan Stanley saw its $50.5 million share of the $191.5 million in fees paid by “Big Brown” to the thirty-ﬁve-member Wall Street underwriting syndicate as just the tip of the iceberg.16 That eve ning, when UPS’s top brass sat down to celebrate the ﬁrst day of trading in their new stock (and its 30 percent pop in value), they were sharing their prime rib not only with the bankers who had sold the stock but also with the Morgan Stanley wealth managers summoned to woo them as clients for that side of the company’s business. Yes, Wall Street was changing.
Some of those who felt as if the new Wall Street was leaving them behind as it drifted further away from its core function came from within the ranks of Wall Street itself. While one group of Wall Street bankers focused on helping companies raise new capital, another specialized in advising corporate clients on making a different kind of match: negotiating a merger with or acquisition of another business. Fees on these transactions may be a smaller percentage (from 1 percent to 3 percent) of the value of the deal, depending on the complexity and the players—but the deal sizes can be large. And a satisﬁ ed client can earn a banking team a series of fees year after year, as a business grows through acquisitions. JDS Uniphase, an optical networking company, forked over $30 billion in stock for big-ticket acquisitions in just a few years, each of which generated hefty deal fees—mostly in cash— for the matchmakers who helped orchestrate them.17
At any rate, this part of Wall Street tended to see itself as an elite group. Other members of their ﬁrms underwrote stock and bond offerings, handled sales and trading, or devised structured products such as CDOs and might generate high fees when their part of the business enjoyed its moment in the sun. But the mergers and acquisitions (M&A) advisory business, in their eyes, was the heart of what Wall Street was really about. “In my mind, the really sharp minds on Wall Street are not doing IPOs or debt ﬁ nancings; they’re doing strategic stuff like M&A advisory work,” says Mike Donnelly* bluntly. Donnelly, who lost his own job in the wake of the collapse of his ﬁ rm, hasn’t lost his awe for those he considers to be Wall Street artists. “Someone who is really great at this has a knowledge of the business, the industry and the company and the strategic issues that lie ahead. He has the technical knowledge, he knows the latest twists and turns in accounting rules and the law. He has experience and is never taken by surprise because he knows the kind of odd things that can happen,” explains Donnelly. “And they can present everything to a board in a lucid and compelling way. I suppose they’re a bit like a Pied Piper; people who hear them will end up following them anywhere. It’s incredibly hard to ﬁnd someone like that, and that’s why they are so valuable.”
Robert Greenhill, Morgan Stanley’s president and Fisher’s heir apparent back in 1992, has always been that kind of banker. Flying his own Cessna from one client meeting to the next, he and his team had propelled the ﬁrm to the coveted top spot in the league table rankings. (These widely scrutinized lists, published quarterly by data groups such as Dealogic LLC and Thomson Reuters, told the world which investment bank had underwritten the most deals in any speciﬁ c area imaginable; the battle for league table credit and the bragging rights that went along with a top-three ﬁnish was ﬁ erce and remains so today.) Alas, merger volumes were down overall that year, and John Mack—whose own background was in sales and trading, the heart of the underwriting function—ended up elbowing Green-hill out of his way. Deposed as president in early 1993, Greenhill resigned shortly after, ﬁrst joining Sandy Weill as the latter began to construct the behemoth that would become Citigroup and later founding his own boutique advisory ﬁ rm. He left behind him what became known as the “Greenhill gap”—there was no one who was his equal as a rainmaker for the ﬁ rm.18
To Gelman, the former Morgan Stanley banker, Greenhill’s departure symbolized the ﬁnal transition of power from the long-term strategic thinking characteristic of an M&A advisor to the emphasis on speculation and short-term proﬁt maximization symbolized by the rising power of the trading desks and their chiefs within the power structure of many investment banks. “By the time Netscape came along, serving investors who were speculating and trading like crazy—and trading for our own account—had become what it was all about,” he says. “Even in the IPO business, what had been a craft became an assembly line.”
But by then, there was no way for Wall Street’s investment banks to become purists, even when it came to fulﬁlling their gatekeeper role. Too much had changed in the world around them, and their responses to those changes had produced a series of unanticipated consequences. Long before the Netscape IPO was a gleam in the eye of the company’s venture capital backers, it had become clear to investment bank CEOs that relying on the basic gatekeeping functions of yore was never going to generate enough proﬁt to keep their ever- expanding empires aﬂoat.