How to reset the Goldman standard: Take the firm private

By Aaron Elstein

Dec 7, 2009 @ 10:14 am (Updated 4:34 pm) EST

Poor Goldman Sachs. The Wall Street firm that's printing money mere months after exiting the federal bank-bailout straitjacket can do no right.

It's mocked on Saturday Night Live for hogging swine-flu vaccine, accused by a newspaper of neglecting kittens living near its headquarters and charged with chintziness after unveiling a $500 million small business aid program. News reports last week even described fearful Goldman executives applying for gun permits.

Worse than the bad press: Shareholders and regulators are pushing Goldman to change the way it operates. Big owners of its stock want more of the firm's spectacular profits flowing to them and less to employees as bonuses. Federal officials are examining everything from Goldman's compensation practices to how much risk its traders take.

“We're going from a world where Goldman generated 80% of its business from running a Wall Street casino to a place where regulators will allow maybe no more than 25%,” says CreditSights analyst David Hendler. “How will the organization adapt? Can it be a public company anymore?”

No more public scrutiny

That's certainly a valid question. Although there's no evidence that Goldman is contemplating a step back in history to take itself private again, that may be the best road forward. No more relentless public scrutiny. No more disclosing lofty bonus figures. No answering to uppity shareholders.

“Some days, I'm sure some of those guys would love to be private again,” says veteran Wall Street consultant Charles Ellis, author of a recent book about Goldman titled The Partnership.

Goldman, which went public in 1999, wouldn't comment on various buyout scenarios posed by Crain's. There's also a huge caveat to any going-private speculation these days: Federal regulators probably would not allow Goldman to take on additional debt to pay for a leveraged buyout, which is how these deals are usually financed, meaning any transaction would have to be done entirely in cash.

Still, private equity experts say the numbers could work.

First, Goldman Shareholders would expect a premium to part with their equity, which is valued at $85 billion. Investors get 50% over market price historically in such deals, according to Baruch College finance professor Raj Nahata, yet premiums tend to be lower for blue-chip outfits like Goldman because their stock prices are high to begin with.

That suggests a take-private price for Goldman of $100 billion to $125 billion—or, more than twice as much as the largest such takeover on record.

Look closer, however, and the figures aren't so intimidating. Goldman is on pace to generate $30 billion in operating cash flow this year and already has $23 billion in its coffers. Additional funds could come from current and former partners ($20 billion has been set aside for 2009's payouts), institutions such as sovereign wealth funds, maybe even über-shareholder Warren Buffett.

While the firm has $200 billion in long-term debt, PE experts say bondholders wouldn't need to be bought out unless Goldman had already promised to do so in the event of a takeover. It isn't clear if such agreements exist. (Again, Goldman declined to comment.)

Two CEOs of firms that compete with Goldman say that a more likely buyout scenario is for Goldman to spin off its mighty trading division and take it private.

Trading unit is the nuclear core

The trading unit has become the firm's nuclear core, generating 80% of revenue this year, compared with about a quarter in 1998, Goldman's last full year as a partnership. One longtime reason that trading activity was kept in check in the old days: Goldman's partners weren't willing to risk much of their money on risky trades. The firm evidently had fewer qualms about playing with other people's money after it went public.

The trading division now also happens to be the source of most of Goldman's PR problems. It's where the huge profits are made and big bonuses get paid. It's also a point of tension with regulators who frown on outsize risks being taken with bank capital, something Goldman traders often do to boost returns.

End result: a less risky firm

“If i was them, I'd be desperately trying to figure out how to get that business out of the public eye,” says a senior officer at a firm that advises on takeovers and restructurings. “It would also be a much more affordable deal.”

Goldman's trading and principal investments division is on pace to generate $30 billion in revenue this year, but the highly volatile business produced less than a third of that in 2008. Knight Capital, the largest U.S. equities trader, fetches a price equal to 1.3 times its revenue, but Goldman's larger and more diverse trading business merits a higher multiple. So value it at twice its average revenue—$18 billion a year since 2002—and a take-private price of about $36 billion sounds right.

The division could lay claim to at least $15 billion of Goldman's cash, suggesting its employees would have to come up with another $21 billion to take control. A crucial unknown is how much of Goldman's debt it could inherit.

The end result of these machinations would be a less risky Goldman that focuses on mergers advice and asset management and has a more valuable stock. Firms that already do this, such as Greenhill and Evercore, have stocks that trade for more than 20 times earnings. That's more than double the current valuation of all of Goldman. Music to any M&A meister's ears.

This story was first published by Crain's New York Business, a sister publication to Investment News.