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Trading Up

Having leaped ahead in underwriting to assume Drexel Burnham’s mantle as king of the junk bond market, Donaldson, Lufkin & Jenrette is elbowing its way toward the senior ranks of Wall Street players under the direction of CEO John Steele Chalsty. Does it have the managerial resources to continue to grow and take on the big boys without stumbling?

The balance of power on Wall Street is shifting from production to managerial talent,” asserts John Gutfreund, the cigar smoking former CEO of Solomon Brothers from 1978 to 1991 who, like Bear Stearns’ Ace Greenberg, basked in his reputation as the quintessential 1980s hard-nosed Wall Street boss. “In the old days, one could afford to have egomaniacs run the business,” reflects today’s kinder, gentler Gutfreund, recalling a time when brilliant traders and in-your-face capital partners topped the industry food chain. “If only to control the childish mercenaries,” he adds mischievously, “as firms become more ‘corporatized,’ they require people at the top who are skilled–managers.” Powerhouses such as Merrill Lynch, Goldman Sachs, Morgan Stanley, and Bear Stearns resemble sports franchises in that they have access to big capital, enjoy major market position and are run by owners or general managers who share some of the power with  the “talent.” These relatively free agents go along as willing mercenaries-though the former have a somewhat shorter shelf-life value to their organizations than does the typical Wall Street trader. The test for Wall Street today, reckons Gutfreund, is to build franchise loyalty by attracting, keeping, and motivating the right players. Just as a star pitcher takes pride in being, say, a New York Yankee, Wall Street is busy building brands through its capabilities, credibility, and people-an increasingly important endeavor as firms devote more energy to proprietary activities, such as their own M&A and account trading.

This phenomenon is evidenced by the sudden rise of Donaldson, Lufkin & Jenrette, a firm that quadrupled its revenues and profits over the last 10 years. DLJ went public in 1970, then was acquired by the Equitable Cos. in 1985, before reentering the public markets in October of 1995 when Equitable sold 20 percent of its stake in the firm. The firm’s rankings in stock underwritings jumped from 15th to fourth last year (see table), and it now ranks sixth in initial public offerings (IPOs), sixth in private placements, and 10th in domestic mergers and acquisitions. It ranks first in high-yield securities and sells a fourth of all new junk bonds in the U.S., a feat accomplished largely by taking risks others might not-a contrarian strategy adopted in part because the company lacked the mega capital resources of the Street’s top firms.

But the history of Wall Street is lined with the graves of firms that grew too fast, then stumbled badly. “We’re a bit like the actor who gets a starring role in a Broadway play that turns out to be a great success,” says CEO John Steele Chalsty, 63, reflecting on DLJ’s success streak. “Sure, we’ve been lucky and we’ve grown fast, but we’ve been planning for this for a long time,” adds the South African-born Chalsty, who joined DLJ in 1969 as an oil analyst.

Napoleon said, “luck favors the prepared mind.” For DLJ, one such moment was the painful Monday in October 1987 that turned into an extraordinary opportunity. Until then, DLJ was a fourth-tier firm lacking in many capabilities. But after the demise of players like Drexel Burnham, the firm seized a once-in-a-lifetime chance to hire extraordinary talent at a time when DLJ was not considered one of the most rewarding places to work. Between 1987 and 1992, 700 people were added to the DLJ team, an increase in staff of 50 percent. This major investment decision positioned DLJ for success in the 1990s when the markets bounced back. In 1991, a record year for the firm, earnings were $89 million before taxes. The following year, earnings leaped to $245 million. After the Mexican peso devaluation in 1994, DLJ hired Bankers Trust’s top Latin American specialists as other companies were pulling back.

But don’t expect DLJ to take on a financial powerhouse such as Merrill Lynch directly by attempting to underwrite the larger offerings of the Fortune 500. As a former investment banker in charge of DLJ’s capital markets group and its CEO since 1986, Chalsty plans to hone the firm’s existing strengths and take advantage of its investment acumen and reputation for institutional research. It’s a performance many on the Street are watching carefully. “DLJ has a reputation for having created a civilized managerial culture that develops talented people, and Chalsty deserves much of the credit-although one shouldn’t overlook the contribution of the three maverick Yalies who founded it in the ’50s.” says Gutfreund. “They were different than people like me.” More circumspect is Roy C. Smith, former president of Goldman Sachs International and now professor of finance at NYU’s Stern Business School. “DLJ may be equally well-managed, but it’s not in the same bracket as the first-tier firms yet.”

Recently CE caught up with the contrarian patrician-and one of Wall Street’s highest-paid CEOs-in DLJ’s new headquarter digs on New York’s Park Avenue.

What are you doing to ensure that DLJ continues to grow, yet avoids the missteps that so often follow success?

I think being bold in difficult times is an important strategic element. The offset of that is to be focused and disciplined during the really good times, because Wall Street makes its worst mistakes during the best of times. We are trying to be as disciplined as we can in these good times, and not to just relax and say, “Nothing can go wrong,” because we know it can.

I think we’ve now put in place the fundamental pillars of our business. We have a good fixed-income presence, are best known for the high-yield area, but with a good participation in real estate and a good presence in derivatives. We continue to be a leader in equities with this research base. And, finally, of the three pillars, investment banking-particularly the merchant banking area, where we have established ourselves as the industry leader-has been a great success for us.

We’ve looked very hard at some of the businesses that we’ve made a lot of money in during the past, and have cut back on those that appear to have changed circumstances or dynamics. We’ve backed out of the municipal business because it just wasn’t a business we could add any special value to. So even during a time of growth in total people, we made some very dramatic decisions to lighten up in areas we thought were no longer appropriate for us.

What we will do from now on is what I would call incremental expansions. While I don’t perceive any major weakness, I am sure we will incrementally add to our presence in fixed income.

We looked at the derivatives business years ago, at the balance-sheet requirements, and at the real profitability, and concluded that there were better uses for our capital. Now that we’ve added to our capital significantly, we have more flexibility to be a significant derivatives player. We are doing what we consider to be the better part of the derivatives business, but I suppose one might argue that derivatives will become respectable again, and that might be an area to look into.

In an industry of established firms that go back for a century or more and are now being revolutionized by new distribution technologies and globalization, how do you view the competitive landscape?

Our business faces a somewhat different competitive environment than we have before in that major international players have decided that to survive as world-class players, they must have a major presence in the U.S. I won’t say that they are working to establish a presence at any cost, but certainly with what appears to be less attention to the short-term results than the rest of us. So there’s significant competition for people now and compensation proposals that we find unusual.

In a funny way, technological advances help level the playing field somewhat, because this is so new to all of us. I don’t doubt that among our competitors there are some who can bring great financial resources to bear in the technological arena. But we are as up-to-date as anyone in terms of the technological changes taking place in our business. We are all going into new areas, and as technology is developed, we will all fall heir to it-we’ll follow and learn from one another. If anything, the technological developments may help us overcome some of that 200-year history.

Our Pershing Division was a frontrunner in electronic distribution. Some of us can remember one person sitting behind a little computer and waiting for it to start clattering. An order would come in at 2:00 in the morning and we’d be proud of it.

Today, it is far and away the largest of the PC-driven brokers. The PC-individual investor business is now the basis of a growing industry and has been, perhaps our single fastest growing business. We do about 10 percent of the daily volume on the NYSE through our Pershing Division-that means 50 million shares transacted on a 500 million share day.

The competition is going to get very tough, no doubt about it. Schwab and others have concluded that the business is significant and are entering it with great élan. And every technological advance will continue to provide other vehicles, other mechanisms for distribution, in the process putting more pressure on us. We will get all sorts of new players in our business. Already, commission rates have dropped considerably as a result of competition, both in terms of knowledge and execution capability, in the distribution arena.

Yet, the human element in the trading function continues to be important. When you’ve got a buyer and a seller meeting, in effect, through their representatives, there is the ability to bargain, there’s an opportunity to seek advantage from each side, which you don’t have even in some of the more automated exchanges or some of the more nomadic exchanges

Is a “virtual exchange” viable?

Clearly, we live in an age of extraordinary technology, and I have no doubt that before putting something like that in place they will do all they can to replicate the benefits of human interaction. Maybe they will succeed.

On the other hand, why do we get paid for doing a transaction? One, we get paid to physically execute the trade. And two, presumably we get paid because we add value to the investment decision through our research. I don’t just mean research in the sense of knowledge of the companies and industries and their prospects, but research in terms of a sense of the market, what’s happening in the marketplace, what’s going on among holders of the particular security that a client wants to buy.

If this virtual market and its clones-should clones appear-eliminate part of that function, presumably we will get paid for the other parts of the function. So it’s hard to tell what will happen to the income we receive. But I have no doubt that the real value we add is simply adding value to the decision-making process.

Historically, every new thrust of entrants that was looked on with apprehension has been absorbed into our industry. We will all have to adjust and shift to address the new players.

Market Cassandras speculate that the high-yield market is getting overheated. How do you respond to critics who warn that there are fewer good deals and greater risk?

I think the business has become more rational, more ordinary, in the sense that now there are a large number of high quality investors out there, including institutions, who like the yield available to them. So the market has grown significantly. One no longer has to create a market.

The high-yield market serves a very useful purpose: to provide credit at a higher price to those whose credit rating doesn’t qualify for high-grade. That’s such a simple statement, but there are hundreds of very good companies who due to various reasons or circumstances-the youth of the company, for example-don’t qualify for investment grade.

So I don’t think there are fewer good deals, but there are more competitors. As competition has increased-because everyone is now entering the high-yield business-DLJ’s market share has gone up, which indicates that the quality high-yield companies are going to go to the people they have confidence in. We do very intensive high-yield research, and I think we still do the best job on that.

There is a group of firms-and we’re happy to he the leader of that group- who will continue to do good transactions. Does that mean that there won’t be poor transactions done? Of course not. We’ve some high-yield disasters. And it’s worrisome, because it gives a negative slant to the whole business. But I think one has to recognize that the number of good transactions that should and will be done are still ample.

Now that DLJ is a public company, are you redefining risk criteria?

General proprietary trading in the market, which others do more of than we do, is actually riskier than high-yield. The market is more vulnerable to fluctuations. In the private equity business and the leveraged buyout business, awful mistakes can be made, and we’ve seen transactions that went truly awry. But I think that the research that went into those was inadequate. If you look at DLJ’s record as a merchant banker-and even our record in the bridge-loan business, which was considered the riskiest segment of merchant banking-we had no failures.

Even with the great firms in our business, things can happen. We all witnessed Merrill Lynch being hit with a single trader dropping $345 million, and the Barings situation is another one of great sadness. Of course, it’s very easy to be smart after the fact. At DLJ, we spend an exorbitant amount of time and effort and money on controlling our business. That doesn’t mean to say that we tell traders they cannot make decisions. We start with a serious attempt to hire the right people. That’s easy to say, tough to do. Until a year ago, we were always a capital-constrained firm, so capital preservation and effective use has always been an item of faith around here. You start with people who buy into that philosophy. Of course, you cannot be in this business without taking proprietary risk, but we are not making proprietary judgments to the same extent that others do.

One of our strengths is that our people stay. Seventeen of our senior people have been here an average of 20 years. So if we look at the firm together and say, “Let’s be sure we batten down the hatches appropriately,” that’s just a series of individual decisions.

Prior to going public last year, we wrote up $28 million for a bridge loan, although we hadn’t given up on it, because I didn’t want to go into the public offering with the likelihood of having to write off something afterward. It now looks as though that loan, Coram Healthcare Corp., is going to be okay. So we will again be able to say we’ve had no bad bridge loans in 10 years.

Research has made that possible. Of course, we have missed deals that we should have done, because we’ve been too cautious. But I prefer to miss a few deals that we should have done than to do one deal that we shouldn’t have done.

You seem to be taking a selective approach to foreign markets. Can you outline your strategy regarding emerging markets?

We look very carefully at our opportunities. For example, we have not made an arbitrary decision to have a major presence in all the global markets of the world. That would be foolish, because for us to send a handful of people to London or Tokyo to take on the major firms-both domestic and international-would be the kind of thing that was done in the ’80s.

On the other hand, we do see growth opportunities internationally, particularly in the emerging markets. In fact, we have been entering some new businesses and making investment decisions-in essence people decisions, because our investments are assets of people and money.

What special expertise do you bring to the international arena?

A high-yield presence, our equity presence, our research commitment, and the way we market-and finally, the fact that we are willing to put our own capital to work. We were slow to get into these markets because, first, there was so much opportunity in the U.S. that there was no need to expand elsewhere. Second, we did not have a special series of skills that we felt were significant enough for us to go to investors or companies in those markets and say, “Here’s why you should deal with us.” But now I think we can.

Latin America, for example, has been the province of a group of investors who think of themselves as Latin American investors. We have said to Latin American companies, “You’ve outgrown that. If you are an extraordinary chemical company in Chile, you shouldn’t be marketed in the U.S. as a Chilean company or a Latin American company and be under pressure if something goes wrong in Mexico. We have said, “You’re a world-class chemical company. You should be owned by the same people who own Monsanto, Dow Chemical, Hoechst, or BASF, so we will market you that way.” We bring in a leading chemical analyst, like Bill Young, who stands up and says, “This is a world-class chemical company.” And those people who have bought Bill’s ideas before end up doing this. That’s the different approach that we bring, and the reason why people should come to us.

How important is having people on the ground in those areas?

It’s important to raise a flag-to have good people there who will represent the firm well. We established small offices in Argentina, Mexico, and Brazil to give us a presence there. But the major function is to be able to call immediately on expertise from New York.

We operate our Eastern Europe business for the most part from London. We are embarking on a serious attempt to be a significant player in the emerging countries of Eastern Europe. This is a very early time in those markets. No one has done high-yield transactions in Europe at all yet. We recently brought to the market the first Russian company, Vimpel Combinations, to be listed on the New York Stock Exchange. We did the transaction at 20, and it opened at 28.

In South Africa, we allied ourselves with a black investment group and said, “We want to be a minority partner with the leading black financial group.” It’s turned out to be a terrific position for us.

In Southeast Asia, we did something a little different. We took a dozen bright young bankers and set up a sort of Hong Kong-based SWAT team to pursue business there. In India, we have a joint investment operation with Alliance, and we are looking to make direct investments. We’ve also done the first high-yield bond transaction in Indonesia.

China has been to some extent over-plowed in that everybody is in there chasing deals. What do you see happening in that market?

It’s interesting that a number of our competitors that made big commitments to China have backed away significantly. I think the opportunities are not going to develop as rapidly as was thought a few years ago. At DLJ we tend to be cautious builders. The difference between our approach to China and some of the others is starting with a very few people. For our SWAT team, China was, first, not their only market-Indonesia has been attractive-and second, the number of people we have there does not signify a major spending investment.

We are optimistic about China and its capital markets, but the problem of an exotic legal system necessitates treading cautiously. For that reason we have been selective in terms of transactions. We’ve stuck with substantial entities, again of world class. At the same time, we continue to look for direct investment opportunities, which we tend to do with local partners.

How would you respond to Indian Prime Minister Dewe Guddha’s frustration  that India is getting a fraction of the foreign direct investment of China?

India hasn’t marketed itself as well as China. There is a more developed economic infrastructure in India, yet there has been a self interest in keeping the market somewhat closed, whereas in China, there was such a huge need for everything. However, I think India will emerge as an very attractive market, because there is less legal and social risk in India and more of an infrastructure of business law, which will make it easier for companies once they have overcome the reluctance of the Indian government. In the near term, I think it will be a more fruitful market than China.

Looking at the industry today and projecting forward, what is your vision of what the market will look like in 2010?

I think that there will only be a handful of major financial supermarkets doing everything, and another tier of high quality companies who will find niches and fill in the cracks. I don’t believe the world is going to become homogenized. I think quality is going to become more standardized and that we will have those major players who are building those positions right now, as well as opportunity for others. Financial barriers, which have come down so rapidly, will continue to come down. A common European currency and the disappearance of trade barriers is going to make the flow of capital even greater by the year 2010. I think corporations will be more international and the market will be global, every deal will be a global deal.

About J.P. Donlon

J.P. Donlon
J.P. Donlon is Editor Emeritus of Chief Executive magazine.