Reinventing Goldman Sachs


Part of Goldman Sachs' (NYS: GS) business is advising public companies on the virtues of returning private. Gone are the worries of beating expectations every quarter. Focus can shift to the long term. Dirty laundry isn't aired out for all to see. No disgruntled shareholders. No outside influences. Just business.

It might be time for Goldman to heed that advice itself. It should go private.

That only sounds bold if you forget that Goldman has been a private partnership for 92% of its existence. Founded in 1869, the bank didn't go public until 1999.

Goldman survived the financial crisis far better than any other investment bank. That much is unquestionable. But what's equally clear is that it took on risks, engaged in questionable practices, and promoted a culture that damaged its reputation beyond repair and nearly cost it its life. When asked if Goldman would have survived 2008 without being bailed out by the government, CEO Lloyd Blankfein responded: "Hard to say. ... The risk was enough so that I'm glad to not have tested it." No, in other words.

Those missteps may have roots in its decision to go public in 1999. Before then, Goldman was owned by its senior employees -- its partners. Capital literally came out of partners' annual income. As Charles Ellis writes in his book, The Partnership: "Goldman Sachs retained most of each partner's yearly earned income. As a result, anyone who became a partner in Goldman Sachs usually experienced a drop in spendable income."

These partners owned the firm in every sense of the word. Not only were they entitled to the profits, but they were equally responsible for losses. Lisa Endlich's 1999 book, The Culture of Success, describes how aligned partners were to Goldman's success -- and failure:

In a private partnership none of the assets of partners are shielded from liability, and the individual partners are exposed down to the pennies in their children's piggy banks. Large trading losses or lawsuits could pose a threat to the firm's capital and ultimately its existence. The actions of a rogue trader could spell personal bankruptcy.

This is hardly how Wall Street works today, now that all major investment banks are public companies. Soon after Bear Stearns imploded in 2008, former CEO Jimmy Cayne muttered a telling remark that encapsulates today's Wall Street culture: "When you lose a billion but you still have several hundred million left, then it's your heirs that get hurt, not you," he said.

In the partnerships of yore, Cayne would have been left penniless, bankrupt, and buried in lawsuits. But since Bear Stearns was a public company, he walked away richer than most could ever dream of.

This no doubt played a role in how he managed Bear's appetite for risk. As public companies, banks gamble with someone else's money. As partnerships, it was their money, their debt, and their reputation.

The latter promoted a culture of responsibility. During Goldman's partnership days, partners meticulously scrutinized each other's activities, lest one take a risk that threatened another with personal bankruptcy. "The partnership was a small, intimate organization -- a fraternity in the very best sense of the word -- in which no one was above criticism and the more senior partners regularly challenged their leaders," Endlich wrote. In 1998, the year before Goldman went public, trading made up 28% of revenue. The rest of the business consisted of advising clients -- a low-risk job that operates like a law firm. By 2009, trading made up 81% of revenue. Advising was merely an afterthought.

The late 1990s was not the first time Goldman floated the idea of ending its partnership. In the 1980s, the success some of its competitors gained after going public was a point of bitterness among Goldman's partners. Salomon Brothers had gone public, and its newfound capital turned it into a trading dynamo. That gave Goldman the itch to IPO. "The firm would be transformed into a trading powerhouse, one that would challenge top-ranked Salomon Brothers, which was operating with considerably more capital," Endlich wrote.

Even then, the partnership culture won out. After weighing each side's arguments, Goldman's partners decided to stay private. Former senior partner John Whitehead made the point that restraints on capital were a good thing, enforcing the firm's commitment to prudence. "Everybody here knows we have restraints on capital. Capital should be a restraint," he said. "It helps you make selections. You have to make choices." Without that restraint, partners worried that life as a public company would push Goldman to the edges of greed. "The prime fear was that a public company could never replicate the close-knit culture of a partnership, where financial rewards are measured in lifetimes instead of months," Endlich wrote.

The dam finally broke in 1998, when Goldman's partners voted to go public. With personal stakes worth up to $100 million in the public market, their incentives were too great. And with trading becoming dominant on Wall Street, Goldman needed capital.

What has it gained since? Goldman's employees have done staggeringly well. In 2009, average compensation was more than $600,000 per employee, up from $294,000 per head in 1998. Its shares, on the other hand, reflect misery. When Goldman went public, shares commanded a multiple of more than five times book value. At today's multiple of 0.8 time book, the market is valuing the company far less than it would be worth as a partnership.

The argument for not returning to a partnership is that Goldman couldn't be, well, Goldman. When Charlie Rose asked CEO Lloyd Blankfein why Goldman isn't a partnership today, he became almost incensed. "It would beimpossible to be a partnership today."

Why? "We are a big financial firm," Blankfein said. "We're not just big in the United States. We are one of the biggest in every country of the world."

That takes capital. "We could not do those activities unless we have a balance sheet that had permanent capital. That was why, reluctantly, with much observation, much regret and tears, the firm stopped being a partnership in 1999," Blankfein said.

His comment baits two questions. First, are the activities that require such a large balance sheet favorable? I don't know how one can, with a straight face, argue that the financial system worked better in the 2000s than it did in the 1990s. Goldman, which flourished as a partnership for 130 years and survived the Great Depression, nearly went bankrupt a handful of years after going public. This is the track record it is fighting for?

Second, it's a bit rich to be crowing about the need for permanent capital when your balance sheet is leveraged more than 20-to-1, as Goldman's was in 2007. Permanent capital -- money that can't be stripped from the company when partners retire, as it could during the partnership -- loses all meaning when a company leverages to the moon. Lehman Brothers had permanent capital. Bear Stearns had permanent capital. It was no substitute for sanity.

Goldman should go private. It should embrace its old partnership culture. Alas, I don't think it will. The incentives not to are too great. Public shareholders have become chumps, tickled at the thought of participating in Wall Street success when in reality they are financing the dynastic wealth of its employees. "I determined many years ago that if you want to make money on Wall Street, you work there; you don't invest there," former Goldman partner Leon Cooperman said. "They just pay themselves too well."

And so Goldman will, I think, carry on as it has over the past few years, taking outsized risks that reward its employees at the expense of its cherished brand name. They call this the tragedy of the commons: when what's rational for the individual can be destructive for the whole. A tragedy, indeed.

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