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.