An investment bank’s problems rarely prompt an outpouring of joy. But since Brazilian leader Garantia ran into troubles, triggered by last year’s Asian crisis, competitors, ex-employees and even regulators and journalists have been out celebrating. They see Garantia’s fall as a punishment for past arrogance and high risk taking.
A group of Sao Paulo traders were the most brazen in their Schadenfreude. They posted “for sale” signs on the cars of their opposite numbers at Garantia, just after it took a staggering hit in the Brazilian Brady bond market last October. Their actions were also prophetic – six months later Garantia is on the block.
After a period of denial, Garantia partners now admit they have held talks about a deal with several overseas banks, including Goldman Sachs. But with Goldman involved in its own debate on whether to go public, this prospect now appears less likely. A trip to Europe by Garantia founder and major shareholder Jorge Paulo Lemann late last month fuelled speculation that Credit Suisse First Boston is the frontrunner.
Lemann, a 59-year-old former tennis champion, who built the banking partnership from scratch (see box), is believed to want to sell the bank and concentrate on his other investments. He suffered a heart attack on the tennis court some years ago and has distanced himself from day-to-day operations. An austere and determined character, Lemann will get his wish eventually, even though younger partners may be against any sale, say observers of the bank. But it is proving a challenging proposition. The recent losses and Garantia’s trading room culture have so far scared off all potential suitors and Garantia’s 19 partners have yet to decide whether they prefer the bank to be an independent niche player, concentrating on trading and restricted in underwriting capabilities by capital size and distribution, or whether they want to compete with international firms now closing in on the Brazilian market. To do this means tying up with a foreign house substantially compromising their ability to trade as aggressively as in the past.
Roger Wright, who heads corporate finance says that a conclusion will need to be reached in the next two or three months. “We have got to make up our minds very quickly,” he says. “This is something that is coming to a head and I think we have had time to talk, examine, converse. We have obviously talked with Goldman and talked with others as well. Now we have to make up our minds which direction we want to go.”
Losses shock
The older partners were undoubtedly taken aback by the scale of Garantia’s October losses, put at $110 million by the bank, around 20% of equity. They are estimated by the market to be many times higher, but that probably includes client losses. Garantia’s Carlos Castanho, who heads private banking, says that 60% of the $110 million resulted from the bank’s own positions and 40% from losses in market-making as the bank was unable to widen spreads as fast as Brady prices fell.
The shock was all the greater because, until October, it seemed Garantia could do no wrong in the markets and the logic behind its heavy position in the Brazilian Brady bond market seemed solid. Interest rates were heading downwards, the government was expected to launch a 10-year Eurobond that would have tightened spreads across the board and there was talk of a debt restructuring involving a Brady buy-back. As a result the widely traded Brady security, the C-bond, had risen from 75% of face value to 87% at the end of October. Then, spooked by the Asian crisis, it collapsed to 65% in two weeks and the Brazilian central bank doubled interest rates.
Garantia was hit badly because it was a major player and highly leveraged. “Garantia has been one of the principal traders in Brazilian Brady bonds. They like to be in the top three of something or not at all,” says Paul Bydalek, president of the Brazilian rating agency Atlantic Rating. A lot of the leverage came from repoing Bradys and using the cash to buy more. Moody’s, which gives the bank an unsolicited rating, downgraded its financial strength from D+ to D after the crisis. The partners stumped up $45 million to replenish the bank’s capital. “When you hit a minor banana skin like we did in October we decided it was a good statement to dip our hands in our pockets,” says Fred Packard, who runs Garantia’s representative office in London and is the only British partner. Rumours that the partners have sold private equity holdings to raise the money have been denied by Garantia. The bank says that first-quarter earnings in 1998 are back to the levels of its best years – 1994 and 1995 – but refuses to give details.
The 1997 annual report states that the bank has learnt its lessons: “Going forward we have addressed this issue [of the trading losses] by creating a dedicated risk control department, staffed with senior partners of the bank, to focus exclusively on risk management.”
It is skimpy on figures though, containing only a basic balance sheet and income statement for the combined onshore bank, Banco de Investimentos Garantia, and offshore bank Garantia Banking Limited, the two principal entities of the Garantia financial group. However Euromoney has obtained a more detailed set of figures, including a breakdown of trading-account assets and liabilities that is made available to the central bank, creditors and counterparties. This shows that the position in Brady bonds fell from $294 million at June 30 1997 to $42 million at the end of the year. Holdings of corporate equities fell over the same period from $1,083 million to $103 million.
These are enormous reductions. Do they signify losses or are they an attempt to be more liquid and to run a substantially less risky book? Garantia partner Roger Wright, who heads corporate finance, says that if there are good trading opportunities in the market Garantia will be taking them. Castanho counters that these figures are only a snapshot and also include client positions that may have been liquidated. “Embedded in these figures are assets that we carry on behalf of clients. In October, 70% of our Brady and equity positions were in reality client positions and since October they have been selling because they needed liquidity,” he says. “They feared a worsening of the crisis.” The same report reveals that at the end of 1997 total net assets of Brazilian and international investment funds and portfolios managed by Garantia were $3 billion, down from $6 billion in June and $4.1 billion at the end of 1996. Castanho says these figures represent net worth and don’t take account of leverage.
Since the crisis the central bank has ordered that asset management and proprietary trading in Brazilian institutions be kept separate and Garantia has responded by moving its asset managers off the trading floor.
Wright explains that Garantia had a separate asset-management operation between 1987 and 1992 – the first Brazilian bank to do so – but was pressed by clients to merge it with the main bank. The clients wanted to be invested alongside Garantia. Asset management has always had its own portfolio managers, traders and research but it was not run as a separate profit centre until the recent changes. “It means we have separate directors [Marcelo Medeiros and Bruno Licht] responsible only for asset management, we have a team of people sitting separately running only client money,” says Wright. “They get the same information that the bank gets but they can outsource and use outside brokers, do whatever they want to maximize returns on their funds. We haven’t prohibited them from talking [to the proprietary traders] but they definitely run their books and their assets in a different way altogether.”
No connection
Garantia partners deny there is a link between its market losses and discussions with foreign banks. They say they have been talking to some institutions for four or five years. “There is a distortion here, at least in the Brazilian press,” says Castanho. “Their false logic goes like this: ‘Well, you had a crisis in October. So, since the crisis, Garantia has been shaken. So they began to talk with foreign institutions since they would like to be sold – a kind of Peregrine type of transaction’. This is pure nonsense. First of all the scale of the losses that we sustained in October was pretty much in line with our models and nothing unpredictable. The probabalities were low but nothing unpredictable from a theoretical point of view. There was no real crisis in the sense that you are being pressed to do something from a financial standpoint…. The globalization dilemma … is one we have been discussing for a long time.”
However, the losses and the culture that created them have narrowed the firm’s options as foreign buyers pause for thought. The Goldman talks are believed to have foundered because the US bank would have imposed tight controls on the high-risk/high-return traders. Other banks too have expressed concern.
Corrado Varoli, head of Latin American M&A for Morgan Stanley Dean Witter, is typical: “Garantia’s trading operation is very large and difficult to assess, difficult to value and difficult to judge where the risks and benefits are. My impression is that the trading operation is the difficulty for any investment bank thinking of acquiring Garantia. The trading operation is very much like a large hedge fund which is leveraged and takes positions. This has paid off handsomely for them in the past but in October they bet the wrong way and had too big an exposure for a bank of their size. It was the kind of position no [global] investment bank would take. Morgan Stanley would never do it.” Morgan Stanley was one of the banks approached by Garantia about a tie-up but has since stated that it is not interested.
CSFB might be a more tolerant master but no global house could take on Garantia without bringing its structure more into line with international norms. At present investment bankers, proprietary traders, sales and research all sit on the same floor – and until very recently asset managers did too. Chinese walls go against the grain of Garantia’s culture, which involves a small group of partners and senior employees from across the bank conferring on key operational decisions. None of the partners working at the bank has a private office and they share secretaries. The ability to move quickly and confidently has enabled Garantia to place leveraged bets in the markets that for many years made it Brazil’s most successful and profitable investment bank – and the most hated. During their winning streaks Garantia traders gained a reputation for being aggressive and cavalier and in the good years they pulled off some spectacular coups.
One in particular came after the introduction of the Real Plan in 1994 when most Brazilian banks bet rightly that the real would strengthen against the dollar. They could arbitrage between dollar and local-currency interest rates (the latter being considerably higher) and pick up currency gains as well. Garantia is rumoured to have made $1 billion out of this trade alone.
A glance at Garantia’s recent income statements sheds a clear light on the firm’s emphasis on trading. In 1996 out of three sources of non-interest revenue, the net trading gain was $218 million, roughly three times the $76 million earned in investment management fees or the $62 million in corporate finance, underwriting and brokerage fees. Even with the disastrous market upsets last year, trading comes out neck and neck with investment management and ahead of corporate finance, underwriting and brokerage.
The proprietary trading culture affects perceptions among domestic as well as foreign firms. Garantia is not popular with its peers or with the authorities. “The bank is not what it was one or two years ago. They have lost a lot of respect in the market and frankly when this thing happened people were filled with glee,” says a banker in Rio de Janeiro, where Garantia first started in 1971. A stockbroker in Sao Paulo, where Garantia moved its head office in 1990, agrees: “Garantia are considered very arrogant and they have a lot of enemies around town.”
Few of Garantia’s critics are prepared to go on the record with their comments. Paul Bydalek, president of the Brazilian rating agency Atlantic Rating, who is not a detractor, explains the situation: “Garantia had built a formidable reputation for success. In any Brazilian trading organization some of the main people will have come from Garantia. The paragon is now tarnished. That’s why people are enjoying it so much.”
It isn’t only competitors who are ready to criticize. Despite the fact that chief executive Claudio Haddad used to work at the central bank and partner Guilherme Arinos is the father of central bank governor Gustavo Franco the bank has occasionally run foul of the authorities.
“Whenever you see confusion in the markets, Garantia is usually at the centre,” says a source close to the central bank. “They always push the rules to the limit. It’s them against the world.”
This banker recalls an incident when Garantia, together with a number of banks and investors, sued the government in a dispute over the inflation indices used to calculate interest rates on government bonds at the time of the transition to the real. Shortly afterwards the central bank removed Garantia as one of the central bank’s forex dealers and Garantia gave up the case. Six months later it was reinstated.
Another banker argues that though Garantia created the model for Brazilian investment banking it became too aggressive in the markets. “If there was a big option trade in the market Garantia would always be on one side,” he says. “They started to challenge the central bank. They tried to play against the market in sensitive times. They were often excessively negative and they could move the market.” The source adds: “Garantia’s heavy selling in the Brady market [last October] pushed it down further.”
And the focus on trading may have led to loss of position in other businesses. As Morgan Stanley’s Varoli points out: “Garantia has enjoyed a position of leadership in Brazil [in the M&A market for example] but it has started to lose that position as the big US banks have come in.” In 1996 Garantia posted fourth place in a table of Brazilian M&A deals having advised on seven deals worth $1.5 billion. But last year it fell to 28th position with its market share shrinking from 15.5% to 5.6% on similar deal volumes, according to US-based Securities Data Company. Last year Garantia also lost its position on the Sao Paulo exchange as the largest broker by volume of shares traded to Banco Bozano Simonsen (though it does some trade through third-party brokers). It remains, however, an impressive performer in emerging-market trading – 14th in the world in debt trading last year, 13th in Brady bonds and 12th in sovereign Eurobonds and globals.
To sell or not to sell
Despite the concerns, the traders – the younger, more active partners – want to preserve the status quo and are fighting a rearguard action against a sale. The theory that the partners are split along generational lines is denied by Castanho and Wright. But it is persuasive, given the realities of pay and power within the bank. Packard admits: “There are always generational issues in any tribe.”
Lemann and other older partners who now work mainly outside the bank, such as Marcel Telles, and Carlos Sicupira, are thought to favour selling; as is Haddad. They are well-established figures in Brazilian finance. Telles is a former head trader at Garantia who runs Brazilian beer company Brahma, in which eight current partners have personal stakes. It is easily the most successful investment made by Garantia partners, largely thanks to Telles’s efforts in modernizing the formerly family-run business. These days Garantia is noted for the gruelling hours worked by executives but, in Telles’s time at the bank, things may have been gentler. He is noted there for telling colleagues: “If you can’t do your work in nine hours then you shouldn’t be working.”
Sicupira runs Garantia’s direct-investment fund, GP. He used to manage supermarket chain Lojas Americanas in which he, Lemann and Telles have stakes. He has a reputation as a tough negotiator. “If you’re sitting on the other side of the table from Sicupira, be careful,” warns a banker in Sao Paulo.
Haddad, a former central-bank director of public debt whose doctorate from the University of Chicago was on the quantitative economic history of pre-war Brazil, took over from Lemann as chief executive in 1994. He has a remarkably low profile for the chief executive of a major independent bank and obsevers say he has made few fundamental changes.
Their reason for wanting a sale is straightforward. Garantia does not reveal partners’ shareholdings but on one estimate the four partners – Lemann, Telles, Sicupira and Haddad – have a combined 60% stake, with Lemann’s share put at between 20% and 45%.
Younger partners – such as head of trading Eric Hime, risk controller Luis Alberto Rodrigues and Fernando Prado, in charge of equities – all in their thirties want to remain independent. And for good reason. Their power – derived from seats on the executive committee – would be diluted and their earnings capacity drastically reduced.
Many of the younger partners have known little else but Garantia in their careers. These include Hime, who joined the bank from school, and Rodrigues, a trained engineer. Prado has a Stanford MBA and is noted for being erudite even in Garantia’s cerebal environment. Analysts who have worked under him say he reads and digests their reports faster than anyone, asks searching questions and corrects their spelling and grammar for good measure. His telephone cord is extra long and he walks around constantly while talking on the phone. He has been cited as a possible future chief executive. All three partners are heavily biased towards trading. All three also sit on Garantia’s powerful executive committee, appointed by Lemann to run day-to-day activities, giving them enormous sway over the bank’s future. None returned Euromoney‘s telephone calls.
The partners and the executive committee decide on the critical decisions that affect an employee’s career. The partners decide about someone becoming commissioned or a partner, the executive committee decide how bonuses are distributed. Former staffers say no-one does any work at the bank a week before the meeting to decide how the half-year bonus should be shared out and afterwards everyone is unhappy no matter what he receives. But they agree that staff staying with Garantia are well rewarded. “Once you are commissioned no-one pays what Garantia does. You have to pay the toll,” says one.
The prospect of assimilation into Goldman Sachs must have been dismal. Although Garantia is said to have been modelled on Goldman Sachs, there are few similarities apart from the partnership structure. In reality the firm is more like Salomon Brothers in its proprietary-trading heyday and a merger with a firm like Goldman Sachs would likely clip these partners’ wings. “They would lose their power,” says an observer.
More important they would lose their money. If the traders are to be stymied, they say, the price worth paying for the Garantia franchise comes down, pushing down the size of the partners’ windfall. And then there is compensation.
Garantia uses a highly skewed compensation system that pays below market levels at the low end and fantastically well at the middle to high end. Multimillion dollar bonuses are commonplace and Hime was reported to have made $23 million one year, a figure denied by Garantia (though market rumours also suggest his personal wealth took a bad hit last October). The incentive for junior staff is the profit-related bonuses they expect to receive as they advance up the ladder.
Basic salaries are low – between $1,500 and $4,000 a month – with no-one earning more than $50,000 a year. But 25% of profits are distributed every six months with the lion’s share (about two-thirds of the pool) going to partners and what the bank calls commissioned staff – that means they get a percentage of the distributed profits. About 70 of Garantia’s 300 staff are commissioned, including partners. This system is unlike other partnership arrangements which tie partners in long-term. At Garantia if short-term leveraged bets pay off, you get paid a lot of money quickly, particularly if you are a trader.
The system is undoubtedly effective when things are going well and has been copied by other Brazilian investment banks. But when profits nosedive, as they did last year, falling from $117 million in 1996 to $12 million, the stresses show – particularly in those departments that feel undue risk taking by the trading operation has cost them their bonuses.
No year-end bonuses were distributed except for token allocations to those in the general pool, which includes administrative staff. As a result Garantia résumés have been flowing more actively than usual in Brazilian financial circles. The bank says it has lost only 10 staff since October across the range of private equity, brokerage and corporate finance. Outsiders say corporate finance is the most vulnerable as Garantia’s fortunes appear ever more beholden to its trading operations. The most high-profile departures were those of Jose Olympio and Eduardo Alcalay, both corporate financiers, who left Garantia to join Donaldson Lufkin & Jenrette in Sao Paulo in February. Olympio was apparently upset at not being made a partner in January.
Acting as a bridge between the generations on the executive committee are Haddad and to a greater extent Wright. Wright, in his mid-forties, came to Garantia from fertilizer company Adubos Trevo and is credited with building from scratch the bank’s equity sales, distribution and research. Former Garantia employees say Wright, who is fluent in English, Spanish and French as well as Portuguese, has better man-mangement skills than his other senior colleagues at the bank. They describe him as a brilliant salesman who could “sell sand in the desert”.
He and Castanho say that differing opinions among the partners are not a matter of age or of conflict between investment bankers and traders. Rather it is a sentimental attachment to a way of doing business that would be lost were the bank to grow or be acquired. He says that traders would get a lower cost of capital if there were a merger and so it could be to their benefit while people who have been at the bank longest have emotional ties to partnership. He agrees that a merger would bring about huge changes in the bank’s organization and the informality would disappear.
Another worry
The biggest risk any foreign buyer faces is that their best assets walk out the door. “Garantia is the most impressive Brazilian investment bank and what you are mainly talking about is people,” says Winston Fritsch, president of Dresdner Kleinwort Benson in Brazil. “Under the enlightened guidance of Jorge Paulo Lemann the bank has excelled at hiring and motivating its workforce. In the current crisis, their single most important challenge will be to keep their ranks together.”
The firm hires only the brightest and best and these are put through their paces to give top performance. Fresh recruits are favoured over seasoned professionals from outside as no doubt it is easier to adapt them to the Garantia culture. Last year Garantia interviewed 700 people and only took on 25. Most of these went through about 12 interviews. The average partner will spend about three hours a week interviewing and Guilherme Amaral Ferraz, who is responsible for foreign exchange and personnel, devotes about 15 hours a week to this.
Successful professional staff are allowed great leeway and the partnership structure and bonus system mean their wealth is on the line if they make a mistake. Garantia’s research team frequently wins awards and even former employees and rivals agree that the bank’s professionalism cannot be faulted. “Anyone working at the bank learns a huge amount from the senior partners. They are highly professional and would never let personal disputes get in the way of professional decisions,” says one.
The work ethic too is absolute. Says one former employee: “Two years working at Garantia is like four years anywhere else.” Prado is reported to have once told colleagues: “Garantia is not a workplace, it’s a religion.” Personal lives are sacrificed there and one former employee says his family came to him to say “thank you” when he quit. This does not suit everyone and some former employees think a shake-up in the way the firm operates would be no bad thing. They characterize the bank as a dog-eat-dog environment in which professional staff toil late into the night desperate to impress the partners. Far from a collegiate atmosphere in which intellectual inquiry prospers, their picture is of a paranoid establishment in which younger members look out for themselves and try to score points off each other at morning meetings. Garantia, they say, is an inward-looking and self-obsessed place. “Research reports are not aimed at the market but at the partners,” says a former analyst.
As Dresdner Kleinwort’s Fritsch points out, Garantia is examining its future at a time of “serious introspection among Brazilian investment banks of what their role in post-Real Plan Brazil should be. The demand characteristics have changed dramatically from the times when Garantia excelled.” Like most other niche players, the bank has to ask itself whether it can remain a profitable boutique when larger domestic and foreign players are using mergers and acquisitions to defend their existing franchises and invade new ones.
In the past Garantia has deliberately acted to make itself unattractive to acquirers. It has used profits to buy stakes in industrial and commercial companies. The early purchases, such as Lojas Americanas (1982) and Brahma (1989) are owned directly by individual partners but in 1992 the bank set up GP to make direct investments such as those in textiles company Artex, cable television company Multicanal (which has since been sold), theme park Playcenter, two supermarket chains which have since been sold and privatized railways. Garantia partners have money invested in GP funds but the GP management entity is owned only by Lemann, Telles and Sicupira.
Wright says that previously competitors to the industrial companies would not be customers of the bank. They feared the partners were too closely involved with the investments to give them fair treatment. This structure in which a partner’s money is held in GP for 10 years has opened the door to these customers.
The acquisition of Lojas Americanas was a dramatic affair. It was bought through the stock exchange using several brokerages to acquire stock so as not to attract the attention of the owners. Companies are rarely bought this way in Brazil and voting stock is normally closely guarded by family owners.
But Lojas Americanas has not performed well recently. Analysts say it has not adapted to the new consumer market in Brazil.
“The amount of that investment [in GP funds] and the amount we [partners] can make on that investment is clearly much smaller than what we can get in the bank,” says Wright. “In my decision-making process I’m not at all interested in favouring any company in GP because that may give me a profit somewhere down the road. I’m more interested to see that the six-monthly bonuses paid at Garantia are as high as possible.”
Wright says one reason for diversifying this way is to stop the Garantia share price from getting too high and making it difficult for new partners to buy in. Market observers believe another explanation for purchasing Brahma and Lojas Americanas was that their considerable cash flow could be invested through the bank.
Castanho refuses to admit that the bank is for sale acknowledging that Garantia’s speed in operational decisions is in marked contrast to its tardiness in strategic moves where the partnership structure and the need to reach a consensus slow things down. “There is no decision that is taken by vote or by proxies or whatever auctioning process that could be conceived,” he says. “Every decision is a consensus decison among the partners. It doesn’t matter if it’s a very seasoned partner or a recently made partner – all the opinions are taken into consideration and it’s mandatory to have a consensus for all strategic decisions. Even at the beginning when Jorge Paulo theoretically had 100% of the institution, as far as I recollect he never exercised any controlling voting power or anything like that and today there is no controlling stake at Garantia.” Castanho adds: “There is no deadline [for a decision]. It could very well be that we choose to remain independent and retrench to some core competences [rather than taking a global partner]. The decision is still open.”
But Garantia has already hired US M&A specialist Gleacher NatWest to act on its behalf in sales negotiations and the price is thought likely to be around $1.5 billion. The young Turks may want to keep their cash machine running their way but, in the words of one seasoned observer, “If Jorge Paulo Lemann wants [a buyer] to come then it will happen.”
If it does, Castanho and the other partners could do worse than former alumni. Dick Thompson and Eduardo Moura became farmers. Luiz Cezar Fernandes left in 1982 to set up Pactual, now one of Brazil’s foremost investment banks and also a partnership. Three former partners – Diniz Batista, Jose Antonio Mourao and Clovis Macedo – started the Rio-based investment bank Modal while Bruno Rocha started asset-management company Dinamo. The culture will live on.
