Authors: William D. Cohan
The top executives at Goldman Sachs became risk managers as much as anything else. “I didn’t say, ‘I’m a banker, I don’t understand this
stuff,’ ” Paulson recalled. “I was at every risk committee meeting. I was doing everything I could to understand the firm’s risk. I did that right up until I left the firm.” In September 1995, Corzine explained to
Institutional Investor
that he had “rededicated the firm to client service” and the “days of Goldman being a hedge fund in disguise are over.” But he was careful to say that did not mean Goldman would simply return to being a low-margin broker between buyer and seller. “You can’t achieve the kinds of returns we want by just buying on the bid and selling on the offer,” he said. “Reading flows and taking positions is still a very attractive revenue producer for Goldman Sachs in the fixed-income and foreign exchange areas.” Corzine conceded that Goldman had been hurt by the departure of the forty or so partners who left at the end of 1994. To help compensate for the loss of talent, Corzine moved
John Thain, the CFO, to London to co-head Europe with
John Thornton, the M&A banker, to help “clean up the fixed-income mess.”
By the annual partners’ meeting at Arrowwood in mid-January 1996, the firm was hitting on all cylinders. In the weeks leading up to the offsite, the papers were filled with speculation about whether
this
time—after five rejections in the previous twenty-five years—the Goldman partners would decide to go public. Corzine himself fueled the speculation by saying an IPO was being considered. “
If you did not have this discussion there would be a big debate about why we aren’t talking about this,” he said. “In the long run, Goldman’s capital structure is expensive and vulnerable,” one rival Wall Street CEO said at the time. “
It’s not as strong as a public company’s would be. It’s untenable.” He said, “If earnings are high, the capital structure is not a problem.… But if earnings are not great, they are vulnerable, and if they lose money there will be a crisis.”
The other looming question, though, about the potential Goldman IPO was a simple one of greed and mathematics. Since Goldman named new partners every two years, the fact was that 98 of the firm’s 174 partners, or 53 percent, had been partners only since the end of 1992. With 1994 being such a bad year, the majority of the firm’s partners had not had the chance to build up sufficiently large capital accounts to make it seem worthwhile to them to push for the IPO. They had not had “
a shot at the golden carrot” yet, as one competitor put it. It seemed like déjà vu all over again. For Corzine, with a reported 1.5 percent stake in Goldman’s profits—the largest individual stake at the firm—the rewards were obvious, but he was just one vote. Corzine knew he had to tread carefully. “
Now would be a good time to go public,” one newspaper observed on the eve of the meeting, “but it doesn’t need to.… Should the older partners risk alienating the younger ones by pushing for a flotation
which would allow them to take their cash out?” Added another observer as the meeting opened, “If Goldman’s partners are salivating a little today, it will not be over the pheasant on the dinner menu. But not everyone will be so enthralled. Partners only recently instated will have accumulated much smaller stakes, perhaps of only $1 million, and will favour waiting for them to grow larger before the bank is sold. They want the jackpot, too.”
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W
ITH THIS BACKDROP,
Corzine and Paulson assembled the Goldman partnership at the Arrowwood meeting. “A year and a couple of months does make a significant difference,” Corzine said in his remarks. “We—all of us—have turned the tide for this great organization.” Goldman had earned $1.4 billion pretax in 1995 (and its run rate during the last six months of the year was $1.75 billion) and therefore to meet Corzine’s goal, the firm needed to earn an average of $2.2 billion during the next four years. Up went his $10 billion chart again. “A year ago,” he said, “the chart behind me was categorized as, at best, improbable and, at worst, simply Pollyannaish.” Not anymore. “It’s a big objective,” Corzine told his partners. “But it is clearly doable.”
Corzine articulated three goals and aspirations for the firm, the likes of which no other Wall Street firm had ever attempted, at least with anything resembling a straight face. First, Goldman needed to be “the world’s recognized best at providing a broad range of financial services” in the judgment of “our clients, outside regulators and creditors and, most importantly, in the eyes of our partners and people.” Second, Goldman needed to “constantly maintain and enhance our culture of excellence.” He noted, of course, the importance of “teamwork and mutual support.” The firm was committed to focusing on the long term and to a “merit-based reward system,” where “what you do” determined “your career path” not “who you know.”
Then, having fed the crowd boilerplate rhetoric, Corzine got to the heart of what Wall Street firms were really about: Goldman Sachs existed to “provide superior wealth creation for the owners and the best people” at the firm. The firm’s “financial objective,” he said, “was to achieve meaningful absolute profits” that would generate after-tax return on equity—net income divided by the firm’s capital—of “at least 20%.” Then Corzine mentioned in passing the subject that had been on his mind for years: whether Goldman would remain a private firm in the future or would go public. It was just a quick mention, but it offered a glimpse of what he planned to talk about the next morning and indicated that it was a matter of some ongoing importance to Corzine, especially since the
whole idea had been dismissed summarily a year earlier. “We are going to move to a [return-on-equity] orientation regardless of our future capital structure,” he said. “In a private firm, ROE is a means for capital allocations, and in a public firm ROE is what drives multiples and therefore shareholder wealth.” He emphasized that focusing on ROE was a significant change for the firm and “will stimulate changes through time in how we run our business” and cautioned his partners that “we must get the benefits” of focusing on ROE “without its potential for seeding divisiveness” by favoring certain businesses over others, depending on their relative profitability.
He spoke about the need for Goldman to develop further its “proprietary businesses,” those where the firm took risks as principals—whether in trading or in private equity or in hedge funds—and wanted to have “a unique blend of client and proprietary businesses” because Goldman was “uniquely positioned” to do it. Corzine’s vision was for Goldman’s “proprietary activities” to “tie to and support our client focus. And they can.” His logic was simple. “It is certain that we will know markets better and can give better advice by being a participant rather than an observer,” he said. “It is certain that many of our clients expect and welcome the firm’s use of its capital to facilitate meeting their objectives.” Corzine wanted Goldman to be “a recognized leader in financial and quantitative research,” in the “development and use of technology,” and in “innovating products and in solving financial problems.” When conflicts arose—as they inevitably would between acting as an agent and acting as a principal—Corzine argued that the conflicts could be managed if the right “checks and balances” were in place. “That is execution,” he said.
The “biggest challenge” of leadership, he said, was “getting the right balance between the energy of the enterprise and the hustle of 174 partners, especially in the context of a firm with the potency and reach of Goldman Sachs.” Then he explained how he intended to keep the balance. “Risk control is fundamental,” he said. “Legal, credit, market, operational, reputational, expense, and liquidity provision must have first-order priority. A breakdown here can be fatal.” Next, “performance accountability must be accepted” and focus on total profits, profit margins, and return on equity. But was this relentless focus on profit a recipe for dispensing with the system of “checks and balances” that was in place to prevent conflicts between client needs and Goldman’s own trading accounts? This question would come back to haunt Goldman with a vengeance in 2010.
To Corzine, the lessons of 1994 were clear. “Permanency of capital was essential,” he said. “You could not have everybody’s life at risk
because people have different risk tolerances and can take their capital out at a moment’s notice. I didn’t have religious fervor [about an IPO] in 1986, but I was supportive. I had religious fervor after 1994 because you can’t have a two-hundred-and-fifty-billion-dollar balance sheet stretched around the world, operating twenty-four hours a day built on capital that could walk out the door and have no real transparency whatsoever about what you’re doing.” What he could also have mentioned—but didn’t—was that Goldman’s balance sheet was increasingly leveraged, risky, and costly, chock-full of capital invested from Sumitomo and the
Bishop Estate (which were taking away a combined 25 percent of the firm’s profits annually) and with capital borrowed from institutional investors at rates of interest averaging around 10 percent.
By 1996, the firm was the only major Wall Street securities firm that still operated as a private partnership, and there was no longer any doubt that the firm needed more capital to compete and also needed a new corporate structure to shield the partners from potential catastrophic liabilities.
Before turning the podium over to Paulson, Corzine broached the delicate subject of the Goldman IPO. “We are the strongest and best firm in our business,” Corzine said. “The question for us is how to assure that Goldman Sachs continues to optimize its strengths. In that regard, we must ask now—when our health is strong—the question of where our future weaknesses might arise. The experiences of 1994 and the events of the last decade raise long-term questions with respect to our jugular vein—our capital structure.” During the next day, the conversation would be about Goldman’s capital structure and whether to keep things the same, “create an enhanced partnership,” or go public, via an initial public offering of stock.
Corzine knew the issue was contentious. He had quickly lost support for an IPO the year before—the firm was in no shape for it then, of course—and in the interim year, he had been lobbying his partners relentlessly in order to build support for the idea. By then, the tension was well known between those who wanted to keep Goldman private and those who believed the firm needed ready access to capital to compete. Left unarticulated was that every Goldman partner present on the day of the IPO, as well as every limited partner (albeit to a lesser degree), would become mind-bogglingly rich as a result. “Goldman Sachs had been a partnership for well over one hundred years,” Paulson said, “and so for one generation to reap the rewards, and sell it, so that no other generation could do what the one generation had done, when you do it you’d better do it in a first-rate way, and it better be driven by strategic reasons,
not by one group wanting to harvest the rewards that were built for those who went before them and take the opportunity away from those that came after them. You had to have a good strategic reason for doing it.”
That fact cast a pall over the group. “The important thing is to keep an open, dispassionate mind,” Corzine said. For Corzine, the matter came down to one question: “What’s in the best interest of the firm and its people—all 8,200?” He said, “The question should not and cannot be what’s in your own self-interest.”
For his part, Paulson barely mentioned the possibility of the IPO, thinking that it would be the main subject for the following day. Instead, he spoke about the need for “paced expansion” and to continue the firm’s growth outside the United States in a more judicious manner while not neglecting its backyard. He also mentioned a number of opportunities the firm was seeing in trading—high-yield debt,
syndicated bank loans, foreign exchange—and described two strategic initiatives the firm would focus on in the coming year: growing Goldman’s asset management business and building up its electronic distribution system.
Finally, Paulson spoke about the problem of managing the firm’s increasing number of conflicts, as Corzine had, but with considerably more concern. “In order to realize our strategic objective of creating a unique blend of client and proprietary businesses,” he said, “we must develop a sophisticated management approach for ‘relationship’ conflicts as well as legal conflicts.” This had not been going too well in recent years. In 1996, he said, Goldman needed “to do a much better job of managing conflicts” internally and in how “we articulate our business principles, policies and procedures.” He wondered, rhetorically, why the firm was experiencing increasing problems with conflicts and then answered that the reasons were the firm’s “growing principal investing business,” its “growing market share and increasing global reach,” and the efforts by competitors to “use conflicts as a ploy to take business from us or tarnish our reputation directly with clients or indirectly through the media.” He also thought it was partly because clients “seem to be more sensitive about their competitors” and had been demanding “exclusive relationships” with their bankers. But, he said, the problems stemmed, too, from “our own inability to understand, articulate and manage these issues as well as we should.” He said the firm owed its clients “full disclosure” about conflicts, “100% dedication to achieving their interest,” and “professional execution.” One thing “we don’t owe them,” he said, was the “pledge to never work with anyone else who may have a competing economic interest.” The key to success, he concluded, was “keeping our momentum, our hustle, and executing with intensity.”
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P
AULSON WAS RIGHT
to be worried about the firm’s increasing problem with conflicts of interest. Goldman had been confronting the issue of conflicts for years, ever since Levy set up the risk arbitrage department in the 1950s. Time and time again the firm had to decide whether to arb a merger or advise on a merger. Sometimes the decision would be complicated by timing, as in the case of KKR’s interest in
Beatrice Foods. In that case, Goldman had been hired to work with Beatrice’s management to take the company private and, at that moment, Bob Freeman put Beatrice on the gray list, which theoretically prevented Goldman from trading its securities. But after that management-led buyout failed, Beatrice came off the gray list and Freeman started trading the Beatrice stock (much to his own personal misfortune, it turned out). But in the late 1980s and 1990s, as Goldman’s principal business exploded—among them private equity,
hedge funds, and the Special Situations Group, or SSG, a little-known fund of partners’ money run by
Mark McGoldrick—the potential for conflicts exploded, too. Increasingly, the joke around Goldman was, “If you have a conflict, we have an interest.” The updated version of Goldman’s conflict with KKR over Beatrice came in May 1995 when KKR hired Goldman to represent it in the purchase of
Westin Hotels & Resorts from
Aoki, a strapped Japanese company that needed to sell.
Peter Weinberg, the grandson of Sidney Weinberg, was KKR’s banker at Goldman at the time. This was his first assignment working for KKR since he had joined Goldman from
Morgan Stanley, and he had never met
Henry Kravis before. The two firms signed an engagement letter for the Westin deal and Weinberg went to see Kravis. As he was walking in to the KKR offices, Goldman put out a press release that its private-equity arm had joined with two other investors to buy Westin. “
You got to be kidding me!” Kravis said to Weinberg. Indeed, “the stress between KKR as a principal and Goldman Sachs as a principal was always enormous,” according to someone familiar with their relationship.