Turning up at a local charity event recently, a San Francisco investment banker was stunned by the number of Chanel suits. It was like something out of Bonfire of the Vanities. "Social X-rays" - the term Tom Wolfe coined to describe New York's skeletal society matrons - had replaced the laid-back "California girls" the banker remembered from his college days at Stanford University.
All this haute couture is just one sign of the San Francisco Bay area's financial coming of age. A posting here was once the kiss of death for an investment banker's career, but the boom in technology-company flotations has changed all that. "There's a ton of money coming in here," says Mike Hall, an attorney at Venture Law Group in Menlo Park's Sand Hill Road, a two-mile strip in Silicon Valley where scores of venture capitalists have their offices. Thirty miles (50 kilometres) south of San Francisco, this street of unassuming suburban business parks houses some of the most expensive real estate in the US, rivalling Manhattan and Honolulu.
A huge amount of money has been pouring through this district. Last year, venture capitalists raised $4.5 billion to pour into technology start-ups, the biggest chunk of it going to Californian companies. Just two years ago, they raised only $1.5 billion. And this is just the first step in the process towards an eventual public offering (IPO). In 1995, technology-company IPOs raised almost $9 billion, about 40% of the $20 billion total Wall Street financing that year and more than double the amount raised in 1994. This year, the trend has accelerated. By the end of June, more than $10 billion had already been raised.
For the handful of investment banks that dominate the area, it's a licence to print money: last year bankers earned $1 billion in gross spreads off technology deals. Investors can't seem to get enough of technology stocks. As Frank Quattrone, recently recruited as chief executive of DMG Technology, notes, technology companies now have a combined market capitalization of nearly $1 trillion.
Quattrone should know. As one of Silicon Valley's leading bankers when he was at Morgan Stanley, he helped float many of the stars, including Internet pioneer Netscape, whose IPO last summer set the standard for all others since. At DMG Technology, Deutsche Morgan Grenfell's new high-tech banking operation, he is set to shake things up further. DMG says it is going to be the low-cost producer, somewhat amazingly, since Quattrone was reportedly lured to the company by a compensation package valued at $20 million over three years.
Not since the Gold Rush last century has the San Francisco Bay area seen such easy money. But will it all be spoilt by speculative fever and cut-throat competition? Old-timers say the quality of companies is already diminishing, just as it did during the similar, if less spectacular, technology boom of the early 1980s, or the ill-fated biotech boom of the early 1990s, when investors discovered it took time and money to make the start-ups profitable. "Both investment banks and venture capitalists have become more aggressive," says Gary Morgenthaler, who heads the Silicon Valley office of the venture-capital firm Morgenthaler Partners. "There is a lot of pressure, and they are reaching for companies. We see a lot of companies going public where we're scratching our heads. It's dangerous." The arrival of foreign banks, and the interest among foreign investors - demonstrated by the overflowing attendance at American boutiques' European conferences this year - are considered two of the clearest signals yet that the market is nearing its top.
Local investment bankers predict that margins will be squeezed and at least one of the high-tech investment boutiques, which have expanded their staffs to churn out the deals, will be gobbled up by a big institution before it's all over. At the same time, bankers say they are preparing for an eventual downturn in IPO business. Noting that many newly-public companies have built up huge cash reserves, the bankers are beefing up M&A teams to help advise on the expected consolidation. They are also looking abroad, seeking both investors and corporate-finance clients. Regardless of how this boom plays out, no one is betting on technology going away.
Historically, technology has been viewed as a niche business rather than a strategic interest for bankers and investors. Financing was mainly handled by a small group of boutiques such as Hambrecht & Quist (H&Q), Robertson Stephens and Montgomery Securities (all partnerships based in San Francisco) and Alex Brown (the lone East Coast firm). H&Q and Robertson Stephens are the purest technology boutiques. Alex Brown, which went public in 1986, has $500 million in equity and is bigger than the other three, calling itself a "major-bracket" firm. Montgomery, three times the size of H&Q, boasts of its New York-style pressure-cooker atmosphere. It has the largest trading operation west of Manhattan, which is run by former New Yorkers.
New Yorkers head west
The latest boom has doubled or tripled the workforces of many local institutions, bringing in many self-styled "survivors of New York" to work in the Bay area. New York institutions such as Donaldson Lufkin Jenrette, Lehman Brothers and Merrill Lynch have also boosted their presence. But only two of New York's bulge-bracket firms, Morgan Stanley and Goldman Sachs, have shown a consistent commitment to the business. Last year they ranked second and fifth, respectively, in the league table of technology IPO lead managers, as measured by the amount raised, according to Securities Data. This year, by June, they ranked first and third.
Price competition has so far been non-existent, with relationships critical in landing deals. But all that could change as technology becomes mainstream and the competition heats up. "It is one of the most strategic and rapidly growing segments of industry," says Brad Koenig, who heads Goldman Sachs's San Francisco investment-banking operation.
Local bankers like to talk about how many silicon chips are in cars and kitchens and how the Internet will eventually replace telephones as the dominant mode of communication. Technology, they argue compellingly, is invasive. By some definitions, it already accounts for 10% of US GDP and is growing at 10%-plus annually. Moreover, it's a global industry. Half of the sales of the big US-based high-tech companies are already international, notes Koenig. And while some 80% of the world's high-tech companies are located in the US, with half of those in Silicon Valley, companies in places as far-flung as Israel, Belgium and Singapore now account for 20% of the bankers' business. Goldman estimates it will soon be 25%. "You have to target this business to be successful, and every one of the global firms is evaluating how it can do so," says Koenig.
The big European players have taken note. Union Bank of Switzerland (UBS) hired a team of bankers from firms such as Hambrecht & Quist and Alex Brown a year ago, and Swiss Bank Corporation (SBC) has approached San Francisco boutiques about possible joint ventures. But it is Deutsche Morgan Grenfell that took the boldest step, when its US subsidiary set up the boutique-like DMG Technology. Headed by Quattrone and staffed by almost three-quarters of Morgan Stanley's former technology team, including corporate financier Bill Brady and M&A specialist George Boutros, it already has a professional staff of more than 40.
DMG Technology is counting on Deutsche Bank's financial strength, low cost of capital and, most importantly, relatively low target for return on equity (ROE) to help bring in the business. While US firms must show their shareholders a 20% ROE, the universal bank needs to make only half of that. And DMG is willing to pass along the savings to the client. "We will be more aggressive in using our capital to the benefit of our clients," promises Quattrone. Deutsche is also willing to pay more for talent, and the Quattrone team's huge pay package has already boosted salary levels in the Bay area. All told, it's almost certain to mean lower profit margins for the industry, predicts a Silicon Valley banker. Morgan Stanley "will have to increase its cost structure or risk revenues going away," he notes. Morgan Stanley did not return calls to comment, but it is said to be trying to repair the damage done by the defections from its technology team and has offered huge bonuses to keep those members that are left.
The idea of price competition surprises DMG Technology's potential customers. "It's novel," muses Morgenthaler, a long-time Goldman client. "It would cause a fundamental rethinking of the business, which has never been characterized by open competition." Investment banks now charge a flat 7% on equity underwritings, regardless of size. That makes it more lucrative than fixed-income, which earns 1%, or high-yield, with 3%. "I think there is room to compete profitably," says Morgenthaler, "but if they take that approach, they will challenge the business."
Others don't think such a tactic is necessary, and many believe it will be used only as a loss-leader. "I don't think you pick your underwriter based on price," says Andy Rachleff, who runs the venture-capital firm Benchmark Capital Partners. He and his peers are critical to the investment bankers' success, since they have a key role in deciding who wins mandates for their start-ups' activities. Rachleff advises his companies to choose their underwriter on the basis of quality of research, trading support and "chemistry". "I don't think Frank needs to [cut prices] in order to win, because he's so good."
Whether or not there is a price war, the sudden shift of players is sure to have a major impact on the business. And while every bank is trying to take advantage of Morgan Stanley's loss of staff, none is more confident than Goldman Sachs. "We're in the best position to take advantage of it," says Koenig. Goldman has the global reach, the top-ranked analysts, what one competitor calls a "marquee name", and a record of success. Last year, the IPOs it launched showed an average 66% return, putting it third among the top 10 lead managers. Alex Brown - which has the broadest reach of any of the smaller players - came first with 84%, and Morgan Stanley was second with 73%. Goldman is now aggressively courting Morgan Stanley's clients, including Apple Computer, for which it recently did a $660 million convertible overnight financing. Morgan Stanley represented Apple during its ill-fated merger talks with Sun Microsystems, which was represented by Goldman.
Most of the smaller firms have no ambitions to be bulge-bracket players, but they're not sitting still. As a group, they tout their expertise and believe their focus is what sets them apart. "The rest of the world is waking up to what we knew 20 years ago," says Andrew Sheehan, a managing director at Alex Brown, pointing to the firm's success in promoting success stories such as Microsoft and Silicon Graphics in their early days. Although Alex Brown is based in Maryland, with offices in Tokyo and London, its San Francisco office now employs 60 investment bankers out of its 190 worldwide. This year, the firm has jumped to number two in lead-managing technology IPOs (in terms of amount raised), up from third place in 1995.
"Depth of knowledge can't be possible if you're spread in 10 to 15 sectors," says Misha Petkevich, a managing director at Robertson Stephens, last year's top technology lead manager in terms of number of deals and amount raised. A salesman at a bulge-bracket firm, who might be trying to sell Latin American debt as well as the latest Internet IPO, can't have the technical expertise required, he argues. "The big investment banks have always allocated resources based on the flavour of the month," he says. "Our view is that there are good and bad markets. I love downturns: they get rid of all the big boys."
The venture-capital companies may be enamoured of the big New York firms and their cachet, but the specialists get their share of deals, and are often sought as co-managers because of their depth of research and commitment to coverage. Venture capitalist Morgenthaler explains: "Since fees are the same, and if the stock is hot anybody can get it sold, the difference comes down to, 'What is the quality of the research?'"
Highly-regarded, independent research has been key to the success of Alex Brown, which claims to have the largest research team covering technology in the US, and of Cowen & Co, a research and money-management house that covers only three other industry sectors. "We have exceptional research and more all-star analysts than some bulge-bracket firms," boasts Terrence Connolly, who runs Cowen's investment-banking activity.
The Internet craze
Flushed with success, the smaller firms are trying to make their mark abroad. Hambrecht & Quist recently reopened its London office, closed in the late 1980s following a financial scandal that almost bankrupted the company. And Cowen has been sponsoring conferences in Europe for the past three years, showcasing its European corporate clients to US and foreign investors. "The entrepreneurial community in Europe is active and robust. Those companies need to go public and need to use investment bankers," says managing director Robert Valdez. The reason European companies turn to US bankers is simple. There is still no easy route for a small company to go public in Europe, though attempts are being made to establish a European equivalent of Nasdaq, the US's over-the-counter stock market.
Robertson Stephens has just added a London office to its branches in San Francisco, New York, Boston and Tokyo. It sponsored its first conference in the city last month. "It was fabulous, wildly successful," says Petkevich. The 200-strong audience was double what the firm expected, and 80% of those present were Europeans eager to find out about US technology companies such as America Online, which Robertson Stephens took public several years ago. Likewise, Montgomery Securities syndicate head Dick Smith notes that a conference his firm held in Paris in April was an "enormous success".
Europe, like other parts of the world, may be creating more high-tech companies in which US investors are eager to invest. But whether European investors can be convinced to buy technology stocks is a matter of great debate among Silicon Valley bankers. Robertson Stephens's Petkevich says the firm has consistently placed between 15% and 20% of its deals in the hands of European investors, even though they were covered out of San Francisco. Others, however, note that European investors have largely missed the high-tech boom in the US stock market.
Barry McCurdy, the research director for the highly-regarded San Francisco boutique Volpe Welty, is among those who doubt there will be any great European interest in the near future. He headed H&Q's UK office in the 1980s, and covered Scotland. "I'd never bother to go there now," he says. "If a market cap is less than $500 million, they're just not interested." Scottish money managers have been out of the market for four or five years, he says. "Either they feel they've missed it, or they haven't gotten to the point of pain yet because their returns are adequate."
In a way, of course, many Silicon Valley bankers don't want to see a great influx of foreign investors. They recall with trepidation the stock-market crash of 1987, which occurred shortly after European investors finally bought into US equities. Almost by definition, foreign investors are less informed, say the us bankers. "There are market-top signals everywhere," says one veteran, "but when European investors start throwing fistfuls of money at it, that'll be the real top."
What may finally pull in the foreigners is the craze for Internet companies, estimated to represent half of the investments in the venture capitalists' portfolios. At Goldman, which just lead-managed the IPO of Yahoo!, the Internet directory firm, Koenig says this is the firm's greatest emphasis. "The Internet is the biggest story and will continue to be for some time," adds venture capitalist Rachleff. Investors and bankers alike admit they are looking for the next Netscape. Kleiner Perkins, the venture-capital firm that backed Netscape, earned an estimated 2,000% return on its $5 million equity investment.
Bankers note that Internet stocks are particularly vulnerable to bad news. Without any historical method of valuation (ie, no price/earnings ratios), flotations are supposedly priced on the basis of price/revenue ratios. In reality, however, they are priced on the basis of other Internet company IPOs, leaving little room to reflect differences in quality. This makes their stock prices particularly volatile. "There can't be as much value in the Internet as the portfolio of money suggests," says Venture Law's Hall. "There will be some crash-and-burn stories." Unable to pick the winners from the losers, many bankers and venture capitalists are said to be playing a batting-average game: if they do enough deals, they're bound to score some hits. So far, so good: venture capitalists say that many had returns of over 100% last year, though 30% is more normal.
Surviving a bust
The bust that followed the original Silicon Valley boom in the early 1980s dragged many technology firms under. But today's market is even wilder. "Very few Internet businesses today are profitable," says Morgenthaler. "When the dust settles, and investors come to their senses, they are going to look at which businesses are generating a return on equity." The fear investors have is that the good companies could get dragged down with the bad.
"We have absolutely zero control about what happens out there," philosophizes Robertson Stephens's Petkevich. Competitors like to point to his company, the number-one lead manager last year, as the most vulnerable to any downturn. Last year, it came fifth among the top-10 technology IPO underwriters in terms of deal performance, with a 38% average return. This year, it has so far taken things easier, ranking only seventh in terms of dollars raised. Has it done the right deals? "We won't know until it starts to slow down," says Petkevich. In past downturns, he points out, the firm has stuck to its knitting and come out all right. In 1994, for example, when many Wall Street firms suffered losses, Robertson Stephens's revenues were basically flat. "We were focused. When the market turned, we were already having conversations with companies. If you focus on a special industry, you pay attention to it."
In preparation for the next phase, though, most of the firms are trying to change their emphasis or at least tout their M&A expertise. That is where the big money is to be made next, and where companies such as Morgan Stanley and Goldman Sachs excel (Morgan Stanley has already advised Netscape on several acquisitions). But the smaller firms are also gearing up. Cowen & Co, for example, recruited Lehman alumnus Valdez in 1994 to set up its M&A advisory practice. And some are already well positioned. Alex Brown's global reach helped make it number seven in global M&A deals last year. It represented US companies Software Toolworks (sold to Pearson) and Teknekron (bought by Reuters) and helped Diamond Multimedia buy the German graphics company Spea Technology. "We were brought in because the small advisory firms that took it public couldn't do it," says Sheenan. In addition, he jokes, the firm has an active bankruptcy and reorganization department.
Silicon Valley's original boom was financed by a group of banks known as the Four Horsemen - Hambrecht & Quist, Robertson Stephens, Alex Brown and LF Rothschild, which was wiped out in 1984's high-tech crash. With technology becoming a fixture of the industrial landscape, bankers hope the next downturn will bring mergers among financial institutions, rather than outright failures. There is also talk of companies selling out soon, while the market is still hot. "The time to be selling your business is when everything is just fine, not when you're in trouble," says Volpe Welty's McCurdy. "If you want to sell, the time to do is when everything never looked better."
Bankers also think the time is ripe for greater foreign investment or joint ventures. Reports that SBC was on the prowl for a small boutique have met with denials from all concerned; however, bankers close to the situation admit the European bank has talked to some of the private-partnership boutiques about possible joint ventures. Montgomery's Smith confirms his firm has been talking to SBC about possible deals that would give him greater access to potential European corporate-finance clients. Robertson Stephens executives insist they want to remain independent, and Hambrecht & Quist is in the midst of registration for an IPO and is keeping mum altogether.
Precisely because its capital structure is changing, H&Q is widely viewed as the most vulnerable to takeover. An estimated 20% of the firm will be sold, but, more importantly, the partnership system that helps keep many such firms together will disappear. Already H&Q has lost four of its most talented research analysts, three to UBS and one to DMG.
Robertson Stephens may also be ripe for picking. San Francisco-based Bank of America has been rumoured to be negotiating to buy the high-flier, but Robertson Stephens's president has vehemently denied it. Still, other bankers speculate that the firm's strategy of doing so many deals that bring in current income but might come undone in a few years suggests it is setting itself up for a quick sale.
A financial market characterized by highly-profitable, small partnerships that are suddenly thrust into a much bigger, bare-knuckled competitive world reminds many newcomers of their past. Could it be, wonder veterans of New York in the 1980s, or London after Big Bang, that San Francisco is the next spot for a shake-out in investment banking? McCurdy, a former London banker, reminds those who have spent all their banking lives on the West Coast of what happened to the City's small firms after Big Bang: "There wasn't a single success story."
"Just suspend your disbelief" After barely two months in business, the newest player in technology banking has already landed a dozen M&A assignments and minor positions on six equity mandates. "We had a strategy to get into the flow," says DMG Technology's boss, Frank Quattrone, who until April ran Morgan Stanley's high-tech team. Last month DMG landed the lead-management mandate for a $100 million secondary offering for Wind River Systems, and another lead-manager spot on a software IPO for Document Sciences, both of which are in negotiation. "We're off to the races," Quattrone declares.
DMG Technology has a lot to prove, though. Until recently its employees made up the bulk of Morgan Stanley's high-tech team; now they must show they can work as well for new backer Deutsche Bank. "People are watching to see if DMG can succeed," says Andy Rachleff, who runs the venture-capital firm Benchmark Capital Partners. Rachleff and his peers are critical to the investment bankers' well-being: the first financiers for start-ups, they also play a central role in deciding who handles public offerings or M&A assignments. Even after the companies they sponsor go public, venture-capital companies usually retain hefty stakes and are often represented on the board of directors.
Rachleff is well disposed towards Quattrone and his colleagues. At Morgan Stanley, they underwrote more of his business than anyone else. "They do a fantastic job of packaging the company's story for investors," he says, "and they are incredibly valuable as advisors helping understand the public-market perspective and thinking through acquisition strategies." And yet, Benchmark has just chosen Morgan Stanley as the lead underwriter for an IPO it is planning. "They just made a more compelling case for how good a job they would do," he says. As for DMG, Rachleff notes: "In any start-up it's an up-hill battle. If they can recruit quality analysts and can build a quality distribution channel, it ought to be very successful."
Quattrone realizes that winning over the venture capitalists is one of his most important tasks. "There are some influential companies we need to make the case to. It's the 80/20 rule: 80% of the high quality IPO prospects are in the portfolios of 20 venture-capital firms." Quattrone convinced his former employer, Morgan Stanley, to set up its office in Silicon Valley's Menlo Park, where it would be close to the venture-capital firms; DMG Technology is located there as well, while most of the investment banks are an hour's drive away in San Francisco.
As a result, he has close working and personal relationships with the main players. His message now is: "Trust us - we're going to deliver the goods. We've delivered before and we're going to do so again. Just suspend any disbelief and you may imagine us succeeding."
Already DMG Technology has more senior high-tech bankers than Goldman Sachs and more professionals than many of the local boutiques. Since Morgan Stanley's respected technology analysts did not follow Quattrone to DMG, he has had to recruit in that area and has nabbed such well-regarded individuals as Internet specialist Bill Gurley of CS First Boston. He is also working hard to convince venture capitalists that CJ Lawrence, the US equity-distribution arm of Deutsche Bank, which has 200 institutional accounts, can find buyers when the time comes to float high-tech start-ups. - MC
| 1996 high-tech IPO managers* |
|
Proceeds |
|
Market. |
|
No. of |
| Managers |
($m) |
Rank |
share |
issues |
| Morgan Stanley |
3,032.5 |
1 |
29.3 |
|
9 |
| Alex, Brown & Sons |
1,140.4 |
2 |
11.0 |
|
19 |
| Goldman, Sachs & Co. |
792.1 |
3 |
7.6 |
|
7 |
| Donaldson, Lufkin & Jenrette |
700.3 |
4 |
6.8 |
|
8 |
| Merrill Lynch & Co. |
453.8 |
5 |
4.4 |
|
4 |
| Hambrecht & Quist |
444.0 |
6 |
4.3 |
|
12 |
| Robertson Stephens |
415.3 |
7 |
4.0 |
|
12 |
| Salomon Brothers |
313.5 |
8 |
3.0 |
|
4 |
| Montgomery Securities |
304.5 |
9 |
2.9 |
|
8 |
| CS First Boston |
261.8 |
10 |
2.5 |
|
3 |
| UBS |
257.3 |
11 |
2.5 |
|
6 |
| Cowen |
231.0 |
12 |
2.2 |
|
6 |
| Smith Barney Inc. |
213.2 |
13 |
2.1 |
|
4 |
| Lehman Brothers |
199.5 |
14 |
1.9 |
|
6 |
| Volpe, Welty & Company |
152.1 |
15 |
1.5 |
|
4 |
| NatWest Mkts/ Gleacher NatWest |
120.5 |
16 |
1.2 |
|
3 |
| Piper, Jaffray Inc |
103.5 |
17 |
1.0 |
|
2 |
| Dillon, Read |
86.4 |
18 |
0.8 |
|
3 |
| Wessels, Arnold & Henderson |
84.2 |
19 |
0.8 |
|
3 |
| PaineWebber |
84.0 |
20 |
0.8 |
|
2 |
| Morgan Keegan |
72.7 |
21 |
0.7 |
|
2 |
| Oppenheimer |
64.2 |
22 |
0.6 |
|
3 |
| Needham |
61.8 |
23 |
0.6 |
|
3 |
| Adams, Harkness & Hill |
60.6 |
24 |
0.6 |
|
2 |
| Robert W Baird |
59.1 |
25 |
0.6 |
|
1 |
| Top 25 totals |
9,708.1 |
- |
93.7 |
|
136 |
| Industry totals |
10,365.4 |
- |
100.0 |
|
183 |
| Source: Securities Data Company *as at June 28 | |