The Battle of the Bulge Bracket

By Stephen J. Morgan

Key Players in Investment Banking and Financial Services Weigh in on the Industry’s Heftiest Mergers – and What Could Happen Next

Frank Quattrone is an intense guy in an intense business. If you ask him why investment banking is consolidating like crazy these days, the head of Credit Suisse First Boston’s Technology Group will shift into overdrive.

The three high-margin areas where investment bankers make money – equity underwriting, high-yield bond underwriting, and mergers and acquisitions – are concentrating in the hands of fewer and fewer firms, says Quatrrone, W’77. And if you want to play ball with the world’s top investment banks – Goldman Sachs Grooup, Morgan Stanley Dean Witter and Merrill Lynch – you must be big and broad, with an array of capabilities. A firm can develop and strengthen those capabilities either from within – or via acquisition.

Frank Quattrone“Clients want to deal with winners,” Quattrone says. “It’s hard for investment banks not ranked in the top five or even the top three to win the important business that drives market share. If you look at market share of the top five or three in equity, high-yield and M&A, they’re becoming increasingly concentrated in those hands. If you can’t compete, you have to do something. So, why bang your head against the wall?”

Why, indeed.

If you are Zurich-based Credit Suisse Group, parent of CSFB, you don’t try to grow organically – you buy Donaldson Lufkin & Jenrette and merge it with CSFB. If you are UBS, another Swiss banking giant, you acquire PaineWebber Group. Or, if you happen to be Chase Manhattan Bank, you buy J.P. Morgan. These three deals, announced within months of one another in 2000, shook the increasingly intermingled world of investment banking, commercial banking and brokerages, and left Wall Street wondering who would be next.

In recent years, consolidation has changed the automobile, telecommunications and defense industries, and, of course, financial services. Wharton alumni, faculty members and industry analysts say it is likely to continue as banks and securities firms in the United States and Europe jockey to put together the right combination of people, products and assets to achieve competitive advantage and boost global market share. In the investment banking business, that means attaining or retaining “bulge bracket” status — Wall Street jargon for the most elite investment banks.

Robert J. HurstAnd consolidation is affecting all of financial services, not just investment banks. The merger of Citicorp and Travelers Group in 1998 created the quintessential business model for the super-big, one-stop-shopping, universal-bank for customers seeking everything from underwriting to insurance to credit cards. The Chase-J.P. Morgan deal will create a similar giant. Robert J. Hurst, WG’68, vice chairman of Goldman Sachs, cites several key factors in commercial and investment banks’ drive to seek partners.

“Commercial-banking consolidation has really come about because banking was a fragmented industry nationwide and globally,” says Hurst. “And it has been a relatively slower growth industry, and so consolidation has made a lot of sense. In general, in banking acquisitions, there has been a little loss of revenue and lots of synergies and overlap, which means cost cutting and expense savings. On the investment banking side, consolidation has been driven by a different set of factors. Acquisitions have happened to create scale, to strengthen product areas and to become global or increase capital. But it’s not driven by the need to offset slower growth with expense takeouts.”

Hurst and others say that, in general, it’s OK to be big and OK to be a small, boutique firm with a well-defined niche. But middle-of-the-pack firms, they say, are finding themselves in the most difficult competitive position: They may be too big to be nimble but too small to offer the variety of services major clients demand.

Tanya Azarch, a Standard & Poor’s analyst, says the current wave of consolidation began in the late 1980s. “It waxes and wanes,” she explains. “When stock prices are high, firms will sell out. When the stock market falls, there’s less compulsion to do that.” A consolidation “crescendo” took place in 1997, when Chase Manhattan Bank merged with Chemical Bank. A brief hiatus followed.

“Now,” she says, “we’re starting to get different kinds of consolidations, across industries more. I would characterize Chase and J.P. Morgan like that. There’s been a convergence between corporate banking and investment banking in terms of products. Chase has proven that you can do it all, from soup to nuts, and that puts pressure on investment banks to provide bank loans and banks to provide underwriting of securities. The pressures are felt both ways. There’s a sense that commercial banks all these years have not developed an investment- bank franchise [of sufficient capability], as J.P. Morgan proved. It’s terribly difficult and expensive to develop equity underwriting.”

Is Bigger Really Better?

Rightly or wrongly, bankers believe that bigger is better, Azarch says. “There is a sense that [firms] want a commanding market share. And as the business globalizes, the business gets bigger, so [each firm feels it has to] get bigger.” Hence, European and American financial institutions have been scrambling for acquisitions. “U.S. investment banks are more successful than any investment banks in the world, and everybody wants to buy them,” says Azarch. “There’s almost a frenzy because there’s almost nothing left to buy.”

Finance professor Anthony Santomero, who took a leave of absence from Wharton last summer to become president of the Federal Reserve Bank of Philadelphia, has analyzed consolidation in a research paper titled “The Determinants of Success in the New Financial Services Environment.” Santomero and co-author David Eckles of the Wharton Financial Institutions Center found that size does indeed give financial institutions advantages that can boost profits.

Large institutions enjoy certain economies of scale, he says. Plus, diversification across businesses provides some earnings stability. If an institution only sells mutual funds, for instance, the whole company will suffer if the fund business turns sour. But if that same firm also has a brokerage business, revenues and earnings from that operation can soften any blow from the fund side. Big firms can also leverage distribution channels to cross-sell products and services.

But the article, which appeared in the October 2000 issue of Economic Policy Review, a publication of the Federal Reserve Bank of New York, says size is no guarantee of success. In fact, there are several reasons why a universal bank-style institution may actually become less stable. For one, a firm’s brand name will become associated with all of its products; if something bad happens to one business segment, the whole franchise may get a black eye. Further, a firm may deceive itself into thinking it is diversifying into different businesses when in fact it is not. For example, the article says, third-world lenders became emerging-market trading houses only to court disaster. A firm offering many products also becomes more complex, and complexity can cause management to be sluggish in reacting to changes in the market.

“It is not automatically the case that size will overwhelm the more focused institutions,” Santomero says. “It may be the case that the midsize firms are the ones having the most difficulty because they’re big enough to have management problems but are not big enough to leverage their scale. As a result, small, agile firms tend to be more successful. Firms in the middle end up being vulnerable and merge into other organizations. That’s what we’re seeing in almost every aspect of the financial markets.”

Where does that leave the industry? “Individual firms will be in lines of business which will at times require high scale and at other times small scale to be reactive [to competition],” Santomero says. “Essentially, one size doesn’t fit all. The question every organization has to ask itself is this: What are my core competencies and how do I leverage them in an effective way?”

Richard HerringFinance professor Richard Herring says financial services consolidation is driven in large measure by the expanding needs of the clients the industry serves. “Bigger clients need bigger financial-services firms,” Herring says. “If you are an investment bank that wants to offer services to other industries in a meaningful way, you have to have a bigger balance sheet. You have to have enough capital to take the underwriting risk when you underwrite securities for very large firms. Some of these mergers are also aimed at distribution capacity, the ability to deal securities worldwide; the riskier the underwriting, the riskier the distribution.”

Garrett Moran, WG’82, vice chairman of DLJ’s Banking Group, says the combined CSFB and DLJ entity brings together the complementary strengths of two very different firms.

DLJ brought to the table a large merchant banking business, a successful telecommunications practice, strong high-yield and private-equity businesses, a broad presence with middle-market clients, the DLJ Direct brokerage operation and 500 brokers, says Moran, who plans to begin a six-month leave of absence in March. For its part, CSFB contributed a top-rated technology practice, headed by Quattrone, robust M&A and equity research capabilities, a larger balance sheet than DLJ’s, large corporate clients and an international footprint.

According to Institutional Investor Magazine, the combined company last fall ranked first in U.S. equity research, first in high-yield research and underwriting, third in global M&A, third in primary debt issuance and fourth in primary equity issuance.

“It’s more and more useful to have a global brand,” Moran says. “You might be the best at a certain kind of execution. For example, we are the top high-yield-bond underwriting firm in the world. Now, when the high-yield market begins to open up in Asia, it will be easier for us to build our position there. Brand has advantages.”

The Talent Factor

Alumni and faculty agree that cultural issues are important in ensuring that consolidation works.

Richard Marston“When you buy into an investment bank, you’re buying people,” says finance professor Richard Marston, director of the George Weiss Center for International Financial Research. “If you can’t retain the key players, you’re not going to have a successful acquisition. That’s true of Deutsche Bank buying Bankers Trust or UBS buying PaineWebber. PaineWebber consists of talented people in the investment area. If they were to lose a good portion of those people in this acquisition, UBS would end up with a hollow shell. UBS is aware of that and it is structuring reward to PaineWebber people who stick around.”

To illustrate this point, Marston points to General Electric Chairman Jack Welch’s decision to call on Geoffrey Boisi, WG’71, to provide advice on GE’s bid to acquire Honeywell in October. Boisi, a former partner at Goldman Sachs, left Goldman years before to form his own boutique, the Beacon Group. Chase bought Beacon in July 2000 for a reported $450 million. And Boisi, who is head of investment banking at Chase and will be co-chief executive of investment banking at the combined company, soon began playing a pivotal role not only in guiding the acquisition of J.P. Morgan, but in advising Welch.

“When corporate executives are looking for financial advice, what they really want is a bright individual,” says Marston. “They’re not always looking for the largest organization. Welch called upon Geoff. He wasn’t calling upon an institution but an individual to give him advice. Geoff would have been called upon even if he were with the firm prior to Chase. In investment banking deals, many times the institution helps tremendously, and the resources of a J.P. Morgan Chase will be enormous. It was a coup to attract [Boisi] to the firm. But when push comes to shove, the key players have to be good in their own right, which is why Jack Welch called on him.”

Hurst of Goldman Sachs says, “Three things have made a difference in deals that have worked. First, move quickly in terms of the integration. Second, remove uncertainty with regards to people. Third, be very focused on the areas that are strategic and build those up, and prune or divest the non-critical businesses.”

Of the three big mergers in 2000, the one that was “easiest to justify in terms of synergy” was UBS’s acquisition of PaineWebber, Herring says. “PaineWebber has a wonderful high-net-worth client list and UBS is the preeminent provider of private-banking services worldwide.”

In the case of Chase and J.P. Morgan, “success will depend on whether executives can keep the best people,” Marston says. “I believe Chase, with the success it has had in the past with mergers, will be careful to keep the best of these organizations. But it’s going to be a difficult task, and it will take a lot of time to make the merger successful because there’s an awful lot of overlap.”

One threat to any successful consolidation is differences in compensation, particularly if commercial banks are acquiring investment banks, says management professor Harbir Singh, who studies mergers and acquisitions. For instance, if bankers at one company know that people in the firm being acquired are earning a lot more than they are, management may find employees bolting for the exits or, if they stay, feeling resentful.

“In the best-case scenario, the acquired firm sees the acquiring firm as having access to customers in international markets, some cross-selling opportunities and maybe depth in financing,” Singh says. “But the negative is all the other excess baggage. The acquiring banks often are not used to living that high, so there’s a culture clash.”

In the “war for talent,” Moran says, “people can be over-paid because firms feel they have to over-pay to get people. It’s hard to do lateral hires from competitors. Every time you hire someone, you pay a ridiculous figure. You tend to attract the most mercenary people and end up disenfranchising the most loyal people in your organization. Consolidations will succeed only if they are places where people like to work.”

“The most important thing to get right,” says Quattrone, “is the culture.”

It is also true, says S&P’s Azarch, that “in investment banking where your assets are your people, you don’t do hostile mergers. It would be suicidal.”

David PottruckSize is another hurdle to be overcome by merging firms. “Size offers as many challenges as advantages,” says Dave Pottruck, WG’72, President and Co-CEO of Charles Schwab, which last June completed its merger with U.S. Trust. Over the past several years, Schwab has also acquired online and discount brokerages in Canada, Australia and the United Kingdom and has bought a 401(k) administrative firm which now has over $35 billion in client assets. “None of those deals involved layoffs,” Pottruck says. “We now have 25,000 people in our company; only two years ago we had 11,000. We are struggling to recruit the kinds of people we need but not dilute our culture.”

Many consolidations, Pottruck says, “have been driven by the balance sheet and income statement; driven by companies wanting to achieve financial efficiencies. Frankly, that’s a gruesome path to success and something I don’t think I’d be very good at. The reason you merge is you think that at the end of the day you’ll have more value for customers and shareholders than at the beginning. There are some people who merge because they think bigger is better. But once you’ve gotten a certain degree of critical mass, being bigger does not at all make you better or more successful.”

All of those interviewed say consolidation will continue. The cocktail party chatter, though, is about whom will merge with whom.

Here’s Azarch’s assessment: “If anybody wants to make the next big move, it will take a bulge-bracket firm: Morgan Stanley, Merrill or Goldman. I don’t see a merger between them. They have co-existed for a very long time. It’s more likely that a universal bank would want one of those to fill out their investment- bank franchise.”

In a report to clients, Bear Stearns analyst Amy Butte says European financial institutions are “best positioned to win bidding wars.” One reason these firms, relative to U.S.- based institutions, can afford to pay more for acquisitions is “reduced public scrutiny,” which may give them “incremental flexibility in producing results for shareholders,” she says. Butte identifies HSBC, ING Barings and ABN Amro as potential buyers.

Throughout last year, speculation on mergers remained intense. An official of Deutsche Bank, which acquired Bankers Trust in 1999 and was said to have had J.P. Morgan on its wish list, reportedly told analysts in November that it was going to take a break from shopping for an investment bank. Instead, the official said, the Frankfurt-based giant, not unlike other institutions, wanted to focus on strengthening its asset-management and private-bank operations.

Today’s securities environment is far different from when Quattrone, son of a clothing factory worker from South Philadelphia, broke into investment banking with Morgan Stanley in 1977.

“Back then it was like a gentleman’s club where each firm had its own clients and nobody tried to take clients away,” he recalls. “There was fragmentation in the market, and Morgan Stanley and First Boston and White Weld had blue-blood clients. Some upstarts like Goldman and Salomon Brothers were trying to crack the Fortune 500.”

But even then, consolidation was occurring. At the same time, high technology firms that are now household names emerged – manufacturers of personal computers, software and silicon chips. In 1981, Quattrone was part of the group that began to build Morgan Stanley’s technology practice. Nine years later, he took a company called Cisco Systems public. Since then, he has advised on hundreds of initial public offerings, common stock and convertible offerings and M&A transactions for such firms as 3Com, Amazon.com, America Online, Netscape, Intel, Intuit and Oracle.

“The business has become more capital intensive,” Quattrone says. “The clients who are driving our business are global enterprises. Companies want complete, global solutions and a narrow number of vendors to be complete suppliers of all products. Hambrecht & Quist, Montgomery Securities and other specialist firms have all disappeared [by being acquired]. They couldn’t cut it anymore, either capital-wise or full-service- wise.”

Being big, says Quattrone, allows firms to pursue what he calls “elephant” deals — transactions in the tens of billions of dollars. Of the combined CSFB-DLJ, he says: “If we can go out in the world and say we’re working harder and that we’re in the top three in every product, region and industry sector, more people will want to deal with us because we’ll have the stature to get their business.”

Who Needs New York, Anyway?
Taking Wall Street to the Alaskan Tundra

By Nancy Moffitt

About 10 year ago, Bob Gillam gave Wall Street the cold shoulder. As in subarctic.

In 1990, Gillam, W’68, founded McKinley Capital Management Inc. in Anchorage, Alaska. Gillam had grown up largely in Alaska, and knew he wouldn’t be happy surrounded by skyscrapers and subway .

Though he initially worried that McKinley’s location might be a liability to the money management firm, Gillam felt there was no reason – thanks to technology – that he couldn’t make it work.

Indeed he has. Today, McKinley, with about $5 billion under management, has racked up impressive returns year after year, catching the eye of the Wall Street Journal and other major media, as well as a growing cadre of institutional investors. Even during last year’s tumultuous market climate, all but two of the firm’s investment product outperformed the benchmark indices: McKinley’s growth-equity portfolio, for instance, had a one-year return of about 65 percent as of September 30, outpacing the Russell 3000 Growth and the S&P 500. Its global growth product gained 21 percent for the year, versus 8 percent for the Morgan Stanley All-Country World-Free. A variety of reporting databases, including Nelson’s Directory of Investment Managers, rank the firm in the top 1 percent to 5 percent for all of its investment products.

SeaplaneAnd Gillam, 54, can trade in the morning – there’s a four-hour time difference between New York and Alaska – and fly his float plane or fly fish in the afternoon after the market has closed. McKinley’s Northern Exposure locale has, surprisingly, turned into a selling point: the firm has attracted a core of young investment gurus who are drawn to the wilderness lifestyle and low cost of living. It’s also part of a growing trend among money management firms: Technology has made it possible for investment companies to set up camp just about anywhere. Today, many of the nation’s largest investment/ money management companies are far from Wall Street, from Colorado-based Janus to Boston’s Fidelity.

But it wasn’t always so easy for Gillam, who tackled some unique challenges during McKinley’s infancy.

For one, leasing the high-speed telephone line necessary for coast-to-coast data transfer – timely data is the lifeblood of investment firm – was too costly an option for the then three-man firm. While the going rate was $600 to $900 a month elsewhere in the U.S., McKinley’s Anchorage base meant the line would cost “several times that amount,” Gillam says. “Since accessing data is so vital to our business, we were forced to seek out alternatives. As a result, we were one of the first asset management firms to use the satellite for data transfer. We discovered then what we all know now – that streaming data from space was a cheaper and more reliable way to go.”

McKinley also faced indifference from Alaskans, who believed that “you’ve got to be from out-of-town to be any good,” Gillam says. So during its first five years in business, the firm didn’t market its services in its home state.

“This meant that that our next closest market, Seattle, was 1,300 miles from our primary location,” Gillam laughs. “But initially, I looked for clients in Texas or the West Coast, starting very small. And we grew, we picked up business across the U.S., including here in Alaska, and also in Europe and Asia.” Today, about 80 percent of the firm’s business is institutional, with clients including Bell South and Volkswagen of America.

As McKinley Capital has grown, its Alaska base has become less of a challenge and more of a way to give the firm a distinct, memorable persona of sorts. The entry page of the company’s website (www.mckinleycapital.com), for instance, shows a suit-clad man giving a presentation to an audience of attentive brown bears back-dropped by Alaska’s snow-topped mountains. The slogan? “Our location at the top of the world means only one thing. A better view.”

Bob Gillam“The lifestyle here is incredible,” Gillam says. “And I don’t just say that because I was raised here. Most of our employees live within a 10-minute drive to the office. And other than property taxes, there are no taxes in Alaska. There’s no state income tax and no sales tax. Housing is really, really cheap. The cost of fuel, as you might expect, is low. And the recreational opportunities are immense. If you’re a fly fisherman, if you like to ski, if you like to hike, boat, all of those things, you can’t do any better.” Gillam’s son Rob, W’94, and one of five children, is also a portfolio manager at McKinley, which now has 75 employees.

An avid big-game hunter, fly fisherman and float plane pilot, Gillam lives his pitch. In recent years, he completed a 15,000-square-foot private lodge/retirement home overlooking the Lake Clark National Park and Preserve. No roads exist anywhere near the area, so Gillam built a 3,500-foot runway to service the more than 100 cargo planes that brought in over 50 loads, a million-plus pounds, of building supplies to the site. It took four years to build the lodge, where brown bears stroll through the front yard.

After earning an undergraduate degree from Wharton, then an MBA at UCLA’s Anderson School of Management, Gillam joined the brokerage business, working for two Pacific Northwest firms that ultimately merged with larger financial services organizations. In the late 1980s, after weathering the second merger, Gillam decided he’d had enough of being sold –”slavery is illegal,” he jokes –and decided to open his own money management firm in his hometown of Anchorage. He bought four computers and hired Ted Gifford, a computer science professor at the University of Alaska, to help create programs that would turn Gillam’s market theories into market returns. McKinley Capital was born in 1990 with three employees and a quantitative, computer-focused investment style that’s typically atypical. The firm’s computers calculate and link a series of mathematical functions that search for and evaluate stocks based on earnings surprises and expectations. Gillam’s strategy, called Modern Portfolio Theory, zeroes in on stocks the computer models find will likely grow faster than Wall Street expectations. As of last fall, for instance, McKinley had sold its holdings in large technology stocks such as Microsoft, Dell and Cisco in favor of smaller, secondary technology shares flagged by the firm’s mathematical computer models as the next growth powerhouses.

Despite the swift consolidation underway in the financial services industry, McKinley remains independent, with about half of its employees holding equity in the firm. “It’s my observation that the majority of mega mergers bringing together banking, brokerage, investment management and insurance firms have not worked very well,” Gillam says. “But there is a learning curve, and I think that many of the mergers that are underway today might work. There will likely be a large pile of rubble as history is written, but a number of the mergers will be successful, particularly the merger of banking, investment management and brokerage, versus banking and insurance.”

Asked about McKinley’s likely future independence, Gillam says that, for now, the firm intends to stay its present course. “We don’t need, at the moment, any additional marketing channels. We don’t need any more capital or young motivated people. So, at least for this little firm, being independent is just dandy.”

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