Assuming the decision is made to proceed with a transaction, the next task is one of valuation, for the purpose of divining the buy or sell price or of determining an exchange ratio if stock is involved. "In this connection, we may analyze the securities and debt instruments of both companies in order to protect the security holders of the company to be acquired and the existing securities of the acquiring company, as well as the integrity of its balance sheet. We would surely be asked to advise our client on the optimum structure for the acquisition, whether it should be an exchange of stock, tender or exchange offer or a purchase of assets. This judgment can be made only after financial, legal, accounting and tax considerations are brought to bear on the information previously developed." Felix then conveyed the bane of every investment banker's existence: "It should be obvious that for every transaction that is actually consummated, many times that number never see the light of day, for a variety of reasons, after considerable efforts."
Felix said that negotiating a deal is Lazard's "major function" on behalf of a client.
Typically, we are asked to participate in discussions with the management of a prospective acquisition candidate to explain the background of the proposed acquisition and the nature of the business of our client. It may be our job to sit down with the investment bankers or financial advisers of the other company involved to discuss the merits of the acquisition and to arrive at mutually acceptable terms which are inevitably the result of arm's-length bargaining and arduous negotiations. What emerges from this process, if it is successful, is an agreement in principle which all parties in good conscience recommend to their respective clients and on which Lazard will often be asked to opine as to fairness. The skill in performing this function, however long or short the time period over which it is performed is one of the fundamental contributions of an investment banking firm in the merger and acquisition area.
Once an agreement is reached, the bankers would review drafts of the various legal documents required to be executed depending on the type of transaction. Bankers might also give advice about publicity for a deal, the preferred exchange for listing securities to be issued, or the solicitation of shareholder proxies, if needed. In his closing thought, Felix said insightfully, "The only generalization that can be made with respect to mergers and acquisitions is that no two are similar. Consequently, our activities from case to case will be different but in each case some or all of the above will be included. We believe it is in the public interest that the mechanism for the acquisition or sale of a business be handled as professionally, ethically and soundly as the investments of individuals or the financing of companies. We attempt to provide this service in this fashion."
The first series of questions for Felix from the committee went to the heart of the most proprietary of investment banking information: how Lazard decides what to charge corporate clients for its advisory services. Felix was appropriately evasive. When asked whether the size of the deal had an impact on the size of the fee, he acknowledged that it did. "As I tried to indicate before, philosophically we think of an acquisition as not being a terribly dissimilar service to raising money for a company," he said. "If we negotiate a private placement for $3 million, our fee to the client will be different than if we negotiate a loan of $300 million. Actually, the analogy is not too dissimilar to an acquisition."
Today, every M&A group on Wall Street has an approved "fee grid" where, depending on the size of the deal, a percentage fee is derived. For every $100 million increase in deal size, a new percentage kicks in. The smaller the deal, the higher the percentage fee; the larger the deal, the smaller the percentage fee. Obviously, bigger deals generate larger fees. But as Felix suggested, even these printed and approved fee grids are subject to negotiation, a fact well known by clients. Managers of M&A groups are constantly urging bankers to stick to the grid, but the reality of investment banking is that that rarely occurs, especially in the era of the financial supermarkets, such as Citigroup and JPMorgan Chase, where to win ancillary financing business, or even to capture "league table" credit (the constantly updated list of which banks have advised on the most deals), bankers constantly cut fees.
The other historically revealing aspect of Felix's testimony is his equating M&A fees with financing fees. Thirty-five years ago, investment bankers raised capital privately, both debt and equity, for their corporate clients and got paid for it. So, for instance, on behalf of ITT, Lazard might negotiate a bank facility from a money-center bank and some private subordinated debt from a few insurance companies and charge a fee based on the amount of capital raised, with lower fees for debt and higher fees for equity. There was no syndicated loan market. There was no public high-yield market. Now, aside from raising private equity, investment bankers are rarely paid for raising capital for clients. What they are paid for, rather, is underwriting the loan, high-yield deal, or equity offering. Using their own balance sheets, the banks agree to provide their corporate clients the money they are seeking and take the risk themselves of syndicating the loan, bond, or equity to the world of investors, be they other banks, hedge funds, insurance companies, mutual funds, or the public. Usually the risks for underwriters are minimal and the fees disproportionately generous, but when markets crash--after September 11, or upon the collapse of Long Term Capital Management--these same underwriters can get stuck with major capital losses. Lazard, with a tiny balance sheet, has never been very interested in making loans or underwriting junk bonds, which require large amounts of capital.
The subcommittee then zeroed in on another of Lazard's secret competitive advantages: its so-called interlocking directors, where Lazard partners also sit on their clients' boards of directors. Felix produced a list for the subcommittee showing that he served on two boards, ITT and Howmet, the manufacturer of aircraft parts. Stanley Osborne served on three boards. Andre served on six boards, including Fiat and RCA, to which he was appointed in 1957, the payoff for years of courting David Sarnoff. And Albert Hettinger, the former professor and economist, served on eight boards, among them Harcourt, Brace & World, the book publisher, and Owens-Illinois, the glass manufacturer. Kenneth Harkins, the chief counsel on the committee, pointed out to Felix that in nearly 40 percent of the deals Lazard gave M&A advice on between 1964 and the end of 1969, a Lazard partner served on the board of one of the companies involved in the deal. "Does having a member of your firm on the board of directors of other corporations assist your organization in its merger activities?" Harkins asked. Felix replied, "I would say that in general having one of your partners on the board of a company would certainly enable us to serve that company better by being more intelligent about what the company is doing and what it needs. Whether it would give us a competitive advantage, vis-a-vis other investment banking firms who give that service, I would say no, because corporations today are pretty sophisticated and they will go to whomever can perform the service for them."
Harkins later walked Felix through a year-by-year analysis of the percentage of Lazard's M&A fees that derived from companies where Lazard had a board seat. In 1965, it was 85 percent. In 1966, it was 63 percent. In 1967, it was 29 percent. In 1968, it was 58 percent, and through Labor Day 1969, it was 42 percent. Harkins then tried again. "Do you find that having a director on these various corporations increases the business of your firm?" he asked.
"No, sir," Felix responded, sticking to his guns, "but I find that generally corporate clients sooner or later will invite one of our partners on the board, because really this is the way it happens. We can't force our way on a board of directors. If we had dealings with a company and have performed services, by and large, at some point or another we will be invited on the board, and the relationship will become close."
"What you are saying is that obtaining director positions is a natural evolution in the business community as a result of the relationship of investment bankers or marriage brokers, with their clients?" Harkins asked.
Clearly offended at the reference to "
marriage brokers," Felix replied: "We don't view ourselves as marriage brokers. But in terms of what we render, it is a very personal service." The concept of Lazard as a marriage broker would come up again. Five weeks after his testimony, Felix sent to the subcommittee a list of all the deals its clients did from 1964 to Labor Day 1969 where Lazard did not get a fee and where Lazard had a board seat. The list included ten deals ITT did in 1968 and 1969, including Sheraton and Yellow Cab Co. (Kansas City), where Lazard had not been hired. It also showed five deals "done away" by Howmet, Felix's other board seat, during the time period.
The subcommittee then turned the spotlight on Lazard's arbitrage business, the then-little-known strategy of simultaneously buying and selling the securities of companies involved in a merger in the hope of profiting from discrepancies in their prices over time. Felix read aloud for the committee a surprisingly succinct and understandable overview of the arbitrage concept as it applies to the securities industry. "While it is highly technical, it is age-old in concept and execution and represents essentially the hedged short-term investment of funds at fairly high risk with commensurate rewards," he explained. "The classic example in present day markets is the arbitrage of a merger between two publicly traded companies after the exchange values have been announced. Theoretically, since one security is soon to be exchanged at a specific ratio for other securities, the two values should be identical but for reasons enumerated later they are not." Among these reasons, Felix explained, were "abrupt changes in securities and money markets," "various warranties and other 'outs' in the merger agreement," "governmental opposition," and "shareholder opposition." He continued, "The arbitrageur is willing to take the risk that the transaction will go through and to profit by the difference between the present market and the ultimate realized value." While Celler commended Felix for providing an "excellent" definition of arbitrage, his general counsel wanted to dig into whether Lazard partners were profiting improperly from mergers on which Lazard was advising.
"Do you have a rule that prohibits dealing in securities of companies to which Lazard Freres is providing merger services or where Lazard Freres has a director on one of the companies involved?" Harkins asked.
"Yes, sir," Felix responded. "With respect to our arbitrage department we have two rules. We have a rule which has been in effect since our inception in the arbitrage business, which goes back maybe three to four years only, actually, and that is that we have never arbitraged securities involving transactions where one of our partners is a director. We have, last year, or at the beginning of this year, extended that rule to exclude transactions involving companies where we do not have a director, but in one way or another we act in an advisory capacity. In addition, we obviously have rules throughout the firm of not getting involved in securities transactions on the basis of any inside information we may have."
When the chairman pressed Felix to explain Lazard's self-restraint in this regard, he continued,
First of all, we don't feel that we should in any way be involved in short sales of any securities of any company where we have a director because we feel that is a philosophical contradiction to begin with. Secondly, when we excluded transactions involving our firm in any advisory capacity in arbitrage transactions, we became concerned, Mr. Chairman, as we became involved in more and more of these transactions, with the internal security problems within our firm. Although we have always managed to be absolutely purer than Caesar's wife, and been able to limit the information within the firm to the people who really need to know, we felt that we might make a little less money in the arbitrage department, but we would sleep a great deal better if we just simply excluded them from any of these transactions.
In perhaps the first recorded instance of a congressman trying to come to grips with the massive problem soon to be known as insider trading, the Illinois Representative Robert McClory asked Felix what he would think if an M&A banker told his clients to buy the stock of a company targeted for purchase before the deal had been announced.
"It would be illegal," Felix said.
"What is the illegality involved?" asked McClory, trying to follow.
"The situation as you describe it, sir, would be if we, for instance, were retained by a corporation to act as their adviser in the acquisition of another company, and prior to the announcement of any transaction we went around to our clients and said, 'Buy this stock,' that would be the use of inside information," Felix said. "The arbitrage as I tried to underline, only begins--"
"Does that violate the SEC rules?" McClory interjected.
"Yes, sir," Felix continued. "But the arbitrage transaction only begins after the announcement of the terms of the transaction, so there is no use of inside information involved here, because the terms are out in the open. But the situation as you describe it, Congressman, would be an out-and-out illegality, as least as far as my understanding of the law."
Celler then stepped in. "Let me ask you this question," he said. "This restriction that you have placed on yourselves, has that restriction been followed by other houses on Wall Street who are competitors of yours?"
"I don't know, Mr. Chairman," Felix answered. "We don't talk to our competitors."
"You don't know?" Celler continued.
"No," Felix replied.
"They know about your restrictions, don't they?" Celler asked.
"No, sir," Felix answered. "They would not."
"It is not secret, is it?" Celler wondered.
"Well," Felix replied, the irony of the situation apparent, "the way we operate our firm, Mr. Chairman, is not something that we--let me say we are very jealous of our privacy."
"What you have adopted is credible," the chairman concluded. "Would it be to your advantage to spread that good gospel around the street?"
"I think, Mr. Chairman, people might think that we were being a little presumptuous," Felix answered.
"Maybe they would think you are fools," Celler followed.
"Maybe," Felix said.
After this pleasant exchange, the subcommittee moved on to Lazard's role as a paid strategic adviser to corporations. Celler said, "Can you tell us, roughly, how many concerns, and for want of a better term I use the words 'marriage brokers'--how many so-called marriage brokers effecting these mergers there are, say, in New York City, of the size and consequence of Lazard Freres?"
"I would hope that you would add moral caliber, Mr. Chairman, as another of our characteristics," Felix responded. "I would say, Mr. Chairman, that of the major, reputable investment banking firms that perform functions in this area, you would find most of the major investment banking firms in this business, I would say, being 10 or 15 firms of a major character." Felix would return often to this public obsession with the moral and ethical conduct of his fellow investment bankers--seemingly so fraught with cognitive dissonance--even as recently as July 2004, some thirty-five years after his testimony before the Celler commission. In a New York Times interview, he opined, "You should come to the business with a moral code. You're certainly not going to learn it later on. If people conduct themselves in ways that could be deemed immoral, I really wouldn't blame Wall Street, I would blame the individuals themselves who by and large should know better."
BETWEEN 1966 AND 1969, investment banking fees soared, mirroring the merger boom across Wall Street. The year 1970 would be very different. On Wall Street a full-fledged crisis was brewing, with brokerages becoming overwhelmed by an explosion in the volume of equities traded, without having the back-office capability to handle the increased paperwork. While the problem sounds mundane in the computer age, it was anything but boring for those involved. Even the most prescient firms suffered. The New York Stock Exchange quickly figured out it had a major problem. To get a handle on how to solve the crisis of failing firms and to salvage as many of them as possible, the exchange created the Surveillance Committee of the New York Stock Exchange, loosely referred to as the Crisis Committee. The exchange appointed Felix to head up the Crisis C
ommittee in June 1970. He had been appointed to the stock exchange's board of governors in May 1968. Among his five partners in the effort were Bernard "Bunny" Lasker, then chairman of the board of governors. These wise men were very concerned that the collapse of one big firm would start dominoes falling, badly undermining confidence in the markets and potentially destroying the country's position as the center of global finance.
The crux of the problem, which Wall Street historians have dubbed the "back-office crisis," was that during 1967 trading volumes on the major stock exchanges exploded, and the private, poorly capitalized Wall Street partnerships were ill equipped to handle the extensive paperwork of settling trades occasioned by the "sudden and unexpected upsurge" in volumes. Many firms were slow to add the back-office personnel required to handle the new flow. Unfortunately, when the personnel were eventually hired--in a rush, of course--talent suffered. Some firms were drowning in a sea of unprocessed, and inaccurately accounted for, paper. But by the end of 1969, "the worst of the paperwork problems had been surmounted," according to Lee Arning, then a New York Stock Exchange executive. The crisis, though, had just begun, for at the very moment that many brokerages had increased their personnel costs to scale the mountain of paper, the volume of business fell off a cliff.
There was a feeling that 1970 was capitalism's most acute test since 1929. "We were looking at the world from a 650 Dow Jones, the Penn Central bankruptcy, a credit crisis, Cambodia, Kent State--and we didn't know where anything was going and it was a pretty grim world at this time," Felix told the New York Times. By midsummer 1970, Felix had a full-fledged crisis to resolve as head of the Crisis Committee: the near dissolution of the old-line, blue-blood retail brokerage Hayden, Stone & Co., where Joseph P. Kennedy had begun to build the fortune that would be used to propel his second son to the presidency. Hayden, Stone had sixty-two offices nationwide, but its back-office systems were a mess. Compounding its problems, the firm's older partners, upon retiring, were withdrawing their capital from the firm. This, combined with the failing fortunes on Wall Street in general, created operating losses that together pushed Hayden, Stone dangerously close to defaulting on a $17.5 million loan made in the spring of 1970 to the firm by a few of its clients in Oklahoma. When a lawyer for the Oklahomans discovered that Hayden, Stone couldn't account for some $7 million in securities, Felix and the exchange began searching for a buyer.
The last tycoons: the secret history of Lazard Frères & Co Page 13