CHAPTER 3

Netscape Communications, Mountain View, 1995

As the power of the money managers rose, so too did the influence of the analysts, the men and women in charge of delivering new investment ideas and the trading revenue that would result. Ben Rosen’s influence had helped Morgan Stanley win the Apple IPO. It was just one example of how analysts trusted by investors could have a large influence on whether money managers bought the shares of a particular company.

Wall Street research analysts had to keep pace with the intelligence and training of the portfolio managers, and the investment banks soon turned to business schools to hire analysts. The money and prestige that the banks could offer to promising recruits soon created an advantage over the smaller research shops that had been first to the business model.

“Institutional investors had the ability to vet IPOs, read the prospectuses, do some earnings modeling, compare it to the models of analysts,” Foerster said. “As the SEC loosened the restrictions on an analyst to make projections and to do forward modeling, retail brokers on balance had no ability to do that. They didn’t have the time to do it, they didn’t have the skill sets to do it, and most individual investors had neither the time nor the skill sets to do it either.”

That also meant that bankers who were underwriting stock and bond issues for those same companies came to rely on the analysts to help them sell the companies’ stories to institutional investors. To sell the stories, though, analysts needed to be bullish on the companies’ prospects.

Investors, in turn, would seek out the smartest analyst on a particular stock to help them understand its prospects. If a bank employed that analyst, it would mean more trading business from investors who had read the analyst’s research. And it meant investment bankers could offer a more compelling case to potential clients making a decision about which bank to pick for a stock or bond deal. If an analyst had a loyal following among investors, it became that much easier for the bankers to sell the security.

The growing importance of analysts also gave them more power, and placed them between company executives wanting positive spin at the investment bank they’d hired and investment bankers who wanted particular analysts to offer their rosy projections in pitch meetings to win the deal. Once the deal was won, analysts could be discouraged from tarnishing the company their colleagues had just underwritten with a negative opinion.

“Equity research became so powerful,” Foerster said, recalling an example to prove his point.

In 1987, PaineWebber’s transportation banker, Joseph Steuert, and the firm’s top-rated railroad analyst, James Voytko, almost came to blows over the latter’s refusal to improve his numbers in order to win underwriting business, Foerster recalls. PaineWebber was pitching to underwrite the IPO for Consolidated Rail Corp. (Conrail), the successor to a number of railroads that went bankrupt in the 1960s and 1970s. To win the deal, Joe Steuert believed that the firm needed to come up with a particular valuation for the railroad. That was the analyst’s job. “We had a very headstrong head of the transportation group with PaineWebber, a very talented new business guy, and we had the number one analyst,” said Foerster, who was then head of stock underwriting at PaineWebber. “The head of the corporate finance transportation group’s putting pressure on the analyst.” Foerster recalled Steuert saying, “‘You’ve got to come up with this multiple or we’re not going to get on the cover of the document.’”

“I can’t do that,” Jim Voytko responded. “I won’t do that.”

Foerster recommended that the team fly down to Washington early and practice their pitch at a lunch at the Army Navy Country Club in Arlington, Virginia. The idea was that Steuert and Voytko would keep talking and try to find a way to bridge their differences, or at least come up with a number that everyone could agree on. By the end of lunch, the two sides were getting closer as everyone left the dining room for taxis that would take them to the meeting.

Foerster recalled standing at the front desk paying the bill when one of the young bankers came running in.

“Bruce, get out here right away.”

“What’s going on?” Foerster asked.

“Joe and Jim are ready to square off and have a fistfight in the parking lot over the multiples.”

PaineWebber didn’t get chosen to underwrite the offering. Conrail chose Goldman Sachs.

Foerster wasn’t deterred and he came up with another angle. Under SEC guidelines that sought to prevent underwriters from overhyping a company they were taking public, research analysts at banks involved in a new issue were prevented from publishing research until almost a month after the IPO. Regulators wanted investors to have that time to read and digest the final prospectus before they were influenced by Wall Street research analysts. Foerster turned down Goldman’s invitation to join the deal—PaineWebber’s roster of individual investors was attractive to the other firms—so that PaineWebber could write a report on Conrail prior to the IPO.

Titled “Guide to the Conrail Prospectus,” the pre-IPO research report was a huge success—hundreds of institutional investors asked for a copy. Banks provided research to investors for free in return for an expectation that investors would pay for it if they found it helpful or useful for making an investment. With so many reports going out to investors, Foerster prepared to reap the gains when those firms came to PaineWebber on the day of the IPO to buy shares as payment for the report.

As Foerster was standing on the trading floor waiting for the orders to flow in, the head of block trading came over to him. The word was that the Goldman bankers running the deal were so incensed by PaineWebber’s actions that they had issued an ultimatum to their trading accounts: “Nobody’s going to do business with PaineWebber today or else,” Foerster recalled the trader saying.

His firm didn’t do much business that day. “We didn’t write a ticket, basically,” Foerster recalled. “That’s how strong Goldman’s power was by then.”

Institutional investors’ power had also continued to grow. In March 1991, PaineWebber was underwriting a hot biotech deal, Foerster recalled. The deal was well oversubscribed, meaning that Foerster’s firm had many more orders to buy than it could fill. Fidelity called asking for a discount and threatening that they would walk away from the deal if they didn’t get it. Foerster instructed a colleague to tell Fidelity to take a hike. He had more than enough buyers without them.

Soon after the deal was priced successfully, Foerster was strutting around the trading floor when his secretary came up to him and grabbed his shoulder. Donald Marron, PaineWebber’s CEO, wanted to see Foerster in his fourteenth-floor office.

“Don, how are you doing?” Foerster said as he walked in. He noticed Marron wasn’t smiling, but then he seldom did.

“I understand we priced a big offering,” Marron said.

“Yes, we blew it out the window.”

“How much did we give Fidelity?”

“Well, they were trying to run the deal for us and they tried to price it, and I told them to go stick it.”

“Yeah, I know you did. I just got a call from Ned Johnson,” Marron said, referring to Fidelity’s CEO.

Johnson was one of the most powerful men in the investment management industry. In the few minutes between when Foerster’s guy had informed Fidelity that they were out of the deal and the time the deal was priced, the news had traveled all the way up in Fidelity to Johnson, who had rung Marron.

The call served to remind Marron, and Foerster, that Fidelity could take its very lucrative trading business elsewhere if PaineWebber ever tried that again. During those years and later, Fidelity also liked to invoke what was known as its “two-for-one” rule, which required banks that wanted to do business with the mutual fund manager to allocate twice as many shares to Fidelity as they allocated to any other investor.

“I don’t know what Fidelity’s revenues at PaineWebber were, but they were huge,” said Foerster. He had no idea how much Fidelity paid his firm in trading commissions. “We couldn’t afford to lose that order flow, and so they used that as a club. And if I had been at Fidelity, I would have done the same thing. It was war.”

In 1991, a research analyst named Lise Buyer joined T. Rowe Price, which, like Fidelity, was growing into one of the most powerful institutional investors. With wavy hair and a big smile, Buyer was the daughter of a Buffalo, New York, journalist father and educated at the Nichols School, a local private institution. She studied economics and geology at Wellesley College before matriculating at Vanderbilt University’s business school.

After her MBA, Buyer moved to New York for a job at Fred Alger Management, a pioneering firm in a type of investing that made wagers on fast-growing stocks like those of the technology industry. Fred Alger emphasized fundamental analysis, the practice of evaluating companies based on economic forecasts, industry trends, and specific financial metrics to determine if they would make a good investment.

Buyer got her start as a retail analyst, visiting stores and local malls to poll workers about what was selling, but it wasn’t long before she started covering technology stocks. After a few years, she left Fred Alger for Prudential-Bache Securities Inc., where she covered Tandy, the precursor of RadioShack, which sold an early personal computer called the TRS-80 that competed with Apple.

When T. Rowe Price came calling, she moved to Baltimore and joined the company’s Science & Technology Fund. Started in 1987, it was one of the first mutual funds to make focused investments in the rapidly developing technology space. As the use of personal computers and accessing of the World Wide Web became more commonplace, Buyer helped T. Rowe Price place money on the companies leading the wave. By 1995, she was quoted in news articles as a T. Rowe Price analyst willing to explain new technologies.

By then, Hambrecht had handed off the CEO title at Hambrecht & Quiet to Daniel Case and stepped into a chairman’s role. The firm still used the same strategy Hambrecht had started with, taking stakes in promising companies as a venture investor and acting as an underwriter when those companies or others wanted to access the public markets.

One of H&Q’s investments was the early internet browser Netscape Communications Corp. Founded by Marc Andreessen and Jim Clark in 1994, Netscape was quickly becoming the dominant browser people used to search the internet. The company chose Morgan Stanley and Hambrecht & Quist to underwrite its IPO.

When Lise Buyer heard about the IPO, she explored whether T. Rowe Price should buy Netscape’s stock for the Science & Technology Fund. Buyer was a free spirit who often saw through pretense. The internet economy was just so new, she didn’t know how she could come up with a valuation for the company’s shares. “Everyone is using their own set of growth rates based on current net-related products and a little crystal-ball gazing and fairy dust,” she told the Wall Street Journal, unafraid to say what others might have been thinking. “I don’t know how you put a value on it—you pick a price you’re willing to pay and you find a way to rationalize it.”

Those limitations didn’t imperil the company’s IPO. When Netscape went public in August 1995, it sold shares for $28 apiece. The price was already a doubling of the initial level the investment bankers planned to sell at, but when the stock opened the following day, it surged to $74.75. It closed the first day at $58.25, a 108 percent increase over the IPO price.

The internet boom was officially underway.

In anticipation of the Netscape IPO, Hambrecht wanted to know what to do with a stake in the company that H&Q held in one of its venture funds. Should H&Q keep Netscape’s shares, or distribute them to the limited partners who had placed money into its funds? Hambrecht wanted a data-driven answer, so he had asked a couple of colleagues in H&Q’s venture department to run some numbers. What they learned startled him.

Like many assets, stocks traded based on supply and demand. If there was more demand for the shares than the supply, the price increased. If there was more supply than the demand could soak up, the price could be expected to fall. Investment banks liked to insist on IPO agreements that prevented company management, employees, and early investors from selling their holdings before 180 days had passed. Known as a lockup, it artificially constrained supply until the company and its backers could sort out investor demand.

Hambrecht’s analysis uncovered a surprising pattern in how stocks traded in the days and months after an IPO. Time and again, a company sold stock for a certain price, watched the price increase on the first day of trading, and then noticed it hovering at around that number for four or five months. Investors would then begin selling the stock, and its price would drift lower. At six months, underwriting agreements allowed insiders to finally sell their stakes, or distribute them to investors who could now sell them. The sales dumped more stock into the market. Between six months and two years after the IPO, the stock price often underperformed.

Hambrecht brought the Netscape data with him to the Bahamas, for a meeting he had with John Templeton, the American-born British investor then known for an almost forty-year record of putting up 15 percent returns in his mutual fund. Hambrecht had struck up a relationship with Templeton and tried to meet him every so often. When he did, he tried to bring a new idea or insight he could share.

“I took that chart now to Nassau and I showed it to Sir John,” Hambrecht said later. “He took one look at it and he said, ‘My God, there’s a scam going on.’”

Templeton immediately picked up the phone and called in a programmer.

“Write a program to get us out of the IPOs four months after,” he said. “Let’s look at the ones we really like two years later.”

Templeton’s reaction stuck in Hambrecht’s mind.

Even as technology companies captured the market’s attention, the banker worked on other deals for companies in decidedly older industries. The same year as the Netscape IPO, 1995, Hambrecht teamed up with Foerster on the IPO of Boston Beer Company, the maker of Samuel Adams lager. Boston Beer’s founder, Jim Koch, had asked Foerster, who by then had left Wall Street and struck out on his own, to serve as an advisor on the IPO. Koch had a novel idea he wanted to try: selling stock directly to the customers who drank his beer.

Foerster thought it was a lousy idea. So did Alex. Brown & Sons. Goldman Sachs, where the cousin of Koch’s mother was a partner, didn’t want any part of it either.

Hambrecht was by then open to trying something different. H&Q was already an investor in Boston Beer. So Koch asked Hambrecht to figure out how to sell stock to his customers, and at a lower price than he sold it to the professional investors. “Jim just wanted his beer drinkers to have a bargain,” Hambrecht recalled. “Give a little edge over the institutions.”

SEC rules wouldn’t allow companies to have two different prices on an underwriting deal. But with Hambrecht’s help, Boston Beer ultimately agreed to conduct two deals. It would sell stock to beer customers and then close the deal. Investors couldn’t sell. Then it would open the sale for institutional investors.

After some negotiating, Koch and his bankers decided that they would allocate a third of the offering to retail customers.

Koch came up with the idea of putting neck hangers on the six-packs. They advertised that the company was going public and told customers that if they were interested, they should call a number and order a prospectus. The response was overwhelming. More than one hundred thousand people called in saying they wanted to buy stock and sent in checks to purchase shares.

But no one knew how to allocate shares to so many people. Hambrecht ended up hiring a mutual fund system to do it, ultimately apportioning the shares through something like a lottery, almost like pulling names out of a hat. About thirty thousand people got about five hundred dollars’ worth of stock each. That meant that they had to return checks from the more than seventy thousand people who’d sent in money and didn’t get shares. “I remember thinking there’s something wrong about this system when you’re sending all that money back,” Hambrecht said later.

When the transaction was complete, Hambrecht recalled, he had a conversation with one of H&Q’s board members, who was also a top technology executive at Charles Schwab. Schwab was a leader in the hypercompetitive world of retail brokerage, where many firms competed to offer trading accounts for smaller investors. Acquiring customers was hard. Hambrecht told him the story of the Boston Beer IPO.

The executive just looked at him. “You dope,” he said to Hambrecht. “It costs us, in advertising, three to four hundred dollars to open a new account. You had a hundred thousand accounts you just gave away!”

Hambrecht realized it was a missed opportunity.