The last tycoons: the secret history of Lazard Frères & Co

by William D. Cohan

  After solving which businesses would be part of the public company, Bruce had to figure out where the money would come from to pay off the inviolate $1.616 billion to Eurazeo, Michel, and his cronies. Actually, Bruce needed even more than the $1.616 billion. He needed to raise more than $1.9 billion in total because he also intended to leave the "separated" businesses--capital markets and private equity--with $150 million of operating capital to cover certain liabilities (mostly for the U.K. pension liabilities) and he wanted to refinance a preexisting $50 million Lazard debt obligation issued in May 2001. There were also $87 million in fees to be paid, to bankers, lawyers, and accountants. The IPO itself--the public sale of the firm's equity for the first time--would raise gross proceeds of $855 million (before a heavily negotiated 5 percent, or $42.7 million, fee to the underwriters; usually the underwriting fee on an IPO is 7 percent. Bruce also ended up capitulating to the demands of underwriters Morgan Stanley, Citigroup, and Merrill Lynch for a more equitable split of the fees with lead underwriter Goldman Sachs.) and net proceeds of $812 million. That left a balance of around $1.1 billion Bruce still needed. For this money, he turned to other sources of capital. His negotiations with Caisse d'Epargne were fruitful and yielded a $200 million investment--$50 million of common stock at the IPO price and $150 million of debt convertible into the Lazard common stock. Another $550 million came from the public sale of new unsecured senior debt.

  To raise the remainder of the capital he needed, Bruce got a little creative. He raised $287.5 million through the public sale of "equity security units" that offered investors a combination of interest-paying debt and equity securities. What he was doing with Lazard is known in Wall Street argot as a "leveraged recap," a fairly common structure in the private-equity world. By adding nearly $900 million in new debt to Lazard's formerly pristine balance sheet and then taking that money plus the expected IPO proceeds of $812 million, Bruce was able to buy up all the stock of the existing shareholders and make himself the largest individual shareholder in the process. It wasn't an original structure, but as a way of getting control of Lazard with other people's money while at the same time getting rid of Michel, it was nothing short of brilliant.

  More clever still was Bruce's decision to incorporate Lazard Ltd. in Hamilton, Bermuda, a well-known and controversial tax haven for American companies. Bruce is nothing if not creative when it comes to avoiding taxes. Lazard became the first large Wall Street investment bank to incorporate there, after first considering and then rejecting both Luxembourg and Delaware. Since the United States taxes corporations (and individuals) on their worldwide income, regardless of where it is earned, by incorporating in Bermuda, not only would Lazard not have to pay taxes there (there are no income or capital gains taxes on the island), but also its income from outside the States would not be subject to U.S. taxes. Income earned abroad would be subject only to the tax rates of those localities. Critics have called such tax avoidance "unpatriotic" and the "great tax evasion." Stanley Works, a 163-year-old Connecticut-based tool manufacturer, abandoned its plan to reincorporate there after intense criticism.

  Bruce didn't care, though. Lazard acted as though Bermuda were simply a location neutral to its far-flung operations. The Financial Times chided Bruce: "The tax part was only a secondary consideration, of course. Who hadn't wanted to see Wasserstein's legs?" (a reference to the possibility that Bruce might soon be wearing Bermuda shorts).

  Ironically, since Bruce was a historical shareholder--having bought some Lazard stock from Michel in 2001--he was entitled to be cashed out of this stock, just like Michel. But being a magnanimous sort and wanting to send a signal of support for the IPO to the market (he had also promised Caisse d'Epargne he would do this), Bruce converted his $32.9 million cash-out into Lazard stock at the $25 per share IPO price, for 1.317 million shares. These shares were in addition to the 9.958 million shares he was given by Michel as part of his original five-year contract. After a successful IPO, Bruce would own 11.275 million shares of Lazard, making him, by far, the largest single individual investor in the firm. (As far as can be deciphered, Ken Jacobs would be next, with 1.98 million shares.)

  And Bruce would have paid absolutely nothing for those shares. At the IPO price of $25, all of his shares would be worth around $282 million. At that price, Lazard's 100 million shares of equity would be worth a total of $2.5 billion, and its market capitalization (equity plus debt less cash) would be around $3.5 billion, not far below what Michel, Loomis, and Bruce had attempted to sell the firm for previously, but a full $1 billion below the valuation at which Lazard would buy back Michel's stock. Still, for Bruce to have something for which he paid nothing be worth close to $300 million certainly qualifies, in capitalistic America anyway, as one of the leading definitions of "genius."

  But Bruce was not done performing miracles. He still needed to show the market that his Lazard could be a profitable enterprise. While the businesses to be part of the public company had been consistently profitable on the operating line, Bruce's contractual obligations to his partners had eaten up all of that profit plus a good portion of the firm's historical capital. As a result of these contractual obligations, Lazard had been paying out between 70 and 80 percent of its revenue in the form of compensation--in 2002 and 2003, 74 and 73 percent of net revenues, respectively, were paid out as employee compensation--far above the industry average of around 50 percent. The underwriters knew this would not fly in the marketplace. Lazard's compensation expense needed to be brought more into line with industry norms.

  To do this, Bruce and Golub resolved that after the IPO, Lazard's compensation expense as a percentage of net revenues would be fixed at 57.5 percent. In IPO parlance, this all-important change was called a "pro forma adjustment." And so even though Lazard in its history had never had a compensation expense equal to 57.5 percent of its revenues, by simple decree Bruce told investors it would be so--just as Mezzacappa predicted he would do from the outset. And that is how Bruce was able to show the market that on a pro forma basis for 2004, Lazard Ltd.--the public company to be--had net income of $32 million, even though in actuality Lazard had lost around $120 million in 2004. In other words, even though in 2004 Lazard's compensation expense as a percentage of net revenues was 74 percent (including payments made to people in the to-be-"separated" businesses), Bruce showed the market what the "new" Lazard would have looked like in 2004 had compensation expense been only 57.5 percent. Miraculously, Lazard was now profitable and could even pay a dividend to its new shareholders. Abracadabra! This must have been what Jean-Claude Haas meant when he said investing in the Lazard IPO was "an act of faith."

  To be sure, in order to be able to reduce compensation expense by some $175 million annually (in the end, the reduction amounted to only $100 million), Bruce had some powerful weapons. First, he had the promise of the IPO itself as a way to create wealth for the partners. The Lazard goodwill that Loomis and Bruce had distributed in late 2001 and early 2002 was now going to have a public market and a public valuation--just as Bruce promised it would. Having that equity, most of which had vested but could not be sold, was key to getting the working partners to agree to reduce their current cash compensation. That was the carrot, a trade-off between reduced cash compensation and a higher firm equity value.

  There was a stick, too. As part of the protracted negotiations leading up to the filing of the IPO documents, Bruce got nearly all of the firm's managing directors to sign so-called retention agreements that stipulated that "annual bonuses will be determined in the sole discretion of the Chief Executive Officer of Lazard Ltd."--in other words, Bruce alone could determine compensation. Since he had promised the market that compensation expense would be 57.5 percent, he had the sole power to make that happen. He just needed to convince investors he would do it. Warned one Lazard banker working late on Christmas Eve, I'd sure hate to be one of the many highly paid, non-rainmaking VPs and Directors...the axe is about to start falling." Of course, the "risk factors" section o
f the IPO prospectus gave Bruce all the legal wiggle room he needed in case he was unable to meet the new target compensation expense number. During the first three years under Bruce, "following the hiring of new senior management, we invested significant amounts in the recruitment and retention of senior professionals in an effort to reinvest in the intellectual capital of our business. We made distributions to our managing directors that exceeded our net income allocable to members in respect of 2002, 2003 and 2004"--this seemed to be a near admission that Michel's way of looking at the numbers was correct. The prospectus went on to say the firm intended to operate at the 57.5 percent target, even though compensation expense had been 74 percent in 2004. But "increased competition for senior professionals, changes in the financial markets generally or other factors could prevent us from reaching this objective," it said. "Failure to achieve this target ratio may materially adversely affect our results of operations and financial position."

  Bruce was saying, in effect, "Look, we'll give it a try. I have the power to make it happen. If we make the 57.5 percent target, good enough, and if we don't, well, so be it--we warned you." Caveat emptor.

  Bruce and the firm's other top four executives--the SEC requires all sorts of disclosure about a company's top five executives--also signed retention agreements with Lazard. Bruce's agreement guaranteed him an annual base salary of no less than $4.8 million for the subsequent three years. The Lazard board was left to decide what bonus, if any, he would get. If Bruce's employment were terminated without cause and without there being a "change of control," he would be paid twice his annual salary as severance and receive health care benefits for him and his family for life. If there were a change of control and Bruce lost his job, he would be paid severance equal to three times his annual salary--the standard over-the-top American CEO compensation package.

  If a regular managing director were fired, he would receive no severance at all, other than his salary for a three-month period. By the terms of his retention agreement, Bruce was also permitted to remain chairman of Wasserstein & Co., even though that firm competed with Lazard's private-equity funds. If the IPO were to happen, Bruce would be the only CEO of a publicly traded Wall Street firm who was also the head of his own buyout firm. Nowhere in all of the reams and reams of revelatory paper Lazard filed with the SEC during the five months following the initial December 17 document was there a copy of Bruce's original employment agreement with Michel. Presumably that document was deemed irrelevant to the new Lazard.

  THE FILING OF the S-1 in December was merely the first step of the official IPO process. There were many other formal steps along the journey. For instance, prior to starting the "road show," a two-week, multiple-city, worldwide tour where top executives meet with investors, make presentations, and answer questions, Lazard amended its original registration statement six times, each time peeling back another layer of the onion and revealing more and more about the Lazard omerta. But there was much for Bruce and his lieutenants to accomplish outside the realm of SEC filings. The first problem for Bruce came in Europe, where rival investment banks were heavily recruiting the Europeans who refused to sign Bruce's letter of support for the IPO. Firms such as HSBC, UBS, Lehman, and Deutsche Bank were said to have approached many of the dozen or so bankers in Europe who did not sign.

  This was a mere sideshow compared to Bruce's need to extinguish the increasingly fractious skirmishes he was having with various groups of nonworking partners inside the firm--the aftershocks that followed the earthquake of the IPO filing. So little information had been conveyed to those partners about the IPO, and how they would be treated by it, that they devoured the document when it was filed. Many of them did not like what they read. What became quickly apparent was that the deal Bruce initially cut with Michel involved only the sale for cash of Michel's goodwill and that of the French founding partners. Left unaccounted for initially were the ten or so now "limited" partners who had been around since the creation of Lazard Partners in 1984 and thus had tiny slivers of goodwill, valued, in total, at around $20 million, a mere rounding error in the context of the overall deal but understandably extremely important to the partners involved.

  When they discovered that Michel had essentially left them to fend for themselves--they would not get cashed out in the IPO--they were livid at both Michel and Bruce. They hired legal counsel to fight to be included in the cash-out. "These provisions [in the buyout agreement] are inappropriate except possibly in the context of a COMPLETE buy out of ALL our interests," one of these angered men wrote. "That complete buy out should be our prime goal. And Section 7 of the Operating Agreement seems our best negotiating weapon to get there." This group quickly got the attention of Steve Golub and Mike Biondi, and a measure of satisfaction. Soon enough, Bruce agreed to treat their goodwill like Michel's; they would get cash, too.

  Another bunch of retired London partners presented Bruce with a thornier problem. Dubbed the London Group, these ten or so partners hired their own legal counsel to fight Bruce about their concern that their pension plan, which faced a $95 million shortfall, would not be fully funded at the time of the IPO, leaving them slighted and angry. "They believe in a strong attack not only on BW but also on MDW (breach of fiduciary duty, self dealing, front running etc.)," one partner wrote, adding this group's intention was to send "a stiff letter to both setting out their position, backed up with firm action to the SEC and if necessary recourse to the press." This battle would not be so easily resolved, and the London Group did resort to planting a number of negative stories in the press on the eve of the IPO. This tactic worked. Lazard agreed to set aside cash from the IPO to make sure the U.K. pensions were fully funded.

  Bruce also needed to resolve a lingering dispute with Damon Mezzacappa, the longtime head of capital markets who retired at the end of 1999. Michel's gluttonous side deal with Damon called for him to get a large salary plus 3 percent of New York's profits from 2000 to 2002 at Michel's discretion. When Michel and Bruce allocated the goodwill at the end of 2001, Mezzacappa did not receive any despite still having his profit percentage. Soon after Bruce arrived and the profit percentage no longer had any value because there were no longer any profits, Mezzacappa was not happy. Like many others, he never imagined that the old Lazard way of paying partners based on a percentage of the profits could be turned on its head by Bruce, and junked. Damon sued, and the matter went to arbitration, per the Wall Street rules for settling bonus disputes. At the beginning of 2005, just as the arbitration was set to begin, Bruce and Damon settled (for stock worth at least $5 million at the IPO price). Then there was the battle with the so-called Walking Dead, those few Lazard partners who had received their goodwill in the firm when Loomis and Bruce distributed it at the end of 2001 but who were no longer at the firm at the time of the S-1 filing in December 2004. Ironically, Loomis himself was the former partner with the largest chunk of goodwill who had left the firm after the distribution and before the filing. But his "insurance" policy with Michel--negotiated on September 10, 2001--guaranteed him his goodwill (said to be more than a 1 percent stake in the firm, worth more than $25 million at the proposed IPO price) even though he was not at the firm. Together this loosely formed group, which also hired a lawyer, was said to have between 4.5 and 5 percent of the goodwill. Whereas Michel was getting cash at the IPO, and if they stayed at the firm, the working partners could convert their goodwill into equity in the public company in years three, four, and five, since they were no longer at Lazard, the goodwill of the Walking Dead would be trapped at a holding company for eight years before it could be converted into stock in the public company and sold. "Which is just not right, because we should be on par with everyone else," one member of the Walking Dead said. "We really should be on a par with the capitalists, because that's what we are effectively."

  There were at least two parts to the Walking Dead strategy. First, with $1.616 billion in cash proceeds at a high valuation at stake, the thinking was that Michel and Eurazeo would
not do anything to jeopardize that money--and thus the IPO--and so a bout of negative publicity and a lawsuit from former partners with 5 percent of the goodwill was to be avoided at all costs. Second, Bruce had actually allocated more than 100 percent of the firm's goodwill to the collective group of partners, and so he needed to get some of that goodwill back. (Bruce thought he would have plenty of time--at least three years--to get the overallocated goodwill back before it was convertible into the public stock.) The combination of these two points of leverage ended up working well. Bruce and his deputies negotiated one by one with the members of the Walking Dead, and in most cases settled with them--Loomis included--by buying their goodwill points back at around a 50 percent discount to the suggested IPO price.

  JUST AS BRUCE was having increasing success solving all of these simultaneous equations came shocking Lazard news. Soon after lunch on March 2, Jerry Rosenfeld, the former Lazard partner and CEO of Rothschild North America, sent the following e-mail with the words "Tragic News Item" in the subject line: "It is being reported in the 'Lazard Loop' that Edouard Stern has been murdered in his apartment in Geneva." Rarely had a simple nineteen-word message screamed more emphatically, "Tell me more!" While on the surface, Stern, then fifty, appeared to have severed all ties with Lazard after Michel fired him in 1997, the truth was far more complicated, as with almost everything in Edouard's life. As his parting gift from Lazard, Michel arranged for Eurazeo to invest $300 million in Edouard's $600 million private-equity firm--Investments Real Returns--with Edouard and his friends contributing the rest. Edouard managed the fund out of Geneva without taking much input from Eurazeo, and IRR--as it was known--was not doing too well, and there was ongoing tension as a result. Edouard, who literally had teeth like a wolf, was also in the habit of making halfhearted attempts at getting Lazard involved in major M&A assignments where he had ongoing relationships. As a way to needle Michel, he had a nasty habit of suing Lazard (and lots of others) whenever he could. Even though Michel had fired him from Lazard, because of the French partnership rules, he retained a small stake in that partnership, and when in 2000 the three houses were merged, Edouard withheld his crucial vote for the merger until he was paid off, a sum said to be around $25 million.