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Merger fees that bend the mind

This story is from the January 20, 1986 issue of Fortune. It is the full text of an article excerpted in Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012, a Fortune Magazine book, collected and expanded by Carol Loomis.

Companies are on the table as Bruce Wasserstein, director of First Boston Corp.’s merger group, seated, consults with managing directors Charles G. Ward III, 33, center, and Bill G. Lambert, 39.

FORTUNE — On an ordinary workday morning last October, a chauffeur-driven limousine pulled up outside the midtown Manhattan headquarters of First Boston Corp., an investment banking firm. A yuppie in his early 30s alighted and disappeared into the building as an older man on the sidewalk, passing by on the way to his own office, stared in astonishment. The passer-by is treasurer of a major industrial company that is a First Boston client; he had just witnessed the grand arrival of one of the middle-level merger and acquisition specialists working on his company’s account.

Corporate America is hooked on a very expensive habit — paying huge fees to the handful of investment banking firms that dominate the merger and acquisition business. The year just ended has been the most lucrative in history for America’s professional dealmakers. By some estimates, the merger units at three leading firms, Goldman Sachs (GS), First Boston, and Morgan Stanley (MS), each pulled in about $200 million in fees in 1985, not counting commissions for helping raise the money to finance deals.

More than ever, an insistent question resounds through U.S. corporations: Are the dealmakers really worth that kind of money? With customers willing to pay, the quick answer is yes. But clients are muttering, and dealmakers are getting a bad image. You can’t count on their loyalty, grouse many chief executives; the merger maven who is your hired gun today may wind up in the enemy camp next time around — possibly armed with intimate details of your operation. These fellows, it is further said, will stop at nothing to get a deal going. Merely calling a dealmaker for advice may put your company in play.

Such grousing has not dented fee structures and isn’t likely to anytime soon. But the fees clearly rankle, and the issue is so charged that many senior executives who discussed it with Fortune refused to be quoted for fear of the dealmakers’ wrath. Many dealmakers, wary of inviting a backlash, also insisted on anonymity.

The dealmakers owe their huge take to the current merger wave — some $200 billion worth in 1985, according to W.T. Grimm & Co., a Chicago research firm — and the increasing dominance of a few dealmaking firms. Like patients with a rare disease who demand the best doctors money can buy, corporations turn to an oligopoly of investment firms that keep honing the latest stratagems. Price is secondary, considering what can go wrong in a big deal. In bidding for an acquisition, says the chairman of a company that made a large buy in 1984, ”I can screw up badly. So I get the best people and pay what I have to pay. You pay investment bankers for knowledge of the game. They’re good at it; they created it.” Says one young dealmaker at a major firm, ”We always deal with the same players — the same lawyers and bankers — and there are accepted protocols that guys from the sidelines just don’t know.”

That’s why interlopers and lesser fry have had a tough time winning a piece of the merger business. According to statistics compiled by First Boston on more than 400 U.S. deals valued at $100 million or more in 1985, corporations hired one of the top three firms in 35% of the cases and one of the top seven dealmakers 57% of the time. Drexel Burnham Lambert has bulled its way in by bundling dealmaking services with junk-bond financing. Commercial banks, on the other hand, are still in the minor leagues. For years they have offered merger assistance, sometimes at cut rates, but have landed none of the top deals.

The son of a steelworker, chief dealmaker Jay F. Higgins, 40, of Salomon Brothers has his arm in a sling because of an old sports injury.

Faced with towering fees, some corporate chieftains play do-it-yourself. According to First Boston’s figures, that happens only 14% of the time, typically in situations where private companies are being bought or sold. In deals between public companies, some executives have learned the hard way that the do-it-yourself approach can be more costly than paying investment bankers’ fees. In January 1985 a Delaware court held the directors of Trans Union Corp. liable in a lawsuit following the railcar-leasing company’s acquisition by Marmon Group, a private firm controlled by Chicago’s Pritzker family. The plaintiffs were Trans Union shareholders who felt the price was too low and the deal hastily done. They argued successfully that the board made an ill-informed decision, which it could have avoided partly by getting an investment banker’s opinion of the price.

Successful do-it-yourselfers tend to be financiers with extraordinary talent for sizing up a transaction. When CBS was threatened with a takeover by Ted Turner, Loews Corp. (L) Chairman Laurence Tisch rode to the rescue, taking a position in CBS stock that could go as high as 25%.

Another do-it-yourselfer faced down two of Wall Street’s most famous gunslingers. Warren Buffett, the Omaha investing wizard and chairman of Berkshire Hathaway (BRKA), stepped in last March on behalf of Capital Cities Communications in its effort to acquire American Broadcasting Cos. Buffett, who is taking a 19% stake in Capital Cities in conjunction with the deal, went into negotiations assisted by merger lawyer Martin Lipton of the firm Wachtell Lipton Rosen & Katz. Across the table were Bruce Wasserstein, co-director of First Boston’s mergers and acquisitions department, and takeover specialist Joseph Flom of the law firm Skadden Arps Slate Meagher & Flom.

As the two sides neared an agreement, the professional dealmakers held out for more. ”Buffett is so smart,” Wasserstein remembers, ”that you had to be careful to avoid being picked.” As the dealmaker tells it, he and Flom demanded that Capital Cities sweeten its cash offer for ABC with stock; but Buffett, who was not to be pushed far, finally closed by throwing in some small change — a thin veneer of warrants that raised the deal’s value by perhaps 3%. Buffett has declined to comment.

Today’s high fees reflect a fundamental shift in the relationship between investment bankers and clients. Less important than a decade ago are long-term associations in which a corporation depended on one Wall Street firm for discreet help and advice in a range of financial affairs, of which mergers were only a minor part. Today’s relationships are shorter lived, sometimes breaking up after a single transaction, and the investment bankers must ceaselessly stalk new business. Laments a well-known and powerful New York financier who deplores the dealmakers’ fat fees and fast moves, ”There are no investment bankers anymore, only brokers out to make a mark.”

One top dealmaker agrees. ”Investment bankers are independent,” he says bluntly. ”We don’t serve anyone anymore.” But he claims corporations have only themselves to blame. Ten years ago the bulk of the bankers’ income from corporate finance came from the cozy businesses of underwriting securities and making private placements for those long-term clients.

Morgan Stanley’s merger boss, Eric J. Gleacher, 45, was almost acquired himself. He quit Lehman Brothers before its merger with Shearson.

In this dealmaker’s view, the old relationship went out in 1982. The Securities and Exchange Commission, urged on by major corporations, instituted so-called shelf registration of new issues. This allowed corporations to register large amounts of new securities at one time, issuing portions whenever they chose. As a result, companies had less need for investment bankers’ services, and underwriting securities turned into an uninviting business with skinny margins. ”When major corporations pushed for shelf registration,” says the dealmaker, ”they cut the umbilical of the client relationship.”

Looking for other ways to make a buck, the Wall Street firms pushed dealmaking. By happy coincidence, mergers and restructurings had taken a quantum jump by the time registrations went to the shelf. In setting stiff fees for this growing part of their business, the investment firms took full advantage of their new easy-come, easy-go relationship with corporations. ”When you had client relationships,” says an investment banker, ”it was sometimes hard to charge what you wanted to.” Today dealmakers make their money the old-fashioned way — by charging what the market will bear.

For those multimillion-dollar fees, clients get the services of such dealmaking virtuosi as Wasserstein and Joseph Perella, who together run First Boston’s mergers group; Geoffrey Boisi, co-head of investment banking services at Goldman Sachs; and Eric Gleacher, head of mergers and acquisitions at Morgan Stanley. They also get the services of merger departments — which in some firms have grown into deal factories employing scores of professionals. By standardizing dealmaking techniques and recycling information churned up in earlier deals, these organizations multiply the efforts of the gifted few who devise clever stratagems and think up new kinds of transactions.

Celebrated dealmakers still negotiate the biggest transactions, but the top firms insist that much of their advantage today comes from teamwork and information technology. Deals incubate and hatch in nests of printouts — asset analyses, profiles of potential partners, and what-if scenarios. Intelligence gets pulled into a deal from all over the firm. Corporate finance experts size up the details of offers, for example, and security analysts and arbitragers give readings about whether investors will think a deal’s price is right.

In courting clients, the big dealmaking shops trumpet such prowess. Over the past year, by giving young dealmakers more leeway, buying more computers — and aggressively selling its services — Morgan Stanley has quadrupled the number of deals its mergers unit handles. But the archetypal deal factory is First Boston’s. The unit’s goal, according to managing director Bill Lambert, is to make sure that First Boston becomes involved in every major deal — even if the original participants haven’t invited it. Go-go marketing catapulted First Boston past old-line names like Morgan Stanley and Lazard Frères (LAZ) to match Goldman Sachs as the biggest dealmaker in 1985. First Boston did an estimated 175 deals worth roughly $60 billion.

The 120 professionals in First Boston’s renowned deal factory work in squads, some in regional outposts, some specializing in those industries where merger activity is hot, and some assigned to push particular types of deals — or ”products” as First Boston calls them — such as divestiture plans and leveraged buyouts. By mixing and matching the experts from the various squads, says Wasserstein, the unit can quickly analyze and structure transactions that otherwise would seem unspeakably complex.

Goldman Sachs’s dealmakers are led by Willard J. Overlock Jr., 39, and Geoffrey T. Boisi, 38.

Edward Hennessy Jr., chief executive of Allied-Signal Corp., is one of many corporate chiefs who are avid users of the dealmakers’ services. In five major deals since 1982, Hennessy has laid out more than $20 million in dealmaker fees, transforming Allied from a poky oil and chemical producer into a technology and automotive company. One investment banker says Hennessy drives a hard bargain and chides dealmakers when they collect high fees from other clients on foolish deals. The wisdom of his own moves has yet to be proved. On a split-adjusted basis, Allied’s stock recently sold 55% above its high in 1982, the year Hennessy began merging, acquiring, and divesting. But the market has climbed more.

Another heavy patron of the deal factories is Donald Kelly. As chief executive of Esmark between 1977 and 1984, he made over 50 acquisitions and divestitures and finally sold the company to Beatrice Cos. Now he is in line to run Beatrice after it is taken over by Kohlberg Kravis Roberts & Co. (KKR) in a $6-billion leveraged buyout, the biggest ever attempted. Kelly says he fought hard about fees a decade ago. ”I’d say, ‘Whatever you charge is too much,’ and they’d say, ‘You’re too cheap,’ ” he recalls. Now, he says, he has a ”gut feel for what’s fair,” and if he underpays a firm on one transaction he lets it overcharge on the next.

Unlike a lot of corporate chiefs, Kelly is comfortable with the newly casual relationship between dealmaker and client. Too many executives, Kelly says, are still counting on that old loyalty. ”The thing hardest for most people to understand is that one transaction does not create a lifelong association,” he says. ”You can find Bruce Wasserstein alongside you in one deal and on the other side of the table in the next.”

When the modern dealmaking machinery of an investment bank works, it can warn clients away from costly mistakes and deliver lots of money into shareholders’ hands. Morgan Stanley and Shearson Lehman Brothers, for example, kept Nabisco Brands from stumbling into shark-infested waters on the way to its $4.9-billion acquisition by R.J. Reynolds Industries. The deal initially planned by Nabisco chief F. Ross Johnson and J. Tylee Wilson, his Reynolds counterpart, was a so-called merger of equals — a friendly, cashless transaction in which Nabisco shareholders would exchange their stock for Reynolds shares.

Mergers of equals were in vogue several years ago. But in today’s frenzied merger market, they often trigger competing tender offers that lure shareholders by offering cash premiums. Johnson’s investment bankers advised him that if he wanted to keep other acquisitors out of Nabisco’s cookie jar, he needed a much higher price, preferably in cash, from Reynolds. The Reynolds chairman went off on a business trip, and on his return agreed to pay a hefty premium — about 50% above the shares’ market price before the talks began — in cash, preferred stock, and notes. The dealmakers’ trophy: $10 million cash, divided between Morgan Stanley and Shearson Lehman Brothers.

One of the most spectacular combinations to roll out of the deal factory in 1985 was Baxter Travenol Laboratories’ $3.7-billion acquisition of American Hospital Supply, the largest distributor in the hospital industry. Baxter won after torpedoing a planned merger between AHS and Hospital Corp. of America, the largest operator of private hospitals. The planned merger was a $2.5-billion sweetheart deal that fell into the same sort of merger-of-equals trap that Nabisco and Reynolds had avoided.

Convinced the sweetheart deal could be broken up, First Boston began a two-month search for a customer willing to move in. Vernon R. Loucks Jr., Baxter’s chief executive, had independently decided he wanted AHS for himself. Loucks sought out First Boston after another investment banker warned him not to proceed. That firm thought a bid too risky; it argued that AHS, much the larger of the two, with $3.4 billion in 1984 revenues compared with Baxter’s $1.8 billion, might respond with a Pac-Man defense and swallow its suitor.

On June 20, only two weeks before AHS’s shareholders were due to vote on the Hospital Corp. merger, a First Boston plan won a go-ahead from Baxter’s board. Baxter offered $50 per share in cash and stock for AHS, far more than the estimated $35-a-share value of the Hospital Corp. deal. The offer was good until July 5 and for AHS’s board raised the specter of a shareholder vote against the HCA merger.

Loucks apparently intended to stick by his insistence that the bid be friendly. But when AHS rejected the offer out of hand, Loucks changed his mind about withdrawing. AHS soon discovered it was in a tar pit. Security analysts pronounced the Baxter merger a better fit than the earlier accord, the media feasted on the story, and speculators snapped up AHS’s stock. Desperate to keep from losing the cherished Hospital Corp. deal, AHS postponed its shareholder vote, and a storm of protest erupted.

Scott Mohr, the 31-year-old ”project director” whom First Boston stationed in Baxter’s offices for the duration of the deal, remembers the four-week struggle as a blur of unbroken work. At times 15 First Boston staffers worked on the deal, many putting in 100-hour weeks. Days were consumed in meetings with potential allies, bankers, and publicists, as well as in devising securities to finance the deal and endless analytical drills. ”We had 20 strategic alternatives,” Mohr remembers, ”and we kept developing more.”

AHS finally yielded to a sweetened $5-per-share offer from Baxter on July 15, and Hospital Corp. agreed to accept a $150-million settlement. The deal was settled, after four days of nonstop negotiation, during a three-hour phone call beginning at 1 A.M. between Wasserstein and Goldman’s Boisi, who had been belatedly brought in to represent AHS. First Boston earned $8 million on the deal, Goldman Sachs $7.5 million.

There is no way, investment bankers sometimes admit, to calculate the value of their services. But they have a variety of rationales for charging a lot. Knowing how to structure a complex deal without costly mistakes, or how to squeeze the last few dollars out of a suitor, they say, is worth much more than dealmakers ever charge. ”We got one bid raised from $75 a share to $83,” says the head of one merger department. The investment firm’s fee was the equivalent of 40 cents a share. ”Ask yourself,” says the dealmaker, ”whether we provided the equivalent of 40 cents a share in value.”

The dealmakers like to cite their costs. A major transaction not only ties up the top dealmaker and his harried assistants, but can also put heavy, unpredictable demands on senior colleagues elsewhere in the investment bank. For example, Robert Scully, chief of the big capital markets services group at Salomon Brothers, had to be pulled off the desk repeatedly over many months when General Motors (GM) acquired Electronic Data Systems in 1984 and agreed to buy Hughes Aircraft in 1985. Scully helped devise the new classes of common stock GM used in the deals, on which Salomon collected more than $15 million.

Dealmakers also trot out the opportunity-cost argument — the potential income they forgo when doing deals. Whenever the firm’s dealmakers are in on a transaction, for instance, the SEC requires its arbitragers — who speculate in stocks of companies involved in takeovers — to sit on their hands. ”Fees help make it worth our while when we can’t arbitrage a deal,” says an investment banker. The events leading up to Du Pont’s (DD) 1981 acquisition of Conoco, for example, threw Salomon’s arbitragers into a dither. They were stuck on the sidelines on a deal in which several big arbitragers made over $10 million each, while Salomon’s dealmakers collected a mere $500,000 for representing Texaco, a loser in the bidding contest.

Egos and precedent play big roles in how fees are set. Dealmakers often negotiate with a customer by pulling from a briefcase a printout showing what bankers have received for comparable deals. ”I give the comparison sheet to the chief financial officer, the financial policeman who wants to chisel anything he can,” confides a veteran dealmaker. ”Then I negotiate the fee with the chief executive, whose company is on the line or who is about to make the biggest purchase of his career. The sheet keeps the chief financial officer from objecting too much.”

The prevalent practice among dealmakers is to peg fees to the total amount of the deal, using a sliding scale of percentages that drops as the deals grow larger. For some dealmakers, the touchstone is Morgan Stanley’s fee scale, which occasionally turns up in proxy material. In an early 1984 version, Morgan charged 1% for a $100-million transaction and 0.5% for a $500-million deal. A $1-billion megadeal will cost you 0.4%, or $4 million; a $4-billion deal 0.23%, or $9.2 million. Later in 1984, Morgan Stanley hiked its prices for deals between $100 million and $900 million by about 15%, citing heavy demand.

Whether the client is an acquirer or acquiree makes a difference in how the bills pile up. When Goldman Sachs represents a buyer, the fee is fixed so that the client won’t pay more if the deal price goes up — and Goldman won’t earn less if it negotiates a bargain. The fee is negotiated beforehand in two parts: an ante the client must pay even if nothing happens, and a success fee if the deal goes through. Morgan also offers a different, racier arrangement to customers who want to be acquired. The seller pays a fee slightly below the regular schedule until the bidding reaches the price he expects, and then a whopping 5% of the amount by which Morgan can get the buyer to raise his price.

Unless they are helping a besieged client stay independent, Morgan and other dealmakers almost always agree to take a relative pittance if no deal is brought off. When Lazard helped sell Houston Natural Gas to InterNorth in a $2.3-billion transaction, its contract called for $7 million if the deal closed, and only $1 million if not. In a recent bank merger, Morgan was scheduled to collect $3 million upon completing a deal that turned out to be worth $900 million, but only $200,000 if it fell through. The latter sum, interestingly, was Morgan’s estimate of actual hours worked on the deal.

Dealmakers always make sure they’re paid and out of the picture if a deal goes wrong. Fees are spelled out before a transaction takes place, in detailed, confidential engagement letters that cover all foreseeable eventualities. Goldman Sachs right now must be sighing with relief that Getty Oil signed such an agreement in January 1984 while Pennzoil was bidding to take Getty over. The single-spaced, four-page agreement came to light in Pennzoil’s recent lawsuit against Texaco for outbidding Pennzoil and breaking up the deal.

The fees were munificent as usual. Goldman was guaranteed $6 million no matter what the outcome. If Getty voted to accept Pennzoil’s bid, which Pennzoil contends Getty did the day after the letter was signed, Goldman’s cut would work out to $10 million. When Texaco swooped in and snatched Getty away, Goldman was able to collect $18.5 million.

But it is the agreement’s boilerplate indemnity clause that could turn out to be worth all the gold in Goldman Sachs. It is designed to insulate the investment bank from paying damages in lawsuits, even though a lawyer for Pennzoil says it scarcely considered suing the Wall Street house. Texaco, on the other hand, has hell to pay for Goldman Sachs’s success at peddling Getty Oil.

According to jurors, testimony from Goldman’s Boisi and merger lawyer Lipton helped swing the case against Texaco. Their accounts of frenetic 11th-hour efforts to get more for Getty than Pennzoil was offering reinforced the jury’s impression that Getty had welshed on a deal. Juror James J. Shannon Jr., a city of Houston employee, derides Boisi’s attempt to play down his role: ”Boisi said he didn’t shop the deal, he made ‘courtesy calls’ — that was totally unbelievable.”

For the time being, dealmakers are basking in a happy status quo. Most corporate executives regard them as necessary evils — necessary for their skills and connections, evil for their fat fees and opportunism. But merger mania could fade, cutting their fee income; Morgan Stanley expects a dropoff in deals in 1986. Two principal reasons: higher stock prices and a diminishing supply of conglomerates ripe for busting up.