The day after Morgan Stanley Dean Witter started the roadshow for Healtheon – its fifth internet initial public offering of the year – the leading global investment bank in technology investment banking suddenly pulled the plug. Although the firm says it had commitments from enough institutional investors to go forward, the markets suddenly nose-dived on the news that Long-Term Capital Management was sinking. Internet IPOs are blatantly speculative, and Healtheon’s aftermarket performance in early October was difficult to predict. So Rex Golding, Morgan’s co-head of the global technology group, advised a private placement instead.
“We hit terrible market conditions,” says Golding, who had been worrying about the environment for IPOs ever since the summer slowdown, when scores were pulled, and August 31 when there was a sell-off of even big-cap tech stocks such as Microsoft, Intel and Cisco. By late October, however, the markets rebounded, and individual investors propelled internet stocks to record heights. “The markets are challenging for a finance professional,” admits Golding. The heavy retail buying, often by young, online investors who buy “anything ending in a .com,” has “disintermediated the professional”, he complains.
Despite the gloom about Russia, Brazil, Japan and Y2K – a technology boom continues. The frothy internet stocks that dominate are enough to unnerve the most sanguine bankers. They know, as Morgan internet analyst Mary Meeker puts it: “This party’s got to end some day.” Nevertheless, investment banks are clamouring for business – none more than Morgan Stanley.
Bankers say the stakes are just too big to ignore : “Technology today is analogous to the railroads and steel at the turn of the century,” says Joseph Perella, managing director and worldwide head of investment banking at Morgan, which made its mark as the leading bulge-bracket firm in technology in 1980 with its IPO for Apple Computer. Despite the defection of key bankers to Deutsche Bank two years ago and keen competition from arch-rival Goldman Sachs and new efforts by such institutions as Merrill Lynch, Donaldson Lufkin & Jenrette and Bear Stearns, Morgan’s market share has increased.
Technology investment banking may seem an insignificant part of Morgan Stanley’s overall activities. But it is probably its highest-profile business. Morgan’s merger with Dean Witter in 1997 helped spread the word through some 4 million retail accounts, as has its own online brokerage service.
As an industry group, technology accounts for some 10% of Morgan’s investment banking revenues and about the same in profits. At the same time, notes Perella, “it’s probably the highest-margin business we have.” After all, it’s primarily equity underwriting and M&A – the twin pillars of fat fees. It is the one business that has been impervious to the market corrections that have hurt profits elsewhere.
And Morgan’s dedication to it is fanatical – clients are deluged with analysts’ reports and pitch charts on market share. “We’re a phenomenally paranoid group. If we don’t think about it and obsess about it, we may have a mis-step and somebody can exploit it,” says Ruth Porat, managing director in equity capital markets in New York, who specializes in technology. Her attitude is a far cry from what insiders reckoned was institutional complacency, if not arrogance, in the late 1980s and early 1990s. During the 1980s Morgan refused to let Salomon Brothers co-lead an IBM debt deal.
Since then, Morgan Stanley has re-emerged under former fixed-income salesman John Mack. Mack took over as president in 1993, orchestrated the merger with retail giant Dean Witter in 1997 and propelled the firm to the top tier of the global bulge bracket. “He’s energized the place,” says Porat, who rejoined Morgan after following former president Robert Greenhill to Smith Barney in 1993.
Morgan’s 1995 IPO for Netscape Communications established the new medium and technology investment banking, long a niche business of the West Coast, across the US investment community.
Now virtually every financial institution that is hungering for the business, from Merrill Lynch, to Bear Stearns and DLJ, looks on Morgan as a role model. Morgan was the only firm that never wavered, even during the 1980s tech slump.
Morgan survived, and even thrived on, a failed palace revolution by Frank Quattrone, its then technology head and leader of the Netscape deal, who left for Deutsche Bank in 1996. Quattrone is now at CSFB with his team of former Morgan bankers.
Quattrone’s complaint
Quattrone had long complained that his team’s growth warranted more resources than management would provide, and it is ironic that his departure forced Morgan’s hand. It restructured its technology business into a stronger, more global operation that could draw on all the strengths of the firm instead of being controlled by one strong-willed banker. “We didn’t realize how huge the market opportunity was,” admits a relocated New Yorker who joined what was left of the team. There are now three co-heads of the technology group, including one in London, and an M&A team headed by one of the most seasoned bankers at the firm.
Since 1996, Morgan has led the technology category in nearly all the global league tables, from IPO underwriting, to secondary offerings, to M&A and this year, convertibles – zero-coupon converts are a speciality for the cash-starved young companies. Competitors reckon one of Morgan’s key strengths is its technology analysts. “The banking landscape out here is determined by research, and a strong firm supporting it,” says another technology banker.
Morgan has also benefited from the waning influence of the Silicon Valley boutiques: BT. Alex. Brown, Hambrecht & Quist, Robertson Stephens and Montgomery Securities. All but H&Q were purchased by commercial banks last year. As the business matures and companies merge or branch out internationally, they look to larger investment banks with greater resources. Golding points out that $300 billion market cap companies such as Microsoft, Cisco, Lucent, Oracle and Intel need the financial services that can only be offered by a bulge-bracket firm.
But Morgan’s gain also springs from instability at the superboutiques. For example, George Bell, the president of internet search engine Excite, taken public by Robertson Stephens, says he turned to Morgan for a secondary offering in part because Robertson was being sold to Bank Boston at the time, after a brief ownership by BankAmerica.
Deutsche Bank’s DMG Technology group was making inroads until early this year, when Quattrone and his team went to CSFB. Competitors and clients point to a famous “trust me” letter Quattrone wrote to clients when his departure was rumoured. Quattrone promised it wouldn’t happen, and now clients say his credibility has suffered. (Quattrone couldn’t be reached for comment.)
That leaves Goldman, which has been working hard at catching up with Morgan since 1986, when it took Microsoft public. Goldman also boasts specialist bankers and analysts and will move its tech HQ from San Francisco to Silicon Valley’s Menlo Park next year, where Morgan has long been located. There Morgan has readier access to tech firms and the venture capitalists that back them.
League-table tussle
Morgan claims it has extended its lead against Goldman this year, with $2.4 billion, or 40% of global IPOs (in dollar value) to Goldman’s $0.9 billion, or 15% share and $51 billion, or 42% of pending and completed M&A transactions to Goldman’s $19 billion, or 15%. Goldman admits Morgan will come out on top in equity underwriting and completed M&A deals this year but says that a three-year ranking puts Goldman in a better light. Goldman bankers also stress some of Morgan’s lead in IPOs comes from one deal: an $800 million IPO for UK company Equant, in which Morgan Stanley also invested.
Morgan’s strength in Europe goes a long way towards explaining its rising market share. Now that European equities have boomed, and even IPOs of small companies are attractive, Europe accounts for 15% of Morgan’s tech business, says Dhiren Shah, one of the group’s three co-heads.
Goldman offers its own three-year tech investment banking rankings that show it on top in IPOs and convertibles. Rankings are easily manipulated by what’s put in, or left out – Goldman’s rankings are domestic only, and it counts co-leads and some telecoms deals, which Morgan does not – and they can easily be skewed by one big deal. “On any given day of the week, one of us is winning and one of us is not winning,” says Golding. Goldman points out that it lead-managed more of the hot internet IPOs, including the best performer, Yahoo! (Morgan turned down the offering, which occurred shortly after the Netscape’s in 1995: “We kick ourselves for that,” admits a Morgan banker.)
Internet IPOs may be hot now, and Morgan is no doubt smarting from Goldman’s lead there. But it reckons it has spread itself more evenly among products and types of companies. In theory, that should make it less vulnerable to the internet bubble.
For some time, Morgan has viewed M&A as the biggest technology growth opportunity. As a result, when Quattrone took the Silicon Valley M&A team with him, the firm quickly dispatched its most senior M&A banker, Charles Cory, to Menlo Park. With a background in telecoms, media and pharmaceuticals, and clients such as AT&T, McGraw Hill, Reed Elsevier, and Viacom, Cory quickly solidified Morgan’s strength in M&A.
Morgan has won the mandates for most of the industry-defining mergers in the sector. This year, it was an adviser in eight of the top 10 global M&A deals. As the industry matures, mergers are getting larger, and Cory expects even more consolidation. Such big deals as the $9 billion merger of Bay Networks and Nortel, the $8.6 billion Digital/Compaq merger, the $6.6 billion US Robotics/3Com merger, the $4.4 billion America Online/Netscape deal or the $3.5 billion Cascade/Ascend union are typical of what’s to come. Morgan was on one side of all these deals.
Morgan’s client courtship is intense. “fie overkill on customer focus,” says Michael Grimes, co-head of the West Coast technology group, offering a list of clients that have switched from other firms this year: Excite (from Robertson Stephens), Dell Computer (Goldman Sachs), Hewlett-Packard (Goldman), Amazon.com (DMG Technology).
The team was quickly rebuilt after Quattrone left. New York-based James Liang, who had been number two under Quattrone, called Golding, who he had worked with at Salomon in New York in the 1980s. Golding had been in California for a decade, first at Salomon, then as a partner at what was then Volpe Welty and finally at a start-up, 3DO, where Golding grew closer to the movers and shakers in venture capital, Kleiner-Perkins. K-P had backed Netscape and 36 other tech companies Morgan has taken public. Golding and Liang became global co-heads with Shah, a Morgan veteran who was based in London.
New York exports
Quattrone had taken the entire M&A team, so Morgan quickly shipped out Cory and others from New York. Long-time Morgan banker Paul Chamberlain, who got to know the tech clients through his work with equity capital markets in New York, also relocated to become co-head of West Coast technology with Grimes and is also a managing director. Within 30 days, recalls Grimes, “all of a sudden we had a bigger team.” Now two Menlo Park offices house 125 employees.
Quattrone had been close to one of Netscape’s founders, James Clark. So when Mack came out to survey the new group, Chamberlain set up a meeting with Netscape CEO Barksdale and the two hit it off. “Netscape was a high priority for us as were a lot at that time,” recalls Chamberlain. Since then, Morgan has been Netscape’s sole investment banker, through two secondary offerings and culminating in the deal with AOL.
In what Morgan bankers call the early post-Quattrone days, Ingram Micro was another client wooed incessantly. It was in the midst of putting together an IPO, for which it had chosen Morgan, when Quattrone left. “They were scared to death we’d go over with Frank to DMG Technology,” says Michael Grainger, vice-president and CFO for Ingram Micro, which was spun off from privately held Ingram Industries, whose banker was Goldman. In the end Ingram Micro decided to stay with Morgan.
Competition had been intense for the $425 million IPO. Grainger says he chose Morgan for the deal because its presentation “had a substantive feel as opposed to a sales feel. You felt there was more meat on the bone.” As for the parent company’s banker, he says: “Goldman has a good reputation in technology but they have not delivered. I think they know it.”
Since then, Ingram Micro has used Morgan abroad in several acquisitions and also tapped it for a zero-coupon convertible deal earlier this year. While other banks, including DMG and Goldman, vied for the convert deal, only Morgan suggested getting a debt rating before going on the roadshow for the offering. Morgan debt analysts’ relationship with the rating agencies paved the way. It may not be in the best interests of investors for analysts to cosy up to clients, but that’s the prevailing wisdom on Wall Street., and few practice it better than Morgan. Grainger says the analysts coached him on how to respond to hours of grilling by the agencies. As a result, Ingram Micro became the first in its business to get an investment-grade rating and the deal sold at a 60% premium to the stock price. “It really rattled the market it was so revolutionary. I give them a gold star for that.,” says Grainger.
Wall Street veteran Perella notes that things have changed since the Quattrone days. “Individuals matter less and the team matter more as the business becomes more institutionalized,” he says. Former Morgan bankers contrast that with their experience at other Wall Street firms. At Smith Barney, for example, “if there was a weak link in an M&A deal someone was doing, they had to fix it themselves. There was no-one else,” says a banker. Those who left for DMG were equally frustrated, and when the group moved, en masse, to CSFB this spring, a few tried to come home to Morgan. But in vain: “It wasn’t personal, but we didn’t need them any more,” says a Morgan source.
At Smith Barney, retail distribution was another problem. While Morgan had feared Smith Barney’s network of brokers would give Greenhill a competitive edge, bankers there quickly discovered that the Smith Barney brokers had been burnt so many times in by crummy Smith Barney offerings that they refused to touch anything coming from corporate finance.
Since then, Morgan Stanley has hooked up with its own retail distribution force, with much better results. Chamberlain, who previously had Porat’s job in equity capital markets, says he long ago knew how powerful the retail sales force could be. Equity capital markets is where the institution feels out investors on offerings and tests pricing as the roadshow moves along. Pre-Dean Witter, bankers like Chamberlain looked enviously at Merrill’s success in landing privatization mandates worldwide based on its retail distribution. But they weren’t quite prepared for how powerful a force retail would become in technology, especially for internet companies. “Dean Witter has been a tremendous success from the technology banking perspective,” says Golding.
Institutional predominance
The most important buyers of tech IPOs are still institutional investors. It’s simply easier to build a book based on a few investors bankers know than to depend on anonymous retail investors. Morgan even has a dedicated tech sales force, immersed in the technology industry, who sell only to these buyers – a strategy that Merrill Lynch says it is adopting in its current build-up.
Historically, tech stock ownership became split 50-50 between institutional and retail investors as the institutional investors – the price makers – sell out to retail – the price takers, over time. With many of the top institutional buyers becoming skittish about the high prices of internet stocks, and the retail appetite seemingly insatiable, that time frame has become compressed. Within a month, the split has become 50-50 and by six months, it’s 80-20 in favour of retail, says Golding.
Porat says Morgan doesn’t place much of an IPO into the Dean fiitter retail accounts even though they were “starved for product” before hooking up with Morgan Stanley and would take as much as the bankers would give them. Today, the retail allocation is 25%, up from 10%. Because retail distribution is so important, she says, “you have to protect the channel”. In other words, as she learned at Smith Barney, long-term it’s not wise to dump junk into retail hands. Even more important than the IPO placement is the fact that the Dean fiitter brokers will be spreading the news to their 4 million accounts after the IPO and talking up the analysts’ picks.
Bankers have long argued that they can get retail distribution through a syndicate, and obviously Goldman has no problem landing internet IPOs without a retail arm. But that distribution becomes even more important during a secondary offering, which may be one reason Morgan Stanley outdistances the competition in secondaries as well. This year, Morgan Stanley had a 26% market share in follow-on offerings totalling $2.6 billion. Even boutiques like Hambrecht & Quist see retail as more critical; H&Q recently hooked up with Charles Schwab so it could market its offerings to individual investors.
According to Chamberlain, the ability to sell to a retail system in a secondary offering “changes the competitive nature in pricing dynamics” – in other words, clients will get a better deal. The reason, he says, is that the stock is already liquid and there is a benchmark for its price. By contrast, an IPO is less price sensitive, and the underwriter has more leverage. “In a secondary, it’s like five-card poker, with two cards of the dealer’s hand exposed. In an IPO, the underwriter has all five cards.”
Since institutional investors already own the stock, “you don’t want them to exert price pressure. They will want a discount”, he explains. Having ready access to another group of investors, who by their very fragmented nature are less able to exert price pressure, ensures a better price for the client.
“With Dean Witter, the capacity for them to drive retail is much higher than in the past, and internet stocks are largely retail,” says Excite’s Bell. That’s one reason Excite opted for Morgan Stanley when it did a secondary last year. Another attraction was Morgan’s strong internet research. “They’ve developed a good following around Mary Meeker, and we were desirous to make sure the coverage was strong.” Excite, as it turns out, was the one stock Meeker upgraded after the tech stocks crumbled during July and August.
Meeker, the self-described Grandma of the internet – she is 39 years old and covered the PC industry in the 1980s – says she recalls the day Netscape went public in 1995. On vacation in Amagannsett, Long Island, she was rereading one of her favourite books, Charles Kindleberger’s Manias, Panics and Crashes, the classic on financial bubbles. Inside the cover she wrote “Summer, 1995, Netscape just went public: Can it get any more speculative than this?”
It could. Since Netscape’s debut, there have been more than 80 internet IPOs. In another huge research report published in May (before the stocks’ recent run-up), Meeker noted that Yahoo! was up 1,787% since its IPO, @Home was up 226%, Netscape was up 109%, and Amazon.com had risen by 369%. So far, all her stock picks have traded above their offerings (again with a brief exception for Netscape).
She’s a believer
Like all the techies at Morgan, Meeker is a true believer that the internet will change everything. She hasn’t put out any “sells” on the stocks. That rating no longer exists at Morgan – nor elsewhere on Wall Street. Indeed, institutional investors know that analysts have become part of the investment-banking machine and look to them for insights, not tips. While not putting any stocks on a hit list, she thinks a 25% decline in internet stocks would be healthy. The prices, she says, assume flawless execution of a company’s strategy as well as tremendous growth in the internet.
In contrast with Morgan’s caution, Goldman has done more internet IPOs this year, even though at least one, Evolving Systems, collapsed as its first-quarter numbers disappointed investors. Morgan argues that Goldman has taken a “portfolio” approach, assuming the winners will offset the losers.
Morgan’s tech team suspects that when the internet IPO craze burns out, there will still be work – in M&A. Netscape is a case in point. After an assault on its market share by Microsoft, its Morgan bankers began looking at strategic options and merger partners. The outcome was the $4.4 billion AOL-Netscape deal, which includes a side-marketing arrangement with Sun Microsystems. Cory terms the combined entity a “synthetic IBM”. Says Meeker: “AOL-Netscape set the stage for a lot of consolidation.”
