GE'S COSTLY LESSON ON WALL STREET Despite a disastrous two years, General Electric thinks it can make a winner of Kidder Peabody. Maybe. It has learned a lot, and its strategy still makes sense.
By Stratford P. Sherman REPORTER ASSOCIATE Julia Lieblich

(FORTUNE Magazine) – WOULD HE sell them off, shut them down, snip their suspenders, and send them weeping into the street? Kidder Peabody's top investment bankers had every reason to worry in March as they waited for Jack Welch to address them at a suburban hotel 25 miles from New York City but light years from Wall Street. Welch, blue-eyed and passionate, relentless in his focus on achievement, efficiency, and return on investment, is chief executive of General Electric, and well known for presiding over the elimination of some 100,000 jobs in the quest for profits. The Kidder people realized they were vulnerable. GE's once heralded 1986 acquisition of their venerable investment firm looked like a flop. No: a disaster. The honeymoon ended early last year when dreamboat dealmaker and former Kidder director Martin Siegel implicated the firm in his confession to criminal charges of insider trading. After that, just about everything that could go wrong did, from Feds brandishing handcuffs in Kidder's Wall Street headquarters to the stock market crash of October 19. For all that, Welch's speech struck the Kidder bankers as surprisingly, well, sweet: ''We never would have touched Kidder Peabody with a ten-foot pole if we knew there was a skunk in the place,'' confessed Welch. ''Unfortunately we did, and now we've got to live with it. But we're as committed to winning as we were on day one. We'd love you to win -- more than any mother in the world.''

Even with Welch's more-than-maternal support, Kidder is unlikely to provide its parent with a winning return on investment anytime soon. The firm lost money in 1987, and Welch expects it to eke out only a tiny profit this year. Security analysts recently valued GE's stake in Kidder at only two-thirds of the $600 million the company paid for it just two years ago. Concedes GE vice chairman Lawrence Bossidy, the forceful former auditor to whom the company's mammoth financial-services sector reports: ''We're a little overinvested.'' View that as the price of GE's education in the ways of Wall Street. General Electric has learned a lot that should be of interest to any company contemplating an acquisition in an unfamiliar industry. Indeed, the wised-up management of the industrial giant thinks it has a thing or two to teach denizens of the investment banking business. Students of the post-crash financial-services sector, take note. Unpromising though it looks at the moment, GE's plunge into investment banking may yet produce impressive payoffs. Not because Kidder is such a stellar firm or because GE's executives are managing it so well -- it isn't, and they aren't -- but because the strategic idea that brought the two companies together is too sound to screw up. Compared with GE, with its annual revenues of $39 billion, Kidder is less than a flyspeck. But Kidder's ability to underwrite and trade securities, and to earn fees as an adviser, vastly expands GE's potential in finance. General Electric is best known for manufacturing products, but its financial-services unit is a first-rank competitor in leasing, insurance, and lending. Among the biggest financiers of leveraged buyouts, GE Capital takes equity positions in LBOs as well as lending money. Kidder can bolster these activities in countless ways, from packaging and reselling GE assets like auto leases to bringing in LBO deals. GE, in turn, can strengthen Kidder by providing it with capital and financial discipline. Welch figures that to win in the increasingly competitive investment banking business, firms will have to demonstrate confidence in the advice they sell by betting their own money along with their clients'. GE's earnings in financial services are six times what they were in 1980, with most of the growth coming from acquisitions. Kidder has tarnished GE's brilliant reputation as an acquisitor. Now Welch is determined to show that GE can revitalize Kidder and push it from the dreary middle ranks to the top of its industry. The effort promises to make Kidder the foremost test of a new, more strait-laced business style, which harder times are bringing to Wall Street. The disarray of Kidder's competition encourages Welch's hopes. Having generally accepted the view that risking their own money, both as traders and as principals, was key to success, Wall Street firms were appalled by their vulnerability to the successive crashes of the bond and stock markets. Most major houses lost millions in the October equities collapse. Kidder actually made a few bucks that month, but L.F. Rothschild almost folded, and E.F. Hutton fell unhappily into the arms of Shearson. At firm after firm, top executives abruptly decided that investment banking was a business rather than an art form after all, that costs and capital risks really had to be closely managed. But the application of this concept, second nature to GE, deeply upset experienced professionals on whom the banks' livelihood depends. Ego- driven millionaires in their 30s and 40s, many have defected from increasingly corporate firms like First Boston and Salomon Brothers to small, narrowly focused ''boutiques'' where substratospheric pay and -- yuck! -- cost controls may still be avoided. THE CONFLICT between Wall Street's fading whiz-kid culture and the new bean- counting ethos is rooted almost entirely in the growing need for capital. As investment banks risk their own money on equity investments and huge loans to facilitate clients' deals -- activities usually lumped under the rubric ''merchant banking'' -- it is no longer unusual for a bank to bet its entire net worth on a single transaction. That means the firms need not only more capital but also what Bossidy calls ''the checks and balances you normally associate with a large business.'' No investment bank on Wall Street actually had such controls, mind you. But while the bull market raged, most firms were making too much money to notice. Kidder certainly was. During the five years before it sold out to GE, the firm doubled earnings and averaged about a 20% annual return on shareholders' equity. In those days Kidder was dominated by CEO Ralph DeNunzio, an affable, paternalistic executive with the thick shoulders of a football player. DeNunzio is credited with maintaining Kidder's warmly collegial atmosphere, but he also brushed aside subordinates' calls for change and allowed Kidder to lag behind its peers in crucial ways. Judged by the industry's wacky standards, the firm paid its people much too modestly. It also avoided risky but strategically important businesses like junk-bond underwriting. Says a longtime client: ''Ralph was a superb No. 2 man -- he wasn't a leader.'' Despite its profits, Kidder was losing ground to the competition. Senior bankers like Peter Goodson, a charismatic colleague of Marty Siegel, began muttering darkly about the need for change. By 1986 even DeNunzio had to admit that Kidder needed more capital to compete. In the course of discreetly shopping the firm, he received what many insiders regarded as an astonishingly high bid from GE, which had been lusting after Kidder for years. GE began studying the investment banking business in 1981, and had settled on Kidder partly because it was a middling firm with plenty of room for improvement. Goodson, a marvelous salesman with a face so trustworthy and open he could host a kids' TV show, took GE's Robert Wright through ten days of intense negotiations, much of it conducted in the dining room of DeNunzio's Connecticut home. Wright, a lawyer closely allied with Welch, was then head of GE Capital, the finance unit that reports to Bossidy. Overeager to make the deal, Wright gave Kidder the long end of the stick. GE's $600 million bought 80% of the partnership's stock. That worked out to about the same fat multiple of book value that Morgan Stanley, a vastly superior firm, had commanded in its initial public offering three months earlier. Kidder people still giggle about Wright's naivete in locking up the firm's biggest shareholders with three-year noncompete agreements: Most of the real producers owned too few shares to be covered. KIDDER'S FORMER partners gleefully pocketed an average of $1.2 million, while retaining a fifth of the firm's stock for distribution to key employees. An estimated $30 million went to DeNunzio. Since none of that money flowed into the firm's coffers, GE threw in another $100 million to boost Kidder's capital, promising more as needed. Best of all, GE promised that it would let the firm operate independently. Why should it interfere? Kidder's splendid financial performance in the bull market more than satisfied the new corporate masters. For six months after the deal closed, GE pretty much kept hands off. Kidder went profitably about its business, its management reporting to the head of GE's financial-services unit. Wright left that post two months after the closing, to take command of NBC, which GE had also acquired. Gary Wendt, a round-faced executive esteemed mainly for his dealmaking skills, replaced him; he too left Kidder alone. During those tranquil months, Kidder bankers began to feel they had a right to operate independently of their corporate owner. Then, in February 1987, former Kidder star Marty Siegel showed the colors of a crook. Siegel had been the best dealmaker in Kidder's history, a charming smoothie blessed with a pretty face and extraordinary smarts. His specialty was defending corporations from takeovers, and in the shark-roiled Eighties, that business was awfully good. Siegel personally brought in a big chunk of Kidder's profits. Early in 1986 he abandoned Kidder for a multimillion-dollar- a-year post at Drexel Burnham. Siegel's departure traumatized the remaining partners and bolstered their decision to sell. A year later, facing indictment on insider trading charges, Siegel copped a plea. He confessed that in return for suitcases filled with cash -- a total of $700,000 -- he had passed confidential information to Ivan Boesky. According to Siegel's confession, he also led Kidder to profitably trade on inside information for its own account. The maraschino cherry topping off the whole poisonous thing was the arrest of Richard Wigton, the plump, well-liked, and apparently harmless head of Kidder's arbitrage department, as a co- conspirator. It was the distraught Wigton whom federal marshals handcuffed in Kidder's Manhattan offices the day before Siegel's confession became front- page news. The government indicted Wigton for violations of securities law, then dropped the charges last May; it may file a broader indictment in the future. These days Siegel lives in a luxurious Florida home while awaiting sentencing. In an instant, Siegel's confession destroyed the trust that GE's executives had placed in Kidder's management. For all practical purposes, the old Kidder died the day Siegel declared his guilt, and the clash of cultures began. GE manifested its changed attitude almost immediately, after U.S. Attorney Rudolph Giuliani privately threatened Kidder with criminal charges. DeNunzio and Kidder's legal team initially wanted to fight. But Bossidy, a big, blunt- talking man with thick features, meaty ears, and an extremely sharp mind, replaced Kidder's lawyers with GE's, seizing personal control of the talks with government officials. Next thing you know, GE had reached settlements with both Giuliani's office and the SEC, which had filed a civil complaint. Bossidy, who had investigated Siegel's allegations of insider trading at Kidder, says GE ''had no choice'' but to settle. Without admitting or denying guilt, Kidder agreed to pay the government over $25 million in fines. To placate the SEC, General Electric also assumed voting control of Kidder's board of directors and replaced DeNunzio and other top managers. The move was typical GE, bold and decisive. Says Bossidy: ''It was clear to me the business had to be run in a different way to be successful.'' What got lost in all the rapid-fire action was any recognition that GE deserved a share of the blame for the mess in which it found itself: Hungry for some of Wall Street's spectacular profits, it had behaved carelessly when it bought Kidder. The company paid scant attention to evidence of control problems at the firm, such as the 1984 Peter Brant scandal, in which a Kidder broker illegally traded on tips from R. Foster Winans, a writer for the Wall Street Journal. Wright might have questioned Kidder's major clients, at least one of which had told DeNunzio that it suspected Siegel of insider trading. GE also could have contacted arbitragers, many of whom were openly discussing suspicions that Boesky and Siegel were conspiring. ''We all make a living on reading people,'' says Welch, explaining why GE was not more suspicious, ''I had looked DeNunzio in the eye. I trust him.'' In retrospect, GE's initial hands-off policy only made things worse once the scandal broke. Barely acquainted, people from the two organizations were suddenly forced to work together on a set of soul-wrenching issues. They quickly discovered how little they had in common. Kidder's culture was based on reverence for the skills of individual employees, a natural attitude for a firm that mostly sold advice. GE Capital, by contrast, based much of its business on investing its money in complex transactions where financing was desperately needed. Its culture was rooted in the recognition that the company's billions were more crucial to the business than any employee. Thus the tough-skinned GE finance people, who managed money, were somewhat contemptuous of the softies at Kidder, who sold air. The precepts by which GE governs its highly disciplined operations are so lucidly rational that GE people, from Welch down, seem perplexed that anyone would have trouble following them. The idea is to make a fat return on the shareholders' money. The way to do that is to face reality, gathering lots of information and ardently seeking the best business decisions through a constant process of open, competitive debate. Winners get independence and more capital to invest, losers get dumped. Simple. Protected first by government regulations and old-boy attitudes, then by surging markets, the investment bankers at Kidder never had had to face the brutal competition typical of most GE markets. Partly as a result, the Wall Streeters were accustomed to coddling the weaklings in their ranks. Years of subtle, subterranean politicking failed to prepare the leaders of the firm for the combative rough-and-tumble of GE's management style. Uniformly vigorous and self-confident, the GE people came on strong, rather like Robocop in last year's hit film. They frequently bruised the feelings of Kidder's bankers. Says Bossidy: ''To win in the way we see the world, there must be a willingness to surface issues, to debate, and to act on the basis of consensus. The Kidder people came from a very different business environment. I suppose we have wounded some people, but that wasn't the intention.'' EVEN SO, the damage was done. GE provided Kidder with what it considered a swell new management lineup. Silas Cathcart, DeNunzio's replacement, was an outside director of GE and a Welch pal of unquestioned integrity. Guiding Illinois Tool Works through eight recessions, he had built a spectacular record, which included introducing the now ubiquitous plastic six-pack holder. A confessed ''tool-and-die man,'' Cathcart, 62, knew little about investment banking, but much about management. GE also provided Kidder with a top management-systems expert, Charles Sheehan, as chief financial officer. And to introduce strategic thinking to a firm that had gotten by without it, GE sent over Dan Hale, a skilled planner. Only one Kidder banker made it into the top rank of the new team: Max Chapman, an athletic ex-Marine who had been DeNunzio's heir apparent, became chief operating officer. Cathcart launched a GE-style review of Kidder's business, while Sheehan rushed to generate the detailed financial information Cathcart needed to make informed decisions. Not enough data were available to show which lines of business were profitable. ''The firm had been managed basically from a revenue viewpoint rather than from a profit viewpoint,'' says Cathcart, still amazed. At the same time, the violent upheaval embittered veteran Kidder bankers, some of whom now felt betrayed by GE as well as by Siegel. ''DeNunzio was like Dad,'' mourns a former Kidder banker. Complains another: ''The GE people were clods; they broke two-thirds of the china in the shop.'' Many bankers resented the nitpicking about expenses and made fun of the new fretting about variances from planned budgets, called ''Vs'' in GE's technocratic lingo. Disaffected Kidderites began to defect to competing firms, leaving key departments such as mergers and acquisitions critically understaffed. Finally the markets fell apart, robbing Kidder of its protective force field of high profitability. While the firm continued to do extraordinarily well in corporate finance, the trading side of the house veered from record earnings in 1986 to a modest profit in 1987. Responding more quickly than most Wall Street firms to the tougher business environment, Kidder announced its new strategic plan in December. The firm would reduce costs by 10%, or $100 million; it would also eliminate 1,000 of Kidder's 7,500 employees. The party was over. After accounting for GE's acquisition expenses, and setting aside an estimated $38 million for employee-severance costs and reserves for pending lawsuits related to Siegel's insider trading, Kidder posted a net loss of $50 million for the year. As GE's methodical hatchet men carefully chopped away at the deadwood that had been accumulating at Kidder for years, the uncertainty dragged on about who would be laid off next. When bonus time came around last January, Kidder paid out roughly 20% less than many bankers had been led to expect by their supervisors. Resumes from Kidder Peabody flooded the Street. Then came the Montgomery Ward fiasco. Late last winter Kidder finally got involved in several deals that seem to demonstrate the enormous potential of the alliance with GE. Two of these transactions rank high among the biggest so far in 1988, and Kidder owed its participation in both to its new parent: the attempt by Macy's, 20% owned by GE Capital, to buy Federated Department Stores, which ended with a compromise in April; and Montgomery Ward's management-led LBO. These big-time deals potentially were worth as much as $60 million in fees to Kidder. But so fierce was the battle between GE and Kidder executives over the Montgomery Ward transaction that news of the infighting spilled over onto the front page of the New York Times. The problem exploded because Cathcart's troops and Wendt's people at GE Capital didn't trust or respect one another enough to resolve differences arising in the normal course of business. Kidder had established ties with Bernard Brennan, the burly chief executive of Montgomery Ward credited with turning the troubled retailer around. Brennan wanted to buy the business from Mobil, which wanted to sell it. According to Wendt, the Kidder bankers proposed a traditional LBO, in which the firm would risk up to $250 million of its own capital and try to raise the rest of the $3.8 billion price mostly through debt. Dennis Friedman, the volatile Kidder banker running the deal, approached GE Capital as a potential financier. MEANWHILE WENDT and his people came to favor a more novel and intricate structure for the transaction, one that Kidder had also considered. GE Capital would buy Ward's credit-card operation for $2.8 billion, folding it into its own substantial credit-card business. That plan made the remaining LBO deal much smaller, safer, and easier to finance. Protecting their turf, the dealmakers from GE and Kidder had not come to terms when Mobil unexpectedly announced that it was about to sell Montgomery Ward in an open auction. This brought the disagreement to a head. The Kidder team regarded the Montgomery Ward deal as their property and feared that GE Capital was trying to rob the firm of its fees. The members of Wendt's team thought their deal structure was smarter and much more likely to win the auction for Brennan. Wendt pulled rank, refusing Kidder the authority to commit funds to the deal. The Kidder people were instructed not to talk to their own client. Understandably, Brennan flipped out. He went straight to the top, phoning Jack Welch in Boca Raton, where Welch was attending a GE management conference. In forceful and vivid language, Brennan expressed his misgivings. Welch, in turn, talked sense to Bossidy. Bossidy rushed to meet Brennan at Montgomery Ward's sprawling Chicago headquarters. At Bossidy's request, no one other than Wendt and Cathcart was permitted to join in the discussion. Kidder's humiliated Friedman had to wait outside. Surprisingly, the story has a happy ending, probably the best signal yet that GE's strategy for Kidder will eventually pay off. Friedman and one other senior Kidder dealmaker have since quit the firm, but the Montgomery Ward dispute was ultimately resolved in a matter satisfactory to just about everyone else. Structuring the deal along the lines GE Capital preferred, Brennan won the auction and paid Kidder a fee estimated at $20 million. Recognizing their folly, GE and Kidder belatedly established a joint committee to review all transactions in which conflicts might arise. In its recent ! announcement of first-quarter earnings, GE described Kidder's performance as ''excellent.'' And when Jack Welch took the podium in March to address all those nervous Kidder bankers, the guy actually smiled.