The Partnership: The Making of Goldman Sachs

By on June 9th, 2010

My Takeaways from the book by Charles D. Ellis.

This is a longstanding project and I aim to finish this before I get back to Singapore.

Comment: this is a book that will perhaps have a very troubling second edition.

  1. Beginnings
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  2. Disaster: GS Trading Corporation
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  3. The Long Road Back
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  4. Ford: The Largest IPO
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  5. Transition Years
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  6. Gus Levy
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  7. The Wreck of the Penn Central
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  8. Getting Great at Selling
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  9. Block Trading: the Risky Business that Roared
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  10. Revolution in Investment Banking
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  11. Principles
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  12. The Two Johns
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  13. Bonds: The Early Years
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  14. Figuring Out Private Client Services
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  15. J. Aron: Ugly Duckling
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  16. Tender Defense, a Magic Carpet
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  17. The Uses and Abuses of Research
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  18. John Weinberg
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  19. Innocents Abroad
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  20. Breaking and Entering
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  21. How BP almost became a dry hole
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  22. Changing the guard
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  23. Transformation
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  24. False Starts in Investment Management
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  25. Robert Maxwell, the Client from Hell
    • Maxwell committed suicide on his boat with over $2b in debt. He was given a state burial in Jerusalem.
    • From 1951 to 1971, he had gone from obscurity to affluence, and back down to severe criticism and exile. Then from 1971 to 1991 he rose back again to wealth and power and then was sent all the way back down again.
    • GS was his agent through partner Eric Scheinberg who was ambitious and trying to make it in GS. Risk controls were lax as people all over GS did not want to deal with Maxwell because of his bad rep but Sheinberg needed to get ahead and thought he was smarter than Maxwell.
    • Gene Fife got a great settlement that saved GS with only $250m under a reserve price of $500m. The damages were paid out of partners’ pockets, and risk controls were enforced without exception from then on.
  26. Making Arbitrage a Business
    • Distinguish between risk and uncertainty – risk is actuarial likelihood, while uncertainty is where you don’t really know the odds and the payoffs, and you dont know which direction they are changing.
    • Risk arbitrage centers on making rational judgments of the appropriate prices of the securities to be offered in a takeover if and when it actually goes through. Individual transaction profits are rather small but the bst arbers earn a high return on capital by avoiding mistakes and moving capital.
    • The second type of arbitrage was Gus Levy’s specialty – making markets in when-issued securities from utilities and railroads emerging from bankruptcy.
  27. J’Accuse
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  28. Building a global business
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  29. Steve Quit!
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  30. Collecting the Best
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  31. Jon Corzine
    • Started out as a bond dealer, then CFO, then senior partner in 1994. Main intention was to take GS public.
    • Understood that prop fixed income could be very profitable if it had a strong capital base only attainable with IPO
    • GS was losing money so Jon cut people, but added lots of partners. Target was $10b profits in a decade, which was reached.
    • Management committee was too slow – changed to executive committee, halved to six members. Corzine created a new 18-member partnership committee to oversee partners, and Paulson chaired the new 18-member operations committee to ensure strategic cohesion/coordination
    • Unlimited liability ended by making an LLC a sole GP of GS. 8 year lockup for partners going limited.
    • Called himself CEO, dropped “partner” for everyone and called them MDs, elevating old VPs.
    • But he failed to get support from John Thain, Paulson, and Thornton, and despite extreme campaigning had to say no to IPO – some estimated it would get only 2x book value instead of MS’ 3x
    • Still discussion continued after Jon’s first failure
    • Partnership model was increasingly irrelevant as GS expanded, esp globally – people didn’t know each other
    • But others argued that IPO would dump wealth on current partners at expense of future and past partners. But present partners knew that they would get the same if they held off on the IPO
    • People started fighting to make partner before IPO – 50% time on client relationships, 50% time on internal politics
    • Corzine started merger talks with JPM, Chase, US Trust, Mellon, etc. in advance of repeal of Glass Steagall. He had no authority to do so, was not CEO, was too independent. Alot of opposition from partners, despite the fact that they would become very rich. David Silfen left because of differences with Corzine, and that eventually led to his ousting as senior partner of GS.
  32. LTCM
    • Founded by Meriwether, it sought out thousands of diverse, small, “perfect arbitrage” pairs in bond markets around the world. 40% a year profits.
    • Profit from two systems – one was a computer scouring world markets for paired positions. the other was a secretive system of borrowing from banks and B-D’s around world. $3b equity but $100b assets, notional derivs contracts of $1tr.
    • Lenders had confidence that LTCM was hedged against all risk – but it wasn’t hedged against the event that all different markets would react in the same way to Russian ruble deval.
    • By 1996, LTCM’s ROA was 2.45% but gains to investors was 57%. huge leverage
    • LTCM was a gravy train – $100m of commissions. GS was one of its dealers, but also its competitor on its prop desks.
    • LTCM returned $2.7b of investor money, but borrowed more to do so and did not decrease portfolio size.
    • When Russia defaulted, investors scrambled for quality and liquidity – LTCM longed illiquid securities which got hammered, and shorted liquid securities which got bought up.
    • Volatility is usually mispriced because investors dislike risk and want to buy insurance at more than actuarial value. But volatility shot up.
    • Meriwether had to mark down assets, and called Corzine – who told him that they had to be more transparent or GS would cut LTCM’s credit
    • Trying to sell LTCM to a white knight – Buffett refused, and Soros gave a conditional offer which was not met.
    • Bear Stearns, LTCM’s clearing broker, had no solid agreement with LTCM to clear its trades – and LTCM’s assets dropped to $500m, the point that Bear said it would stop clearing LTCM’s trades unless it got more equity capital over the weekend. Meriwether called Corzine
    • For half ownership of LTCM, GS provided $1b and would raise $1b from outsiders. Also it would get complete knowledge of LTCM’s trading operations. Again Corzine was acting as CEO without authority from the executive committee.
    • Buffett was willing to buy LTCMs portfolio as long as they excluded the management company and Meriwether.
    • Fed did not want to intervene in this and wanted an industry leader to organize a cooperative. Corzine offered to brief the Fed on what needed to happen.
    • One idea to save LTCM was to divide up LTCM’s portfolio and sell them back to the issuers for cheap, but implementation details could not be worked out with 38,000 paired trades. So proposal for consortium investment by all leading banks, needing $4b to avoid a loss of $20b, was taken.
    • Corzine’s battle – GS was losing money in prop trading, but Corzine needed executive committee’s sign-off to save LTCM.
    • All the banks were gathered and ready to buy LTCM, but Corzine tried to play them off against Buffett.
    • The consortium got half of the managing company for $1, and invested $4b, with a list of other limitations. The follow-on negotiations had some close calls with GS reneging on its commitment unless Chase conceded a loan to LTCM.
    • Corzine got OKs from partners, but he had committed a big chunk of firm capital – $300m. GS had to cancel its IPO. Partners blamed Corzine.
  33. Coup
    • Corzine forced out by Thain, Thornton, Paulson, and Hurst. Corzine refused to do anything to do anything to Thain and Thornton preemptively.
    • Corzine lost key supporters in Silfen and Zuckerberg. Corzine also trusted Thain as he picked him to replace himself as CFO, but Thain was independent.
    • Corzine was a popular leader among all the partners, but the exco did not view him as a capable leader who could think like a banker – he was still trading, too sloppy, and not centralized.
    • IPO completed on May 9, Corzine resigned on May 18. Thain’s deal with Corzine was that he had to stay on or they would cut him out of partnership before IPO.
    • Corzine then went in the Senate and then to Governor of NJ.
  34. Getting Investment Management Right
    • Discussion between Hank Paulson and John McNulty over 1995 was the strategy for getting IM right: grafting GSAM’s investing onto GS’ powerful distribution could produce rapid growth in assets and almost riskless growth in profits.
    • The correct way to measure the economic value of GSAM was not current profits, but accumulated assets under management from which future profits and growth could be harvested.
    • IBD also confirmed that the market values asset management companies highly because of AUM not profits.
    • With profits coming from a captive fee-based business these profits would be higher valued than trading profits or banking fees.
    • Corzine let Ford and McNulty hire people from competitors and also invest firm capital in building GSAM through acquisitions. Paulson promised “air cover” and capital.
    • IM firms that earned only moderate profits had valuations 20-25x earnings, but trading only 5-6x earnings.
    • GSAM needed to go global to match GS’s other operations. The strategy: 3x3x10 – 3 continents, 3 marketing channels (inst investors, IMers with distribution, and HNWIs through PWM), 10 investment products (MM funds, high-grade bonds, munis, quant funds, large cap growth, value, small caps, international, specialized funds, and hedge funds of funds).
    • GSAM was actually advocating taking losses for first few years! Management committee prided itself on current earnings.
    • But GSAM pressed on and bought Liberty down in Tampa, FL. Bunch of guys who were addicted to investing. GS would provide great distribution and risk management tools.
    • Ford insisted only that Liberty eventually subsume its brand to be under GS and GSAM.
    • Liberty should focus on investing while GSAM accumulated assets through selling.
    • After 10 years, Herb Ehler bought back Liberty which had gone from 4.5b in AUM to 23 b. GSAM had paid $80m for Liberty, but the buyout was valued at $2b.
    • George Walker suggested buying the British Coal Board’s pension fund’s management to break into the British pension stronghold. It would show GSAM’s performance in the British territory. GSAM bought the business for $75m and got back $95m in fees, but grew its AUM from $2.5b to $100b over 10 years.
    • GSAM compensation was separated from firm results and based more on individual contribution. Operating units small enough for each team to have real ownership commitment.
    • Assets grow automatically at an average annual 7-8 percent because that is stock market growth. If new assets are added on to that base, AUM increases around 15% every year – doubling assets in less than 5 years.
    • When investment management flourishes as a business, commitments to client service, investment professionalism, and quality control often fade.
    • Fees: In a global bond fund, it cost 5% to buy in plus 1% annually for management plus 0.5% for custody and 3% to terminate.
    • Raising capital for other IMers is a lose lose proposition for GSAM – if manager does well they’ll drop GSAM and market their own, if they do poorly then GSAM loses, period.
    • Expanded into alternatives by acquiring Commodities Corp in 1997, a fund of funds with zero marketing capability. McNulty bought when it was losing money, so it was bought for building and land value – $11m – 10 years later it had AUM of many billions.
    • In 1999 and 2000 GSAM lost money but then went to 25m, 120m, 250m, 1b in profits.
    • Conflicts with GS’ dealer business – GSAM wanted salespeople to sell its products but they insisted on GSAM revealing its positions, which GS’ own traders would then trade against.
  35. Paulson’s Disciplines
    • post 1999 – Near merger with JPM, because it was thought investment banks needed large balance sheets to compete with the likes of Citi/Salomon
    • The real strength of a modern day FI is not balance-sheet capital nearly so much as it is reliable, ready, large-volume access to the capital markets, depending on the creativity and connectedness of its people – GS had those more than JPM.
    • Paulson said no to merger after due diligence despite the majority of his team saying yes – but it turned out well for GS in the long run.
    • Paulson was tenacious – high volume, high value relationship banker.
    • Didnt want to move to New York so stayed in Chicago and took Asian investment banking – built huge China contacts.
    • Paulson broke the “no hostile takeover” policy, saying the PR factor was overblown. Mitigated by insisting on non US takeover, and that fees had to be really big. This was Krupp’s 1997 hostile acquisition of Thyssen. It broke GS into Germany, which was held by DB, catching Thyssen off guard over the Easter weekend.
    • Paulson became sole CEO after Corzine resigned – IPO partners stayed for 3 years to get vested stock. GS had reputation of being a giant hedge fund with a sideline in ibanking, because of the size of its trading profits.
    • Changes in GS Leadership:
    • Sid Weinberg  was a leader but firm was a proprietorship
    • Gus Levy expected people to put in everything but was unquestionably THE leader.
    • Whitehead and Weinberg pushed decisions out to unit heads.
    • Rubin and Friedman centralized accountability to the MC but also distributed some authority
    • Paulson continued the expansion of decisionmaking leaders and increased coordination through centralized disciplines. It also invested in developing leaders – getting GE’s Crotonville head Steve Kerr onboard.
    • GS underwrote 56 issues during the dotcom bubble, and was found guilty of breaking acccepted rules of conduct and settled with $150m.
    • Paulson also repositioned GS to establish a business as a principal investor in PE and real estate. Paulson pushed this despite conflicts of interest with GS also serving as agent for some funds, but investing alongside with them. This meant that sometimes GS PIA got better terms than GS’ clients.
    • Paulson was a believer in technology, having seen what it could do for securities business. Hence the need for constant reinvention of GS.
    • Paulson also invested in Sumitomo, and Sumitomo would provide a backup guarantee behind commercial paper issued by GS – now the firm had an enormous balance sheet it could call on at any time.
    • Paulson was only supposed to stay on for 2 years, but soon found he needed longer. Thornton was to be CEO – but dropped the ball once he carved up work as co-COOs with Thain. Paulson told Thornton he would be staying, and Thornton left to teach in Tsinghua’s b-school. A first for a non-American, which must be approved by the Chinese State Council.
    • With Thornton out, Paulson appointed Blankfein co-COO as his units accounted for 80% of the profits of GS, completing his succession plan.
    • Called to the White House – Paulson left GS in better shape with great relationships with corporations, govts, inst investors, banks, PEs, best understanding of companies, industries, economies, and markets, largest appetite for taking risks, ability to commit capital, strongest recruiting, highest compensation.
  36. Lloyd Blankfein, Risk Manager
    • Lloyd rose from Harvard Law School and managed up very well. Cut costs well.
    • There were worries that universal banks like Citi and JPM were using their loaning ability to get M&A/underwritings, so that GS could not compete.
    • GS and Lloyd’s response was to give advice AND commit capital – merchant banking a la pre-Glass-Steagall.
    • The firm transitioned from having as its dominant business the “agency” business (advisory, investment management, etc) to the “principal-with-risk” business. GS Global Alpha blew up in late 2007, but GS was not affected as other people in the firm shorted the ABX.
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