Goldman Sachs and the Future of the Internet - Essay Example

Investing always entails risk. This is especially so when moneys are sunk into a company with little or no track record. On the other hand,such firms often present premium opportunities for brave financiers willing to take on the attendant risks. Goldman Sachs has been profiting from new business start-ups since the 1860s. In the 1990s it played a pivotal role in what is now known as the “dot-com bubble,” during which Internet-related companies received billions in funds from those anxious to get in on the ground floor of what was then an exciting new technology. When the bubble burst many of those firms disappeared, causing massive financial losses for those who bet on them. Goldman Sachs, however, did well during both the expansion phase as well as the period afterwards. This raised the eyebrows of many observers, who suspected the company of deliberately engineering the bubble in order to profit from handling IPOs and feeding the frenzy that drove worthless stocks to unwarranted levels. This paper will examine the history and investment philosophy of Goldman Sachs. It will analyze the dot-com bubble from an historical and sociological perspective. It will also consider the question of whether further investments by Goldman Sachs in Internet related enterprises would be worthwhile. Goldman Sachs and the Future of the Internet Goldman Sachs is at once among the most revered and most loathed firms in the world of investment. Founded in 1869 by Marcus Goldman, it has a long history of earning healthy returns for the investors it represents. In 1896 it was invited to join the New York Stock Exchange, but remained a privately held concern until 1999. The company has long been on the cutting edge of innovations. In the 1800s it pioneered the use of commercial paper, whereby well established businesses are able to borrow funds on a short term basis to meet immediate needs, such as payroll. In the early 20th century it expanded its operations to managing initial public offerings (IPOs) for companies first offering stocks for public purchases. In 1906 it handled the IPO of Sears, Roebuck and Company. As the 20th century unfolded it continuously sought new opportunities. It involved itself in risk arbitrage, acted as a “white knight” is preventing company takeovers, and purchased bonds from emerging economic powers such as Mexico. Gus Levy, senior partner of the firm from1969 until 1976, is known for articulating the firm’s investment strategy as being “long-term greedy;” i.e. willing to absorb short term losses in exchange for the promise of long term profits. The dark side of the company’s dealings has been the fodder of many a polemical writer, however, and not without cause. In 1928 it started the Goldman Sachs Trading Company, which operated much like a Ponzi scheme and collapsed in the crash of 1929. In 1970 it nearly went under when the Penn Central Transportation Company went bankrupt, owing tens of millions of dollars in commercial paper from Goldman Sachs. A crisis erupted which involved numerous lawsuits. In 2007 Two Goldman traders, Michael Swenson and Josh Birnbaum, made a $4 billion profit by short-selling subprime mortgage securities. By 2008 their involvement in the financial products contributed to the global meltdown that occurred that year. A source of long-term controversy has been the ease with which Sachs employees transition into government roles. American president George H.W. Bush made former Goldman CEO Henry Paulson his Secretary of the Treasury. Current Secretary Timothy Geitner’s chief of staff is former Goldman lobbyist Mark Patterson. The current CEO of the company has visited the White House at least ten times since Barak Obama became president. It is reported that the firm was a major contributor to Obama’s 2008 campaign. (A Brief) This dichotomous image of being at once financial geniuses and underhanded opportunists is buttressed by Goldman’s activities since the early days of public Internet use. The company handled the IPO of Microsoft, invested in Yahoo and other fledgling enterprises that are now part of everyday conversation across the world. However. it also has been accused of fanning the flames of the dot-com bubble that lasted from the mid-1990s until the early 2000s, taking advantage of irrational exuberance that it helped to create. According to Goldman critics, this is one example of a pattern the company has exhibited throughout its history: deliberately creating market bubbles, profiting from them, then counting their profits while victims of the resulting financial implosion suffer terribly. This paper shall examine Goldman’s role in investing in web-based firms. It will look at the dot-com bubble, including an analysis of what an economic bubble is and how the phenomena has manifested itself at various points in history. It will consider Goldman’s role in the development of the crisis. In the end it will address the question of whether Goldman Sachs has enjoyed a profit or suffered a loss as a result of its involvement with Internet and IT firms and whether future investments in such concerns are worthwhile.. The term “dot-com bubble” refers to a period of financial speculation that gripped the world’s markets from the mid-90s until the opening years of the 2000s. During this time copious enthusiasm about the emerging Internet-based business phenomena led investors to pour huge sums of currency into dozens of start-up firms, that intended to use the Web as their primary means of marketing and conducting transactions. More often than not these schemes had been poorly thought out and represented little in the way of true commercial potential. Nonetheless, venture capitalists as well as investment houses gave them their money, confident that the returns would ultimately reward their rashness. As history now shows, this proved to be a foolish errand. The vast majority of these firms closed soon after they started. Many did so after using investor’s money frivolously, purchasing items ranging from top of the line office furnishings to lavish vacations, and offering their employees exceedingly generous salaries and bonuses. These results caused a massive market correction in which the bubble burst, destroying many investor’s portfolios and leading to a global correction. 1. What is a Market Bubble? “Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they recover their senses slowly, and one by one.” So wrote Charles Mackay in his classic Extraordinary Delusions and the Madness of Crowds. This is an excellent summation of what occurs during a market bubble, which is defined as one source thus: In markets, a bubble is an extended period of extreme overvaluation. Bubbles occur in stock markets, real estate, commodities and precious metals. There have even been bubbles in the flower market, the most famous example being the Dutch Tulip Mania of the seventeenth century. Bubbles are formed when excessive speculation enters a market. Instead of viewing the intrinsic value of an asset, speculators in a bubble market instead focus on the resale value of the asset. This is sometimes referred to as the greater fool theory of investing. In a bubble, it doesn't seem to matter that a price is irrationally high - it only matters that it can be sold for an even more irrational price at a later date. Bubbles often end with steep declines, where most of the speculative gains are quickly wiped out. (Goldsmith) Goldsmith breaks a market bubble down into distinct stages. The first is when people begin to talk about their investments. Stories of spectacular returns are repeated over and over, and enthusiasm for the related product is stoked. This leads to the second phase, in which the good’s actual value is lost in analysis of how it has risen in perceived value. This in turns drives speculators to sink their funds into the opportunity, further increasing enthusiasm for it. The result is the third stage, in which some persons do earn huge profits from their investment in it. In the fourth phase potential investor’s tepidity is overwhelmed by greed, and consideration of the product’s actual value is flushed away, replaced by mere concern for what it may be resold for. Professional salespeople peddle the opportunity to those looking for strong returns, in exchange for healthy commissions. This continues until the final stage, when overleveraged investors panic, realizing the inherent value of the product in no way matches what they have paid for it. In the final stage, mass selloffs drive prices into a downward spiral, fortunes are lost, lives are ruined, and a chilling effect settles on economic activity for a time, until the cycle begins again. (Goldsmith) Such bubbles are part of the history of commerce. Perhaps the most famous one was the often cited one is the mania over tulips that erupted among Dutch traders in the 1600s. It began in the late 1500s, as particularly beautiful tulips were cultivated in what is now the Netherlands. These quickly became a status symbol among the wealthy, who decorated their homes and gardens with the lovely flowers. By the 1630s prices for the tulips were often as much as a prosperous trader might earn in a year. Prices soared by 1634, as the French began to order Dutch tulips in vast quantities. In that same year trading houses were formed, with individual investors buying the equivalent of futures contracts from growers. As the price spiral continued, more and more persons were drawn into the craze. In 1635 a group of forty bulbs sold for 100,000 Dutch gilders, roughly equivalent to 1,000,000 Eurodollars in modern currency valuations. In 1636 the mania had reached all levels of society. One farmer offered twelve acres of prime land for a pair of bulbs. The manic spirit of the times was described by Mackay: Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clothes women, dabbled in tulips. It is said that what goes up must come down. This adage proved true in 1637. In February of that year growers could no longer find persons willing to pay the going rates. The bottom fell out of the market, and futures traders were impoverished. The Dutch government assisted to a degree by nullifying some contracts, but the overall effect on the economy was calamitous. This pattern has repeated itself since, in different countries, different centuries and involving different products. The South Sea bubble of the 1720s, the railroad bubble in the US in the 1840s, and the stocks bubble of the 1920s are examples. The underlying pattern laid out by Goldsmith has remained the same, however. It fact, it played out precisely in the e-commerce mania that gripped world markets beginning in 1995. 2. The Dot-Com Bubble Prior to the 1990s, the Internet was a tool known only to the US military and certain universities. Originally designed to be a decentralized communications grid that could withstand a nuclear strike, it gained acceptance in the 70s and 80s as a means for professional researchers to exchange scholarly papers and other information of an academic nature. In 1993 this began to change with the release of Mosaic, the first viable web browser for public use. This led to the initial craze among workaday people to “surf the web.” Entrepreneurs were quick to realize the commercial potential of the new trend, and internet service providers such as America Online and Prodigy popped up, selling subscriptions to individual households. Advancement is computer technology throughout the 1990s made PCs faster and more user friendly. This had a feedback effect on the trend, and by the mid-1990s they were approximately 16 million people worldwide using the Internet, a figure that increased to 248 million by the end of the decade. (Internet) Goldman Sachs leaders were not blind to these opportunities, and saw a chance for profit in handling the IPOs of dozens of start-ups that sought the proverbial “ground floor” of web-based revenues. In 1996 it took Yahoo public, despite the short-lived venture’s history of weak fundamentals. In 1997 it managed IPOs for 24 newly minted Internet enterprises, a third of which were losing money by the date of the initial offering. This expanded year by year until 2000, when Goldman brought 47 firms into the public trading fold, including ones such as webvan.com and etoys.com that are remembered now only for being pitiful failures and giant money pits for those unlucky enough to buy shares in them. Acting as facilitators, the financial firm profited irrespective of how well their new offerings ultimately fared. By early 2000 some saw that the exuberance for any company with a .com at the end of its name could not last forever. Barron’s printed an article entitled “Burning Up” in its March issue of that year that predicted the bubble was about to burst. Its opening paragraph was ominous in tone: W hen will the Internet Bubble burst? For scores of 'Net upstarts, that unpleasant popping sound is likely to be heard before the end of this year. Starved for cash, many of these companies will try to raise fresh funds by issuing more stock or bonds. But a lot of them won't succeed. As a result, they will be forced to sell out to stronger rivals or go out of business altogether. Already, many cash-strapped Internet firms are scrambling to find financing. (Burning) The piece was widely ridiculed at the time, with the authors being accused of “yellow journalism” and gross misrepresentation of the facts. (Ouch) By December 31st the publication’s warnings were vindicated, however. Mattel sold The Learning Company, which it purchased for $3.5 billion in 1999, for $27.3 million in 2000, a loss of approximately 1500%. Boo.com burned through $188 million in just six months before going belly up in May of 2000. Freeinternet.com collapsed in October of the same year, losing $19 million in investor funds while generating only $1 million in revenues. 2001 and 2002 saw additional disasters for those who had bet heavily on the dot-com bubble. In all some $5 trillion of wealth was wiped out due to the post-bubble aftermath. Bitter observers attached the appellation “dot bombs” to the poorly conceived, vastly over capitalized ventures that had been the object of billions of dollars in courting over a short time before. 3. How Did Goldman Sachs Fare Financially? Looking back in retrospect, writers, economists and historians have sought to lay the lion’s share of the blame for this debacle at the door of venerated investment firm Goldman Sachs. According to this school of thought, the well established financial company purposely drove up the costs of nearly worthless securities in order to profit from the workings of the “greater fool” theory. Throughout the bubble period Goldman enjoyed profitable years. In 2000 it had net earnings of $3 billion, despite the failures of many of the companies it had backs and whose IPOs it handled. It did worse in the following year, largely due to the 9/11 attacks. (The Goldman) It recovered swiftly, though, and records showed it walked away from the dot-com bubble better off than before. None of this escaped the eyes of government investigators. In 2005 Goldman agreed to pay a total of $150 million in fines do to accusations that it had practiced “laddering,” or purposeful distortion and hyping of a company’s value, during the bubble years. Journalist Matt Taibbi, in his article The Great American Bubble Machine, describes how the technique works: Say you're Goldman Sachs, and Bullshit.com comes to you and asks you to take their company public. You agree on the usual terms: You'll price the stock, determine how many shares should be released and take the Bullshit.com CEO on a "road show" to schmooze investors, all in exchange for a substantial fee (typically six to seven percent of the amount raised). You then promise your best clients the right to buy big chunks of the IPO at the low offering price — let's say Bullshit.com's starting share price is $15 — in exchange for a promise that they will buy more shares later on the open market. Taibbi goes on to explain how Goldman uses their position in this role to its maximum benefit: That seemingly simple demand gives you inside knowledge of the IPO's future, knowledge that wasn't disclosed to the day trader schmucks who only had the prospectus to go by: You know that certain of your clients who bought X amount of shares at $15 are also going to buy Y more shares at $20 or $25, virtually guaranteeing that the price is going to go to $25 and beyond. In this way, Goldman could artificially jack up the new company's price, which of course was to the bank's benefit — a six percent fee of a $500 million IPO is serious money. (Taibbi) To what extent is an increase in funding from Goldman Sachs to start-up companies in the U.S. technology sector financially worthwhile? The answer depends on the answer to a separate question: worthwhile for who? Perception of value is all that is needed to make money from a sale. This relies on a perspective on investing known as the “greater fool” theory. In brief, it sees any price paid for a purchase as justified, so long as there is someone else who is willing and able to pay even more for it. This dynamic is a key part of what drives economic bubbles. (Goldsmith) From a purely mercenary point of view, such bubbles are periods of unrivalled opportunities for making money. Historical data confirms that Goldman Sachs is well aware of this and has positioned itself at key times to profit from the mania of others. It did so during the dot-com bubble, and more recently during the real estate bubble of the past decade. A savvy individual or firm can even profit from the post-bubble climate, during which the opposite occurs and assets are often priced unrealistically low. Flush with cash from the profits gained in pumping the bubble up, said investor uses these resources to swoop in on companies in dire straits, buying their property for greatly deflated costs and holding it until the economy begins an upward swing. Of course not all profits are gained through capitalizing on another person’s stupidity. When a company’s stock rises in realistic proportion to its true value then those who invested in it initially are rewarded for their faith in the enterprise. Goldman stands to win in this scenario as well. But observers of the firm notice what appears to be attempts to induce yet another Internet stock bubble. In January of this year it announced plans to invest $450 million of its own funds in social media giant Facebook. It also gave its favoured clients the chance to sink $1.5 billion into the opportunity. Controversy caused the securities firm to alter the terms of the deal at the last moment, limiting it to foreign investors to avoid conflicts with US security laws that prohibit “hyping” a deal. This is all being done ahead of the anticipated IPO of Facebook stock in 2012. (A Risk Too Far) Some observers see this as a covert way of circumventing the aforementioned regulations that forbid creating an atmosphere of frenzy about a new opportunity. By offering preferred clients first dibs at Facebook, Goldman Sachs may be using the allure of exclusivity to accomplish a de facto atmosphere for a new bubble. This view is far from universal, however. Other analysts point to fundamental differences between the 1990s and now: More important, the tech start-ups that have attracted so much interest from investors have real businesses — not just eyeballs and clicks. Companies like Facebook have fast-growing revenue. Groupon, which has been profitable since June 2009, is on track to take in billions in revenue this year. And since 1999, when 248 million people were online (less than 5 percent of the world’s population), broadband Internet and personal computing have become mainstream. About one in three people are online, or roughly two billion users, according to data from Internet World Stats, a Web site that compiles such numbers. (Investing) Whichever view is correct, Goldman stands to benefit either way. If companies like Zynga and Facebook fare well and long term investors enjoy healthy returns, then the investment firm will be hailed for having the vision to pick tomorrow’s winners. If, conversely, another bubble rises and pops, it will earn money from handling IPOs and relying on the fundamentals of bubble economics to enhance its bottom line. The following decision tree illustrates how this works. As the tree shows, Goldman profits regardless of how the company they promote fares over time. However, there are two possible disadvantages in this scenario. Goldman may not sell its holdings in the company before the bubble bursts. It will then lose the profits earned from the stock’s price going up. Additionally, investors may be reluctant to invest money in firms promoted by Goldman if their reputation suffers over the long term. This in fact occurred after the stock market collapse in 1929. It is also recurring now, as Goldman sinks money into companies such as Facebook. Many observers fear that the company is doing so purely for its own benefit (Taibbi). If this is Goldman’s strategy, then it should weigh prospects for short-term profits over long term damage to its reputation. This danger is illustrated in the following: The final answer to the question of whether it is worthwhile for Goldman to invest in Internet firms such as Facebook is dependent on which scenario best benefits its overall profitability. Given that the last dot-com bubble is still remembered, a cautious strategy would be for the firm to exercise due diligence practices before promoting such companies. Unlike the 1990s, there now exist mature, stable web-based companies that show strong prospects for solid, continued growth into the future. The aforementioned Facebook is one example. On the other hand, Goldman’s managers may choose to aggressively hype companies and earn funds purely from handling IPOs and selling the expansion phase of any resulting bubble. This has the promise of short term profits, provided investors disregard the events in the 1990s. So far this paper has only considered the question from a monetary viewpoint. There are also ethical considerations, however. Deliberately creating bubbles may benefit the firm doing so, but it virtually guarantees an economic contraction and ruined portfolios in the longer term. That same outcome can also be seen as undesirable purely from a selfish viewpoint. The world economy is currently in a very fragile state, largely due to the real estate bubble aftermath. Creating a similar situation any time in the foreseeable future may bring profit to Goldman momentarily, but it might also have the effect of poisoning the well, doing so much harm to international commerce that Goldman’s revenue gains would in the end be a pyrrhic victory. Perhaps the best approach for the firm would be to fall back on proven business fundamentals. Invest cautiously, invest wisely, and invest with the future in mind. Goldman is famous for its philosophy of being “long term greedy.” It likely cannot afford to abandon that approach without working against its own best interests, as well as those of its clients, other businesses, and consumers. Works Cited A Brief History of Goldman Sachs. http://online.wsj.com/article/SB10001424052748704671904575193780425970078.html Bubble. http://www.investorglossary.com/bubble.htm MacKay, Charles. The Madness of Crowds: Past and Present. http://www.businessweek.com/managing/content/dec2008/ca20081216_263901.htm Internet World Statistics. http://www.internetworldstats.com/emarketing.htm Willoughby, Jack. Burning Up. http://online.barrons.com/article/SB953335580704470544.html Ouch! Barron's Scorched by Burning Up Debacle http://boards.fool.com/ouch-barrons-scorched-by-burning-up-debacle-12282742.aspx The Goldman Sachs Group, Inc http://www.answers.com/topic/the-goldman-sachs-group-inc Taibbi, Matt. The Great American bubble Machine. http://www.rollingstone.com/politics/news/the-great-american-bubble-machine- 20100405 A Risk Too Far. http://www.economist.com/node/17969917 Investing Like it’s 1999. http://dealbook.nytimes.com/2011/03/27/is-it-a-new-tech-bubble-lets-see-if-it-pops/ Read More