What Venture Capital Can Learn from Private Equity

What Venture Capital Can Learn from Private Equity

The venture capital game has changed, yet many VCs are still using an old, outdated playbook

By Peter Rip

Business Week

updated 8:00 p.m. ET April 15, 2009

Baseball and venture capital always seem to make an effective pairing for analogies. As in baseball, much of the cachet of venture capital is inspired by the romance of the metaphoric grand slam. The recipe has been the same since venture capital began: Find a team, give it money, sit back, and wait for the bloom. Most investments fail. But a few could be big winners and make it all turn out just fine. It used to be said in this business: "You can only lose one times your money." The implication is that winners will pay back the risk many times over.

The reality is that this approach works for an ever-winnowing number of companies, and shockingly few since 2000. The median venture capital fund has seriously underperformed the Russell 2000 Index since 2000. This is a stunning reversal over the prior two decades. What happened? There was a structural change in the game, yet most of the incumbents kept executing the same playbook.

Traditionally that has meant funding disruptive change and managing execution risk. For example, the decision by Kleiner Perkins Caufield & Byers to recruit Eric Schmidt was a masterful way to take the risk out of business execution at Google (GOOG) early on. Closer to my home, my partner, Jim Feuille, led change in our business model when we invested in Pandora Media, changing from a subscription service to free personalized Internet radio. Today, Pandora is the largest radio site on the Web. Managing execution risk at Pandora meant adding measured risk to capture the return of a bigger opportunity.

The classic VC play has always been to take enough risks and you'll be rewarded with the Great Exit, such as a big IPO or acquisition. VCs learned to excel at team selection and the mitigation of execution risk, often considering other risks inherently uncontrollable. Venture capitalists tended to place less emphasis on issues such as valuation, the timing of exits, and future capital availability precisely because you could only lose one times your money.

The Bull Benefit

Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures.

The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.

Author Michael Lewis chronicled the success of baseball teams such as the 2002 Oakland Athletics in his book Moneyball. The A's didn't have the funds to buy top athletes, but instead assembled a winning team through a more analytical approach. Statistical analyses included in the book found that ballclubs that simply tried to get a man on base as many times as possible won more games than teams that focused on hitting home runs.

Most investors in venture capital understand that you cannot generate an acceptable rate of return by hitting singles and doubles. What they don't appreciate is that a strikeout is far more destructive when grand slams are fewer and further between. And with fewer grand slams, time also matters. In a secular bear market, that Great Exit may take so long to occur that the drought destroys your internal rate of return.

More Risk to Manage

In short, it has become clear since 2000 that financial risk/return is as important as execution risk in venture capital. Financial risk/return refers to weighing the risk that the financial markets may not be ripe enough soon enough to justify investing this much, at this valuation, now. Today's VCs have to pick great markets, great teams, and manage execution risk, as they always did. But they also have to manage valuation risk, timing risk, and investor syndicate risk.

Venture capitalists can learn a lot about managing this new set of risks from their counterparts in private equity. Whereas the traditional venture capital playbook has been about company-building, the private equity playbook has been about financial engineering. Private equity is focused on metrics, comparables, terms, and cost of capital -- more so than innovation, market selection, and team development. Their teams and companies are more mature, reducing the need to be an expert in assessing execution risk.

Think about this in terms of an inflection point, or that period when an additional dollar invested yields far greater shareholder value than it would have at an earlier phase. It's the point at which a little gas fuels a huge fire. Finding the best companies and investing in them at inflection points are perhaps their two most important disciplines. Stage is not a consideration. It is all about that inflection point.

Venture capital is at the intersection of innovation and finance. Fortunately for investors, innovation continues without regard for the financial markets. The jet engine, the helicopter, FM broadcasting, fiberglass, nylon, photocopying, radar, sticky tape, and instant film were all invented during the Great Depression. Breakthroughs are everywhere today, in energy technology, biotechnology, and even information technology. These innovations will continue to disrupt incumbents and create new markets -- and they will all need early-stage venture capital.

But the absence of buoyancy in capital markets means the early bet is not always the best bet. The new venture capital playbook begins by taking into account the macro drivers of growth. Which sectors are most ripe for disruption through innovation? Add to this the venture practice of building networks of entrepreneurs and partners who can place you in the flow of that innovation.

Inflection Points

Here's where the private equity model takes hold. Like private equity investors, VCs need to understand the entire sector, at every stage in the spectrum -- seedlings through large public companies -- to develop a theory of how the industry will evolve. Who will win and who will lose? When will incumbents need to make strategic acquisitions? What events have to transpire to enable big, new markets?

And, like other forms of private equity, the timing and probability of exits are as critical as their magnitude. This necessarily leads to a view toward finding inflection points, regardless of stage. Sometimes the best stage is the napkin sketch in the coffee shop; sometimes it's the phoenix rising from the ashes of $100 milllion of previous investors' capital. Either has the potential for venture capital success. The best performing venture capital investors will be able to find both.

At Crosslink Capital we have been evolving this new venture capital playbook since the late 1990s. We recognized early on that the bull market was over in 2000. We mostly sat on the sidelines for much of 2001 and 2002 with our 2000 venture fund. When we did return to investing, we did many restarts, turnarounds, and private investments in recently public companies, many of which were in Internet and services. This strategy of selectivity, stage independence, and a focus on companies at inflection has served us well.

Letting Go of the IPO Window

By 2006 we began to see two important shifts with our new venture fund. One was the emergence of energy technology as a new and important growth market opportunity. Many energy technologies had reached a point where the scientific risk was being replaced with commercialization risk. This transition is always a tipping point in the emergence of new growth venture markets.

The other shift was a rising inflation in later-stage valuations. It seemed many of our peers anticipated a forthcoming IPO window, whereas we did not. So we tended to find better values in earlier-stage opportunities, where the return multiples would justify the higher financial and execution risk. A few of these companies have had very attractive subsequent financings, suggesting we are off to a very good start. Among the companies funded were Twin Creeks Technologies [energy], Like.com [search], and OpSource [cloud computing].

There are lots of strategies for playing to win in baseball and in venture capital. The best strategies are context-specific. Entrepreneurship and innovation are eternal. A few venture firms will be able to continue to successfully swing for the fences without the bull market tailwind. Most will not. Great returns will continue in venture capital, but only for those who can successfully operate across the spectrum of private companies and find great value regardless of their stage.

Copyright © 2009 The McGraw-Hill Companies Inc. All rights reserved.

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Investment banking: How to make money in 2009

Investment banking: How to make money in 2009

Peter Lee. Euromoney. London: Jan 2009.

Abstract (Summary)

Corporate executives are quickly coming to terms with the need for urgent action: cutting expenditure, paying down debt, reducing costs, husbanding cash and wrestling with how to maintain access to credit while bolstering their capital structures. The coming year promises not only to be one of the most challenging and fascinating years ever to be working in capital markets, it also promises to be hugely rewarding financially. As investment banking divisions within many universal banks have been cut back if not shuttered and several big independent firms have failed or disappeared into mergers, competition is diminishing just as margins start to rise and volumes, too, look set to recover. There is no easy definition for what is now the appropriate capital structure with which companies in any sector should face the economic downturn. One simple rule of thumb for companies is to do whatever it takes to maintain investment-grade status. Without that, they are likely to be shut out of the debt capital markets at a time when banks have severely limited appetite for lending. The debt capital markets are open - but only to strong, investment-grade credits willing and able to pay wide spreads. In theory, the time is right for equity-linked deals. Volatility is high and equity-linked allows companies to monetize the value of their own equity volatility to subsidize debt costs and to raise potential future equity capital on conversion in a less dilutive way than through straight equity.

Full Text (5240 words)

( (c) Euromoney Institutional Investor PLC Jan 2009)

Note: Even in tough capital markets, open onlyto the few, it's still possible to craft gooddeals, attract new investors, bolsterbalance sheets and stave off disaster.For all their past sins and excesses,investment banks -- the good ones atleast -- will prove themselves invaluableover the coming 12 months

Top quality issuers boost debt capital markets

Forget the broken banking system

Even governments face supply constraints

The Future of Capital

The world is running out of capital just as companies realize they urgently need to raise equity, like the banks before them, to strengthen their finances as recession bites. The desperate search is on for wealthy investors willing and able to take strategic stakes to anchor big equity deals. Peter Lee reports.

AN ENGLISH INVESTMENT banker recounts the most troubling moment of a recent business trip abroad. "I was going through passport control and they asked me the purpose of my visit and what I did. For the first time in my career, I thought 'I can't say I'm a banker, I've got to say something else... maybe I can tell them that I'm a doctor'". Amused at this confession of shame and embarrassment at his own profession, the banker's colleague chips in helpfully: "He told them he was a masseur."

He shouldn't feel so bad. The irony is that, while they have been cast, probably rightly, as the villains of the piece, investment bankers and their core skills -- the ability to marry up the capital needs of financially stretched issuers and the investment objectives of those lucky few still with cash to put to work -- have never been more acutely needed than they are today. Those skills have never been more valuable.

Another investment banker recounts a recent visit to a corporate client in the truck-making business. He had been to see the company in the autumn of 2008, at a time when the survival of his own employers hung in the balance. The banker had wanted to talk about how the truck company was prepared to face the difficult times ahead. "They told me, 'look these are your problems in the financial industry, don't come and project them on to us'. At the time, they were sitting on an order book for 20,000 units." He went back to the company at the end of 2008. "I'm always interested in trucking because it tells you so much about the economy and other industries, obviously construction and other sectors as well. Do you know how many cancellations they had had?" Euromoney can't even begin to guess. "They had had 20,000 cancellations."

As a piece of anecdotal evidence, it's at the extreme. But corporate executives are quickly coming to terms with the need for urgent action: cutting expenditure, paying down debt, reducing costs, husbanding cash and wrestling with how to maintain access to credit while bolstering their capital structures.

As one head of capital markets puts it: "Since last October, we went from peacetime to wartime in a matter of weeks."

So 2009 promises not only to be one of the most challenging and fascinating years ever to be working in capital markets, it also promises to be hugely rewarding financially. As investment banking divisions within many universal banks have been cut back if not shuttered and several big independent firms have failed or disappeared into mergers, competition is diminishing just as margins start to rise and volumes, too, look set to recover.

The primary debt markets will be much busier this year than last. And even though much of that will be government and government-guaranteed issues, fees are going one way: up ( see story on predicted volumes of debt capital markets issuance ). As the countdown to Christmas quickened, one banker confided to Euromoney that for 2008, his bank's debt capital markets business enjoyed record profitability. "In revenues, we are 25% ahead of 2007, which was previously our record year, and we've done that after taking out 30% of the overhead costs."

Secondary markets are broken, volumes are down but don't underestimate the impact of wide bid-offer spreads on banks' capacity to make money from relatively risk-free customer business.

Equity is the new debt

The volume of new issuance in the equity capital market is hard to predict. One that can be made with confidence is that there will be more of it. In 2008, the primary equity market was largely the preserve of banks rebuilding their capital through large rights issues, with a handful of consumer companies following suit. The banks will continue to issue this year and more companies will follow where the banks have led.

A debt capital markets banker tells Euromoney: "Companies are fearful not just about what happens this year. We already have companies coming to us and talking about debt maturities falling due in 2010 and 2011 and asking what they can do to meet those."

At a rival bank, an equity capital markets banker poses an intriguing question for corporates. "With CDS indices now pricing in thousands of corporate defaults at low recovery rates and the debt markets only open to the best issuers at coupons close to double digits and spreads way over 500bp, companies should ask whether the present cost of debt is close to their long-term cost of equity," he says.

There is no easy definition for what is now the appropriate capital structure with which companies in any sector should face the economic downturn. One simple rule of thumb for companies is to do whatever it takes to maintain investment-grade status. Without that, they are likely to be shut out of the debt capital markets at a time when banks have severely limited appetite for lending. That's a life-threatening position to be in. How do you stay investment grade? You raise equity by whatever means: selling assets, or selling shares.

Selling non-core assets sounds great: but at what price and who to? Debt-financed acquisitions will be very tough to do in 2009, although theoretically they make sense, as prices have come down. "The good news is that assets are cheap," says an M&A banker. "The bad news is that no one has any money."

So the menu of options for companies looking for a bigger capital cushion is not long. How about selling shares?

Corporate chief executives and chief financial officers resisted the idea last year. They didn't want to sell more equity when their share prices had already tanked, nor further to dilute earnings that are likely to be lower this year. And they might genuinely have held a more optimistic long-term view of their business than debt or equity investors and feared that they were being pushed into raising too much capital and later would be damned for producing too low a return on it.

Matthew Koder, joint head of global capital markets at UBS, says: "In the third quarter of 2008 we tried to talk to corporations about raising equity and many wouldn't even discuss it with us. But by the end of last year it was a prominent part of every conversation we were having with clients."

It's one thing to recognize the need to raise equity, quite another to get the job done. It's not a straightforward proposition.

Jim Amine, co-head of the global investment banking department at Credit Suisse, says: "When I look at the equity markets I see continued volatility and little stability for the next two to three quarters. That makes it very difficult to do IPOs. All the action will be in secondaries and, given investors' preoccupation with liquidity, in large caps. Over the next two years, a number of companies will be raising equity to reduce leverage. Companies will be focusing less on dilution and more on risk reduction. Capital-intensive industries such as energy and natural resources that have financed capex out of cashflow when product prices were high may have to resort to equity now that prices are falling. General industries will want their capital structure to be as robust as possible going into a recession." Companies that follow banks' advice now will find it a costly exercise.

European banks that were doing secondary share offerings for fees of 125bp or 150bp in the first half of 2007 will now be charging 250bp or 300bp. Fees have doubled, although the banks will claim that the underwriting risks have too... and maybe more than doubled.

Outcomes will be binary. Those corporate and financial issuers that succeed with equity and debt raising will live: those that fail... will not. With their very survival at stake, companies will pay almost whatever it takes to raise capital through higher spreads and higher fees.

In the last years of the age of excess, investment banking went virtual. Quants created synthetic products to sell to fabricated investment vehicles or leveraged funds that could only buy the repackaged garbage the banks were selling them with money the banks were lending. When they weren't warehousing risk, banks were essentially dealing with themselves.

For a while, actual corporations, which had strengthened their balance sheets and built up cash after the dotcom bust at the start of the decade, and traditional long-only investors looked on bemused. Leveraged buyouts of some companies were undertaken at ludicrous leverage multiples and others were sucked into borrowing cash to buy back equity and boost shareholder returns through capital structure engineering. Some investors were lured into taking on excessive credit and structure risk in the search for yield. But mostly, investment banks turned away from these old-fashioned clients. The old investment banking day jobs of dealing with corporate fund-raising and trading insurance company and pension fund money in and out of conventional cash markets were delegated to the firms' plodders, or left to computers.

Not now. Ivor Dunbar, co-head of global capital markets at Deutsche Bank, says: "Solving client's capital problems today is every bit as complex as was devising the next-generation structured product. This is still a business model based on intellectual capital. Where and how that capital is deployed has changed. Providing a thoughtful analysis of companies' balance sheets and cashflows and how they might be affected through an economic downturn of uncertain duration and severity is challenging. And, having undertaken that analysis, then providing the right combination of sources of potential capital is extremely challenging. The opportunity for investment banks to make money in capital markets has not been dented by the downturn... but you probably have to work 10 times harder for it."

Banks are quick to draw a key lesson from their own near-death experiences and preach it to corporate clients. Move fast. The world is running out of capital, so grab some while you still can. Those banks that raised equity quickly as the crisis hit the financial industry in the second half of 2007 and the first half of 2008 raised more money on better terms than did most of those who waited and hoped that the storm would soon pass and miss them on the way through.

"When we meet with clients, we tell them to assume that things will be bad, and to deal with it proactively. Cash is king to a degree we have never seen before"

Walid Chammah, Morgan Stanley

Walid Chammah, co-president of Morgan Stanley and chairman of Morgan Stanley International, says: "When we meet with clients, we advise them not to put their heads in the sand or to tell themselves that there is a 50:50 chance that the environment could worsen and that things could turn out badly. We tell them to assume that things will be bad, and to deal with it proactively. Cash is king to a degree we have never seen before. Unsecured finance, which used to be so abundant as almost to be free and taken for granted, is suddenly extremely scarce and valuable. Large firms will have to rely on internally generated working capital, like small, family businesses do. In this environment, equity almost equates to working capital."

Going cap in hand to shareholders and asking them for more money is never an easy thing for corporate executives to do, and especially not when their share prices are 50% below their recent highs. "There is a double sticker shock," says Chammah. "First, there is the shock of how far valuations have fallen, and then there is the second shock of how big a discount might be needed beyond even that to raise primary capital, especially to attract new investors." He adds: "In September, when Morgan Stanley converted into a bank holding company and raised $9 billion by selling preferred stock at 10% to Mitsubishi UFG with the right to convert into a 21% strategic shareholding, we didn't have our heads in the sand. The market was talking to us. And no matter whether you think the market is right or wrong, the market has a vote. And it can vote you out of the game."

Grab it while you can

The challenge for companies right now is particularly acute. The banking system is essentially broken. Spin it however you like, but there is barely a bank in the world that could raise term finance without the explicit or implicit support of governments. Even those selling senior unsecured non-government guaranteed debt can only do so because governments are standing by to guarantee their other liabilities.

Companies that have already drawn down on back-stop bank lines of credit might be in for an unpleasant shock when these come up for renewal. And although the banks might prop up companies to which they are heavily exposed by rolling over financing, they will do so reluctantly, selectively and at the highest cost they can extract.

The debt capital markets are open -- but only to strong, investment-grade credits willing and able to pay wide spreads. Credit default swap spreads have widened for most borrowers and where that widening indicates investor concern over an imminent liquidity event -- such as the need to repay maturing debt -- that gives the equity markets a clear signal to go short and so equity prices fall as CDS spreads widen.

Yet crucial capital-raising deals can still be done, even in the most troubled sectors. Take real estate, where leverage has been high and share prices have collapsed. Australia's real estate sector has been hit hard. But, at the end of November 2008, troubled industry leader GPT was able to complete the first large recapitalization of a listed real estate investment trust, raising A$1.6 billion ($1.07 billion) in a rights offer that was oversubscribed by institutions.

It was a crunch moment. Announcing the rights offer was the final act of chief executive Nic Lyons before he left the company. But its success reduced gearing, prompted ratings agency Standard & Poor's to take the company off negative outlook, gave the company the confidence to renegotiate covenants with bankers to give it more flexibility and bought it time to proceed with asset disposals this year. It also drew in a new, key strategic investor, the real estate investment arm of the government of Singapore.

It was a success but perhaps a mixed one. The rest of the Australian real estate sector was rated down on news of the deal, as investors pondered the implications for other companies of the sector leader's need to recapitalize and as they priced in new supply for this year.

And while it is all very well for the investment banks to tell companies to jostle to the front of the queue with their begging bowls and raise equity capital early, investors have also learnt a painful lesson from the first rounds of bank recapitalization. Even those who bought into the later deals didn't fare so well.

More than a year into the financial crisis, in September 2008, Goldman Sachs sold a strategic stake to Warren Buffett and followed this up with a $5 billion offering in the public equity market priced at $123. The stock rallied on the news up to $130. By mid-December, Goldman's stock price stood at $67. Just a few days after Goldman in September, JPMorgan sold $10 billion of stock in the public market as part of its acquisition of Washington Mutual, pricing newly offered shares at $40.50, a 7% discount to their prevailing price. Investors saw the capital raise as great news and the stock went to $44.50. By mid December, it was down to $30. In October, Bank of America raised $10 billion at $22 a share, an 8% discount. Two months later, the stock price stood at $15.

And as for those investors who supported early equity offerings from Citi, UBS and Merrill: ouch!

Anchor investors are crucial

Michael Sherwood, co-chief executive of Goldman Sachs International, says: "Many of the private equity funds and sovereign wealth funds that went into the early bank recapitalizations lost money and they will be more circumspect in future. I don't think you'll see many more of those big, strategic investments concluded over a weekend with no adviser on the investor side."

"I don't think you'll see many more of those big, strategic investments concluded over a weekend with no adviser on the investor side"

Michael Sherwood, Goldman Sachs International

Goldman famously acted as an adviser to Sheikh Mansour Bin Zayed Al Nahya last October in his investments, alongside Qatar Holdings and Challenger, of pound(s)5 billion ($7.5 billion) in reserve capital instruments paying 14%, mandatory convertible notes and warrants of Barclays. Compared with those sovereign wealth funds that invested early in the banks, he got good terms and good protections in a deal that shows if you've got deep pockets and low leverage, this is a lender's market. But such pockets will only open to the select few.

Sherwood wonders whether, even at the new high fee schedule, underwriting rights issues for three to six weeks is a good way for banks to deploy their capital. He recommends being discerning in supporting equity capital-raising. "On the rights issue underwriting side, there will be no shortage of opportunities to do business for the banks."

The Barclays deal is a pointer to the kinds of investment banking skills needed in a bear market and a recession. The securities themselves -- reserve capital instruments, mandatory convertible notes and warrants -- are nothing complex: devising them requires no doctorates in rocket science. Although technically simple, though, this was a far from straightforward deal. Unearthing key strategic investors, negotiating the right mix of instruments and the balance of their distribution to new strategic and conventional investors, preparing for the angry market reaction to any capital-raising that bypasses pre-emption rights, and making a case for this when the UK government was offering apparently sweeter terms, all required great skill, market intelligence, contacts, capacity to innovate and sheer smarts.

It is a return to investment banking as classical art rather than science. The banker who can fill the role of trusted adviser is invaluable. It's a job for grown-ups -- ideally with business as well as capital markets experience and for leaders who have brought their own financial institutions through the shock of coping with a broken business model and capital and liquidity crunch -- not one for bright boffins who are just very good at maths.

For companies, it is an even more demanding time. Chammah says: "Clients must be flexible, entrepreneurial, and open-minded. In a normal downturn you proceed on the assumption that most companies will make it through. But this time, some will and some will not."

Knowing that if they bring a deal to market and fail with it their company could be launched into a death spiral, corporate executives need to do all the work they can with bankers, existing shareholders and potential new strategic investors to structure deals correctly in the first place.

The extraordinary volatility in the secondary equity markets -- with share prices rising 10% one day and falling 10% the next, on the basis of nothing more than the latest harebrained bail-out plan announcement from the US Treasury -- makes it very difficult to issue in the primary market.

Low earnings multiples might suggest that stocks are cheap, but investors worry that this year's earnings might be only a fraction of last year's. "We need some kind of stability for the equity new-issue market to function," says UBS's Koder. "We don't necessarily need to see the start of an uptrend or even to hit the bottom. It would be enough for a consensus to emerge as to how much lower stocks are likely to go and for the volatility to subside. At that point, perhaps the top quartile of companies in any sector -- even real estate, autos, retail -- will be able to raise equity."

It's an urgent task. There's $1.5 trillion of capital markets debt falling due in the next 18 months and not all of it is going to get refinanced.

Buyers scramble up the capital structure

Across the capital structure, natural providers of capital are looking to move up one notch. So, for example, traditional equity investors are moving into equity-linked debt, attracted by wide secondary market spreads and a senior position in the capital structure with some equity upside in warrants that high volatility makes valuable. Other value investors that can trade across asset classes and who previously bought equity are now buying junior debt tranches -- sometimes even senior debt tranches -- in expectation of being crammed down into equity in restructurings.

Equity income funds, which typically buy safer, utility-like stocks with stable dividend policies, are moving into the investment-grade credit market where spreads are wide on names unlikely to default and there is an arguable prospect for capital appreciation.

In credit markets, investors are moving up the rating spectrum in an exact reverse of what many did during the scramble for yield from 2005 to 2007. High-yield buyers are buying cross-over credits, cross-over buyers are moving into investment-grade bonds, investment-grade buyers that are not won over by the wide spreads on strong single-A names coming to the market are pushing up into the supranational and agency and new government-guaranteed markets.

Is an Irish building society selling 22-month debt, guaranteed by the Irish government, really going to attract rates buyers? It is paying 80bp over mid-swaps. Isn't that a credit product, or perhaps a cross-over between a rates product and a credit investment?

"When I look at the equity markets I see continued volatility and little stability for the next two to three quarters"

Jim Amine, Credit Suisse

And when you look back at the lowest end of the credit spectrum, where high-yield buyers are now exiting in search of investment-grade credit, there is a vacuum. Jim Amine at Credit Suisse says: "Non-investment-grade credit in Europe is an orphan asset class. High-yield bond funds have had disappointing performance and redemptions, hedge funds have had liquidity pressure as they deleverage, most CLOs are severely impaired and syndicate banks are capital constrained. There are very few natural buyers."

Bankers take note of another potentially worrying trend: a reduction in cross-border investment flows as risk aversion prompts investors to look closer to home at companies they know. "We have seen this in recent placements," says Jean-Francois Mazaud, deputy global head of capital raising and financing at Societe Generale. "In Europe for example, where there are big domestic investor bases in the UK, Germany, Netherlands, issuers can expect a refocusing onto these investor bases accounting for 40% or more of new issues, much more than they did before." That raises a worrying question for issuers from countries with a smaller home base of insurance company and pension fund money.

And all this raises another tricky question. When every buyer is jostling up the capital structure, who is the new natural provider of equity at the bottom?

A nervous equity investor base looks on. Thierry Olive, global head of equity capital markets at BNP Paribas, says: "Sovereign wealth funds are much more cautious now. Hedge funds, which used to buy maybe half of any new issue, are facing great difficulties. Traditional long-only investors have less money. They are still trying to do their job and assess the fundamentals but the problem is that equity prices are developing without regard to the fundamentals and there is no trust any more. That means there is no standard way to do a deal. What worked yesterday might not work in two weeks' time."

Olive points to the InBev deeply discounted rights issue in November 2008, by which the company raised [Euro]6.36 billion to reduce leverage after its debt-financed acquisition of Anheuser-Busch. "It probably looks like a normal rights issue. But behind the deal, when it finally came, lay weeks of discussions and deliberations on how best to structure it. Because the best way to do a deal is not always the easiest."

The deal had been due to launch in October but was delayed amid the market turbulence as the global financial system teetered on the brink. The deal was further complicated by decisions of the family interests behind the Belgian company over how much of their rights to subscribe to, how to fund purchases of rights taken up by selling shares, and how underwriters should then distribute unsubscribed rights and develop a theoretical ex-rights price for a share that had been badly beaten down.

Olive says: "You have to be ready to wait, go, wait, go. We were ready with InBev one month earlier but had to halt the process at the last minute when we took the view the market wouldn't support it. We wanted the existing shareholders to subscribe more and they did put more money in. We had to rework it before effectively launching it. The lesson is that all sides have to be very flexible and prepared to do absolutely whatever it takes, because once you launch the deal, if it doesn't work and you don't get the money... you're in serious trouble."

Crafting deals in a tough market

It is still possible to do fairly straightforward deals. Conventional long-only shareholders will not want to give up their degree of ownership of future earnings streams from strong companies that they believe will be winners at a time when general market declines have left their shares cheap. So after Standard Chartered announced its pound(s)1.8 billion rights issue, the share price rallied strongly, reflecting investor faith in the business model, the management team and the rationale for raising capital.

But such deals will be rare in 2009. The more frequent and not-so-subtle pitch to investors will be to consider the likely fate of a company, and the value of their own investment position in its stock, if they fail to support a rights issue. Rights issues will have to be priced to go, with steep discounts, high fees, big syndicates.

Even then, companies will have to explore all their options in a year when the requirement for new equity will exceed the supply. That means looking at ways to do deals with and without redemption rights, underwritten and non-underwritten, targeted at existing shareholders and at new ones.

The search will be on for new strategic investors to anchor deals, as the Qataris did for Barclays and Warren Buffett did for Goldman Sachs. One potential group is private equity companies. In the past, they have shied away from taking minority positions in publicly listed companies. Bankers pick up hints that some private equity funds are now considering the opportunity to put large slugs of money into public markets where they can see a more convincing prospect of realizing value in the next few years than in private market transactions.

"It is actually a good time to lend to private equity," suggests Sherwood at Goldman Sachs, "because prices for assets have come down, multiples are low, earnings are low and sponsors will be required to put in more equity." For all that, the syndication markets are so discombobulated and spreads are very high.

Sherwood points to another obvious source of strategic capital. "There are many large industrial companies with a lot of cash on their balance sheets. They will take out competitors as some sectors consolidate."

Traditional capital markets structures will be reshaped by the times. The agonies of RBS and HBOS have driven home the reality of what capital markets participants have been saying for years. There is nothing wrong with pre-emption rights in principle but the process has to be shortened. If ma and pa can't decide for six weeks whether to take up their rights or not, let's carve out a tranche for them but meanwhile go to Fidelity and Capital and Legal & General and give them 48 hours to decide, because that is time enough. Long underwriting periods leave deals exposed to now frequently occurring market seizures and offer an invitation for market participants to short, especially perhaps when a government provides the back-stop underwriting bid.

Koder at UBS sees a raft of new approaches to raising equity, especially for smaller amounts below the typical 10% limit that triggers the requirement to offer pre-emption rights to existing shareholders. "We'll see more small deals with no documentation, no prospectus or roadshow: quasi-private placements, often pre-circulated and corner-stoned with a key investor and done overnight with banks taking minimal underwriting risk." Koder points to the US market, where what are known as equity shelf programmes (ESPs) allow companies that are current on their regulatory filings to dribble stock out into the market each day. It's a marked change from the traditional approach whereby equity capital is raised in large chunks in public deals partly designed to broadcast the improvement in a company's capital position to various stakeholders including debt investors, bank lenders and trade and other creditors. ESPs enable companies to inch towards stronger capital ratios.

Another innovation -- a device popular in Australia, but little used in the capital markets of the US and Europe -- is the underwritten dividend reinvestment plan. This year, many of those companies that have not already done so will cut back on or abandon share repurchase programmes. The next logical way to reduce capital outlays is to cut or suspend the dividend. But this often weighs disproportionately heavily on a company's stock price, especially if its share register comprises largely equity income funds. One solution for companies is to give investors the option of taking a dividend in new shares at a discount or cash, in the hope that many will choose shares. If investors instead demand cash, a bank group stands by to sell equity to raise the cash to meet these payments.

In theory, the time is right for equity-linked deals. Volatility is high and equity-linked allows companies to monetize the value of their own equity volatility to subsidize debt costs and to raise potential future equity capital on conversion in a less dilutive way than through straight equity.

The problem is that hedge funds had become the core investor base for new issues of equity-linked and they have been devastated, putting many out of the game. Low secondary market valuations make the comparables unfavourable for new issuers; the debt component is hard to price given wide credit spreads and there is a lack of clarity on how to price medium-term equity options relative to extraordinarily high prevailing volatility. "Still, this year could be much busier for equity-linked than last," says Koder. And, rather ominously he suggests, "equity-linked might be easier to do than equity."

SEPTEMBER 22, 2008

MERGERS & ACQUISITIONS

The Secrets of Successful Acquisitions

By KOEN H. HEIMERIKS, STEPHEN GATES and MAURIZIO ZOLLO

Managers who have been involved in mergers and acquisitions know the odds of a painless integration are low. Rarely, it seems, does combining two organizations go smoothly, at least in the short term.

All of which leads to an inevitable question: What do the successful acquirers do right?

Based on our study of the M&A activities of 101 companies world-wide, we concluded that the key factor for successful companies was something simple yet uncommon: They made systematic efforts to learn from their past acquisitions.

Many of the successful companies were "serial acquirers" -- those that made continual acquisitions an integral part of their growth strategy. But it wasn't the amount of prior M&A experience that made the difference. It was the fact that these companies had devoted a lot of time and money and thought to what they had done, and had changed their practices as a result. Companies with lots of M&A experience that didn't invest in a learning process actually fared worse, on average, than companies with less experience.

In other words, "learning by doing" isn't enough. Companies must also "learn by thinking."

For instance, at one company we studied, an international chemical firm, a risk-management team was closely involved in every stage of the company's M&A activities -- from helping to prepare bids to performing post-integration reviews. The team would play key investigative and advisory roles on a host of issues, such as personnel, legal, financial and regulatory problems. Once acquisitions were approved, the team coordinated efforts by both companies to address these issues. And when deals were finalized, the team played a similar role in overseeing integration, ensuring that key parties from both companies were involved.

Pass It On

Such involvement uniquely qualified the team to perform post-integration reviews -- and to preserve and pass on any knowledge gained about the process.

The M&A team at another global chemical maker conducted post-integration reviews in which open-ended surveys were sent to key players and one-on-one interviews were conducted to hear unvarnished analyses of what had worked well and what hadn't.

The team and the business manager responsible for the integration would also codify anything new learned in each acquisition for use in coaching sessions. Lesson subjects could involve assessing the worth of a potential acquisition; environmental, health or safety issues that weren't foreseen; or organizational challenges, such as how to absorb the acquisition's sales force with minimum disturbance to customers. Lessons produced in this manner, including more than 100 scenarios, covered integration issues ranging from customer service and purchasing to engineering.

'Deal Room'

One company, the finance unit of a global industrial conglomerate, used a wiki-style online "deal room" which served as both a forum where integration teams could discuss initiatives in progress, and as a generator of lessons for the future. Details in deal-room discussions were documented and referenced for access on the company's intranet to ensure that employees could easily find the latest insights.

Maintaining a body of M&A knowledge, organizing it into lessons and making it easily accessible are key to developing and leveraging a company's M&A capability. Without such a framework, companies can slip into applying general types of strategies developed in prior acquisitions that are inappropriate to the one at hand. Managers might also become overconfident by thinking that the mere accumulation of experience brings with it a stronger capability.

Codifying and studying lessons from prior acquisition experience makes it easier to foresee, identify and act on specific integration problems. It also can help at the negotiating table, making it easier to walk away from deals that appear overpriced in relation to the expected integration issues. In addition, when managers reflect on acquired firms' contributions to the acquirer, they often find unexpected wisdom that emerges from adopting the target's new perspectives and different ways of doing things.

—Dr. Heimeriks is assistant professor of strategy at the Rotterdam School of Management, Erasmus University, Rotterdam, the Netherlands. Dr. Gates is professor, department of strategy, at Audencia Nantes School of Management, Nantes, France. Dr. Zollo is dean's chaired professor of strategy and director of the Center for Research on Management at Bocconi University, Milan, Italy. They can be reached at reports@wsj.com.

What Other Financial Crises Tell Us

The lesson of history is grim: Expect a prolonged slump.

By CARMEN M. REINHART and KENNETH S. ROGOFF

Perhaps the Obama administration will be able to bring a surprisingly early end to the ongoing U.S. financial crisis. We hope so, but it is not going to be easy. Until now, the U.S. economy has been driving straight down the tracks of past severe financial crises, at least according to a variety of standard macroeconomic indicators we evaluated in a study for the National Bureau of Economic Research (NBER) last December.

In particular, when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning.

Let's start with the good news. Financial crises, even very deep ones, do not last forever. Really. In fact, negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008, as many on Wall Street do, the case for an end in 2009 is less compelling.

On other fronts the news is similarly grim, although perhaps not out of bounds of market expectations. In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels.

Equity prices tend to bottom out somewhat more quickly, taking only three and a half years from peak to trough -- dropping an average of 55% in real terms, a mark the S&P has already touched. However, given that most stock indices peaked only around mid-2007, equity prices could still take a couple more years for a sustained rebound, at least by historical benchmarks.

Turning to unemployment, where the new administration is concentrating its focus, pain seems likely to worsen for a minimum of two more years. Over past crises, the duration of the period of rising unemployment averaged nearly five years, with a mean increase in the unemployment rate of seven percentage points, which would bring the U.S. to double digits.

Interestingly, unemployment is a category where rich countries, with their high levels of wage insurance and stronger worker protections, tend to experience larger problems after financial crises than do emerging markets. Emerging market economies do have deeper output falls after their banking crises, but the parallels in other areas such as housing prices are quite strong.

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role, as we are about to witness in spades here in the U.S. with the passage of a more than $800 billion stimulus bill.

Needless to say, a near doubling of the U.S. national debt suggests that the endgame to this crisis is going to eventually bring much higher interest rates and a collapse in today's bond-market bubble. The legacy of high government debt is yet another reason why the current crisis could mean stunted U.S. growth for at least five to seven more years.

Yes, there are important differences between the current U.S. crisis and past deep financial crises, but they are not all to the good. True, for the moment the U.S. government is in the very fortunate position of being able to borrow at lower interest rates than before the crisis, and the dollar has actually strengthened. Still, deep financial crises in the past have mostly been country-specific or regional, allowing countries to export their way out.

The current crisis is decidedly global. The collapse in foreign equity and bond markets has inflicted massive losses on the U.S. external asset holdings. At the same time, weak global demand limits how much the U.S. can rely on exports to cushion the ongoing collapse in domestic consumption and investment.

Can the U.S. avoid continuing down the deep rut of past financial crises and recessions? At this point, effective policy prescriptions -- such as coming up with realistic costs of the size of the hole in bank balance sheets -- require a sober assessment of where the economy is going.

For far too long, official estimates of the likely trajectory of U.S. growth have been absurdly rosy and always behind the curve, leading to a distinctly underpowered response, particularly in terms of forcing the necessary restructuring of the financial system. Instead, authorities should be prepared to allow financial institutions to be restructured through accelerated bankruptcy, if necessary placing them under temporary receivership, and only then recapitalizing and reprivatizing them. This is not the time for the U.S. to avoid painful but necessary restructuring by telling ourselves we are different from everyone else.

Ms. Reinhart is professor of economics at the University of Maryland. Mr. Rogoff is professor of economics at Harvard and former chief economist at the International Monetary Fund.

Now Hiring: Lehman

As Bankrupt Firm Winds Down, Gigs There Are Hot Commodity
By PETER LATTMAN

It's bankrupt. Its reputation is in tatters. And it has been forced from its plush headquarters building. Yet working for Lehman Brothers Holdings Inc. -- what remains of it -- has become one of the hottest jobs on Wall Street.

That's because Lehman, though a shadow of its former self after selling many of its businesses to Barclays PLC and Nomura Holdings Inc., retains a broad patchwork of assets. It has some $7 billion in cash and more than 1,400 private investments valued at $12.3 billion. Then there's a thicket of about 500,000 derivative contracts with 4,000 trading partners worth some $24 billion.

So for now, Lehman is seen as a relatively secure home for throngs of finance professionals thrown out of work in recent months. It's even become a place for former Lehman CEO Richard Fuld to informally hang his hat.

"We're getting swamped with resumes," says Bryan Marsal, a turnaround expert who is now Lehman's chief executive officer. The inquiries, he says, are from people affiliated with marquee names such as Bank of America, Citigroup Inc., and Morgan Stanley.

"It's just a tough, tough time, and there are a lot of good people out there looking for work."

The wages are not great by past standards. But there are hidden benefits. It could take two years or more to wind down the firm. Such a timeline promises the kind of job security that's a rarity on Wall Street today.

Charged with untangling the mess is Alvarez & Marsal, the New York-based restructuring firm where Mr. Marsal is a co-founder. With 150 full-time employees working on the case, its chief task is to sell off Lehman's remaining assets and maximize recovery for creditors, which are owed more than $150 billion.

Mr. Marsal says the goal is to dissolve the firm in 18 to 24 months from now, though several restructuring experts say that's an aggressive timetable.

Alvarez & Marsal got the gig in September after Lehman's board appointed it to administer the bankrupt company's estate. To carry out the mission, Alvarez & Marsal kept 130 Lehman employees on the firm's payroll. It has also recruited back more than 200 former Lehman employees, and is still hiring staff to handle targeted areas such derivatives and real-estate holdings.

Behind the scenes is Mr. Fuld, the firm's former chairman and chief executive, who was widely vilified when Lehman collapsed in mid-September. Though Mr. Fuld was removed from the payroll on Jan. 1 and relieved of his company-provided black Mercedes, Lehman has agreed to let him keep an office at the firm. He's just around the corner from Mr. Marsal, who says he picks Mr. Fuld's brain about Lehman's business several times a week.

"We asked him to stay if he has nowhere better to go," says Mr. Marsal. "He's been very good about making himself available for questions about Lehman assets."

Through a spokeswoman, Mr. Fuld declined to comment.

Lehman's dismantling is an expensive process. Associated costs run about $30 million a month, excluding fees to lawyers and advisers on the case. Employees are paid a salary -- with modest retention bonus added as "a kiss" says Mr. Marsal -- to entice workers to stay at a place with a limited lifespan.

The assignment is a lucrative one for Alvarez & Marsal, which is charging Lehman hourly fees of $550 to $850 for its top executives working on the case, with rich incentive fees for the firm depending on its recovery for creditors.

Despite Lehman's assured dissolution, executive recruiters say it isn't surprising that the collapsed investment bank has become a desirable place to work.

"This is a well-paying job in one of the worst employment markets in history," says Skiddy von Stade, founder of New York-based executive placement firm F.S. von Stade & Associates. "Through the disposition of Lehman's assets, the employees will have a chance to demonstrate their strengths and skills for opportunities down the road -- possibly with the very buyers of these securities and investments."

Mr. Marsal says compensation is in line with similar jobs on Wall Street, yet far below what it was at Lehman. He and his team are "very, very careful" about the expenses of the firm, which he says are generally lean. "The excess of Lehman was the size of the salaries and the expectations of people with the bonus plan," he says.

Gone are the pay and perks that came with being a top executive at pre-bankruptcy Lehman. Mr. Fuld and his management team sat on the 31st floor of Lehman's former headquarters, a state-of-the-art steel-and-granite building in Times Square. Barclays bought that site and took it over, so now Lehman's command center is a run-of-the-mill office on the 45th floor of the Time-Life building, which long served as Lehman overflow space.

Mr. Marsal and his team are making due without weekly deliveries of fresh flowers and warm chocolate-chip muffins on Fridays -- perks enjoyed by the firm's former brass. Gone too is the executive dining suite where a private chef prepared lunch for Lehman's top executives. Instead, Mr. Marsal and his crew grab a bite in the cafeteria at Time Inc., which has granted access to the Lehman employees.

Henry Klein is part of Lehman's new topsy-turvy reality. A nine-year Lehman veteran, he oversaw a portfolio of investments in India from the firm's New York office. When Lehman failed, Mr. Klein was transferred to Barclays, but says he had little to do there. "I was at Barclays, but my assets were at Lehman."

Mr. Klein left Barclays in mid-November, and then approached Alvarez & Marsal. Today, he's back overseeing the very assets he says he managed at Lehman.

The 46-year-old Mr. Klein is currently focused on a small $36 million real-estate investment in Hyderabad, a large city in south central India. Lehman may continue to back the deal, but also may have to pull its funding. "It's a difficult decision," says Mr. Klein. "We don't have tons of time."

Luc Faucheux, 39, heads up the desk at the bankrupt entity that trades interest-rate swaps and other fixed-income derivatives. "I always wanted this job," laughs the former Lehman staffer who says he had a related, but less senior role. "Be careful what you wish for, because you might just get it."

"Let's face it," he adds. "Given the state of the world we're in, the things I'm learning working on the largest bankruptcy in history are a set of skills that could be marketable for the foreseeable future."

Rather than immediately sell assets into a depressed market, Alvarez & Marsal has opted to retain and manage a chunk of Lehman's holdings.

Last month, Alvarez & Marsal decided to keep a 49% interest in Lehman's money-management business, Neuberger Investment Management, selling the balance to Neuberger's management. It made a similar move with Lehman Brothers Merchant Banking, the firm's flagship private-equity business. The estate also has held on to more than 100 direct stakes in private companies. These include direct investments made alongside Lehman's private-equity clients in large boom-era buyouts such as First Data Corp. and Texas utility TXU Corp.

So far, Lehman has more than doubled its cash reserves to $7 billion from $3.3 billion, in part through the sale of its headquarters to Barclays. It is also raising money by selling off the firm's sizable art collection, whose value Lehman has pegged at roughly $30 million. Some of the photographs and paintings still grace the halls of Barclays and Lehman's Neuberger unit.

Finally, there is a cavalry of corporate jets valued at $164 million. Lehman has already sold six jets, as well as interests in fractional shares service NetJets Inc. for $53 million. Still on the block: Six more planes, including a Boeing 767, and a Sikorsky chopper.

Some of those jets Lehman owned as investments and only four were used for corporate purposes at any one time, according to a Lehman spokeswoman.

"The fleet's been grounded," Mr. Marsal reassured the bankruptcy judge overseeing the case at a hearing last month. "Nobody is flying around these planes and no one is using the helicopter."

Write to Peter Lattman at peter.lattman@wsj.com
Printed in The Wall Street Journal, page A1

Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved

Staff members stand in a meeting room at the Lehman Brothers offices in the financial district of Canary Wharf in London Sept. 11, 2008.

Then & Now

Associated Press

Then:

CEO: Richard Fuld (above)

Employees: 25,158

Cash on balance sheet: $3.3 billion

Alvarez & Marsal

Now:

CEO: Bryan Marsal, (above)

Employees: 500

Cash on balance sheet: $7 billion

Dreamers and Doers

Dreamers and Doers
By JOHN SCHWARTZ

Nicolas Naranjo knocked on Evan Kimbrell’s door at midnight.

At other colleges, this might have been a prelude to a fraternity prank or an invitation to help float the keg at the end of a party. But Mr. Naranjo, who had just arrived in the United States from his native Colombia some weeks before, wanted to talk about starting a business. He had an idea about a hop-on, hop-off bus service for college tours around the Boston area. Mr. Kimbrell had tried to start a bus company the previous year and knew the pitfalls — and was happy for the break from his studies to talk business.

This is life in the E-Tower at Babson College in Wellesley, Mass. Babson focuses on business, and E-Tower focuses, even more tightly, on entrepreneurship. The residents of E-Tower hash out new business plans at Monday night meetings, and they talk shop throughout the day and night.

“We’re really a dorm of dreamers and doers,” says Prinya Kovitchindachai, who is hoping to market a vile-tasting pill, imported from Thailand, that he touts as a hangover treatment. “College students are the largest group of binge drinkers,” he says, quietly gleeful at the prospect of such a large market so close at hand. Friends have helped him bone up on the basics of international shipping, of securing shelf space and — in a consultation with a neighbor who was wearing a towel and still dripping from the shower — of creating Web sites.

“Any school can teach entrepreneurship,” he says, “but at Babson, we live entrepreneurship.”

Now, let’s not get carried away: as a reporter and as a parent, I find myself on plenty of college campuses these days, and many of the students I meet are indistinguishable from the dull-eyed slackers I went to college with (when dinosaurs roamed the Earth and Pluto was still a planet). But then there are those who have this . . . THING, this go-getting excitement to start something, make something. They want money, sure. But the overwhelming desire seems to be to carve out something of their own.

Today’s students have grown up hearing more about Bill Gates than F.D.R., and they live in a world where startling innovations are commonplace. The current crop of 18-year-olds, after all, were 8 when Google was ­founded by two students at Stanford; Mark Zuckerberg founded Facebook in 2004 while he was at Harvard and they were entering high school. Having “grown up digital” (to borrow the title of Don Tapscott’s recent book on the Net Generation), they are impatient to get on with life.

“They’re great collaborators, with friends, online, at work,” Mr. Tapscott wrote. “They thrive on speed. They love to innovate.”

The easiest way to find kids like these is to check in on entrepreneurship education, in which colleges and universities try to prepare their students to recognize opportunities and seize them.

For those who haven’t been paying attention, the idea of entrepreneurshipmight bring up the Memo Minder, the lame invention by the “Future Enterpriser” played by Bronson Pinchot in “Risky Business.”

Reader, you date yourself: that was 1983. In the intervening decades, Tom Cruise has grown up and entrepreneurship programs have boomed.

A report issued last year by the Kauffman Foundation, which finances programs to promote innovation on campuses, noted that more than 5,000 entrepreneurship programs are offered on two- and four-year campuses — up from just 250 courses in 1985. Full-scale majors, minors or certificates in entrepreneurship have leaped from 104 in 1975 to more than 500 in 2006. Since 2003, the Kauffman Foundation has given nearly $50 million to 19 colleges and universitiesto build campus programs.

Lesa Mitchell, a Kauffman vice president, says that the foundation is extending the reach of its academic gospel, which used to be found almost exclusively in business schools.

Now, the concept of entrepreneurship is blossoming in engineering programs and medical schools, and even in the liberal arts. “Our interest is in the whole curriculum,” she says. “We need to spread out from the business school.”

Either as class projects or on their own, students in an array of disciplines are coming up with ideas, writing business plans and seeing them through to prototype and, often, marketplace. In their spare time, students in agricultural economics at Purdue invent new uses for soy; industrial design majors at Syracuse, in a special collaborative laboratory, create wearable technologies; a psychology major, through the Yale Entrepreneurial Institute, starts a limited liability company offering neuromarketing services.

Richard Miller, the president of the Olin College of Engineering in Wellesley, recalls a time that academically packed programs like engineering believed that teaching business and entrepreneurship would require watering down curriculum. “We think differently now,” he says. Dr. Miller says a personal turning point came back in his days at the University of Southern California, when visitors from McDonnell Douglas told a classroom of engineers that the project they were working on in class was actually the subject of a patent worth $200 million. “What’s a patent?” they asked.

Clark University, a liberal arts college in Worcester, Mass., offers a minor in entrepreneurship that can be fitted into just about any degree plan. “It’s too important to be taught by business professionals to business students,” says George Gendron, the founder and director of its innovation and entrepreneurship program. The program, he says, is intended to help students find “what they’re passionate about,” and to learn how to apply themselves to it practically, whether in business or in the growing area of social entrepreneurship, which focuses on societal change.

Even at Babson, entrepreneurship isn’t all about business: in E-Tower, Austin Conti and Gerald Praysman are writing a screenplay about the Middle East that they hope to sell using the techniques for spotting business opportunities. And Gabriel Schillinger, a freshman, is engaged in social entrepreneurship. A nonprofit organization he helped start in high school, For Darfur Inc., put on a concert by Kanye West in Florida that raised $300,000 for Doctors Without Borders, and he is trying to build on that early success.

The entrepreneurship movement has its critics, especially among those who see college as a time for broad academic exploration. Daniel S. Greenberg, author of “Science for Sale: The Perils, Rewards and Delusions of Campus Capitalism,” finds the increasingly fervent campus embrace faddish and narrow. “I just don’t think that entrepreneurship ranks so high in terms of national need, or in terms of what can effectively be taught in the limited time available” in the college years, he says. “What aren’t you studying because you’re studying entrepreneurship?”

Leonard A. Schlesinger, Babson’s president, says that the question of whether innovation really can be taught is “an age-old debate.” Mr. Schlesinger, who has served as chief operating officer of Limited Brands, says that if teaching entrepreneurship is an academic fad, it is one the school has pursued since 1978 — “a fad like wearing pants and underwear.”

Schools do not teach the spark of creativity so much as provide the tools for students to capitalize on that spark, he says.“I’m going to teach you to find opportunity.”

Especially in a bad economy, he adds, the curriculum “gets our people to be much better prepared for the structure and dynamics of the job market they’re likely to face. The thought process and logic that we teach is at the core of stimulating innovation, stimulating innovation is at the core of any developed economy.”

“I’m not trying to be arrogant,” Dr. Schlesinger notes, “but the world needs what we do.”

The urge is strong at E-Tower.

With word of a visitor on the premises spreading, some two dozen dorm residents crowded into the common room to talk about their projects. They were brimming with excitement about their plans, and eager to share them with a reporter who, as more than one noted, might be able to help them make a connection in the business world or get them a little publicity. Prinya Kovitchindachai pressed one of his hangover pills into my hand. I tried it, and grimaced at the taste. “It’s much better if you’re drunk!” he insisted.

Another student grabbed me as I was leaving. He asked that I not use his name in the article. The people with whom he was dealing in his start-up trading business, he said nervously, “don’t know how old I am.” ¦

John Schwartz is a reporter for The Times.

---

I think it is not a waste of time. Entrepreneurship class helps (1) organizing what students have learned to their interests, (2) stimulating the interests of students to conduct more research, (3) understanding important sociological/ economic phenomenon.

Global entrepreneurship and innovation

The Weekend That Wall Street Died

The Weekend That Wall Street Died
Ties That Long United Strongest Firms Unraveled as Lehman Sank Toward Failure

* DECEMBER 29, 2008

By SUSANNE CRAIG, JEFFREY MCCRACKEN, AARON LUCCHETTI and KATE KELLY

With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.

Mr. Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.

Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Mr. Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Mr. Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Mr. Lewis wanted to call back, he would call back.

Mr. Fuld paused, then apologized for bothering her. "I am so sorry," he said.

His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.

As Mr. Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Mr. Fuld, who declined to comment for this article, was the odd man out.

For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.

Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds

Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.

After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.

In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.

Messrs. Mack and Blankfein had some reason to be confident. Mr. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Mr. Blankfein, had even less direct exposure to subprime investments. Mr. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30% from earlier in the year, to $88 billion.

Problems were more acute at Merrill Lynch and Lehman.

John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes

More monumentally, Mr. Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.

Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Mr. Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39%. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.

Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Mr. Fuld, Lehman raised capital. But critics say Mr. Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.

Mr. Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Mr. Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."

In the summer of 2008, Mr. Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Mr. Fuld told executives at the time. "We can't fail now."


Friday, Sept. 12

By Friday, Sept. 12, failure appeared to be an option for Lehman.

Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.

If Mr. Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.

Earlier that week, Mr. Fuld had approached Bank of America's Mr. Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Mr. Fuld's top executives spent Friday shuttling between the two suitors' law firms.

Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.

Lehman's troubles were putting the rest of Wall Street on notice.

In a Merrill Lynch conference room in downtown Manhattan that morning, Mr. Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."

Merrill would be fine, Mr. Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.

But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.

Mr. Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Mr. Fleming worried that Bank of America could buy Lehman instead.

Mr. Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Mr. Fleming said. He was told that Merrill's Mr. Thain would have to approach Bank of America's Mr. Lewis. "I know," Mr. Fleming responded. "I'm gonna try."

At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Mr. Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Mr. Thain was told.

Soon after, Mr. Thain gathered along with Morgan's Mr. Mack and Goldman's Mr. Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.

The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.

An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.

But now, Mr. Fuld's problems at Lehman were possibly beyond repair.

By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.

Mr. Lewis hadn't come to New York for the Lehman talks. He called Mr. Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Mr. Lewis told him.
Saturday, Sept. 13

Mr. Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.

Merrill, meanwhile, was beginning its own pursuit of Bank of America.

At his home in Rye, N.Y., Mr. Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Mr. Fleming.

"John, you really need to call Ken Lewis," Mr. Fleming said.

"Get me his number," said Mr. Thain, who added it to his papers for the day.

Mr. Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Mr. Fuld -- were there.

Federal officials broke Messrs. Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Mr. Thain and Morgan's Mr. Mack, was supposed to discuss an industry-led bailout for Lehman.

Lehman's president, Bart McDade, walked the group through the embattled firm's books. Mr. McDade did not respond to requests for comment for this article.

Mr. Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.

As Mr. McDade discussed Lehman's position, Mr. Thain had an epiphany: "This could be me sitting here next Friday."

Mr. Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.

Mr. Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Mr. Lewis said.

Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Mr. Lewis ordered them back to New York.

Up in Lehman's midtown office, Mr. Fuld was also dialing Mr. Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.

Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Mr. Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."

Throughout the day, Mr. Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.

"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."

Later that afternoon, Merrill's chief executive met Bank of America's CEO, Mr. Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.

Mr. Thain made his opening offer. "How about buying a 9.9% stake" in Merrill, he proposed.

Mr. Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.

"I am not here to sell Merrill Lynch," Mr. Thain responded.

"Well, that is what I want," Mr. Lewis countered.

The two parted with an agreement to keep talking.

Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Mr. Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.

What Mr. Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Mr. Fuld away that weekend. The federal officials had explained that Mr. Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.

At the Fed meetings, much of the talk was on the sidelines. When Mr. Thain returned to the New York Fed from his discussions with Mr. Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9% stake in Merrill and offered to extend a $10 billion line of credit.

Mr. Thain was digesting the news when he was approached by Mr. Mack of Morgan Stanley. "We should talk," Mr. Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Mr. Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.

Mr. Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Mr. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mr. Mack said before the group broke up.

As Mr. Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.

Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Mr. Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.

At Lehman's offices that evening, Mr. Fuld still hadn't heard back from Mr. Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.

But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14

A few hours later, at 8 a.m., Mr. Thain arrived at the Time Warner Center for a second one-on-one meeting in Mr. Lewis's corporate apartment. Over coffee, Mr. Thain made his case for a strong price for Merrill despite its stock's recent fall.

At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9% stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.

At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Mr. Thain arrived, the Merrill chief had a number of options in his back pocket.

Rolling up to the meetings at around the same time was Goldman's chief, Mr. Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Mr. Blankfein: "I don't think I can take another day of this."

Mr. Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."

At Lehman that morning, Mr. Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.

One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.

Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.

Lehman's president, Mr. McDade, and Mr. Cohen, the attorney, called Mr. Fuld from the New York Fed. Passing Mr. McDade's cellphone back and forth, they broke the Barclays news.

Mr. Fuld postponed his board meeting. He made one more call to Charlotte, answered by Mr. Lewis's wife.

By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Mr. Cohen, the attorney, broke the news to Mr. Fuld. "I guess this confirms our worst fears," Mr. Fuld said.

At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.

A senior Fed official asked Mr. Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.

"No," Mr. Miller answered.

"You need more of a plan to prepare to do this," Mr. Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.

Now, Merrill's Mr. Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.

Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Mr. Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Mr. Kraus said.

"We have a great deal in hand, and need to finish doing this deal," retorted Mr. Fleming, Merrill's president. A few minutes later, Mr. Thain called Mr. Fleming, telling him to send some people to work on the Goldman offer.

Mr. Fleming and Bank of America's lead negotiator, Mr. Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.

Mr. Fleming informed Mr. Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.

"When I took this job this was not the outcome I intended," Mr. Thain told directors. After the board meeting broke up after 8 p.m., Mr. Thain called the chief of Bank of America. "The decision was unanimous," Mr. Thain told Mr. Lewis. "You have a deal."

A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.

"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"

One of Mr. Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.

Mr. Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.

"This is serious," said Mr. Cox. "The board has a grave matter before it," he said.

John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?

The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.

As the meeting wrapped up around 10 p.m., Mr. Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.

Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Mr. Lewis said around midnight, a glass of champagne in hand.
The End

Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.

Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.

Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mr. Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.

"We're going to get Mitsubishi done. There is no Plan B," Mr. Mack told one regulator.

Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.

Mr. Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.

The same weekend, Mr. Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
—Dan Fitzpatrick contributed to this article.

Write to Susanne Craig at susanne.craig@wsj.com, Jeffrey McCracken at jeff.mccracken@wsj.com, Aaron Lucchetti at aaron.lucchetti@wsj.com and Kate Kelly at kate.kelly@wsj.com

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