NEW YORK — Wall Street's fabulous new money-making gambit has one of its greatest fans--and one of its most aggressive practitioners--in Barry Friedberg. But Friedberg sometimes can strike an ominous note when he talks about it.
"A mistake by anyone can hurt everyone, and I assure you there will be a deal failure at some point," the Merrill Lynch senior vice president said. The risks "have gone up tremendously" this year.
Friedberg's prediction concerns the financial world's latest passion: Instead of raising money from other investors, Wall Street firms are laying their own money on the line to consummate multibillion-dollar business deals--a practice called merchant banking.
So far, there have been no big disasters, in part because the investment firms' most senior managers personally review the loans. But no one familiar with the merchant banking phenomenon would accuse Friedberg of being an alarmist.
It used to be that only commercial banks could lend their own money for business deals, and they were regulated closely because of the enormous risks. Now investment banks, which once limited themselves to raising money for others with stock or bond issues, are getting into the act.
And they're going even further, frequently taking an ownership position in companies targeted for acquisition. Profits in the $50-million to $100-million range for a single deal are not uncommon.
"Our source of concern is that when an investment bank goes into merchant banking, it takes a step toward acquiring a type of vulnerability that commercial banks have," said Jack M. Guttentag, a professor of finance at the Wharton School in Philadelphia. "The difference is, we have created an elaborate system of safety nets for commercial banks."
Not since the Glass-Steagall Act of 1933 carved out separate roles for investment bankers and commercial banks and established the policy of federal insurance for bank deposits has one event so revolutionized this country's money-lending business as has the onset of merchant banking.
Trying to curb the money-lending excesses of the 1920s, Glass-Steagall gave commercial banks the power to lend money and gave investment banks the securities and advisory business. Ever since, the two kinds of financial institutions have sought to get into each other's business.
In merchant banking, they have essentially found a way to redefine their roles.
The most popular money-lending game in America borrows its name from Britain's merchant banks, which got their start centuries ago by catering to the financial needs of European merchants. But, other than sharing a name, the two are not similar. What Americans call investment banks are called merchant banks in Europe.
As it is being practiced today in the United States, merchant banking is essentially a two-pronged business. When time and lots of cash are of the essence in a financial transaction, the players either put up their own funds in the form of bridge loans--so-called because they span the time between a deal's closing and the arrangement of long-term financing--or they take equity positions in the deal. Increasingly, they are doing both. And both make some independent observers and even some traditional investment bankers uneasy.
One problem is the potential conflict of interest: How can an investment bank offer impartial advice to a client if it participates in a deal as the client's partner? Another problem is the risk: Investment banks are putting an enormous amount of money--a huge percentage of their capital--into deals that may be overpriced and could go sour if the stock market or the economy starts to sink.
Potential for Conflict
Perhaps the most controversial merchant banking maneuver so far was Anglo-French financier Sir James Goldsmith's unsuccessful hostile effort last year to take over Goodyear Tire & Rubber. Goldsmith led the raid but Merrill Lynch committed $2 billion of its own capital to the deal.
Robert Mercer, Goodyear's chief executive, is outspoken about the potential conflicts.
"To call what they do taking an equity position is really just a euphemism for exploitation of a flaw in the free-enterprise system," Mercer said. "It is obscene and it should be stopped."
Speaking of the merchant banking phenomenon in general, Felix Rohatyn, the well-known investment banker, observed: "There is really (a) potential for conflict here. If you're advising a client on a $3-billion deal and at the same time you see a chance to become a principal in the deal and get 20 times the (traditional advisory) fees, whose interests are you going to think about most?
"I say if you need to commit capital to your advisory business, maybe you ought to improve your advisory business," Rohatyn said.