What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences

by Steven G. Mandis

  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.”17

  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.18 The first announced hostile M&A deal for which Goldman advised in North America was in 1999, and that was in Canada.19

  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.”20

  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.21 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.22 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.23 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.”24

  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.”25 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 a
nd 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.

  Changing Underwriting Standards

  When I joined Goldman, strict underwriting guidelines were in place for taking a company public. The process required the team to write an extensive memo for the commitments committee by a certain day and time to be considered in the following week’s meeting. The committee was responsible for the standards that governed which companies Goldman would finance, take public, and be associated with. The memo had to follow a specific format and address standard questions. Mistakes in the memo or unanswered questions usually resulted in a severe dressing down at the meeting. The committee was notoriously tough.

  Typically, Goldman would not take a company public if it had not been in business for three years, and it had to show profitability. But then came the technology and internet boom, and suddenly companies with little track record and no profits started being taken public by competitors. The requirement at Goldman was reduced to two years of profitability, then to one year, and then to one quarter, until finally the firm was not even requiring profitability in the foreseeable future.

  Goldman has denied that it changed its underwriting standards during the internet years, but as Matt Taibbi pointed out in a Rolling Stone article, “its own statistics belie the claim.”

  After [Goldman] took a little-known company with weak financials called Yahoo! public in 1996, once the tech boom had already begun, Goldman quickly became the IPO king of the Internet era. Of the 24 companies it took public in 1997, a third were losing money at the time of the IPO. In 1999, at the height of the boom, it took 47 companies public, including stillborns like Webvan and eToys, investment offerings that were in many ways the modern equivalents of Blue Ridge and Shenandoah. The following year, it underwrote 18 companies in the first four months, 14 of which were money losers at the time.26

  In addition, Goldman’s behavior in managing IPOs was questioned. As Taibbi noted, Goldman took eToys public in 1999. On the first day of trading, eToys, which was originally priced at $20 per share, opened at $79 per share, rose as high as $85, and closed at $76.56. By the end of the year, the shares had declined to $25. In 2001, eToys filed for Chapter 11 protection in bankruptcy court. Later, the eToys creditors committee filed a lawsuit alleging that eToys relied on Goldman for its expertise as to the pricing of its IPO and that Goldman gave advice to eToys without disclosing that it had “a conflict of interest,” allegedly an arrangement with Goldman’s customers to receive a kickback of a portion of any profits they made from the sale of eToys shares after the IPO. In addition, the complaint alleged that Goldman had an incentive to underprice the IPO because an initial lower price would result in higher profits to its customers and therefore a higher payment to Goldman.27

  The case was dismissed in court on the grounds that there was “no fiduciary relationship” between eToys and Goldman: “[W]e find no issue of fact as to whether Goldman Sachs assumed a fiduciary duty to advise eToys with respect to its IPO price,” Justice DeGrasse wrote. “We therefore need not consider whether such a duty was breached. Were we to consider the issue, we would find that Goldman Sachs met its burden of establishing that there was no breach.”28

  The Rise of Stars and “Super League” Clients

  In 1970, long before he drafted Goldman’s business principles, Whitehead had written a set of statements to guide internal investment banking (IBS) business development, including, “Important people like to deal with other important people. Are you one?”29 One partner told me Whitehead’s original statement had been reinterpreted and repeated verbally over the years as, “You can’t run with the big dogs if you pee with the puppies.” By the mid-1990s the slogan, meant to remind bankers to cultivate contacts and relationships with corporate CEOs and decision makers, was reinterpreted further and socialized to mean cultivating only the most important companies and most important people. This shift represented the preference given in partner elections to those who had relationships with important CEOs and important companies, because they had a higher value to the firm than did bankers who covered middle-market companies. Formerly, partners who covered many of these middle-market companies had been considered culture carriers and their role was deemed important, but that view had faded.

  This change was dramatically represented by John Thornton when he spoke in the late 1990s at the annual internal investment banking conference held in New York each December. In his book The Accidental Investment Banker, Jonathan Knee describes the conference. Instead of employing the usual elaborate PowerPoint presentation, Thornton conveyed his message with a plain black marker, drawing a few dots that he said represented the “important people in the world,” of whom, he conceded, there were not many. He added circles representing the orbits of these important people and said, “Pretty much everything important that happens in the world, happens in these circles.” He then marked the point where the greatest number of circles intersected and said, “This is where I want to be. This is our strategy. Thank you.”30

  Few of the people in the room dealt with Goldman’s most important clients or had access to the world’s most important people. The Goldman culture had always prevented stars from emerging and eclipsing their peers. Thornton’s new strategy singled people out, and it was accepted—a clear signal that the “no stars” policy had changed. When discussing “stars” and in explaining how much the policy continued to change, one retired partner pointed out that CEO Lloyd Blankfein was allegedly seen attending a pre-Oscars party in Los Angeles in 2013, and the partner said he guessed that it must have been a first for the head of Goldman.

  This shift coincided with a new practice of designating “star clients.” Clients were categorized and prioritized to help Goldman prioritize and allocate resources, and the largest clients that offered the most revenue opportunities and that had influence or influential CEOs were classified as “Super League.”31 Super League clients received increased attention from management committee members, and Goldman systematically tracked the firm’s relationship and progress with these clients. Employees were also held strictly accountable for these relationships. Many bankers wanted to work on Super League clients’ business, resulting in fights for clients and internal politics.

  The prioritization and metric-measuring culture rose in the firm during my time. For example, senior people asked me to develop lists of the top one hundred people in business and determine who at the firm had relationships with them so that Goldman could identify any gaps. Goldman executives were assigned to make sure they personally called and met with these influential people regularly, conveyed proprietary information or views or “out of the box” ideas, and connected them to other important people. When I was in Hong Kong as an analyst, I was given a list of about ten clients and told to focus primarily on them. I was told these people made all the important decisions and that we wanted to focus all our attention and resources on them—and, if possible, coinvest with them, because that was the closest relationship the firm could have with a client. I was told that if people called me about any other clients to refer them to my bosses.

  Partners pointed out that, starting in the mid-1990s, Goldman introduced time sheets (records of how much time was being spent on Super League clients and on which transactions and products) and revenue scorecards. That led to increasing contention about who got credit for what, with implications for compensation and promotion. In describing this change over time, some partners said it had brought a “FICC or trading subculture” to the banking side, a mar
k-to-market mentality. Before this increased emphasis on quantification and accountability, people were willing to make more time for each other and help think through issues. Bankers didn’t worry about filling out time sheets or taking credit. They worried instead more about giving clients better advice.

  This practice clearly signaled a shift of emphasis, and it changed the firm’s culture, but it also seems to have had positive financial results, at least in the short to medium term. Conceding that Goldman is run more efficiently and with more accountability now than in the past, one partner told me that the client metrics have perhaps gone too far in measuring investment banking clients as if they were trading clients, and investment bankers as if they were traders. The prioritization has made people more accountable and productive and has improved Goldman’s management, but he wondered whether it was really good for the clients—and in the firm’s best long-term interest.

  Rehiring People and Making Counteroffers

  When I started at Goldman, departing employees were persona non grata. While I was an analyst in the M&A department, someone spoke to one of the department heads about being approached by another firm and admitted to thinking about the offer. The senior partner told him to hold on for a minute, picked up the phone, and called security to escort the offender off the floor, telling security to retrieve his suit jacket from his cubicle. Naturally, then, rehiring someone who had left the company was unthinkable.