Wall Street investment bankers have found a new source of funds for leveraged buyouts, venture capital and real estate activities: themselves.
After nearly half a century of acting primarily as agents who earned fees by providing financial advice and arranging transactions for clients, most of the largest investment banks are becoming merchant bankers.
Like their British counterparts, who have engaged in these activities for decades, the major U.S. investment banks are becoming participants and investors in the deals they help bring about.
This trend toward merchant banking marks a return to a practice that was popular in this country before the Glass-Steagall Act of 1933 brought about sweeping changes in the securities industry, leaving the investment banks with small capital bases. Over the last several years, many investment banks have become more interested in returning to merchant banking as they have merged with large institutions, gone public, or managed their assets wisely enough to give them excess investment capital.
The banking firms are hopeful their investments will provide them with a fresh source of profits to enhance their capital bases because they face declining profit margins in their traditional trading and underwriting businesses. But many on Wall Street acknowledge that serious conflicts of interest may arise when advisers, who are supposed to be independent and objective, become investors.
For example, in the proposed buyout of Levitz Furniture Corp., scheduled to be completed early next year, Drexel Burnham Lambert Inc. was retained by Levitz's independent directors to evaluate bids. After advising the company that several offers it received were inadequate, Drexel resigned as adviser and joined an investor group that made an offer for Levitz. The Drexel group's $39-a-share offer, which is higher than the others, appears to be the winning bid.
"The biggest conflict I have ever seen is in the Levitz Furniture deal. How can you be a truly independent adviser if, at the same time, you are putting together your own deal?" one source said. "They [Drexel] also have an advantage because they are on the inside. Even though they later brought in Dean Witter to render a fairness opinion on their Drexel's offer, there is a conflict."
"It is a fair question that causes some difficulties," said Frederick H. Joseph, Drexel's senior executive vice president. "But as soon as we reached a conclusion on [making] our leveraged buyout offer, we said we could not give a fairness opinion. Our offer was higher than the other offers. I think it was handled carefully and fairly. I think it does raise questions and you have to pay careful attention to them. . . . The role of a buyer is in conflict with the role of an appraiser, but we changed roles."
While most private firms have been investing their partners' capital for years in activities ranging from oil exploration to real estate, the current trend is more widespread. For example, leading firms such as First Boston Corp. and Morgan Stanley & Co. have set up separate groups that are focusing exclusively on identifying investment opportunities for their respective firms. Merrill Lynch has loaned or invested more than $1 billion in a wide range of activities that the firm considers to be merchant banking.
In addition to concern about conflicts of interest, merchant banking also may hurt investment banks by diverting their attention from client services and tying up capital for many years. Investment bankers generally have maintained they need maximum liquidity to provide the underwriting and market-making services that have enabled their corporate clients to raise funds by issuing stocks and bonds.
If investment banks purchase stock as part of their underwriting and market-making activities, they hold it for short periods of time. When they engage in merchant banking activities in which they act as investors, however, capital may be tied up for years. But since many of the firms, including First Boston and Merrill Lynch, are now publicly owned, they have large capital bases to support these activities.
Despite the drawbacks and the increased risk of putting their own capital into deals, many investment bankers involved in merchant banking seem enthusiastic. Some of the bankers see their activities as a way to develop new relationships with growing companies that may call upon them for investment banking services in the future. Others view their investments as a way to learn about new technologies and as a means of attracting talented, entrepreneurial executives to their firms. These activities also are considered a way to sweeten compensation for executives who participate in merchant banking investments through their employers.
"This business is here for the long run, and we are going to see a lot more activity," said Robert J. Edgreen, first vice president ofE. F. Hutton. "The reason we want to be a principal [investor] is that the return on investment can be 40 percent compounded annually over the years."
Some firms, notably Salomon Brothers Inc. and Kidder, Peabody & Co., have stated publicly that they will not invest their capital in merchant banking activities, reaffirming strict commitments to client service. But Salomon Brothers Chairman John H. Gutfreund hinted last week that if the right opportunity came along, Salomon's policy might change.
"There is a very legitimate role for unusual investing [of our capital] as the rules change over the years, so it would be foolish to say it is absolutely wrong," Gutfreund said. "In simple terms, we view ourselves in a service business, and we try to avoid getting into conflict with our institutional clients so we can act for them [rather than in place of them] when they want to invest in leveraged buyouts.
"And venture capital is not our business. . . . We are in the business of providing liquidity as market makers. Venture capital implies long-term lockup [of funds], which is not our business. . . . None of this is an absolute rule forever. You need to have some degree of willingness to change your strategy as young people push you to rethinking how you run your business."
One of the most aggressive investment banking firms to move into merchant banking is First Boston, a company that has invested more than $100 million, or about 15 percent of its capital, in real estate, venture capital and leveraged buyouts. (In a leveraged buyout, a small group of investors acquires a company in a transaction financed largely by borrowing. Ultimately, the debt is repaid with funds generated by the acquired company's operations or the sale of its assets.)
First Boston has stakes in three midtown Manhattan office buildings, including its Park Avenue Plaza headquarters. The firm also has invested in several high-technology companies, which make products ranging from fiber optics scanners to computer graphics.
Morgan Stanley holds warrants convertible into common stock in People Express Airlines and is represented on the company's board of directors, in addition to venture capital stakes estimated at $500,000 each in at least five separate computer companies.
Merrill Lynch Capital Markets has participated in about a dozen leveraged buyouts, including two of the largest ever -- the $1.25 billion buyout of part of City Investing, a manufacturing, publishing, real estate and financial conglomerate, and the $750 million buyout of Denny's Inc., the restaurant operator, on which shareholders will vote next month.
"We would like to become a more important merchant bank," said Jerome P. Kenney, president of Merrill Lynch Capital Markets. "This is a growing trend, and capital utilized intelligently [in merchant banking] will become more important as a way to help maintain profitability."
Asked about potential conflicts of interest, Kenney replied, "You have to take extra precautions."
At Goldman, Sachs & Co., merchant banking activities include stakes in two leveraged buyouts, Trinity Paper, a paper-bag manufacturer, and ARA Services Inc., the Philadelphia-based food services company. The privately held firm also has real estate holdings that include its headquarters in New York and the Pennwalt Corp. headquarters building in Philadelphia. All of these investments have been made in the last three years. In addition, some partners of Goldman Sachs own Goldman Sachs Oil & Gas Co., a Houston-based energy firm.
"The primary use of our capital is to serve our corporate and institutional investor clients," said James P. Gorter, a Goldman Sachs partner and co-head of the firm's investment banking division. "To the extent opportunities come along to make investments in leveraged buyouts or real estate, we are obviously going to evaluate those carefully on a case-by-case basis. . . . One of the first things you have to ask is if there is any conflict, actual or perceived. Many potential opportunities never get off the ground because of the appearance of a conflict."
Investment banking experts at Harvard and Stanford business schools believe the trend toward merchant banking reflects a recognition by investment banking firms that greater profits frequently can be earned by serving as an investor instead of as an adviser, albeit with greater risk. However, they wonder whether some investment banks are getting into the leveraged buyout game as investors a little too late. Specialized financial boutiques, such as Kohlberg Kravis Roberts & Co. and Forstmann Little & Co., have been acting as investors in the best leveraged buyouts for several years, they note.
Samuel Hayes, an investment banking professor at Harvard, sees several benefits in the practice, not the least of which is the creation of relationships that can lead to future investment banking business.
"Just as they have gotten into venture capital as a way to scatter seeds and hope some take root and mature into corporate clients, they see the leveraged buyout as a way of acquiring a client," Hayes said. "One obvious problem with this is that they lose their detatched perspective with respect to counseling the company and they compromise their impartiality with respect to advising competitors, too.
"I am fearful that a number of these leveraged buyouts are going to go bad," Hayes said. "By leveraging up their capital structure, these companies have reduced their capacity to ride out adversity. In an uncertain economic environment, a number will not make it. So I can see situations in which it will be awkward for an investment bank . . . where its business judgment turns out to be misplaced."
First Boston officials say that while most other investment banks are using merchant banking as a way to drum up future business, they are aggressively investing in deals strictly because of the lucrative nature of the opportunities. The major risk of these investments, according to First Boston Manging Director William E. Mayer, is that "Once you are in, it is hard to get out. It is terribly illiquid."
A few firms, such as Lazard, Freres & Co., have engaged in merchant banking activities for years. Financiers like Andre Meyer amassed fortunes owning and orchestrating deals.
But as Wall Street's largest and most prestigious investment banks enter this arena, trading their role as agent and intermediary for one as principal and investor, the danger to corporate America is clear: If investment banking firms are hungry to do deals for themselves, they may find it increasingly difficult to put the interests of their clients ahead of their own.