CHAPTER 2

British Gas, Detroit, 1956

By the late 1970s, Bill Hambrecht and George Quist had made a name for themselves bringing small companies to the market. Though Hambrecht & Quist was never guaranteed business from the companies the two men invested in, their stakes gave the firm a stable base of potential clients.

Larger companies still chose the larger investment banks like Morgan Stanley and, to a lesser extent, Goldman Sachs. Morgan Stanley had been quicker to see the vast money to be made in the technology industry. In 1975 the bank hired Ben Rosen, an electrical engineer with a degree from Caltech and an MBA from Columbia Business School, to analyze emerging technology companies. Rosen authored a newsletter and held a conference, establishing himself as an enthusiastic electronics analyst focused first on semiconductors and then microcomputers.

But it was a young venture partner at Hambrecht & Quist, Larry Moore, who convinced his bosses to invest in one of the region’s early personal computing pioneers. Founded by Steve Jobs and Steve Wozniak, Apple Computer soon generated buzz thanks to a Jobs-led marketing push that established the firm as a designer of handsome machines for educational institutions and creative types. Hambrecht invested for a small stake, joining investors including Arthur Rock, Intel’s Andrew Grove, and Sequoia Capital, the venture capital firm founded by semiconductor pioneer Don Valentine.

In 1980, Apple needed money to fuel its growth, and early investors wanted a chance to cash out. The company interviewed investment banks for the job of selling shares to the public, ultimately settling on Morgan Stanley. It was something of a surprise that Jobs also chose Hambrecht & Quist and insisted that the smaller bank be given an equal role to that of Morgan Stanley. “He was deeply loyal to people that supported him early,” Hambrecht said later. “We got our role as co-manager in that offering, I think, primarily because Steve just insisted on it. And not only insisted on us being there, but insisted that we be treated as an equal partner.”

The Morgan Stanley/Hambrecht & Quist partnership wasn’t as strange as it seemed. As an undergraduate at Princeton, Hambrecht had been friends with Dick Fisher, the Morgan Stanley partner overseeing the firm’s equities business at the time of the Apple IPO. Fisher had already gone to Hambrecht a year or so before and asked for help getting Morgan Stanley into the business of underwriting technology firms.

Other large firms, sensing that there was money to be made, also looked at breaking into the burgeoning scene. When those firms approached Hambrecht for his advice, he asked them for a list of the companies that interested them. Almost invariably, they would tick off the top firms by revenue, showing little understanding of or interest in the smaller firms with promising technology that might become future industry titans. But when Hambrecht asked that same question of Fisher, the banker gave him a list that showed real insight. Apple was on it.

“I remember looking at his list, thinking, Okay, he’s the smart one. He’s the one that’s going to win,” Hambrecht recalled. The other bankers “were looking for volume, where Dick obviously had people that were looking for the real technology leaders,” he added.

At that point Morgan Stanley had so much power that it would refuse to co-manage an offering with another firm. You did it their way, or they wouldn’t do it. “They dominated the game,” Hambrecht said.

Jobs forced Morgan Stanley to break that rule when he insisted that they work with Hambrecht & Quist on the Apple transaction. In another first, they also agreed to evenly split the fees from the deal. Fisher’s colleagues gave him a hard time, because the bank could have demanded a much bigger slice. But what Fisher realized, which Hambrecht would only later come to see, was that there would be a huge amount of wealth creation generated by the Apple transaction. He would split the fees on the IPO underwriting and then clean up when it came to managing the money for the founders and employees, all of whom became wealthy. Those were services that Hambrecht & Quist couldn’t even offer. Fisher “said that he looked at a company like Apple and realized that Apple would never be a very good investment banking client for them because it was such a cash generator,” Hambrecht said later. “Once they got the IPO done, they really didn’t need any more money.” In other words, Morgan Stanley couldn’t count on being hired again by Apple, because the company didn’t have much use for its services.

Before he could sell Apple, Hambrecht needed to wrap up the IPO for Genentech, a four-year-old biotechnology company. Hambrecht & Quist had an investment in that firm too. It would be a busy second half of the year for the bank, now in its twelfth year.

Genentech was a biotechnology startup cofounded by a venture capitalist at Kleiner Perkins, one of the valley’s first big-time VCs, and a scientist and pioneer in recombinant DNA technology. Together the two men had led Genentech in 1978 to its first significant breakthrough, synthetically produced human insulin.

In mid-October 1980, Hambrecht & Quist sold Genentech shares for $35. The shares quickly surged by about 150 percent to as much as $88 before settling at $71.25, for a 104 percent gain, in what the Wall Street Journal called “one of the most spectacular market debuts in memory.”

Despite Genentech’s splashy showing, investor attention soon turned to Apple. CEO Steve Jobs had built Apple into a computer maker that captivated the attention of the investor community by focusing on the look of the device and the ease with which it could be used. Jobs later said that he was inspired to strive for perfection by the Beatles’ John Lennon. Media outlets debated the merits of the offering throughout the fall. “Not since Eve has an Apple posed such a temptation,” the Wall Street Journal declared. On the Monday of the week the IPO was scheduled, Jobs and millions of others lost an inspiration when a Beatles fan shot and killed Lennon outside the courtyard of the Dakota, his Upper West Side residence in New York City. The tragedy cast a momentary pall over the offering.

When the company finally settled on the price and completed the offering, it became the largest IPO since the Ford transaction in 1956. Shares began to trade on December 12, a rollicking day at Apple’s Cupertino headquarters. One executive brought in cases of champagne, while other employees debated the construction of a large thermometer that would show the mercury rising as Apple’s share price rose.

The offering created dozens of instant millionaires within the company, largely due to the stock options they’d been granted. By one estimate, there were more millionaires created in Apple’s IPO than in any other IPO in history to that point. Some percentage of those employees brought their wealth to Morgan Stanley to manage, supporting Fisher’s larger plan.

With Apple’s and Genentech’s IPOs putting it on the map, Hambrecht & Quist bred competitors. Soon three regional firms patterned themselves after the early pioneer—Alex. Brown & Sons; L. F. Rothschild, Unterberg, Towbin; and Robertson, Colman & Stephens—and showed the wisdom of catering to the technology industry. The four soon earned the moniker “Four Horsemen.”

Much larger investment banks also began to take notice of how Silicon Valley was growing. By then, in the early 1980s, Morgan Stanley and Goldman Sachs had followed the lead of the smaller brokerages and built out large research arms they used to market ideas to institutional investors and collect trading commissions as payment. As the investment banks consolidated power, so too did the institutional investors. Between 1980 and 1995, the number of mutual funds went from 564 managing $135 billion in assets to 5,724 managing $2.81 trillion, according to a later Investment Company Institute report.

The decade would see Morgan Stanley cede its underwriting dominance to Goldman Sachs. In 1984, a forty-one-year-old trader at Goldman Sachs named Eric Dobkin was promoted to oversee a banking unit that underwrote stock issues. At the time, Dobkin’s boss, Jim Gorter, was looking for a way to improve Goldman’s ninth-place ranking. A confident banker fond of pinstripe suits, Dobkin had been selling large blocks of already public stock to mutual fund clients. He came to an insight in the shower that changed the landscape of Wall Street. Up to that point, trading desks staffed by executives who enjoyed liquid lunches sold IPOs to a largely retail client base by holding a cocktail hour to market the issues. Company management told its story to retail brokers, who went out and sold lots of one hundred to two hundred shares to individual investors.

Dobkin realized that the mechanics of how he was marketing his block trades to large investors could be used to sell IPOs. When a big block came in to sell, Dobkin would turn to the Goldman analyst covering the stock and ask what he thought of it and who might want to buy shares. Couldn’t that analyst play a similar role in IPOs, visiting investors and telling the company’s story?

Public offerings had other advantages too. The SEC required firms to file a prospectus, which was largely considered a legal document. Dobkin figured he could use the business details contained in it to craft a story about how a company was special. Make it into a marketing document. And if Dobkin could get management teams to visit institutional investors in their offices, or at least their home cities, the investors could hear the company’s story straight from the people running it.

The following year, Dobkin created Wall Street’s first investment banking unit devoted to underwriting stock issues and began catering to the likes of Fidelity, T. Rowe Price, Capital Group, and Janus. His timing couldn’t have been better. Just as he was creating the division, British prime minister Margaret Thatcher began selling off large government-owned gas, petroleum, and telecommunications concerns. Other countries were doing the same, which required their chosen underwriters to cast an increasingly wide net for investors with the cash to buy up the issues. Capital markets were going global and becoming increasingly integrated.

Dobkin traveled to Washington frequently to visit the Securities and Exchange Commission, where he huddled with government officials to discuss possible changes to the regulations. The SEC had been created in 1934 by Franklin Delano Roosevelt to oversee the financial markets after the 1929 crash and the onset of the Great Depression. It was charged with watching out for investors and acting as one of the chief regulators of U.S. financial markets. Its lofty mission made officials wary of bending or rewriting rules that had been laid down over the course of decades.

But regulators were also cognizant of being outmaneuvered by officials in other countries and losing clout, and they were open to Dobkin’s entreaties to rationalize U.S. regulations when dealing with these countries. Sometimes that meant translating prospectuses into three or four languages. Other times it meant joining with national securities regulators elsewhere to harmonize rules around pricing and information dissemination.

In those days, Dobkin would often fly the Concorde, the supersonic passenger jetliner, between New York’s John F. Kennedy International Airport and Heathrow Airport in London. He could get on the plane at 1:45 p.m. in New York, land at 10:20 p.m. in London, and get a couple more hours of work in before sleep. The following day, he could do breakfast, lunch, and dinner meetings. He could then wake up the next morning, take a 10:30 flight from London, and be back in New York in time for the start of the workday.

“I could spend literally a day away from the office, do a boatload of meetings and dinner and all, and get back to New York in time for business the following day, or I could spend the next day and go for two days,” Dobkin said. “It was just extraordinarily helpful.”

The travel wasn’t luxurious—the seats were narrow and stacked four across, with an aisle in the middle—but it was fast. And that was the idea. The quick trip allowed Dobkin to visit clients in person, the preferred method for investment bankers who felt it was better to develop relationships in person than on the phone. With easy access to London, Dobkin could meet face-to-face with British officials tasked with choosing the investment banks that would help them sell the government’s assets.

When Dobkin began his quest to climb up the league tables, which ranked companies by fees, deal volumes, and other yardsticks, Morgan Stanley was a powerful presence at the top of the underwriter rankings. The investment bank, which had been formed by two J.P. Morgan & Co. partners in 1935 after passage of the Glass-Steagall Act, had an early leg up on work with the British government.

In 1984, Morgan Stanley made a series of mistakes that opened the door for Dobkin and his Goldman Sachs colleagues. Morgan Stanley led the first privatization of British Telecom (BT), handling the distribution of shares to U.S. investors. In those days, UK rules required banks to hold on to the shares for more or less two weeks before passing them out to investors, meaning they’d be on the hook for any losses or gains.

In the United States, banks weren’t taking much risk. They’d price a deal once they’d built a book of investors and quickly distribute the shares. If they couldn’t sell the entire thing, the bank might hang on to a stub of shares. Many bankers considered that a reasonable risk to take. But Morgan Stanley refused to take the risk of holding the BT shares for weeks, and the Bank of England had to step in to backstop the position. British government officials weren’t happy.

Goldman’s rival made a second mistake. Due to a variety of technical factors, the BT shares were expected to be popular in the UK, and prognosticators believed that the stock would perform well on opening day. When it did, many of the U.S. investors who had received shares from Morgan Stanley turned around and sold them back into the UK market, in a process known as reflow. The result was a more concentrated base of investors than the UK government wanted.

Goldman got its big break two years later. In March 1986, the investment bank underwrote the IPO for Microsoft, the software pioneer founded by Bill Gates and Paul Allen. Goldman and H&Q competitor Alex. Brown & Sons co-managed the sale of 2.8 million Microsoft shares for $21 apiece.

Later that year, Goldman won the job of advising the Thatcher government on the privatization of British Gas. Selected as the lead underwriter for the portion of the deal that would be sold to U.S. investors, Goldman unloaded $8 billion in stock. It was the largest UK privatization and the largest equity offering ever.

In 1987, the investment bank once again outmaneuvered Morgan Stanley for the mandate to help the UK sell off its remaining stake in British Petroleum, a $12.4 billion deal that set a new record for the largest UK privatization. The bank was left with a large underwriting loss when it got stuck with BP shares after the market crashed on October 19, 1987, a day later called Black Monday.

It was UK privatizations more than anything that established Goldman’s name and propelled them to the top of the underwriting rankings, Foerster recalls. “In the early eighties, John Whitehead and others at Goldman Sachs would call Bob Baldwin and Fisher at Morgan Stanley” and ask to get onto deals, Foerster said. But as the decade progressed, it became harder to persuade CFOs to hire an underwriter other than Goldman, he recalled.

“They all wanted Goldman because they wanted to be able to go to the CEO and the board and say, ‘I got Goldman to run that IPO,’” he said. “When they got the BP business away from Morgan Stanley, and Eric Dobkin was key to that, that was a huge coup for Goldman.”

During this time, bankers continued a trend spawned a decade earlier, when ERISA helped give rise to the growth in mutual funds: they moved away from marketing to thousands of retail brokers who held direct relationships with the masses of individual investors scattered across the country and instead largely engaged with a growing class of professional investors.

Such investors had the education and the knowledge to evaluate companies coming to the market for the first time. By focusing on fewer investors with more buying power, bankers were able to better understand each investor’s individual style. And they learned how to fashion their pitch based on the preferences of each. Once the bankers spoke to enough investors, they could pool that feedback and use the common attributes to create a specific marketing and pricing strategy.

Dobkin came to believe that IPOs were exercises in psychology as much as they were capital raising. If that was true, a well-orchestrated marketing effort led by an analyst who was an expert in his field and bankers who were familiar with a broad investor base, he thought, could successfully sell new issues.

Goldman established a model that roughly exists in form and function today. The bankers created a research note, effectively an internal memo, that summarized the deal and got distributed to the sales force. The bankers then held a conference call, typically less than an hour, to answer any questions and brief salespeople on the deal.

It was then up to the salespeople to call the mutual funds that were their clients and talk to them about the deal. While Goldman did have wealth managers, those clients would be individuals and families, and that became a smaller part of the process. Retail went from getting 50 percent of Ford’s IPO in the mid-1950s to getting 15 percent or less of deals that Goldman would bring public in the 1990s and 2000s. To the bankers, this was simply a reflection of a change in how securities got bought and sold.

As the assets held by mutual funds increased, their managers gained a level of power that they quickly learned how to use. It was common in the 1990s, Foerster recalled, for firms like Fidelity to withdraw from an IPO unless they got a discount to the fair value. If that didn’t work, the money manager would threaten to take its trading business elsewhere.