In its recent investment in Facebook, Goldman Sachs demonstrated noteworthy innovation and dynamism demanded by the new economic environment. When markets stabilized as the financial crisis subsided, like other financial firms, Goldman found that
opportunities to make above-market returns vanished. Moreover, competitive pressures intensified, higher capital requirements and fee regulation threatened to diminish future earnings and return on equity.
In environments like these, financial companies face several alternatives. One is to embark on product innovation, another is to become more dynamic in managing balance sheets and risk, and yet another to leverage-up to keep the earnings targets unchanged. Of the three, the last is clearly the least preferable – it was precisely this behavior that got Goldman’s competitors in trouble over the past few years.
Goldman’s role in the Facebook transaction is not new. It had long presented itself as an “advisor, co-investor, and financier” to its clients. This gave the firm access to clients to whom it could sell products, access to companies looking for capital, and the ability to put its own capital to work profitably. With the Facebook deal the firm was able to achieve these objectives – and importantly, without excessive risk.
Goldman invested nearly $2 billion in Facebook, $450 million of its own money plus additional $1.5 million of Facebook it planned to sell to its U.S. clients. The SEC’s limit on shareholder sales proved to be a temporary stumbling block. If the sales of shares to Goldman’s U.S. clients exceeded 499 shareholders, the SEC would require substantial financial disclosure by Facebook – which neither Facebook nor Goldman wanted. After further consideration, Goldman decided to finesse the matter by selling shares only to foreign investors beyond the reach of the SEC, much to the unhappiness of some of their wealthy American clients who had been promised an opportunity to invest.
It’s clear that the deal fulfilled Goldman’s desire to simultaneously serve as advisor, co-investor, and financier. It connected the hottest company to investors who wouldn’t otherwise have access to it; it provided capital to a highly desirable company; and it invested a small amount of its own capital.
With the sale of shares of red-hot Facebook to clients, Goldman was able
to charge much higher fees than customary brokerage commissions. As a combination of placement fees, maintenance fees, and a percentage of gains, the payout to Goldman is likely to resemble more of hedge-fund-type returns rather those of brokers or underwriters. In terms of Financial Darwinism, the Goldman/Facebook deal can be viewed as a business model transformation where hedge-fund-like returns were generated by an investment bank without putting a lot of its capital at risk. It’s a model that we can expect Goldman to continue to develop, as the company continues to look for innovative responses to environmental pressures and challenges.