March 5 2008: 8:02 AM EST
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The man who must keep Goldman growing

By Bethany McLean, editor at large

Just a few years ago, though, Goldman was more an embattled kingdom than an empire. Among rivals there was a palpable sense that it was vulnerable. The firm's traditional franchise - advising companies that were being sold or helping companies go public - was being encroached on by larger banks that would also lend those companies money. Goldman didn't want to take that risk, and in truth, its balance sheet was too small - small enough that Goldman was routinely mentioned as a takeover target. "People were speculating, making book, on how long we would survive as an independent company," Blankfein said in London.

Today, as Blankfein relishes pointing out, the rap is that Goldman is too big and too powerful. But it's more than just a super-sized version of the former firm. Goldman, in a comparison Blankfein likes to draw, remade itself into a modern, and global, incarnation of the old J.P. Morgan, the bank that dominated American finance in the early part of the 20th century. "Goldman Sachs has undergone a brilliant transformation," says Ken Griffin, the CEO of Chicago-based Citadel Investment Group. "It is now one of the world's greatest merchant banks."

“People were speculating, making book, on how long we would survive as an independent company.”

That means Goldman doesn't simply execute orders on behalf of its clients but makes loans and often puts its own principal at stake, just as Morgan did. For example, Goldman not only advised Mittal Steel on the $34 billion acquisition of rival Arcelor in 2006 but also arranged, and contributed to, the $16 billion in financing. And Goldman doesn't act as a mere broker. Instead of earning a commission for selling 500,000 shares of IBM to, say, Fidelity, Goldman is more likely to earn a spread between its cost of acquiring those shares and the price it sells them for. The transformation of Goldman into a merchant bank began years ago, but Blankfein has pushed the strategy at every opportunity. "If we had not gotten into the principal business, we would be a boutique," he says.

Goldman's activities are also integrated in a way that is unique on Wall Street, where firms tend to consist of competing fiefdoms. For instance, a utility may call up a Goldman Sachs investment banker because it wants to hedge the cost of natural gas for ten years. Goldman's commodity trading operation may learn of that opportunity from the banker and offer the hedge, but also offset that position by, say, shorting natural gas in a separate trade. A Goldman M&A banker may be approached by a company that wants to sell, and Goldman's private equity operation might end up buying it. "Five years ago, if you were in investment banking, you'd go all-out to win an assignment, but you wouldn't worry about the other parts of the firm," says Chris Casciato, a former Goldman partner who now works for Lightyear Capital. "Now the mindset has changed. You think, 'What is best for Goldman Sachs as a whole?'"

Its range of operations gives Goldman unparalleled access to information and ideas from around the world. "Goldman has more touch points to more clients around the globe," says Jeff Harte, an analyst at Sandler O'Neill. "It gives them more opportunities and better collective intelligence." Indeed, Goldman's clients give it an information edge that the very best hedge funds don't have. "Clients are our bread and butter," says Blankfein. "Without them we would starve to death."

At the same time, Goldman has to advance its own interests, which may put it in conflict with its clients. And different clients may have clashing interests. Take a private equity firm that uses Goldman as an advisor but then finds itself bidding against Goldman to buy a company. Or a mutual fund that uses Goldman to execute a large purchase of stock. Does the fact that the trade becomes part of Goldman's collective intelligence mean that the mutual fund somehow loses? "We always put our clients ahead of the firm," says Jon Winkelried, Goldman's co-chief operating officer.

But for years Goldman has heard accusations that it puts its own profits first, to the detriment of its clients. "They have embarked on a very aggressive course of having their cake and eating it too," says one private equity executive, who, like many, will not speak on the record because he does not want to lose access to what the firm has to offer. "Are we a client-focused firm with an appetite for risk, or are we a trading firm with client relationships?" asks a former Goldman partner, explaining that he thinks Goldman has tipped to the wrong side of that fine line. And some clients find themselves in a bind: They may worry about the edge their information gives the firm, but they turn to Goldman anyway because often it can do a trade that no one else on the Street can or will. A common refrain is that you "do business with Goldman not because you want to, but because you have to."

Recent events provide a window into one type of conflict Goldman can face. In February the credit crisis spread to obscure instruments known as auction rate securities, long-term debt on which the interest rate is reset frequently via a bidding process. The higher the demand for those securities, the lower the rate. Goldman and other investment banks had supported this market by committing their own capital to buy the securities. But in February the banks abruptly stopped doing so. As a result, even issuers with strong credit, such as the University of Pittsburgh Medical Center, found themselves paying exorbitant interest rates.

Although UPMC considered Goldman its advisor - Goldman underwrote a recent UPMC bond offering and also manages a portion of its investment portfolio - treasurer Tal Heppenstall says Goldman (and other Street firms) withdrew from the auction bond market all at once and without any notice. As a result, UPMC's rates on $450 million of auction rate securities began to leap as high as 17%. UPMC believes that its interests were subordinated to the interests of Goldman and the other banks, and Heppenstall says he wonders who benefited from the higher interest rates. Goldman says its decision to stop bidding for auction rate securities was necessary to protect its balance sheet in a market that seems scarier by the day. "We hate disappointing people, but market conditions are extraordinary, and selling pressure has been unprecedented," says a Goldman spokesman. In other words, even mighty Goldman is vulnerable to today's turbulence.

The episode shows how tough Goldman's balancing act can be. As Philip Murphy, a former Goldman partner who is now the finance chair of the Democratic National Committee, says, "Conflict resolution is not an A- business. Either the client felt like Goldman was looking out for its interests or it didn't." Murphy feels that Goldman does get an "A," as do others. "The world is awash in conflicts," says Ken Griffin, whose fund does business with Goldman. "Firms either pretend they don't exist and get in trouble for it, or they recognize that conflicts exist and deal with them thoughtfully and openly. Goldman does the latter." Nor does client dissatisfaction show up in Goldman's numbers. Goldman, as Blankfein frequently notes, has market-leading positions in many client businesses, including M&A. "Can you imagine how much worse the criticism would be if we weren't No. 1?" he asks. "People say these things, but that is not how they are responding to us." Says Oppenheimer analyst Meredith Whitney: "Ultimately people vote with their feet, and the feet keep marching toward 85 Broad Street."

***

Which isn't to say that Goldman itself isn't worried (that word again!) about - maybe even obsessed with - the questions of conflicts. During the past year Blankfein has held 30 Chairman's Forums at Goldman offices around the world, in which he talks to a small group of managing directors about an area of concern for the firm. His focus? Client relationships.

The most recent Chairman's Forum was what brought Blankfein to London last fall. Blankfein told the assembled managing directors, "We feel we get clients right, but people out there are saying, 'The industry has gotten selfish. The industry is subordinating the interests of clients. And Goldman Sachs, we don't think you're any different. In fact we think, You especially.'" There was dead silence in the room.

The group then talked through several case studies. The first: "A major private wealth-management client calls her GS coverage person to express frustration that while GS is generating record results and outperforming as a firm, returns on her portfolio have been mediocre." This scenario could have been ripped from the headlines (although Goldman says it wasn't). Last August, Goldman's flagship hedge fund, Global Alpha, plummeted. For the year the fund finished down 37%, in sharp contrast to Goldman's record results. The managing directors didn't seem to have any solutions beyond informing clients that their investment objectives were different from Goldman's. At least for now, though, the strength of Goldman's brand is such that despite Global Alpha's results, Goldman was able to raise $7 billion for a new hedge fund last fall.

Another hypothetical could have come straight from a Goldman Sachs detractor. "An investing client delivers the message to his GS salesperson that GS has not been selected to execute a large and potentially profitable trade. When pressed, the client says that his decision was based in part on the assumption that GS is more focused on proprietary investing than client service, and that he and his firm fear that its data and ideas might be used by GS for our own purposes."

"Would someone ever have this reaction about GS?" asks Blankfein sarcastically. The whole room knowingly cracks up. But as Blankfein points out, every Goldman Sachs trader who has left Goldman to start his own hedge fund has chosen Goldman Sachs to handle his business. If Goldman misused clients' information, those traders would know - and presumably pick another firm.

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