Behind the Salomon Brothers Buyout (Fortune, 1981)
Salomon Brothers’ flabbergasting decision to end its highly profitable partnership was taken in typical Salomonic style—secretively, hurriedly, and after intense deliberation. The 62 general partners in the nation’s largest private investment bank and the world’s largest bond-trading firm received just ten days’ notice of a later-than-usual and weekend-long quarterly meeting at the Tarrytown Conference Center near New York City. “Everyone suspected something,” says one Salomon partner. “Quarterly meetings usually take an afternoon.”
Attendance was obligatory and all the firm’s general partners arrived on time—6:30 P.M., Friday, July 31—for the first meeting. It was held in an auditorium in the North Tennis House at the Conference Center, which occupies the former estate of New York society hostess Mary Duke Biddle, of the tobacco Dukes. Some of the partners cut short vacations and others rearranged business trips to be there. Fortune has pieced together the events of that weekend and the astonishing deal it produced.
As the meeting convened, Salomon’s seven-man executive committee was seated at a table, facing the throng of partners. The committee numbered some of Wall Street’s biggest guns: managing partner John H. Gutfreund (pronounced Goodfriend), economist and interest-rate oracle Henry Kaufman, arbitrageur Richard G. Rosenthal, mergers and acquisition ace J. Ira Harris, government-bond chief Thomas W. Strauss, municipal-bond expert Gedale B. Horowitz, and Richard Schmeelk, partner in charge of corporate finance.
Gutfreund, 51, opened the meeting by announcing that operating profits for the first ten months of Salomon’s current fiscal year, which ends September 30, had broken all records. With that bit of fine but expected news out of the way, he dropped the bomb: the executive committee was unanimously in favor of merging the 71-year-old partnership with Phibro Corp. A publicly owned commodity merchant with revenues of $24 billion a year, Phibro is one of the world’s largest traders of raw materials. The name (pronounced Fye-bro) is a contraction of Philipp Brothers.
Everybody in the room had at least heard of Phibro. In May, Salomon acted as investment banker for the former parent, Engelhard Minerals & Chemicals Corp., when Phibro was split off. But merger? That was something Salomon partners thought of for others, not their own firm. Until Gutfreund took over as managing partner in 1978, Salomon Brothers had for 15 years been run by William (Billy) Salomon, who always refused to consider disbanding its partnership. When the idea of merger hit the partners, recalls Gutfreund, “their reaction was shock. Then, ‘What does it mean for me?’ Then finally, ‘What does it mean for the business?'”
Getting their money out
What it meant for the partners was rather a lot, as became clear when Gutfreund spelled out the terms of Phibro’s offer. Salomon’s general partners and its 29 limited partners—investors or retired partners who own roughly a third of the firm’s net worth—would get all their own capital out of the firm in one lump sum when the partnership dissolves on September 30. General partners would take out an average of $2.7 million, not counting profits for 1981—all tax-free because they paid income taxes every year on their profits before adding to the capital fund. After the merger, Phibro would recapitalize Salomon Brothers, putting in upward of $300 million. It would also assume somewhat more than $100 million in loans, mostly from insurance companies, and pay off $14 million in notes held by departed Salomon partners.
In addition, the deal would give general partners (average age: 42) a fat premium over book value—$250 million in 9% bonds convertible into Phibro common stock over five years. The size of each general partner’s premium would be determined by the percent of Salomon’s profits he was entitled to. Members of the executive committee stood to gain the most—$75 million, an average of almost $11 million each. The other 55 general partners would get $175 million, an average of $3.2 million. A first-year partner would snag about $1.25 million.
To underline what was in it for the partners, the executive committee distributed booklets showing how much cash and bonds each could receive. John Gutfreund’s book showed his payout—cash and bonds together—to be $32 million, plus his share of 1981 profits. Ira Harris—the partner who, with Dick Rosenthal, negotiated the terms of the merger—would emerge with around $16 million, plus 1981 profits. Rosenthal’s take would be about the same.
Several new junior partners wondered out loud, deferentially to be sure, whether the money they were to get would be adequate compensation for giving up the exalted status of partner, which they had achieved only after years of grueling work. But no one exhorted the executive committee to preserve the partnership form.
The partners had until Sunday, August 2, to ponder the deal before signing over their ownership and committing themselves to Phibro employment contracts that bar them from working for other security houses for three years. (The executive-committee members were bound to five-year contracts.) The deal was to be signed, sealed, and delivered to Phibro before news of an offer could get out on Monday to upset the financial markets—and before anyone could change his mind. It was understood by all that no one was to leave until the deal was done. The opening of the conference Friday night “was a very, very emotional evening, and a lot of people didn’t get any sleep,” recalls Dale Horowitz, one of the executive-committee members.
A liquid crowd
“I wanted an overwhelming consensus for the merger,” says Gutfreund, who adds, “We would not have proceeded with the marriage if a majority of partners hadn’t been willing or hadn’t been convinced that this was a business fit.” Since the executive committee had already approved the merger, many partners regarded it as a fait accompli. And right off the bat, many were ecstatic. Gloats one: “Anytime someone wants to stick me in a room and give me millions of dollars, please don’t throw me out into the brier patch.”
Throughout Saturday, the executive committee counseled partners individually. In the course of those talks, six partners either chose or were forced into early retirement. Everyone was encouraged to call his wife (but no one else) and consult the battery of lawyers and accountants available for private discussions. By late afternoon, a ground swell of excitement started to roll over the suddenly liquid crowd. Over half the partners signed Phibro employment contracts before the day was over.
Sunday morning at 7, Salomon’s new bigger half arrived in the form of the top men from Phibro, Chairman David Tendler, 43, who had started the merger talks with the executive committee several months earlier, and President Hal Beretz, 45. They explained their view of the merger and responded to partners’ queries about compensation, promising large salaries and bonuses. Around 10 A.M., all partners having signed agreements to sell, the future Phibro employees gave Gutfreund a jubilant standing ovation.
While all this was going on, there was one principal who had never been told that the meeting was to take place—a principal whose name was one of the assets being sold. After lunch, Gutfreund, Henry Kaufman, and Richard Schmeelk flew to Billy Salomon’s home in Southampton, New York, to tell him, for the first time, of the partnership’s end. Salomon, 67, now a limited partner, will get less than $10 million—just the capital he had in the firm. Friends say Salomon believed he had left the firm in trust to Gutfreund, and was enraged at his protégé’s callousness in neither consulting him on the deal nor informing him of it until after its completion.
On Monday, once Wall Street recovered from its stupefaction at the announcement of the merger, it started asking why Salomon had agreed to become the junior partner of a public company. Salomon’s traders lost $30 million to $34 million in the turbulent bond markets of July before closing out hedges. That gave rise to rumors—untrue, as it happens—that trading losses precipitated the merger. But what did?
To keep from losing valuable Salomon people, Phibro is locking golden handcuffs on them.
None of the partners admit that lust for money brought Salomon to Phibro. But even Gutfreund may enjoy getting his hands on his own capital. After remarrying recently, he purchased a fancy Manhattan duplex in River House, where Henry Kissinger lives—an apartment that designer Gloria Vanderbilt had also tried to buy. Says one associate: “He was the most conservative, even chintzy, fellow before his new marriage. He never used to draw out as much money as he could have from the firm. His young wife wants to live high.” But no one who knows Gutfreund suggests that the change in spending habits has stopped him from working his usual ferocious hours.
A millionaire’s catch
It is easy to see how many of the partners could have been seduced by the money, for most of their wealth was locked in. Salomon Brothers has been alchemizing its partners into millionaires for years: the only catch was that they couldn’t spend like millionaires. The year before becoming a partner, a senior trader could earn an after-tax income of $100,000 to $150,000, including bonuses. Once made a partner, his take-home dropped to the standard new-partner salary of about $80,000, plus 5% interest on whatever initial capital—often just $20,000 or $25,000—he had put into the firm.
As a partner, of course, he was also entitled to a portion of the firm’s profits, according to an elaborate formula that divided the earnings into “shares.” A new partner would have half a share. Part of the earnings went to pay his taxes, with most of the rest of his portion going into the capital fund. So his $80,000 salary plus, say, $1,000 interest would be after-tax take-home pay. Still, that would be less than he made as a senior trader. His take-home would increase as his capital account grew, but it might be five years before he caught up to where he had been.
After perhaps ten years, a senior partner appointed to the executive committee might move up to take-home pay of around $300,000. By then, however, he would have accumulated a capital account running into millions. The severe restrictions on how much of their share of profits partners could withdraw helped give Salomon the fourth-largest capital base among Wall Street security firms.
In 1980, Fortune estimates, the firm earned at least $130 million pretax, a return on capital of 39%. But 30% of last year’s earnings were a onetime bonanza from the sale of a side investment that certain partners had made in a Texas offshore oil and gas field—over which one departed partner has filed suit, alleging he was fraudulently deprived of his fair share of the profits. Salomon Brothers denies the allegation.
Since earnings have averaged more than $100 million pretax over the last two years, Phibro’s purchase price of twice book value looks quite cheap. But for the partners, the prospect of more ready money was inviting. They will no longer have to put their own capital at risk daily in trading, and they can add to their net worth if Phibro stock appreciates.
Fixes that failed to cure
Once capital was removed, what was left in Salomon Brothers was people—the main asset of any investment bank save for its inventories of stocks and bonds. And people, both junior partners and vice presidents below the level of partner, had been worrying Salomon in the last five years. How were they to be paid enough to satisfy them when the compensation scheme drastically favored senior partners who had bigger capital accounts and, often, larger profit shares? By gradually upping the salaries of new partners from $50,000 to $80,000, Salomon damped their complaints.
The more refractory problem involved contract employees, especially vice presidents. Traditionally, Salomon reserved 25% of its pretax profits to divide among them, but the number of people grew faster than the pool, and bickering spread over the resulting smaller shares. Under both Billy Salomon and Gutfreund the firm tried various palliatives: a sliding pay scale, discretionary bonuses, and, finally, enlarging the pool to around 30% of pretax profits. But none of these worked well, and the partners weren’t keen on two other obvious remedies—admitting dozens of new partners or entirely overhauling the way profits were distributed. The problem was serious enough for one partner to have believed the secret Tarrytown conference was called to announce the solution to the compensation puzzle.
A kind of savings bank
In considering the merger, Gutfreund agonized over whether the firm’s young employees would do better in a partnership or a corporate structure. The partnership’s restrictions on withdrawing capital forced people to save, and the earnings were tax-sheltered. But salaries at Phibro would provide greater present rewards. Says Gutfreund: “Phibro by reputation pays highly, and I am hopeful that our young people will be well compensated. But the firm won’t be the same kind of savings bank that it was for many of us for years.”
Will the ex-partners of Salomon Brothers work as hard now that they have all that boodle and won’t be daily laying their own money on the line? And will those whose hopes of ascending to partner have been dashed want to remain in a corporation where profits flow to shareholders? Phibro Chairman Tendler, whose compensation last year was $1.8 million, dismisses such questions. “We’ve been motivating people for nearly 70 years,” he snaps. “We’ll deal with it or we’ll cut our throats, and we’re not about to do that.”
Among the golden handcuffs Phibro plans to lock on senior employees and young former partners—who like the other partners will be called managing directors in the new Salomon Brothers subsidiary of Phibro—is an incentive plan incorporating phantom stock. Fortune has learned that perhaps 50 to 100 employees will be given portions of a $30-million to $35-million capital pool that Phibro will establish as a contractual obligation. They will also “own” whatever amount of $30-per-share Phibro stock their portion of the pool could buy. By the end of 1986, when they can draw out their cash portion of the capital pool, they’ll also receive the appreciation of this phantom stock in dollars—calculated, moreover, not on the 1986 price but on the stock’s five-year high. If an employee’s cut of the cashpot is $100,000, say, and Phibro stock (recently traded on the New York Stock Exchange at $35) hits a high of $60 a share sometime in the next five years, the employee stands to collect $200,000 over and above his salary and bonus.
So long as Salomon matches the profits it made as a partnership, both Tendler and Gutfreund are betting that Salomon can keep its people. Not only will their pay be good, but their business will become increasingly complex and exciting. The merger takes Salomon Brothers deeper into commodities trading; for the past three years it has been trading gold and silver commodity futures, but only for its own account. Salomon should also find itself becoming more international. Phibro does most of its trading business abroad; Salomon Brothers is more of a newcomer in international market making and underwriting. The merged company, says the president of a rival brokerage house, “is the first truly international firm in our business.”
The merger may help each part of the new company do its principal business better. Phibro trades 150 raw materials, and now it will have another big one—money. Through the mechanism of futures, commodity and financial trading have begun to resemble each other. Phibro and Salomon may well be able to trade more profitably by knowing what’s going on in the other’s field. Eventually, by exchanging information, contacts, and with any luck, clients—whether companies or foreign governments—Phibro could win more deals, more financings, and perhaps even bring more commodities to the market. The merger might lead to the development of new credit instruments to secure Phibro more trade contracts—novel forms of commodity-backed bonds, for example. At the least, Phibro should find it useful to have Salomon Brothers as a captive securities house to arrange financing for its own gluttonous short-term credit needs.
A place in the ferment
With more resources backing it up, Salomon can diversify into nascent markets and trade in larger volumes. “There’s so much ferment in the whole financial system worldwide,” says Henry Kaufman, explaining why he backed the merger. “Look what’s happening to the savings and loans associations, the realignment of savings through the development of money-market funds, the emergence of a huge Eurodollar market, the growth in Europe of world banking institutions like the Deutsche Bank, the efforts of American commercial banks to move across banking boundaries. We had to ask ourselves where we would be in this ferment five to ten years from now if we stayed the same.”
Other Wall Street investment-banking houses—especially the remaining private ones like Morgan Stanley, Goldman Sachs, and Lehman Brothers Kuhn Loeb—have a huge new rival. Salomon Brothers sees Phibro-Salomon’s $2.3-billion capitalization as a decided advantage in playing tomorrow’s larger, more diversified, more interrelated, and less regulated markets. And those other firms must be wondering about their own place in the ferment. Salomon is the fourth Wall Street securities house bought so far this year by companies in other industries. Prudential’s purchase of Bache, American Express’s of Shearson Loeb Rhoades, and Bechtel’s of a majority interest in Dillon Read raise the disturbing question, as the president of one investment bank remarks, “of whether we are an industry or parts of other people’s business.”
This article was originally published in the September 7, 1981 issue of Fortune.