Intelligent Relationships

The hierarchy of investment banks working in technology has been stable, but a trio of bulge bracket firms is looking at grabbing more deals

By Jonathan Burke
Red Herring

April 1995

The phrase "intelligent relationships" sounds like a marketing spiel, but is actually a good description of the goal of securities firms working in high technology corporate finance.

Intelligence is necessary for two reasons. The investment banks must master the complicated business of corporate finance, and they need to keep pace with a dynamic industry led by Ph.D.s from Cambridge and Palo Alto. Relationships are crucial, because after taking risks on small, unproven companies, the investment banks expect future rewards through later deals as the businesses blossom.

Over the past 15 years, a coterie of Wall Street's ambitious financiers have moved west to build intelligent relationships in Silicon Valley. They were drawn by the potential for spectacular success, realized through relationships with companies such as Sun Microsystems, Cisco Systems, and Oracle Systems. The business that these technology financiers have founded is brisk for several reasons: 1) the rapid market development of high-tech products is unparalleled; 2) the great number of startups and initial public offerings (IPOs), many of which are produced by the premium value placed on intellectual capital, combined with sufficient venture capital for most good ideas; 3) technology companies require the fast money available through corporate finance, because their need to expand often surpasses their revenues; and 4) the modular characteristics of technology create incentives for mergers and acquisitions (M&As).

The importance of intelligent relationships explains the disparity in success among investment banks, regardless of their financial stature. One star player can make all the difference. Morgan Stanley's Frank Quattrone, Goldman Sachs' Eff Martin, and Lehman Brother's Stu Francis have long been high-caliber players in the field. It's doubtful that their banking business will fall off anytime soon, as the franchises they've built promise many more years of growth. Nevertheless, the contenders grow more numerous, hungry, and credible.

Image is Everything

The Herring has never seen anything like the impassioned reaction to last year's investment bank issue. Our voicemail system was backed up with petitions for more favorable coverage, because investment banks can't afford any hint of bad form in the highly competitive technology market. There are 7,400 securities firms in America, but nearly 80% of revenues are held by the top 25. Many of these 25 firms are legitimate players in high-technology, as are a handful of second-tier firms.

Facing so many contenders, technology bankers say that their business is 50% image casting and salesmanship. For appearances, Goldman Sachs' offices are tastefully rich with San Francisco's best view, and Morgan Stanley has pitched a big tent on Sand Hill Road, Silicon Valley's most prestigious real estate, while Bear Stearns tries to impress with its relatively lean, cost-conscious digs. Accoutrements to the sell are tombstones for recent big deals and the after-market performance figures of their clients. After corporate finance professionals highlight the firm's unique culture, the research analyst takes the stage, to impress with industry insight and to provide assurance of future support. The corporate financiers then try to prove their mettle through exhaustive efforts spent getting out an impressive proposal. In some cases, firms will leverage their in-house celebrity to close a deal. According to one banker, "It's very hard for the CEO of a small company to walk away from the table when Sandy Robertson, of Robertson Stephens, is personally selling you."

The technology banker's pitch works best when the client can imagine a muscle-bound, but approachable figure. Consequently, the investment banks struggle to work out the tradeoffs between breadth of services and simplified access to their bureaucracy. The bulge bracket firms try to appear starved for small deals while projecting the sense that they are personable. The boutiques, on the other hand, don't have to sell their accessibility, so they stress the range of their services and their growing size. Robertson Stephens, for example, projects breadth to the farm league through its venture services group, which offers access to analysts and research services to VC-backed companies, and holds an annual conference for venture capital CFOs.

The Phantom Colossus

Technology bankers are quick to say that Merrill Lynch, Smith Barney, and PaineWebber are not in their business. These firms don't approach the technology leaders' numbers. With their institutional might to draw on, however, a smiling fool could win some business. Smith Barney boasts $2.3 billion in capital, plus ownership by the Travelers insurance company, and PaineWebber has $4.1 billion in capital. Furthermore, among investment banks, the trio claim the largest retail distribution networks. Although detractors call this a commodity business of little value to corporate finance clients, these three firms tout their retail distribution strengths.

Merrill Lynch is the world's largest securities firm, with $20.7 billion in capital and 43,800 employees. The firm is also on a roll, taking a bigger profit in 1994 than any other investment bank, while showing an 18.6% return on equity in what was a tough year for many competitors. Operating on such a grand scale, Merrill Lynch has chosen not to make the $30-$40 million technology IPO a priority in the past. But management now recognizes that a technology company can go from nowhere to $1 billion in revenues very quickly. To cultivate business with smaller technology companies, Chris Forester and Steve Strandberg were brought on in 1994 to run the technology operation. Mr. Forester initiated Goldman Sachs' technology banking division, while Mr. Strandberg is a veteran of Donaldson, Lufkin & Jenrette and Morgan Stanley. Mr. Strandberg admits, "Back in the '80s, Merrill Lynch viewed technology as interesting, but it was not a core focus because the mega-deals were driving investment banking. Now we're in an environment where technology is a dominant investment bank franchise." Merrill Lynch's goal is to work on as many sub-$50 million technology IPOs as Goldman Sachs and Morgan Stanley.

The convergence of telecommunications, entertainment, and technology is another big incentive for Merrill Lynch in making a run at the technology industry. Merrill is arguably the biggest player in telecommunications. Last year it managed enormous privatization efforts for both Indonesia and Denmark. Mr. Strandberg quips that Merrill ought to be the biggest issuer of telecommunications securities, because it had a $1.2 billion telephone bill last year, second only in size to the U.S. government. The firm also claims to be the most important investment bank in the movie industry. Mr. Strandberg's strategy, then, is to prove to his potential clients that by working with Merrill, the widest possible avenues will be opened to convergence transactions.

PaineWebber has also been making strides into the technology market. Last year, the firm acquired Kidder Peabody, integrating its well-respected technology research staff, which included eight analysts, five of whom were ranked by Institutional Investor. According to David Dicioccio, who runs PaineWebber's technology division, the firm determined two years ago to make technology a priority and had been hiring new technology staff before the Kidder merger. The buy-out of Kidder Peabody advances this effort by years. Smith Barney is also getting more aggressive in technology. After last year's acquisition of Shearson, the firm boasts 11,000 brokers. Its logical pitch is: "Why go dialing for buy-side dollars, when you'll get a sales army through Smith Barney?"

The Technology Executives' Perspective

CEOs and CFOs of newly public technology companies generally acknowledge that it's impossible to be completely sure that their banks were the best choices possible. Nevertheless, not one of the dozens of executives we spoke with expressed any real dissatisfaction with their investment bankers. Stan Kazmierczak, CFO of Digital Link, explains that it's hard for an investment bank to disappoint. "The actual process of an IPO is a simple transaction--you're not exactly re-creating the world."

Computers, Communications, & Entertainment IPOs
Investment Bank # of Lead-
($mil) # of Co-
Alex. Brown & Sons 11 348 6 224
Bear Stearns 8 281 2 135
Cowen & Co. 3 780 5 140
CS First Boston 3 340 0 0.0
Donaldson, Lufkin & Jenrette 4 242 9 1190
Goldman Sachs 10 2049 3 1400
Hambrecht & Quist 12 242 5 144
J.P. Morgan 0 0.0 2 402
Lazard Freres 0 0.0 4 563
Lehman Brothers 7 224 4 1322
Merrill Lynch 1 361 6 1881
Montgomery Securities 5 135 5 188
Morgan Stanley 8 918 4 743
Needham & Co. 1 14 5 115
Oppenheimer & Co. 3 76 1 36
PaineWebber 2 49 14 858
Piper Jaffray 2 48 3 58
Prudential Securities 3 97 3 160
Robertson Stephens 8 201 5 143
Salomon Brothers 2 204 4 496
Smith Barney 4 190 6 552
Wessels, Arnold & Henderson 2 54 5 158
Firms did more than $100M cumulatively in 1994.

Source: SDC & Company Information

The analyst stands out as the most important factor in selecting IPO underwriters. In fact, the question of selection criteria escaped some CEOs because the answer was so obvious. Woody Rae, CEO of Spectrian, a wireless equipment manufacturer, says that the research analysts whom he went with served his company's general marketing needs in addition to influencing stock price. Based on his seven years of prior experience in venture capital, Mr. Rae says companies shouldn't go public because they need money. The purpose of an IPO is to gain exposure. Spectrian's IPO and subsequent notoriety builds the perception among its clients that the company is a permanent fixture. Mr. Kazmierczak's IPO goals were similar. "We're small and don't have much money for publicity, so having good analysts to communicate for us is a great asset."

There is no scientific approach to determine who is a sector's lights-out analyst. None of the executives we polled mentioned rankings, like those of Institutional Investor, as being influential. Most conducted their own surveys, questioning buy-siders and executives who had been in similar situations, but without receiving conclusive results. In the end, technology executives most often chose analysts whose view of the industry most closely mirrored their own.

The argument put forth by the bulge-bracket firms is that analysts based in New York have an advantage because they write more directly to institutional investors, who determine company values. The result is that New York analysts stay away from a company's product differentiation and stick to its fundamentals and balance sheet, because buy-siders don't want that much information. According to bulge-bracket firms, the best way to select an analyst is to see whether the market moves when he or she changes a recommendation. This line of reasoning is given some credence by the technology companies. A few CEOs say they believe that big firms can afford thicker Chinese walls between internal departments, which makes the analyst more credible to institutional investors.

After determining who the best analysts are, technology companies then have to decide on the importance of an investment bank's capital assets. Most try to balance their offering by using a large New York bank as well as a regional boutique. Those that do not find a warm-hearted reception at Morgan Stanley, Lehman Brothers, or Goldman Sachs often turn to big banks with less mature technology programs. Smith Barney acknowledges that it focuses on pursuing deals with companies that fit its research strengths, which lie in semiconductors, networking, and communications. That leaves out some large technology sectors, but companies that do fit may find a very welcome reception by an enormous investment bank. Similarly, Prudential Securities is solidifying its strengths in semiconductors and imaging, before moving outward.

Conflict of Interest

With a handful of banks grabbing the lion's share of technology deals, envious competitors are looking for arguments to shake up the status quo and grab deals for themselves. One banker says that he thinks Morgan Stanley's stranglehold on the networking industry can't be good for its clients. Firewalls can be built to keep banking information private, but he wonders how Morgan's networking analyst can remain credible when supporting so many of corporate finance's competing clients. Another banker says he believes there's a thorny issue about M&A assignments. "When there's a company for sale with attractive technology, only one client can get the first call as a potential client."

Computers, Communications, & Entertainment M&As
Investment Bank # of Deals $ of Deals ($mil)
Alex. Brown & Sons 24 2,378
Bear Stearns 5 883
Broadview Associates 46 714
CS First Boston 7 1514
Dillon Read 2 250
Donaldson,Lufkin & Jenrette 10 5191
Goldman Sachs 9 5035
Hambrecht & Quist 10 1266
J.P. Morgan 2 381
Lazard Freres 2 269
Lehman Brothers 33 21,014
Merrill Lynch 6 8761
Montgomery Securities 2 115
Morgan Stanley 25 24,577
PaineWebber 8 9302
Salomon Brothers 7 2431
Smith Barney 5 8378
Veronis, Suhler 2 1,580
Wasserstein, Perella 2 1475
Wessels, Arnold & Henderson 3 164
Firms did more than one deal in 1994 and more than $100M cumulatively. Does not include deals with undisclosed sizes.

Source: SDC & Company Information

Morgan Stanley's Bill Brady dismisses the issue as irrelevant mudslinging and answers, "We have never violated anybody's trust and have never heard a complaint about violations of confidentiality." Goldman Sachs' Brad Koenig calls conflict of interest a psychological hurdle. "It can become an issue with young and emotional companies that want an investment bank completely devoted to their cause. As they grow and mature, they see bankers in a different light, and perceive scale as a positive," he says. Certainly competitors like Alantec and Network Peripherals, both of which carry network switching product lines, would have difficulty working with the same banker. Both companies were 1994 IPOs and are very young. Despite sales figures below $50 million, Alantec and Network Peripherals must manage market caps greater than $200 million. Their valuable stock gives the companies a potent tool and exposes them to an enormous liability. Young companies in this situation often rely heavily on the counsel and services of investment banks. With this close and vital cooperation, small but highly valued companies don't want their investment banker working with a competitor.

Because technology companies benefit from investment bankers who provide strategic advice, some banks are reorganizing corporate finance to give bankers the ability to brainstorm with their clients. Bear Stearns' Mike Grimes explains that as M&A transactions have more strategic than financial catalysts, it is important for investment bankers to integrate technology and business expertise with M&A advisory skills. On the flipside, this presents problems for the firms which staff M&A transactions out of a central M&A group, rather than having technology corporate finance professionals who are also proficient in M&A. Technology executives often get frustrated shuffling between technology corporate finance specialists who don't know M&A, and the firm's M&A expert who just completed automotive and mining deals.

Another structure that may help in making clients feel they are getting undivided attention is the organization of technology teams into distinct pods, rather than lumping all bankers together. Goldman Sachs, for example, has three senior bankers who work for different clients. Morgan Stanley has one point man, Frank Quattrone, who has successfully formed very close personal ties with a bulging roster of technology companies. With so much responsibility and success, Mr. Quattrone is prone to being attacked. In the networking sector, for example, Mr. Quattrone's personal representation of 3Com, SynOptics, and Cisco would not have been a problem a few years ago, as their products were complementary. Now the companies compete, because their steady M&A activity has broadened their product bases. Other banks will try to lure those companies away with the promise that their company will be the only one represented in that niche.

Goldman's Mr. Koenig argues that mature companies want the best representation, and don't care who works with their competitors. He points to Goldman's representation of both Dell and Gateway as proof that this issue is a straw man for bigger companies. Other bankers remark that outside the technology sector, it is common for one bank to represent even the bitterest rivals, and that a couple of law firms represent most of the big technology companies in Silicon Valley.

The Work Ahead

The description of the IPO and M&A pipeline, as recited by the investment banks, sounds as if they are all reading from the same script. The market looks healthy, with continued focuses on networking, client/server software, and communications. Illustrating the well-being of the industry, Bear Stearns' Mike Grimes says, "The supply and demand equation for stocks in these areas is still well out of balance, with a relentless search for the next Cisco by fund managers driving extraordinarily high valuations. In fact, the 10 largest datacom and telecom equipment companies that went public in 1994 are trading at an average of 50x 1995 earnings."

Investment Bank Tenure for Computers, Communications, & Entertainment Analysts
Investment Bank # of
Avg. Yrs.
at Firm
Avg. Yrs.
as Analyst
Alex. Brown & Sons 10 4.9 8.5
Bear Stearns 13 2.8 9.6
Cowen & Co. 12 7.3 15.7
Furman Selz 3 3.7 15.0
Hambrecht & Quist 15 3.8 6.8
Lehman Brothers 15 2.4 11.8
Merrill Lynch 11 8.6 19.0
Montgomery Securities 13 2.4 5.0
Morgan Stanley 11 2.6 1.9
PaineWebber 4 3.0 3.0
Piper Jaffray 7 2431 2,378
Prudential Securities 13 4.0 9.5
Punk, Ziegel & Knoell 2 2.3 15.0
Smith Barney 14 6.8 14.1
SoundView Financial Group 2 3.3 4.8
Van Kasper 2 4.0 17.5
Wessels, Arnold & Henderson 3 4.3 7.0
The average number of years that an analyst works with a firm can be a good measure of stability in the research department. However, some firms have hired on new staff, as indicated by the average years as an analyst.

Source: SDC & Company Information

Examining M&A in particular, Mr. Koenig of Goldman Sachs says that it's getting harder to envision a one-product company being successful. "We're seeing consolidation, with several mega-companies in each industry growing very rapidly and doing lots of M&A, while others are falling by the wayside or are being gobbled up." With all of this consolidation, there is the possibility that opportunities for startups will dry up. Mr. Koenig temporizes that he doesn't believe this trend means that the industry is heading toward an unhealthy monopolistic state. "Small companies will continue to be born," he says, "because they are unencumbered by any legacies and can leapfrog the old guard." In client/server software, for example, Oracle, Sybase, SAP, and Informix all have multi-billion market values, but have in no way locked out the competition. Although Sybase addressed gaps by acquiring both Gain and Powersoft, its remaining weaknesses resulted in a one-day, 40% stock price drop.

Conventional wisdom says that client/server software continues to be a wide-open field, because buyers are more inclined to buy the best-of-breed applications than to buy from the broadest channel. Yet Goldman's Mr. Koenig predicts, "We will see several companies in client/server that will be dominant, and we'll see a similar outcome in desktop software." He thinks that Silicon Graphics' purchase of Wavefront and Alias may be followed by other purchases of software companies by hardware companies. He cites Packard Bell and AST's development of their own user interfaces, to differentiate themselves from other hardware vendors, as an example. On the other hand, Mr. Koenig says, "The PC companies are in such a ruthless market that I imagine they'll remain very focused and will not risk much M&A." Rather, he thinks, a hot spot for M&A will continue to be in networking, where he expects 3Com and Cisco to continue to be especially active.

Merrill Lynch's Mr. Strandberg agrees that client/server software M&A activity will soar in 1995 and 1996 and that the market will see more deals along the lines of Sybase/Powersoft. While he doesn't expect the telcos to venture into the software world, Mr. Strandberg thinks they will get more aggressive in networking equipment acquisitions. Like Mr. Koenig, he also anticipates that hardware vendors will be buying more software to fight Microsoft. Mr. Strandberg's final prediction is that the Korean semiconductor companies will become very active in M&A.

Morgan Stanley's Mr. Brady says that he expects to see telecom equipment companies that resemble Ascend and Cascade (two of his clients that went public in 1994) also lining up on the IPO tarmac. He expects that the second big sector will be client/server software applications for things like help desks and as next generation development tools. Mr. Brady does not expect to do much IPO work for computer hardware companies, except for some niche peripheral companies.

In M&A, Morgan Stanley just finished work on Platinum Technology's acquisition of Trinzic. Mr. Brady anticipates a busy multimedia content sector throughout the next year, as cable and media companies look into acquiring publishers. One area that has not seen much M&A lately, but that Mr. Brady expects to become active, is the semiconductor industry. Semiconductor companies have been watching the software industry's M&A success, and hope to emulate it. Lehman Brothers' Stu Francis, who has been very active in semiconductor offerings, expects to be very busy with that sector's M&A this year.

Top Computers, Communications, & Entertainment Analysts
The Herring Tech 250 Sector First Place Investment Bank Runner(s) Up Investment Bank
Broadcasting Drew Marcus Alex. Brown & Sons Dennis Leibowitz Donaldson, Lufkin & Jenrette
Computer Networking Joe Bellace Merrill Lynch Merrill Lynch
Paul Johnson
Fred Ziegal
Wessels, Arnold & Henderson
Robertson Stephens
Punk, Ziegel & Knoell
Design Automation Software Pete Schleider Wessels, Arnold &
Laura Conigliaro
Russ Crabs
Prudential Securities
SoundView Financial
Desktop Computers & File Servers Andy Neff Bear Stearns Mike Kwantinetz Paine-
Distributors & Integrators Steve McClellan Merrill Lynch Paul Fox
Bob Anastasi
gomery Securities
Robinson Humphrey
Education & Entertainment Software Lee Isgur
Steve Eskenazi
David Farina
Mike Stanek
Volpe Welty
Alex. Brown & Sons
William Blair &
Piper Jaffray
Charlie Finney
Keith Benjamin
Volpe Welty
Robertson Stephens
Enterprise & Client/Server Software Chuck Phillips Morgan Stanley Rick Sherlund Goldman Sachs
Enterprise Computers John Jones Salomon Brothers Laura Conigliaro
Stephen Webber
Steve Milunovich
Pam Mondverla
Prudential Securities
;Cowen & Co.
Morgan Stanley
Merrill Lynch
Information Highway Equipment Mary Henry Goldman Sachs Joe Bellace Merrill Lynch
Information Highway Services Jack Grubman PaineWebber John Reidy Smith Barney
Information Providers Keith Benjamin Robertson Stephens Michael Parekh Goldman Sachs
Peripherals Paul Weinstein PaineWebber Steve DuLuca
Paul Fox
Mary Meeker
Cruttenden & Co.
gomery Securities
Morgan Stanley
Personal Productivity Software Rick Sherlund Goldman Sachs Mary Meeker
Mary McCaffrey
Morgan Stanley
Alex. Brown & Sons
Semiconductor Equipment Byron Walker Needham & Co. Brett Hodess Mont-
gomery Securities
Semiconductors Raj Rajaratnum Needham & Co. Tom Thornhill Mont-
gomery Securities
Storage Paul Fox Montgomery Securities Todd Bakar
John Dean
Andy Neff
Hambrecht & Quist
Salomon Brothers
;Bear Stearns
Wireless Communications Eric Zimitz Volpe Welty Susan Passoni
Tony Laugham
Tony Robertson
Cowen & Co.
County Nat West
Robertson Stephens
The above were selected by a panel of prestigious institutional investors focusing on the The Herring Tech 250 sectors.

Source: SDC & Company Information

Random timing may have a greater influence than logic on which sectors are busy throughout the rest of the year. According to Bear Stearns' Mike Grimes, "An interesting trend has been the tendency of a particular subsector to rapidly consolidate through M&A, from companies' fears of being left on the sidelines while competitors stake out positions in new markets." Other technology corporate financiers agreed that although they are pretty sure where the market will heat up, being surprised is part of the business.

Copyright 1995 RHC Media, Inc.