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

by Steven G. Mandis

  According to the clients I interviewed, Goldman has conveniently, for its own purposes, shifted its roles as principal and agent/market-maker back and forth—and has even added a few more potential roles on the same deal. This is an issue Goldman identifies, in its report of the business standards committee, that it needs to make clearer to clients.

  Some people have argued that Lloyd Blankfein is largely responsible for this shift, but trading was already becoming a larger percentage and majority of the revenues before Blankfein became CEO. The firm also played multiple roles, including proprietary investing and investing with clients, before he became CEO. His rise in the firm reflected the pressures and changes.

  Proprietary Trading Becomes a Larger Percentage of Revenues

  When one looks at the business principles that John Whitehead wrote in 1979, it is a particular challenge to reconcile the goals of proprietary trading with putting clients’ interests first, or the goal of being the leading adviser. Proprietary trading has one client: Goldman. As proprietary traders, we were walled off from client activity. We were not there to provide liquidity to clients, manage funds for clients, or advise clients. From time to time, we were asked by banking to tell them or their clients how hedge funds would evaluate a situation. From time to time, we were also approached by banking or trading to help finance a transaction or buy something from a client or coinvest with a client—actions that, most of the time, raised all types of potential conflicts and died because we were too busy to have long conference calls to discuss it. But generally we were in our own silo.

  Proprietary trading at Goldman did not start in the 1990s. Bob Rubin joined the risk arbitrage proprietary trading area in the equities division in 1966, and by the 1980s it was considered one of the most profitable and powerful areas in the firm. When Rubin and Steve Friedman took over as senior partners in the 1990s, Goldman accelerated its additional role of risking its own capital versus being a mere “market maker.” It was the size of the losses from proprietary trading in 1994 that caused many observers to think the firm would not survive.

  How big and important are proprietary trading and principal investing activities at Goldman? Glenn Schorr, a Nomura Securities equity research analyst covering Goldman stock, estimated that the Volcker Rule, which is intended to restrict proprietary trading and principal investing at investment banks, would impact 48 percent of Goldman’s total consolidated revenue. To put this into context, he estimated the impact at 27 percent, 9 percent, and 8 percent of total consolidated revenues of Morgan Stanley, Bank of America, and J.P. Morgan, respectively.

  Certain Goldman client-oriented sales and trading desks had “proprietary trading” operations. They got to see client order flow, but theoretically they existed to provide liquidity or “facilitate client trades.” This was prevalent in less liquid, more opaque products and desks, especially fixed-income securities like high-yield bonds, where it may not have been easy to immediately match a buyer and a seller. It was also prevalent in relatively lightly regulated markets such as foreign exchange. Generally, proprietary trading on client-oriented sales and trading desks was less frequent in highly transparent and highly regulated areas such as equities.

  Merchant Banking and Private Equity Become a Larger Percentage of Revenues

  GS Capital Partners was started in 1992 with about $1 billion in assets and grew to $1.75 billion by 1995 and $2.75 billion by 1998. Ten years later, in 2007, GS Capital Partners had $20 billion in assets, making it one of the largest private equity firms. Goldman’s Whitehall Real Estate Fund also grew to have multiple billions of assets under management.48 Although separate, the funds do leverage Goldman banking and other relationships. When I was at Goldman we were often reminded how much more money Goldman could make investing the deal versus advising on it. Goldman was competing against clients in making acquisitions of companies and real estate properties. Goldman also had internal funds for managing Goldman’s own money and trying to buy assets. (The corporate and Whitehall funds raised money from external sources with Goldman’s coinvestment.)

  The private equity business had many synergies with other parts of the bank and wielded a lot of clout as a profit center. For example, the private equity group could take its companies public, the executives whom it backed could become private banking clients, and the companies that it controlled could use Goldman to hedge its risks or finance its debt. The private equity group was careful to maintain relationships with all the Wall Street firms (similar to an unaffiliated private equity firm), but there was no question it also was aware of its primary affiliation—and disclosed potential conflicts in its documents for investors in the funds.

  An executive of a major real estate firm told me the story of a property his company was trying to buy in the 1990s. Goldman had always been the company’s primary banker, and it had paid Goldman millions in fees over the years. The executive told his Goldman banker about the deal. A short time later, Goldman’s Whitehall Fund purchased the property. He was furious (although he hadn’t hired Goldman to advise him). He asked the banker to arrange a meeting with a senior Goldman executive. According to the client, at the meeting were senior people of the Goldman Whitehall Real Estate Fund. The corporate executive explained what had happened and expressed his frustration as a client. Goldman’s senior executive assured him that there were Chinese walls so that Goldman Whitehall would not know what he had told his banker. The Whitehall executives swore that they did not know about the client’s interest in the property. Goldman’s CEO said that merchant banking and Whitehall were very important to Goldman and that the firm had a fiduciary responsibility to do good deals for the clients they raised money from.

  Skeptical, the corporate executive told me that since that meeting, he had done business with Goldman only if he had to. He doubted Goldman’s ability to manage conflicts, its various roles, and confidential information.

  Steve Friedman, however, expressed confidence that Goldman could manage any conflicts arising from the firm’s new ventures: “The culture was transformed with a new strategic dynamism; and the principal investment business was well launched—although the old guard continued to worry and fret over conflicts with clients even though we explained to them that there are always conflicts, but you could manage the conflicts.”49

  International Business Becomes a Larger Percentage of Revenues

  In 1984 Goldman was primarily an American firm, with one partner outside the United States: an American based in London. After the 1986 partnership meeting, the consensus was to grow the firm globally to better serve clients. Consequently, international revenues increased as a percentage of total revenues, growing at a faster rate than did the US revenues, and a rate much faster than did the rest of the business. At the time of the IPO vote in 1998, 39 of the firm’s 190 partners were based in London, compared to 1 partner in the early 1980s. In 2011, 48 percent of Goldman employees were outside the United States (compared with 35 percent in 1996), and international net revenues grew 30 percent faster than US revenues from 1996 to 2011. One of the challenges Goldman faced with the increase in international business was maintaining its culture and principles outside New York, because many organizational issues arise in dealing with such rapid internationalization and global expansion, including training, socialization into culture and values, communication, local cultural nuances, and more.

  When I arrived in Hong Kong in 1993, Goldman’s office was small, employing fewer than two hundred people. The cultural and legal barriers, as well as low deal volumes and the existence of entrenched local competitors, were major challenges. At the time, Hong Kong was a high-risk posting for a seasoned banker. It offered an advantage to advance more quickly but had the disadvantage that as locals became socialized and trained, they would ultimately have more value than an expatriate. And it was difficult to transfer back home.

  Sometimes, when a senior banker was transferred to an international office, the reality was that the banker had lost a strugg
le back home or had to agree to the move to make partner.50 However, sometimes a foreign posting was intended to train a professional for a larger role. No matter how much Goldman wanted to portray itself as globally important, at the time all major decisions were made in New York.

  Although the office furniture, office sizes, and set-up of cubicles were the same, the culture at Goldman in Hong Kong was different from what I experienced in New York. The Hong Kong office operated in a separate world. At the time, very few senior bankers from New York came for an extended period of time. Senior partners would jet in and jet out. Because Goldman was concerned about quality of execution, any deal of meaningful importance typically had a New York or London banker assigned to it.51

  Because of the cost of supporting international offices like Hong Kong and because of Goldman’s lack of relationships with important local people at the time, the firm realized that merchant banking and proprietary investments were much more profitable there than were advisory businesses. A team of four or five bankers would work on a deal and get paid a one-time fee of millions, and then the team would look for another deal to work on. Investing with clients, in contrast, was viewed as a way to build closer relationships with them. Once an investment was made, hopefully it would make money each year as it produced returns. Eventually, the investment would need to be sold or financed, and Goldman was in a good position to work on the deal and collect a fee (typically at a rate comparable to those charged in Europe or the United States, and not comparable to fees in Asia, which were notoriously low). The Goldman bankers’ close relationship would also provide an easier entrée for private banking. All of this required teamwork and collaboration, supported by a social network of trust among the few partners in Asia and their financial interdependence with the other partners around the world. These partners also had to trust that it was for the greater good to have Americans and British flying in and out all of the time.

  Proprietary trading internationally was simpler, and it was seen as a high-margin business, because it was easily scalable—it took the same time for a trader to research an opportunity large or small. The markets in Europe and Asia tended to be less liquid and efficient, creating many opportunities. As Goldman established contacts and access, there were even more opportunities in which it perceived it held an informational advantage. Interestingly, Goldman preferred that its international offices follow the New York model as closely as possible—from people having the same titles (each person would be head of something and have one employee reporting to him, whereas the counterpart in New York with the same title would have hundreds of reports) to the same style of office furniture—all to make the firm feel united and cohesive. But although similar, the local hires typically had one approach, and the New York expatriates had another, and, to add complexity, the London expatriates that came stood somewhere in the middle. Often, junior people like me were caught in between.

  The internationalization of the firm also had consequences for the acculturation of new employees, which traditionally had occurred through an oral tradition. With the overseas expansion, this method of passing down the cultural legacy was more challenging.

  * * *

  Though the partners had strongly indicated at the time of the IPO that they didn’t want to undermine the firm’s core values, the changes in business practices and policies, as well as in the business mix, clearly illustrate Goldman’s organizational drift. The daily grind of competition, and the success these changes led to encouraged those at the firm, including the partners, to overlook or discount them, or sometimes purposely ignore them, in the interests of rapid growth, which was seen as vital to the firm’s success and survival. This pressure for growth significantly intensified after the IPO, which also brought a new set of changes to the firm.

  Part Three

  ACCELERATION OF DRIFT

  Chapter 6

  The Consequences of Going Public

  WHILE THE IPO ACCELERATED MANY CHANGES ALREADY taking place at Goldman, it also brought about new ones. The newly public Goldman faced the challenges of a change in ownership and financial interdependence among the partners, the elimination of capital and growth constraints, and the need to take into account outsiders’ perceptions of the firm—all had distinct cultural consequences.

  A fundamental change made because of the IPO was the addition of the new principle expressing a commitment to providing superior returns to shareholders. Many observers point to this as the biggest change over time at Goldman because the firm could no longer privately make decisions in its best long-term interests in its relationships with clients, but instead had to focus on the public market investors’ shorter-term interests. They argue that this written addition was the “smoking gun” that muddled up always putting clients’ interests first. Though as demonstrated in this book, organizational drift had begun before this, there is no question that this change introduced its own considerable effects, as did the new structure of ownership.

  Shared Ownership

  When Goldman went public it awarded shares to almost every employee (including assistants), with some portion being awarded according to a formula and some by the discretion of one’s manager. The formulaic part was calculated on compensation and years of service. Generally, the discretionary part was largely determined by seniority and previous years’ compensation. There was a feeling among some senior nonpartner employees (those who were within a few years of partner) that part of the IPO grant should offset the lower income that the employee had gotten versus peers at other firms, now that the firm was going public and it was unclear if the partnership was going to be considered less prestigious and be less lucrative. The IPO shares were restricted to vest over years 3, 4, and 5 after the IPO (one-third each year) to ensure that everyone focused on the future and that potential outside investors knew that employees would not sell shares overnight. Compensation at Goldman had typically been in all cash versus most of its peers, which were public and generally paid bonuses both in cash and in stock that vested over time. The stock awards were also meant to “align incentives” and give employees “a sense of ownership.” It sounded good, and everyone I spoke to was grateful to receive stock (although some questioned the fairness of the allocation process). I remember how proud I was to receive a thick envelope with information about my stock, complete with bar graphs of what it was worth at different prices. But over time I learned that wide stock ownership would not necessarily fully meet its objectives, and it also caused some unanticipated issues.

  About a year after the IPO, Goldman stock rose to around $100 a share (from the $53 offering price) and the partners got approvals to sell shares “in order to improve trading liquidity for shareholders.” That increased public ownership to 27 percent. 1 To sell, the partners needed special approval from the board (the majority of which were insiders) and the shareholder’s committee (the majority of which were insiders). None of the three most senior executives sold shares, but about 160 former partners did, selling over $2 million on average, while eleven sold more than $20 million. No nonpartner employees were allowed to sell shares before the first vesting period, three years after the IPO. 2 I remember a partner sheepishly telling me he decided to sell the maximum he was allowed to in the special offering for “diversification reasons,” almost seeking or expecting some sort of understanding or reassurance that it was ok. At the time a group of my peers discussed that the partners who retired before the IPO did not have the “diversification” option and that the current employees did not have the option to sell after one year. And based on conversations with those more senior to me at the time, some of my peers were certainly not the only ones who were questioning the timing of the sales. One interviewee mentioned to me that it was eerily similar to the 1994 partners “bailing out.” (I am paraphrasing as always in interviewee quotes.)

  A few years after the IPO stock grants, the tech bubble burst. The stock declined to the $70s and the firm laid off lots of employees. The info
rmation that quickly spread like wild fire was that in the fine print of the IPO stock grant was a stipulation that in order to cash out your stock when it vested, you still had to be employed by the firm. For those that were being laid off, the firm was “allowing” people to keep their 2002 stock “as a bonus” even though it had not vested (in some instances getting no cash bonus/severance), but they would lose the amounts for 2003 and 2004. I remember the shock and outrage not just from those laid off but from some of those who remained. There was a feeling by some that the firm had “handcuffed” employees with the large grants but then took them away because this helped the firm reduce the number of shares outstanding and therefore helped the firm’s reported earnings per share to investors, which would help the stock price. To make matters even worse, some felt that the firm paid people less than peers during the tech crash because it knew that it had the “handcuffs” from the IPO shares that had not vested and that managers included the value of the shares that were to vest in the employee compensation calculations. These actions had consequences for how certain employees viewed the firm.