Facebook: In Goldman Sachs We Trust

rcwhalen's picture

Looking at the recent announcement of disclosure changes by Goldman Sachs (GS) meant to make the bank more open, on the one hand, and revelations about the surreptitious GS investments in Facebook (Facebook), on the other, one is reminded of Chapter III of The Great Crash by John Kenneth Galbraith, appropriately entitled “In Goldman Sachs We Trust.”

In the summer of 1929, the partnership that was the predecessor of GS floated two trusts on the New York Stock Exchange, Blue Ridge and Ticonderoga, which in turn were spawned by something called the Goldman Sachs Trading Corporation.  The Goldman firm was still a separate and private partnership, mind you, but the small investment bank struck upon the idea of floating these ersatz trusts on the NYSE.

In 1929 there was no SEC, no government regulation in the equity markets of 1929, only the rules of the various exchanges and bank clearinghouses around the country.  In 1925, Louis Brandeis had issued his landmark decision regarding collateral in trusts, Benedict v. Ratner, but the world of American finance was a dark jungle not unlike today’s world of over-the-counter derivatives and private mortgage-backed securities.

Hundreds of similar trusts had been sold to retail investors in the years preceding the crash and most of these, like the GS vehicles, were frauds to one degree or another.  In that sense, nothing has changed on Wall Street in the past century or more except that there is now a far greater role for government, both directly and via various parastatal corporations.  Banks like GS are now able to arbitrage opportunities between the public and private sector.

The floatation of the Goldman trusts would mark close to the high tide of the speculative wave of 1929.  In the aftermath of the Great Crash, both of these vehicles were busted and ended up trading at pennies on the dollar before being finally liquidated.  Now  wind the clock forward to 2011.  The Boys of Broad Street have created another trust to allow clients to invest in Facebook, the latest iteration of the GS model that traces its roots back to Blue Ridge and Ticonderoga.

As Andrew Ross Sorkin reports in the New York Times, the GS private equity fund would not buy these same shares, but Lloyd Blankfein and his generous colleagues did offer these choice cuts of Facebook to their favored clients.  The situation with Facebook, in my view, illustrates why the Volcker Rule misses the point when it comes to the real causes of the financial meltdown.  The syndicate desk, not prop trading, is where the rule of “yield to commission” still reigns supreme and legal norms such as suitability and know your customer are ignored with impunity. 

It must be stated up front that the trust created by GS to facilitate their clients’ investments in Facebook sure looks like a deliberate violation of securities laws.  Based on press reports, it seems that Facebook is, in fact, a public company by virtue of the number of direct and indirect shareholders.  This assumes, of course, that the GS-sponsored trust is a sham created by Facebook for the purpose of evading SEC reporting and regulation.  Once Facebook starts to make disclosures to the SEC, we will have more information.

And just what are those lucky GS clients getting with Facebook?  Earlier this month I posted an interview on ZH with my brother Michael Whalen on the future of new media.  Below let’s elaborate on the Facebook business model as an investment proposition with some input from Michael as well as my observations as a former dot.com banker.  I’ve been watching the debate over the value of an online “user” since a search portal called Alta Vista was part of something called Digital Equipment Corporation, but the ability of Wall Street to sell vapor to credulous investors remains unchanged.   

Look, for example, how the Facebook portal got a lot of ink last week because of the superlative public relations job by GS.  In feeding their "private investment" hype to the Big Media, GS was effectively front-running their own private market, the little ghetto called Face Book that they created apparently to evade securities laws.  Keep in mind that there is a direct parallel here between the GS trust created for investing in Facebook and the OTC derivatives markets in that both models are set up to avoid public reporting and oversight.

The GS guys are usually the smartest guys in the room - but they must have provided more than the usual incentives to make this deal happen. We can tell stories of the abortive IPO of Alta Vista by something called CMGI in Boston.  The GS bankers and CMGI management tried to convince investors that Alta Vista had a community of users based upon search.  Sound familiar?   

Morgan Stanley was supposedly the lead on a four handed deal, this care of the participation of Mary “Queen Bee” Meeker.  But GS, ostensibly number two, was running the client and the deal.  I was the banker for PruVolpe Securities and eventually told bank management that the deal would never happen.  Meeker was nowhere to be found.  The deal eventually died for lack of revenue, a verity made apparent by the fact that after three draft S-1s, we still had no financials for the deal.

Remember that in those heady days of the Internet bubble, the GS internal private equity fund that apparently turned up its nose at Facebook was freely making investments in all manner of emerging “opportunities.”   With Facebook, GS seemingly convinced a group of Russian "media" investors to drop another $450 million into Facebook (this after an initial $50 million) so as to buy a small stake of the gigantic social network. 

This initial investment apparently opened the doors to the ersatz GS “private market” that allowed other GS investors to play, but GS management may have screwed up yet again and created significant legal and reputational liability for Facebook, itself and the investors.  Thus the observation that the GS investment “conduit” appears to be a public offering of securities and, if so, a violation of U.S. securities laws by Facebook.

Naturally GS is covered with fees on all sides of this one - brilliant.  GS thinks that it has no exposure on the Facebook deal -- more brilliant, unless of course Mary Schapiro and her colleagues at the SEC wake up.  And GS actually got the media to help them in justifying this mess to a group of investors who may not know what they bought - but it was sure expensive.

Here are three reasons why the Facebook deal doesn't work IMHO:

(1)        Obviously, the allure of Facebook is getting 500 million + pairs of eyeballs to look at whatever you want to put in front of them, right?  Facebook drives this traffic via free enablement of our inner narcissist and user defined communities. But comes the question: How are you charging for this?  The very thing that makes Facebook popular is the thing that also keeps it from being monetized effectively.  This is the same problem that has always dogged new web ventures, namely that “free” features attracts lots traffic of questionable value.

News reports suggest that Facebook only generates about $1.5 billion in ad revenue. Hopefully we’ll have some SEC filings to look at soon to better understand this business.  But like Twitter and other broad “social” portals, Facebook has yet to demonstrate how they can make this service a going concern that does not need continuous capital infusions.

And speaking of potential exit strategies, other media companies are still reticent about buying into the "marketplace" scenario that Amazon first created on-line. So, unless the Russians got a strategic plan from Facebook dude Mark Zuckerberg - they are flying blind into media hype land and paying GS handsomely for the privilege.

(2)        Michael and others make the point that the staying power of Facebook remains to be tested.  Facebook is the techno hype love object of this moment -- however, once people stop "playing" with Facebook and they have been virtually “befriended” by literally everyone they have ever slept with, done business with and more - what else is there? 

Facebook needs to claim some content that is theirs or make the delivery of other people's content easier. They also have yet to demonstrate, speaking of monetizing traffic, how they will segment their population for advertisers.  What is really funny is that some of the largest media companies, portals and search engines are literally soling their nappies over Facebook, a company which like Alta Vista is still looking for a business model.

Portals such as Yahoo, Google, Amazon and Ebay use various types of functionality to attract and define users.  Facebook is essentially everything and anything, thus the large base of registered users and the massive ramp.  There has been talk and discussion of a "Facebook TV" which looks an awful lot like YouTube.  However, the grab for control (not ownership) of intellectual property in any digital media right now is intense. Is Facebook throwing around its popularity and some cash to eventually be THE hub for all content?  We'll see, but even if Facebook keeps the eyeballs, they are still going to have to monetize this site.

(3)        In the film "All The President's Men," Hal Holbrook says to Robert Redford "follow the money."  If you did follow the money on this deal, you would likely see that the real source of this Russian "media" money was oil and energy.  Got to love when people from one industry play inside another because it's "sexier," a transaction the GS bankers know how to initiate and facilitate.  And like Andrew Ross Sorkin reports, GS does not have a dollar of their own money in this deal.

The NYT reports suggests that the GS bankers who were willing to throw their own money at all manner of dot.com crap a decade ago, would not buy into Facebook when they had the chance to get in early.  The story is that GS couldn't justify it internally, but if you have ever competed with GS in the private equity channel, you know that GS reticence regarding an opportunity is a red flag.  Bright red.

Were Facebook really so amazing, GS would have quietly ponied up a few billion and no one would have been the wiser.  An IPO would have followed in a year or so.  Instead, they chose to sell the opportunity to clients and ramp the deal to the sky now -- and in the process defy U.S. regulators.   The fact that the unveiling of Facebook was done with so much noise and fanfare by GS, a firm that never does anything rash you understand, suggests that there was a need to divert attention from the issue of valuation.

Based on what we know today, it looks like some Russian investors were sold a "bridge" by the Boys from Broad Street and GS wanted to pump the deal in the mess to help the “valuation.”  Wonder if GS has committed to make a market in the shares of their new trust?   Now that would be a real change in corporate behavior.

But if Facebook ends up like Blue Ridge and Ticonderoga in the early 1930s, I sure would not want to be Lloyd Blankfein and the other senior managers of GS.  When it comes to money, you see, Russians do not have a sense of humor.

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Common_Cents22's picture

$3 revenue per user.   But I think they are profitable on $1.5B rev now.   FB was definitely in the honeymoon phase for most users.  When you first get on, you have a flurry of activity posting and reconnecting w/ friends/colleagues, after that period of a few months, activity slows to a trickle, unless you are one of those who plays the look at me, hot or not, daily multiple posts for attention to fill some void in yourself.

FB does have long term sticky potential to be a communication platform for sure.   The value of FB is most everyone else is on it.  Your immediate sphere of contacts are very influential.  It's a matter of FB keeping it relevant and useful while monetizing.   FB is the bridge and collects a toll on traffic.  

FB can take a big dent out of email use and thus evites of the world go poof.   Look at the success of Open Table, that could go bye bye real easy by a free or low cost app.  Lots of opportunity to leverage the platform.

The power of FB having a huge base now is they are leveraging their "login" power.   That is very important as more sites will let you log in using your facebook account.   People hate maintaining multiple log ins on various sites.  I forget my different logins/pw all the time, except now, I use fingerprint login tech.

FB has also done what no other online platform has done.  People are using their real names.   That is valuable to advertisers, and also operationally reduces cost for FB of having tons of people monitoring the BS people post when they assume some anonymous online ID.

Myspace was too narrowly focused on music and didn't change quickly enough.  Friendster, never did try that one.   Classmates.com was prob one of the first major social sites but they were too blind trying to freemium upcharge you they missed the forest thru the trees.

Don Birnam's picture

<< When you first get on, you have a flurry of activity posting and reconnecting w/ friends/colleagues, after that period of a few months, activity slows to a trickle, unless you are one of those who plays the look at me, hot or not, daily multiple posts for attention to fill some void in yourself. >>

The Facebook machine must keep attracting more "users" to replace those who fall away, in order to sustain itself...in essence, a social Ponzi site. However, now with a reported 500 million user accounts, it would seem that virtually everyone who wants to be a "FBer" is already one; the Giant Squid has picked this top in exquisite fashion.


Common_Cents22's picture

Well, that is true if they cannot deliver value to folks who get past the first few months of connecting etc...   As I posted above there are plenty of opportunities to take advantage of owning the FB platform and collecting tolls.

I mentioned Open Table, why the heck isn't this a free app on FB or mobile apps or on google? Hats off to OT for making a nice profitable biz out of it, nearly 2 Billion market cap. 

ewmayer's picture

Nice piece, Chris -

The hype about FB reminds me of a ginormous version of the brouhaha around Skype when it was still a privately-held company: Large, fast-growing user base, "this could be the next big thing", etc. But the very things about the business which allow the portal to quickly attract a huge user base (in Skype`s case, free or nearly-free long-distance telephony and chat) make it hard to monetize. With Skype, eBay found that out the hard way.

CulturalEngineer's picture

Your analysis seems spot on!

Certain 'inventions' will inevitably arise given the development of the landscape that makes them possible. They are emergent properties of the new landscape.

The casual peer-to-peer networking offered by Facebook is one such form.

Like with search before once a certain tipover point is reached concentration becomes self-reinforcing. Alta-vista may have been first in that field... but Google got the prize.

So it is with Facebook post MySpace. A tipover point may have been reached. But I wouldn't count on it.

Its future may be aborted after achieving wide penetration but only marginal utility. There is nothing other than inertia (all my friends are here)... and a few games I understand are popular with some to keep their numbers up.

Because while Facebook is currently dominant, it doesn't address the requirements for deep peer-to-peer association. It doesn't understand its roots in proximity and capability... in other words it doesn't really help people accomplish anything much with others.

And tragically, sometimes missed potentials of new technologies are not regained.

Example from the past: Television! Which because of cultural inertia adheres to patterns laid down by the first players. Those patterns become extremely difficult to dislodge. The INERTIA of the implementation becomes impossible to shake even when obviously faulty.

[For my 61 years people have been pointing out (and its scarcely disputable) that the public airwaves could make campaigning a lot cheaper... and candidacy available to more than just 'pre-approved' candidates. Yet media costs and the money quest continues to be a thorn in the side of honest politics and good governance. And while I'm a real supporter of enterprise... what effect has a 24/7 TV emphasis on Brands (myth-building) and lowest-common-denominator marketing (lizard-brain appeals) had on the culture? I wonder who's interest THAT serves?]

Facebook and other such sites are trying to bridge a longstanding gap as ICT quickly goes global. In evolutionary terms its essentially instantaneous:

There is a FUNDAMENTAL SCALING ISSUE IN HUMAN SOCIETIES associated with NATURAL HUMAN COMMUNITY SIZE (Dunbar’s Number), THE ALTRUISM PROBLEM* (there’s a problematic discontinuity between biological and intellectual altruism) AND COGNITIVE LIMITS (the attention economy).

In short... our personal networks are smaller than the social organism of which we are a part. This presents potentially fatal problems in large group decision making. (But its out of this realization that pragmatic approaches to solution can be found.) Social Networks &

The Social Organism: Healing the Breach http://culturalengineer.blogspot.com/2009/05/social-networks-social-orga...


What COULD form a root function for a STABLE peer-to-peer network with broad-based persistant utility?

A very abbreviated logic chain for a possibility:

1. There’s potential in the political microtransaction for networked citizen lobbying if it can be harnessed.

2. Problem is the cost and hassle of the microtransaction.

3. This problem is solved by system similar to x-box points (which is how they handle microtransaction issue for certain system content).

4. Additional problem is catalyzing the network

5. Addition of charitable potentials solves this for a variety of reasons related to system monetization and a more general user-utility

6. Patent has been approved for this mechanism.

7. There are theoretical reasons for need for such a system but points 1-6 above are about a PRAGMATIC implementation.

8. Should any of the points above be in doubt (which is reasonable) ask a question.

LinkedIn http://www.linkedin.com/in/culturalengineer Political Fundraising: Act Blue,

Facebook and the Missing Network Imperative http://culturalengineer.blogspot.com/2010/08/political-fundraising-act-b...

Capability ENABLES Responsibility http://culturalengineer.blogspot.com/2008/10/capability-enables-responsi...

Fixing the Political Relationship http://www.youtube.com/watch?v=S5qxJDnwXAU

The Commons-dedicated Account System: A self-supporting , Commons-owned neutral network of accounts for both political and charitable monetary contribution… which for fundamental reasons of scale must allow a viable micro-transaction. Such a network ideally should maintain its own cloud and bank. Accounts may be created and/or maintained with zero balances and/or only momentary balances during a pass-through transfer (monetization model requires no burden on the actual transaction.) P.S. Don't know about you... but the idea of the dominant peer-to-peer network(s) containing personal information being 'owned' by anyone (let alone GS, their wealthiest clients or Russian investors) makes me nervous.

rlouis's picture

Solid analysis, from 1929 historical example to GS strategy to end run SEC.  Monetizing the beast has always been a critical issue and it's puke on Time's Man of the Year.  I have an FB account that was hacked before Xmas.  The "hacker" sent an e-mail to all of my connnections hyping "free" iPads.  My skeptical mind suggested that although it's doubtful FB would be doing something like this now, the pressure on managers to generate revenue in a public company would make this type of activity irresistable.

TideFighter's picture

My company collectively made the decision to relegate 40% of our entire 2010 advertising budget to "social" sites. We had internal staff that were real pros with many years of experience tying commercials and ads to "social", including blogs, tweets, ppc, ppv, page viewing times, 800 number caller tracking, and constant pr releases. Bottom line, FB produced fewer clients with less interest than any other venue. Compare it to giving away a free pizza if you fill out a quickie, 5 space application for a mortgage. People didn't want a mortgage, just the free pizza. FB is just that, extremely low price point with extremely low interest. The net value is actually negative when considering the time spent.

Coldfire's picture

"Brilliant", "superlative", "smartest guys in the room." When will this fatuous public fellation of Goldman ever end? They put on their trousers on one tentacle at a time. And Facebook? Please, it's the CB radio of our generation. 10-4, good buddy. And remember what happened to Narcissus.



Coldfire's picture

"Brilliant", "superlative", "smartest guys in the room." When will the fatuous public fellation of Goldman ever end? They put on their trousers on one tentacle at a time. And Facebook? Please, it's the CB radio of our time. 10-4, good buddy. And remember what happened to Narcissus.



Don Birnam's picture

Facebook calls to mind another techno hype love object which hit its own high water mark over a half-decade ago: MySpace. Even Rupert Murdoch, at the time, was sold on its "staying power," so much so, News Corp bought the Bush-Era social networking portal for $580 million in 2005...it has been all downhill ever since.

Before MySpace, there was AOL...AOL's model supplanted CompuServe..."social" sites, by their very nature -- as human nature, given to whim, underpins their sandy foundations -- will always be fleeting in popularity. 

Armchair Bear's picture


Damn...update from Markets entity...

Too many immediacy values with too high sums in the impact, duration, and tension levels to ignore so had to stop work to extract and post the update below. Rest of the report better not be like this or it will take forever....

Extract from upcoming Shape Report: Markets entity:

As 2010 fades rapidly from sight, and mind, we note that the Markets entity is pretty much as its primary supporting descriptors would have it, a [basket (of) crises]. The [basket-case markets] set has secondary support coming from [interwoven] and [inextricably twined] which are themselves both supported at their primary levels by [bad foods] which, given its supporting sets, we are interpreting as [indigestible products]. These [indigestible (financial) products] are about to make [minions (within markets)] go into [spasms] of [violent puking]. This is indicated to be a [planet wide] level event, that in its turn brings [international grievances] and [inter country tensions] to a [visible] and [frightening] level that will be described (in the msm propaganda press) as being a [boil over] situation. The interpretation that we have about the [indigestible products] is that they fall into the category of [derivatives] in general, but specifically there are linguistics around the idea of a [gold price tied/bound] form of [derivative] that [fails] in an [instant] due to a [crisis] in the [gold/precious metals market]. This forecast is based on a lot of immediacy data value sets and so may be within days of happening, and likely will be occurring by the time that this Shape report is published.



January 11, 2011

covert's picture

gs should be ripping off the muslims instead of the russians.