Bear Stearns Is Bullish in Its New Role : Trader Plunges Into Investment Banking
The management of Pacific Southwest Airlines could scarcely have anticipated having trouble finding an investment firm willing to take it public last year. After all, the chairman of E. F. Hutton, one of the nation’s leading investment banking firms, was on its board of directors.
But PSA was wrong. Hutton and other firms looked at its financial results, which included more than $13 million in red ink for the 15 months following federal deregulation of the airline industry, and passed.
That put PSA in a bind. Under the terms of its union contracts, in which the airline was to contribute a portion of its stock to employee funds in return for labor concessions, PSA was required to have the stock trading publicly by the end of 1986.
Foresaw Merger Mania
In near desperation, J. P. Guerin, the chairman of the airline’s parent company, called on Michael E. Tennenbaum, a Bear, Stearns & Co. investment banker who earlier in the year had taken public Guerin’s small genetic engineering company.
The burly Tennenbaum, who had helped establish a Southern California beachhead for his firm in 1976 and had promptly installed himself in a home in Malibu, saw something the other firms had apparently missed. A PSA stock offer could be priced not on the basis of the airline’s past earnings, he reasoned, but on the likelihood of a profit recovery in the industry and, even more important, its value as a merger target.
“Michael was smart enough to see that the merger mania in the airline industry would soon enough come our way,” Guerin recalls. Tennenbaum was so sure that PSA’s West Coast routes would be indispensable to a larger airline seeking to establish a coast-to-coast business that he insisted, as a prerequisite for taking on the deal, that Bear Stearns have the right to act as middleman in any subsequent sale of PSA.
He was right. PSA went public at $7 a share and promptly fell to $6.50. Then American Airlines moved to acquire PSA competitor AirCal, and PSA jumped to $10. In December, 1986, PSA accepted a takeover offer from USAir for $17 a share.
For underwriting the stock issue, Bear Stearns had gotten a fee of several hundred thousand dollars. On its bet that PSA’s value was really as a takeover candidate, the firm made real money: $3.8 million.
It is unsurprising that Bear, Stearns & Co. would take what amounts to a trader’s plunge on an otherwise unloved investment banking opportunity. The New York firm, known principally as a securities trading house and for its profitable business of handling securities trades for smaller firms, has been moving into the investment banking business by cooking up deals that larger powers in the industry would not have conceived, and doing those its rivals have shunned.
Advisory Business Lucrative
While other firms have been shying away from handling hostile acquisitions, Bear Stearns has moved from simply accumulating large holdings of stock for corporate raiders cheaply and efficiently--a skill for which the firm and its chairman, Alan C. (Ace) Greenberg, have long been prized--into the takeover advisory business, a potentially much more lucrative trade.
Among its takeover clients are Coniston Partners, a New York investment group that bid earlier this year for Allegis Corp., and Charles Hurwitz, the head of Maxxam Group and a veteran client of Drexel Burnham Lambert, the investment firm most closely associated with financing hostile takeovers.
Bear Stearns has also enterprisingly marketed to blue-chip corporations a wide range of innovative corporate finance products. These include currency exchange warrants, which allowed General Electric Credit Corp. and other clients to sell retail investors a parlay on foreign exchange rates, and Australian- and New Zealand-dollar denominated securities that pried clients such as Ford, Pepsico and Disney away from more established investment firms.
“The financial officers of corporations don’t consider themselves tied directly to an investment bank anymore,” Greenberg says. “If you have an idea, you can get in to see almost anybody.”
This strategy has inspired skepticism among some observers on Wall Street, where Bear Stearns is otherwise admired for its consistently strong earnings and a return on equity exceeded in the industry only by Morgan Stanley & Co. With investment banking a highly competitive business dominated by several well-established firms, Bear Stearns, securities analysts say, must count on developing its one-shot deals with top clients into long-term relationships that give it a dependable flow of “plain vanilla” financings.
That is something that has not yet happened, but Greenberg says it is not crucial to the firm’s success in investment banking. “It would be a nice dessert, but we don’t need it,” he says.
Yet many investors place their trust in the trader’s culture of Bear Stearns. The trader makes a distinction between moving cautiously and moving hesitantly. “They tend not to jump into new areas until they’re established,” says Lawrence Eckenfelder, brokerage analyst for Prudential-Bache Securities. “But then they’ll fight you tooth and nail for every basis point.” (In the bond market, a basis point is one-hundredth of a percentage point.)
‘Doing Something Right’
One investor that has made a big bet on Bear Stearns’ success is Jardine Matheson Holdings, the giant Hong Kong trading house, which Wednesday said that it would buy 20% of the securities firm for $391 million.
Jardine Managing Director Brian Powers says his company was attracted by Bear Stearns’ financial performance. “We thought these guys must be doing something right,” he explains. “Once we talked to them, we were convinced they know their business as well as anybody.”
Although the Jardine agreement does not involve any new infusion of capital into the firm--its current capital of $1.4 billion places it among the top 10 U.S. investment banks--the association may give Bear Stearns an entree into a region that it has been eyeing hungrily for some time, but where it has been moving only slowly to establish offices: As a leading investment enterprise in Hong Kong, Tokyo and throughout the Far East, Jardine could give Bear Stearns a presence in the booming Pacific markets that it could only dream of before.
One key to the firm’s investment banking strategy is the growth of its Los Angeles outpost in Century City, which now employs 360, compared to 140 just two years ago. With 13 corporate finance professionals (up from two) and 100 retail brokers (up from 50), the office is the largest of Bear Stearns’ seven branches and may be the largest full-service branch of any investment firm in Southern California. (Its closest competition may be the Beverly Hills office of Drexel Burnham Lambert, which surely outstrips the Bear Stearns unit in corporate finance work, but reportedly earns less from its retail sales force.)
The Bear Stearns office is unusual in having broad in-house corporate finance capability. “We rejected the other firms’ practice of having ‘bird-dog’ offices, where as soon as the local people make contact with clients, the professionals from New York fly in,” says Allen D. Schwartz, the firm’s corporate finance head.
Instead, the firm last year installed Peter Jaquith, a former mergers and acquisitions specialist at Lazard Freres, as its Los Angeles corporate finance head and gave him authority over its San Francisco staff as well.
“With L.A. three hours away from New York,” says Thomas R. Anderson, head of investment banking, “we want people out there who can get to clients, understand the local problems. I see nothing but growth for that office, because there’s too much business there to be continually flying people in.”
The Bear Stearns that is moving aggressively today into the expensive and unpredictable business of investment banking is hardly recognizable as an offspring of the Bear Stearns of old.
Sleepy Past
That firm was one of Wall Street’s sleepiest. One of its managing partners, V. Theodore Low, carried business cards bearing only his name, without the firm’s address or telephone number, as if anyone wanting to do business with the firm had better find his own way up to its offices.
“I guess he thought that, if they couldn’t find him, they weren’t worth doing business with,” says Tennenbaum, who joined the firm while Low still held sway over the office suite at One Wall Street.
The second managing partner was Salim (Cy) Lewis, one of the street’s premier traders. In pioneering “block trading,” which then was the difficult art of placing huge orders of stock into the market, Lewis established his firm at the heart of one of the most profitable businesses of the ‘60s. But by the 1970s, competition had robbed block trading of its profitability. Lewis, beset by age and failing health, was scaling new heights of obstreperousness. A master of the Wall Street of the ‘50s and ‘60s, he could scarcely adjust to the accelerating pace of change of the 1970s.
“There is no question that Cy Lewis distinguished this firm from a little commission house into what it was,” says Greenberg, sitting in the glass-walled office he scarcely uses, preferring his seat at the head of the firm’s trading desk about 100 feet away. “But over his last 10 years, he was like a grizzly bear, in horrible moods, fighting with everybody and over everything. In the last years of his life, we knew he was probably holding us back.”
Slowly the firm’s other partners began to wean it from the financial grip of Lewis and Low. The two senior partners held perhaps 60% of Bear Stearns’ capital, meaning that when they died their heirs would have the right, over a short period of years, to withdraw the firm’s lifeblood. The younger members brought in some limited partners to give the firm’s capital some stability, and later, in 1985, took Bear Stearns public.
After Lewis died in 1976--he suffered a fatal stroke at the partners’ function marking his retirement--Greenberg moved into the chairmanship.
Ace Greenberg was born in Wichita, Kan., 60 years ago and raised in Oklahoma City. He joined the firm in 1949 as a clerk sticking pins on a map to locate oil wells. Soon after that, he moved to the risk-arbitrage desk, a fringe operation that in those days focused on the securities of railroads and utilities slowly recovering from bankruptcy.
Greenberg’s character and preoccupations help define those of the firm. In a business in which philanthropy is often brandished as a weapon of respectability, Greenberg’s devotion to charity distinguished Bear Stearns as what New York magazine last year identified as the largest per-capita donor on Wall Street to the United Way and the largest in the country to the United Jewish Appeal. The firm’s officers are required to contribute 4% of their compensation to charity.
Folksy Memos
From his seat also comes the firm’s niggling attention to expenses, its relentless pressure on overhead that today gives it one of the most flexible expense bills in the financial industry. It is as if he is waging an intractable war against what he calls “slop,” whether it’s wasting clerical supplies or being late for meetings.
One Greenberg memo complains about professionals who leave their offices without word of their whereabouts: “I conducted a survey of the 200 stock exchange firms that disappeared over the last seven years, and 62.349% went out because their important people did not leave word where they went when they left the desk if even for 10 minutes.”
Another takes stock of the summer’s slump on Wall Street by reminding associates that Bear Stearns prefers to do its hiring just as other firms are cutting back (that way, salaries are lower and trained personnel more available): “Bear Stearns is not having a hiring freeze,” it read, just before admonishing that the firm is freezing “expenses and carelessness.”
It continues: “I am tired of cleaning up poo-poos. The next associate of mine that does something ‘un-neat’ is going to have a little meeting with me and I will not be the usual charming, sweet, understanding, pleasant, entertaining, affable yokel from Oklahoma.”
Yet the homespun thrust of these memos reflects a more fundamental thriftiness. In recent years, while most brokerages have lured top stockbrokers and other professionals with lavish up-front bonuses and special compensation deals--a practice that has driven up payrolls throughout the industry while inviting favored professionals to jump from firm to firm in search of the best short-term offers--Bear Stearns refused to cut any such deals.
“They pay no up-front bonuses whatsoever,” says Richard Zander, a Los Angeles headhunter specializing in placing stockbrokers. “Their feeling is they don’t have to. The name of the firm is so good in our circles that people will come to them.”
Bear Stearns retains its brokers by paying them close to the highest share of gross commissions in the industry--nearly 50% in some cases. Also attractive is the firm’s exceptionally affluent retail clientele. Compounded by the benefits of low overhead--the firm has only seven retail branches, compared to Merrill Lynch’s 525--the result is a sales force with average gross commissions of nearly $500,000, compared to the industry average of just over $200,000.
“They do not lose brokers with anything near the frequency of other firms,” Zander says.
Retail brokerage is only one of Bear Stearns’ odd mix of niche businesses. Perhaps the most important are a complex of businesses known inside and outside the firm as “the bank.”
The bank’s foundation is the “clearing” relationship that Bear Stearns maintains with more than 200 small securities firms and close to 300 other professional trading enterprises that use it as a proxy clerical operation, or back office, and for its New York Stock Exchange seat. For a fee, Bear Stearns provides the trading and clerical work needed by these correspondents, but the key to profitability is the margin account.
Huge Margin Pool
Like almost all securities firms, Bear Stearns lends money to customers, using as collateral the securities in their accounts. The firm also has the right to lend those securities out to short sellers. (A short seller tries to make money by selling borrowed stock, hoping to buy it back later at a lower price.)
As of April, analysts estimate, the margin account balance on which Bear Stearns charged interest was close to $4 billion (up from $500,000 in 1981), one of the three largest such pools on Wall Street. As much as half of that pool came into the firm through its clearing correspondents.
What makes this business particularly attractive is that profits are all but assured, as Bear Stearns always lends money at retail that it buys at wholesale, charging margin clients interest at an established spread above its own cost of funds.
In the year ended April 30, 1987, the firm’s revenue from interest and net dividends came to $134.3 million, up from $101.4 million a year ago; much of that derived, it said, from an increase in margin balances. Interest and dividends (not including what it earned from bond trading) accounted for 39% of the firm’s revenue in the year ended April 30.
Bear Stearns also profits handsomely from its expertise in trading; principal transactions, or those for its own accounts, provided 25% of its revenue in the last year. An important part of this category is risk arbitrage.
The firm’s commitment to arbitrage was underscored last November, when insider trading charges against leading risk arbitrageur Ivan F. Boesky gave the whole specialty a black eye.
Top investment banks all over Wall Street, appalled at the potential damage to their reputations, wound down their arbitrage operations just as Boesky was being ejected from the game.
In contrast, says Greenberg, “Our immediate decision was to quadruple the personnel and double the capital for risk arbitrage. If you were playing poker with six people and you were making money even though two had marked cards, imagine how you would do once the cheaters were thrown out.”
Greenberg’s trading expertise has also made him a valued hand for any number of corporate raiders. “By and large, they give excellent service,” says the principal of one active takeover fund. “The firm is best known for Ace’s ability to buy stock in a cost-effective way.”
When the firm disclosed its operating results in the course of going public in 1985, its rivals discovered that its unusual mix of businesses had made it one of the most consistently profitable firms in the securities industry.
The pattern even held through April, when bond-trading losses devastated profits at such top firms as Merrill Lynch and Salomon Bros. Bear Stearns averted losses in fixed-income trading, perhaps because it avoided over-committing itself to the more volatile and unpredictable sectors of the bond market. Unlike other firms, Greenberg says, Bear Stearns also avoided giving untested and potentially unreliable young professionals too long a trading leash.
“A tremendous number of people come into this business from schools of higher learning,” he says sarcastically, “with theories and models. They sell people on them--they tried to sell us, too--then they want you to bet the ranch. Then something always happens in the markets that never happened before--like Treasuries dropping 13% in one week. So what can you do? Sue the model?”
Culture to Be Tested
But Wall Street observers believe that the Bear Stearns culture of treading cautiously in new markets will be strongly tested as it expands its investment banking business.
“Their investment banking growth has shown up nicely on the bottom line because they started with a small base,” says Michael Blumstein, brokerage analyst for First Boston, “but they’re not going to be in the bulge bracket tomorrow”--that is, the top tier of three or four investment banks that do the vast majority of deals.
Moreover, investment banking has brought with it some big-business headaches. Bear Stearns was a co-manager of some underwriting syndicates for bonds of the Washington Public Power Supply System, the infamous WPPSS at the center of the largest municipal bond default in history. The firm’s involvement means it will have to pay at least 2.4% of any fees, judgment or settlement imposed on the issues’ lead underwriters.
More potentially troublesome is the firm’s relationship with Wedtech, the Bronx, N.Y., defense contractor that recently collapsed amid charges that its officers defrauded the government and bribed officials to ensure continued federal contracts. Bear Stearns has been named as a defendant in five shareholder lawsuits contending that the company management’s illicit practices amounted to a fraud on buyers of the securities.
Federal investigators are also contemplating whether Wedtech can stand as a test case of the legal liability of auditors, lawyers and underwriters of companies charged with crimes. Bear Stearns was sole or co-underwriter of four Wedtech stock offerings that raised $163 million; one of its managing directors, Paul Hallingby Jr., sat on the hapless company’s board of directors and for a time chaired its audit committee.
For its part, Bear Stearns, like the company’s new management, contends that it was the responsibility of auditors at Touche Ross & Co. and KMG Main Hurdman to have alerted directors to irregularities.
Still, Bear Stearns has won a cadre of devoted clients by executing some particularly well-crafted deals. By many accounts, one of its principal investment banking assets is Tennenbaum.
There are some who think Tennenbaum’s move to Los Angeles was inevitable after Ted Low began ranting about his taste in office furnishings: Few other business offices anywhere are arranged around a blond wood chair sculpted in the shape of an upturned palm. (The model is Tennenbaum’s hand; “when you sit in it the fingers give your back a nice massage,” he says.)
Clients say that despite his talk about the comfortable life style he has carved out for himself in Malibu, Tennenbaum’s distinguishing characteristic is hard-nosed tenacity.
“Once he sees a deal and believes in it, he really can’t be deterred,” says John G. Drosdick, president and chief operating officer of Tosco Corp., the ailing petroleum refiner for which Tennenbaum executed a crucial refinancing late last year to pay off a consortium of 19 lending banks. “Michael was faced with questions from our board, the banks, and even his own firm about whether he was convinced this could be done. The deal wouldn’t have happened without the kind of talent Michael represents.”
The key to the $350-million refinancing was a 10-year agreement through which Arco would purchase gasoline that accounts for 40% of the output of Tosco’s Avon, Calif., refinery. The agreement was designed to ensure that Tosco would earn enough revenue to cover the debt service on the company’s bonds, regardless of the swings of profitability in the refining business over the life of the contract.
“A lot of ‘geniuses’ thought the agreement was worthless or unnecessary,” Tennenbaum recalls. But he saw it as a way of grafting Arco’s considerable credit to Tosco’s, which was almost non-existent. In the end, Tennenbaum had to commit several million dollars of his own money to persuade even his own partners at Bear Stearns to accept the underwriting deal.
