Why Do Investment Banks Go Public?

Goldman Sachs–a New York investment bank owned by 190 partners–plans to go public sometime this fall. It is the last major investment bank to do so. The firm will sell shares representing 10 percent to 15 percent of its value, with the remaining 85 percent to 90 percent going to current partners and employees and Goldman’s few current outside investors. What is the point of an investment bank going public, and why did Goldman resist for so long?

One point is money for the partners. Currently, a Goldman partner can cash out only after he retires. After the firm goes public, today’s partners will own a liquid asset. (They may be forbidden to sell for a few years.) The average partner’s stock may be worth close to $100 million.

But investment banks say that further enriching already-wealthy partners is not the point. The point is that the revolution in financial services of the past couple of decades requires traditional investment banks to expand or die, and going public is essential to expansion. How so? Well, many firms prefer to expand by paying for other firms with stock (the so-called stock-swap). Because only a publicly-held firm can issue stock, Goldman must go public before expanding through a stock-swap.

Alternatively, the Goldman partnership could borrow the money needed for expansion. Borrowing money for a cash purchase would allow current partners to retain control of the company. One downside of cash purchases relative to stock-swaps, though, is that they decrease reported earnings. (The disadvantage of cash arises because when a company acquires another’s stock, it is willing to pay more than the fair market value. Accounting rules define the difference between fair market value and purchase price as a cost, and thus reported earnings fall.) In a stock swap the firm need not reduce reported earnings, though of course the firm must still pay a premium over the fair market value. The second downside of cash purchases is that if the purchasing company has overvalued stock or the purchased company has undervalued stock, it is cheaper to purchase with stock.

And so if going public is such a “no-brainer” (as investment bankers call an obvious or inevitable decision), why did Goldman wait so long? In truth, there are strong arguments about the merits of a partnership, which have not lost their force over the years. (Partnerships have superior incentives and firm culture.) What has changed recently is the force of the arguments for going public. First, Goldman’s officers may believe that the market’s valuation of the firm is at an all-time peak. A splendid price is important for the obvious reason–traders like to “sell high”–and a particular one. At Goldman, equity grows with seniority, meaning that junior partners hold relatively little equity. The firm considered going public in 1996, at a lower expected price, and demurred because junior partners with small equity shares argued that they could not be sufficiently compensated (they would sacrifice present and future equity for present value). In contrast, the whopping expected price in 1998 is high enough that Goldman can afford to generously compensate junior partners and valued employees on the cusp of making partner. Second, several of Goldman’s competitors have recently expanded or merged and, third, in the last few years stock swaps have supplanted cash transactions in merger financing. These two trends suggest that only a publicly-held company can remain competitive.

Explainer thanks Davis Wang of Morgan Stanley Dean Witter and James Suroweicki.