Lean on Leverage
April 22 2010 by Jennifer Pellet
A few decades ago, Wall Street investment bankers might have scoffed at the core business philosophy that has guided operations at Little Rock, Ark. – based Stephens Inc. since its founding in 1933: “To be in business the next day.” They aren’t scoffing now.
After the near-overnight demise of Lehman Brothers and fire-sale fate of giants like Bear Stearns, an approach that might have seemed ridiculously conservative now seems downright prescient. “We’ve never taken a risk where if we lost everything, it would impair the ability of the firm to survive,” says Warren Stephens, the firm’s chairman, president and CEO. “Even when the opportunity is extraordinary and the odds strongly in our favor, if it would endanger the firm if it didn’t work out, we’re just not going to do it.”
The nephew of founder Witt Stephens, Warren Stephens acquired all the outstanding shares of Stephens Inc. in 2006. Due to his large – and undisclosed – stake, the company’s posted shareholder equity of a mere $99.9 million in 2009 reflects just a fraction of its true financial wherewithal.
This privately held status largely exempted the company from much of the performance pressure on its publicly held peers. While pursuit of returns spurred some investment banks to let their leverage ratios creep up to 30 times capital, Stephens has long been content to maintain a ratio of about two-to-one. “We view our investment banking operation as a true middleman, where we only get a middleman rate of return,” explains Stephens, who joined the company as an associate in corporate finance in 1981 and was named president five years later.
“The people who provide the capital and the people who take that capital and make a return for investors are the ones who get the larger return,” he continues. “We take our middleman slice and try to have our return on equity come from successful private equity investments.”
Successful investments are an area where Stephens Inc. has an admirable track record. Witt Stephens funded the company by borrowing a few thousand dollars and investing in Arkansas highway bonds, then trading at 10 cents on the dollar. The bonds were eventually redeemed at par. He soon brought in his brother Jack, Warren’s father, and they built a thriving bond business. From municipal bonds, Stephens made its first significant private equity investment in the energy field. Over the next few decades it morphed from a muni bond house into an investment banking and financial advisory services firm – which served small and mid-cap companies, governments and individual investors – with a private-equity investment arm. Along the way it profited handsomely from backing a series of winners – among them Sam Walton’s then-$32 million retail chain, Tyson Foods and Alltel.
Stephens credits a sharp selection process and a focus on partnering with clients for the long term for that success. The company historically stakes strong management teams able to realize growth opportunities – and often stays for the duration, he says. “Can the CEO articulate for us in a succinct way what his company does, its competitive advantage, strategy, and goals? If so, he or she will be able to do that for employees.”
“What makes us different is that we don’t have any [outside investment] funds – it’s all our own money,” he adds. “And because we are not a fund, we don’t have a tight time horizon. Our experience is that good management teams are a rare commodity, so when we find one, the last thing we want to do after five years is say, ‘You’ve done a great job; we’re selling.’ We’re going to keep growing that business and adding value.”
Warren Stephens also aims to continue to take advantage of the troubles on Wall Street to grow Stephens itself. The allure of the company’s incentive program – providing employees with the ability to buy subsidized stakes in the private equity investments it makes – once paled in comparison to the stock options offered by other firms. No more.“This environment has been a real opportunity for us,” says Stephens, who brought in more than a dozen investment bankers in 2009. “When I first came into this company it had 125 employees. Now we have about 750. That’s not big by a lot of standards, but it’s big for us.”