Another sign that the culture had already changed significantly was a Hank Paulson–orchestrated management coup that forced Corzine out and put Paulson in charge. According to interviews, he and other partners were worried that Corzine “was going off the reservation.” They had found out that Corzine had merger/sale conversations with other parties without the direct consent of the executive committee. Over the Christmas holiday in 1998, while Corzine was away, Paulson made his move. Corzine had made the organizational change of consolidating power into a small executive committee versus the larger management committee, and there were some recent changes in the membership, which together opened up the possibility for a coup. In what was eerily similar to Paulson’s alleged quid pro quo support for the IPO to be named co-head of the firm, allegedly Thain and Thornton agreed to support Paulson in return for what they believed was an informal promise: Paulson would be the CEO for only a few years (the time was debatable) and then transfer the CEO job to both Thain and Thornton. Thain was a longtime lieutenant and friend of Corzine. According to interviews, he justified the decision with the argument that he was doing what he thought was best for the firm in the long run. In early to mid-January, Goldman partners received an e-mail from Paulson and Corzine: “Jon has decided to relinquish the CEO title.”42 Corzine remained co-chairman, but only to help the firm complete the IPO. Several partners I interviewed said that in hindsight they believed the alleged coup sent a bad message regarding behavior and highlighted how much the firm’s culture had changed. It would also affect how the next CEO would organize the firm (discussed later).
With the markets and Goldman’s earnings recovering, Goldman went public on May 3, 1999, pricing the stock at $53 per share, implying an equity market valuation of over $30 billion. In the end, Goldman decided to offer only a small portion of the company to the public, with some 48 percent still held by the partnership pool, 22 percent of the company held by nonpartner employees, and 18 percent held by retired Goldman partners and Sumitomo Bank and the investing arm of Kamehameha Schools in Hawaii. This left approximately 12 percent of the company held by the public.
Less than six months after Goldman went public, in 1999 certain provisions of the Glass–Steagall Act were repealed by the Gramm–Leach–Bliley Act, and President Bill Clinton signed the legislation that year. Former Goldman co-senior partner Bob Rubin was secretary of the Treasury at the time, and he later joined Citigroup.
The repeal meant that commercial banks, investment banks, securities firms, and insurance companies could be combined.43 Commercial banks started to buy investment banks, spawning a massive consolidation in the banking industry. Some believed it was inevitable that Goldman would be bought. The firm suddenly looked small compared to its new direct competitors, and, with its market position, brand, and relationships, it would have been a prize. It turned out that Goldman CEO Jon Corzine and others held merger discussions at the time, talks that were disrupted by Hank Paulson’s ouster of Corzine (to be discussed more later). Rather than be taken over, the partners decided to grow.44
The dismantling of Glass–Steagall led to many changes in the ways banks competed, changes that put a great deal of pressure on Goldman to rapidly evolve its own ways of operating. The changes in practices and in the firm’s culture were greatly accelerated. These new powerhouses began challenging Goldman with “margin-reducing, risk-heightening competition.”45 The impression was that competitors like J.P. Morgan or Citigroup would tell their clients, “If you want a corporate loan, you have to hire our M&A bankers.” This bundling of low-margin commercial banking product offerings (such as revolving lines of credit) with higher-margin investment banking products (such as M&A work and equity underwriting) threatened Goldman’s most lucrative businesses. In short, the investment banking business was becoming commoditized. In addition, clients put a premium on retail distribution—that is, selling securities to the general public, who were willing to pay ridiculous prices for tech stocks to cash in on the technology boom.
Even before the repeal of Glass–Steagall, in 1997, Morgan Stanley had responded to this pressure by merging with Dean Witter Reynolds. Morgan was considered a “white shoe” firm, referring to white buck shoes—laced white suede or buckskin shoes with red soles, which stereotypically were worn at Ivy League colleges, while Dean Witter Reynolds was a firm with strong retail distribution: nine thousand stock brokers serving more than 3 million customers. Dean Witter also owned Discover Card. Generally, white shoe investment bankers often looked down on retail stock brokers, whose alma maters typically were not the elite schools. I remember when the deal was announced, a Goldman associate called his Ivy League business school classmate working in investment banking at Morgan Stanley and teasingly asked him if he could now help him get a Discover credit card. Little did he know that I had worked on a project to evaluate whether Goldman should buy a retail distribution firm or build a scalable internet-based technology platform to access retail investors for distribution.
In the early 2000s Goldman divided most of its M&A department into industry groups. A lateral M&A partner told me that client CEOs couldn’t tell the difference between excellent and average M&A advice or banks’ business practices, but they could tell whether you knew their industry.
Competitive pressures forced Goldman to reexamine and modify its strategy. For example, Goldman redesigned and restructured into industry groups. Industry knowledge was so valued that, for example, I worked on projects evaluating whether Goldman should buy a consulting firm with deep industry knowledge and CEO contacts, or a boutique investment bank focused on an industry-like technology. Goldman also put greater emphasis on expanding its powerful network of key decision makers (CEOs, chief investment officers, government officials, etc.) and on trying to ensure that the relationships and information were highly coordinated and selectively and tactically shared. Access and information were strengths of Goldman’s, as they required a culture of serious teamwork. This was highly valued by clients and a key distinguishing factor in hiring Goldman. In addition, Goldman focused more on coinvesting with clients. A coinvestment relationship was seen to have many advantages, including establishment of a closer relationship than did a merely advisory one.
The industry consolidation brought about in part by the changes to Glass–Steagall resulted in fewer but much larger banks—banks that many would later argue were “too big to fail,” so large that their failure was deemed a risk to the stability of the entire banking system. Another result was that the pace at which these companies now had to grow in order to stay competitive challenged their organizational cultures. Companies growing via acquisition have significant cultural and integration challenges.
Pressures Intensify
Following consolidation, the financial services industry became intensely competitive, and Goldman now faced competition for scarce resources not only from other banks but also from insurance companies, investment advisers, mutual funds, hedge funds, and private equity firms.46
To gain market share, commercial banks aggressively offered highly competitive pricing for services, resulting in additional pressures for Goldman. Commercial banking competitors also had access to cheaper financing, and they could take a longer-term view in pricing assets and loans on their balance sheets than could those who remained strictly investment banks. That’s because investment banking firms must mark to market or use fair-value accounting (which means that the fair value of an asset is based on the current market price), compared with commercial banks, which can use historical cost accounting for assets held for investment.
Some Goldman partners often privately complained about this advantage, in addition to accusing the commercial banks of illegally tying lending to investment banking business. Goldman faced increasing pressure to retain market share by committing more capital to important clients and conducting transactions on terms that often didn’t offer returns commensurate with the risks or didn’t meet Goldman’s internal return hurdles. Moreove
r, consolidation significantly increased the capital base and geographic reach of some of its competitors. It wasn’t only Goldman’s US competitors; foreign banks were buying US banks (Deutsche Bank bought Bankers Trust/Alex Brown, UBS bought Warburg and Dillon Read, etc.). Goldman also faced competition from the advent of electronic execution and alternative trading systems, lowering commissions. It also faced disintermediation by hedge funds, alternative asset management companies, and other unregulated firms in providing or raising capital.
Goldman also began facing stiff competition in attracting and retaining employees. “We live in a competitive environment,” said David Viniar during his tenure. “We still have people leaving for multiyear offers away from us, some from our competitors, some from other industry participants.”47
Goldman’s client base also began to change. Its traditional banking clients were corporations, which were typically relationship oriented. In the early 1990s, there weren’t many private equity firms. For example, in 1992, when I started, I worked on the sale of one of a company’s divisions to a private equity firm. We must have contacted fewer than a dozen private equity firms, because there were not many of them around. Nor were there many large hedge funds. Later in the 1990s, however, private equity firms and hedge funds began to boom. Generally, these firms were much more transactional and generated large fees in the short term compared with Goldman’s traditional corporate clients or “buy and hold” mutual funds. People at hedge funds tended to be more transaction oriented than relationship oriented. Similarly, private equity firms tend to be transactional; buying and selling companies and taking them public are shorter-term transactions than traditional corporate client business. Goldman executives decided to focus on this growing industry and even started a group in the mid- to late 1990s to cater to this client base.
Reflecting on the shift, a Goldman partner I spoke with said that perhaps Goldman’s emphasis on doing the right thing was too extreme to be practical in the competitive business environment and that an emphasis on more transaction-oriented clients, like private equity firms, was needed in banking. He felt that too many Goldman people were focused on maintain unproductive client relationships and were being rewarded simply for their internal Goldman relationships or caretaking historically loyal Goldman clients and contributions to recruiting and mentoring.
Because private equity firms and hedge funds valued and treated Goldman differently than did traditional corporate clients, Goldman’s approach to clients began to change. The private equity firms valued any investment bank that could get them the inside track on deals and could provide the best financing terms (including guaranteed or bridge financing, which puts the investment bank at risk if it can’t sell or distribute the loan to other lenders or investors). Many of the private equity firms felt they already had people (many of them former bankers) who were smarter and more skilled than those in the banks in the kinds of deals the firms were doing. In an interview, one private equity client described most investment bankers who maintained a relationship with his firm as “order takers.”
Hedge funds also changed the landscape. Unlike many traditional mutual funds, which had a “buy and hold” mentality, many hedge funds went in and out of securities with high frequency. They typically borrowed money from investment banks to buy securities, and they shorted securities. All of these activities generate significant fees, and so Goldman organized groups to focus on these growing clients and their special needs.
I remember working on a special project to analyze Goldman’s top fee-paying clients, and I was shocked by how many were hedge funds. They, along with private equity firms, quickly became the largest fee payers on Wall Street. The hedge funds were sharp and sophisticated. In trading, there is an inherent tension between buyer and seller. Because of the sophistication of the hedge funds, they also typically viewed Wall Street firms as “places of execution” that provided liquidity and securities. They valued “the edge”—receiving special access to decision makers who gave them a competitive advantage, or to traders who were willing to take the risk and provide them with liquidity, better execution, or a better balance sheet and who offered low-cost, easy financing terms so that the hedge funds could leverage their investments and improve their returns. The private equity funds and hedge funds generally treated Goldman more like a necessary counterparty than a trusted adviser for the long term. Most of these funds were under intense pressure to produce short-term results and did not value long-term relationships in the same way that many corporate clients did.
As Goldman grew its proprietary investing activities and became a more active competitor to its investing clients, some hedge funds and private equity firms suggested that Goldman was introducing too many conflicts of interest into its operations—as when Goldman had the Water Street Fund in the late 1980s and early 1990s—causing mistrust. They felt Goldman had access to proprietary information from clients and had the potential to use it to Goldman’s advantage. According to most of my interviewees, these accusations began in the mid-1990s and accelerated as the hedge fund and private equity industry became more competitive and added players, and at the same time Goldman dedicated increasing amounts of capital to these competing activities.
Many hedge funds came and went, gaining a few years’ worth of great returns and growth and then hitting a rough patch or falling out of style and shrinking as investors fled. Hedge fund traders also tended to move around. So there was not the same traditional long-term relationship mentality with hedge funds as with corporate relationships. But even corporations changed in this regard in the 1990s as pressure for performance increased on corporate boards and CEOs. Boards came under pressure to replace underperforming CEOs, a trend that continued in the 2000s. The average tenure of a CEO has consistently declined.48 So relationships with corporate CEOs were also becoming short-term propositions.
Technological Pressures
Technological innovation was another source of significant pressure on Goldman and the whole banking sector. New technology has added transparency to financial markets, as with electronic trading, while also making them less transparent, as with the design of increasingly complex investment products, such as the mortgage securities behind the 2008 crisis. Generally, more transparency in markets and electronic execution hurts investment banks’ profitability, and the hit on profits drives banks to seek greater scale and a higher volume of transactions to offset the losses. This is happening today, for example, with the sale of treasury notes. More than 20 percent of the $538 billion of treasury notes auctioned this year have been awarded to bidders who bypassed the traditional dealers at the banks by using a website to place their orders.49 That’s almost twice the amount as in 2011 and up from 5.6 percent in 2009. This direct-bidding system has eaten into the profits of government bond traders at investment banks. Typically, low-transparency/high-complexity products have the highest margins. So it’s understandable that banks focus on developing and selling complex products, especially to offset the negative impact of transparency from technology.
Technological pressure contributed to the change in Goldman’s culture in various ways. For one thing, technological changes increased the emphasis on trading, both within Goldman and generally. Traditionally in investment banking, information was exchanged primarily by word of mouth—in person or over the phone in the context of long-standing relationships. It was a labor-intensive, human capital–intensive business, as well as an apprenticeship business, more art than science. In Information Markets, William Wilhelm Jr., a professor of management, and Joseph Downing, an investment banker, point to technological pressures as being so powerful that they were key reasons that Goldman went public. Information technology provides a lower cost, more reliable way of disseminating, aggregating, storing, and analyzing information, and it has diminished the role of long-standing relationships and human capital in banking. In response, Goldman began to put less emphasis on selecting its human capital, and on mentoring, training
, and developing the culture to support the maintenance of relationships.
Ironically, the technological advances have also put a higher premium on star players. According to one part of Wilhelm and Downing’s theory, there are a few exceptional “human capitalists” or “stars” who have an ability to transcend technology and utilize their skills and talents to build relationships to bring in the kind of money that technology-driven trading does. And these stars require outsized compensation. The way this affected Goldman was that its relatively tight bands for compensation for people at the same level started to widen, and the partners decided that exceptions in hiring, compensating, and promoting “stars” must be made, further impacting Goldman’s culture.
Technological innovation also required greater specialization by employees at the firm. People needed to be specialists in order to add more value to clients. This also created more silos—and the conditions of structural secrecy, where information isn’t completely shared or understood by all of the appropriate people.
More Than the IPO
Too much emphasis has been placed purely on the IPO as the force of change at Goldman; as this analysis shows, the change began well in advance of the IPO. John Whitehead had pointed to issues related to Goldman’s earlier growth as his motivation for writing down the business principles. The pressure to grow was there at the time the principles were written—organizational drift was already in motion—and the principles were intended as one way to manage or constrain the change. In fact, the agreement of the partners to finally go public after resisting for so long was one of the products of the cultural changes that preceded the IPO.
What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences Page 12