Last month's announcement that pioneer online investment bank Wit Capital Group Inc. would buy struggling rival E*Offering in a $328 million stock acquisition was a surprise to the tech heads of the investment banking world. After all, it was Wit, with its high-priced talent, multi-million dollar losses and Goldman Sachs equity stake, that had been the subject of takeover talk on Wall Street for months.
As surprising as it may have been, the deal points to a characteristic that may indeed be Wit's salvation: its ability to change its stripes in Internet time. Through two recent huge acquisitions-first the $320 million deal for institutional tech bank SoundView Technology Group and now E*Offering-Wit is undergoing a total transformation, now calling itself Wit SoundView Group. The three-year-old firm is unloading its online retail brokerage operation, which is losing $20 million this year, to E*Trade Group. Instead, Wit is betting it can become a solid institutional investment bank that can stay in the running by capturing elusive lead mandates, garnering hefty M&A fees and keeping a finger in the venture capital pie. At the same time, it plans to keep the retail accounts at arm's length, through a distribution arrangement with E*Trade.
The shift in strategy is certainly dramatic, but nothing new for Robert Lessin, the chairman and chief executive officer who built up Wit Capital from the shell of a near-broke online beer company called Spring Street Brewing Co. Pragmatism seems to be a strong suit. Moreover, he doesn't think these changes negate the firm's underlying vision. "If the world was not transforming itself, we would not be here right now," he says from his Manhattan offices above the Strand bookstore, a quirky Greenwich Village landmark that sells used books.
Perhaps no other securities firm more embodies the stormy history of Wall Street on the Web-and its prospects- than Wit. Indeed, Lessin likes to say that he wants to "Witize" the world, which he takes to mean that Wit would become the global authority on Internet and technology. That kind of New Economy hype may sound a little passe these days as the world has transformed itself in ways that Lessin probably didn't anticipate a year ago. That makes Wit's ultimate success a difficult call to make.
Consider the following: Technology stocks have plunged. Internet initial public offerings are suspect. Online trading volumes, the engine of the new retail paradigm, have slumped. IPOs, Wit's bread and butter, have almost disappeared, and the firm's stock has dived to as low as $7 per share from its high of $35.75 per share.
By the end of the first quarter, after three years of operation, Wit had gone through two-thirds of the cash it has received in its short life: $88.5 million in venture capital, including a $25 million investment from Goldman, and $72.8 million in last June's IPO. But even though the stock is weak, the firm appears to be stabilizing. It earned a profit of more than $19 million in the first quarter and analysts expect it to eke out a small profit even during this disastrous quarter. Moreover, the $66 million in cash it has left will last a lot longer now that the $20 million in losses will be transferred to E*Trade in the third quarter.
At the same time, however, the competition is intensifying. The big three tech underwriters (Morgan Stanley Dean Witter, Goldman and Credit Suisse First Boston) have been gobbling up equity market share from smaller banks, and they have also gotten more aggressive in developing the type of online underwriting capabilities Wit pioneered.
"The bulge bracket firms get smart pretty fast," says Mark Loehr, one of two Wit co-presidents (Russell Crabs is the other. Loehr is from Wit, Crabs joined the firm with the merger of SoundView, which he headed.) "For every innovative thing we come up with, they are going to have a lot more resources and they are going to be working on their [own] innovative products." Whether Wit can overcome that handicap, or be swallowed by an institution for its online savvy, is one of the firm's many challenges.
Even competitors, however, seem to think Lessin has the brainpower to pull it off, and the savvy to negotiate the many minefields ahead. "To Bob Lessin's credit, he recognized that the right formula to success is not to have both feet in the new paradigm," says a rival banker, "but also to have one in the old."
Forget democracy
Back in 1997, Wit Capital opened its doors with modest expectations as a niche player promising to democratize the IPO process for retail investors. The failure of that strategy was highlighted by the deal with E*Trade. Further evidence that retail is a thing of the past, Ron Readmond, the former Charles Schwab Corp. executive who joined in 1998 and was co-CEO with Lessin, announced two weeks ago that he would leave at the end of the year. Despite years of retail experience with Schwab, even Readmond couldn't staunch the red ink. (He will retain a board seat and is a roughly 3% shareholder.)
The shift in strategy may be a survival tactic, but it has ruffled some feathers. Upon the Readmond announcement, Wit's already-battered stock fell another 4%. "Wit's problem is that it has to decide what it wants to be when it grows up," says analyst Amy Butte of Bear, Stearns & Co. During the road show before its June 1999 IPO, she recalls, "Wit was talking about being the champion for the individual investor. Wit spoke about supplying IPO shares to everyone-Ameritrade, Charles Schwab, you name it. This is not what happened."
Back then, the idea of an online investment bank focused on technology that targeted retail and institutions alike looked brilliant. Technology was on cloud nine, the market was pouring Internet money on just about everyone, and IPOs for the masses was the rallying cry. Wit's utopian plan to make a living exclusively off Internet investment banking as a co-manager-in a transparent, issuer-focused, equitable way-seemed not only possible, it even looked inevitable.
Fast forward to the present, however, and the picture is much different. "The mania that created the opportunity for this business to get up and running will also set them back," says one tech investment banker, requesting anonymity.
Last year, when most tech-oriented market players were raking in the dough, Wit was just gearing up. It finished 1999 with a loss of $20.9 million on total revenues of $3.5 million. In the first quarter of 2000, Wit made money for the first time, thanks to the SoundView acquisition, which closed on Jan. 31. By incorporating its already-profitable business into Wit's balance sheet, Wit finished the first quarter with record revenues of $106.6 million, earning $19.3 million. The numbers are even more dramatic when compared with the first quarter of 1999, when Wit lost $4.9 million on revenues of $3.9 million.
The first quarter may be something of a one-off, at least for the foreseeable future. More than half, or $60.5 million, of the first quarter's $106.6 million in revenue came from investment banking, most of it fees from its co-manager slots on 30 IPOS, most of them originating with SoundView, according to Thomson Financial Securities Data.
During the bearish second quarter, by contrast, Wit has participated in only 12 deals. Analysts expect it to finish the quarter with roughly half the investment banking revenues, or about $30 million, to eke out a profit, earning $67.8 million.
In the third quarter, when the E*Group deal is expected to close, Wit is expected to just break even, even as it hands off its annual $20 million retail brokerage loss. That's because the share dilution from the deal also will kick in.
Lessin must deliver
But once Wit has plugged the hole in the dike, how will it move forward? Wit has advantages: It is young, focused and nimble. With no legacies to uphold, it can move in whatever direction will benefit it, say observers. But most critically, this is the time when the talent and connections of the key people in the firm will be tested. In other words, can they bring in any M&A deals rather than just IPOs?
"They have many talented and very smart people," concedes a competitor. But more than before, the heat is now on Lessin, the firm's largest shareholder and its sole CEO since Readmond's announcement, to prove his mettle. A well-known figure on Wall Street, Lessin spent a good chunk of his career at Morgan Stanley, where he was a managing director, head of the strategic planning committee and vice chairman of the investment banking operating committee. He left Morgan Stanley, along with a slew of other disgruntled investment bankers, with then-President Robert Greenhill, for Smith Barney in 1993. Lessin stayed there only months after it agreed to merge with Salomon, even though he had been named vice chairman.
At that time, he took some time off and wrote a book,
"The Middle Chapters", before lining up the financing for Wit Capital. Other bankers give him high marks for targeting tech banking early. "He thought a lot about where American business was heading," says former colleague Hans Morris, managing director and co-head of global financial institutions group at Salomon. "He turned out to be right on a lot of things."
Lessin continues to revise his approach, but not the underlying philosophy. "We want to be the toll collector in the new economy," he says. Realizing that IPO fees will not suffice, in March he hired Mack Rossoff, a senior M&A banker from J.P. Morgan to beef up and head the M&A group and work directly under him. Rossoff himself is a heavy hitter: a founding partner of Wasserstein Perella Group who also headed up investment banking at Schroder & Co. Inc. before joining J.P. Morgan.
"Our mission is broader than M&A," says Rossoff. "Our mission is to help our clients develop and implement their own strategies. The more problems they have, the more they have to consider transaction partners. This puts more spotlight on what we can do." So far, however, the list of mergers is short, with three deals so far this quarter. Still, they will bring in $10 million in fees.
Lessin argues that advisory work and private equity are "counter-cyclical" to IPOs and will balance the downturn in that business. Wit's two VC funds have $320 million ready to invest, and have already made some significant investments, such as in Internet mega-search engine GuruNet Corp., in which Goldman is also an investor. Lessin himself has his fingers in many deals that can eventually bear fruit. He is on the board of MarketWatch.com Inc., Fingerhut Companies Inc., iParty Corp. and MaMaMedia Inc., and is also a partner in venture capital fund Dawntreader Fund I.
But whether M&A fees and VC investments can make up for lost IPO revenues remains to be seen. After all, venture capital investments are typically cashed out through IPOs. So that leaves M&A. At least one Wit client, Bill Coleman, the CEO of Web infrastructure software provider BEA Systems Inc., says he believes that M&A and advisory work can account for part of the void left by IPOs but not all of it. "IPOs are big money," he says.
Trimming the fat
The other task for Wit is to cut its gargantuan expenses. "If revenues go down, will expenses go down too?" asks Butte. Wit's compensation expenses have been a bone of contention, as the firm was losing money by the buckets. It spent $64.9 million in compensation in the first quarter, or 61% of revenues. The number is much higher than the more typical 50% ratio, which firms such as Merrill Lynch & Co. and Goldman Sachs maintain, according to analysts.
Wit says it is reducing the ratio, which analysts point out has gone down somewhat since last year and is expected to be even lower if the second quarter finishes anywhere near the projected $34 million in compensation.
But Wit has been forced to spend the big bucks to get the brand names. Some $5 million was spent to entice Internet analyst Jonathan Cohen from Merrill Lynch in February last year, a move that arguably was necessary in a time when Internet star analysts attracted business. More recently, Wit lured Rossoff, and in March took on Edward Annunziato, formerly the co-head of investment banking for Merrill in Europe, to head Wit Capital Europe.
Adding more talent, moreover, will be difficult for a bank whose stock acts like an Internet play. Wit's shares, already beaten up, were further diluted by the all-stock acquisitions of both SoundView and E*Offering.
At the same time, Since Wit acquired SoundView in January, it has expanded its scope. The $335 million acquisition ($22 million of it in cash) increased its professional staff to 58 bankers from 35, and to 44 analysts from 14. It also broadened the coverage to all technology, which is more in line with banks' tendency to dissect technology narrowly in a less start-studded fashion, and which the institution hopes will pay off as investors become more discriminating.
"We slice and dice the industry narrowly," says Russ Crabs, the other former SoundView executive who is now Wit co-president. The in-depth analysis "keeps the institutional investor addicted to our research."
BEA Systems' Coleman vouches for the research. He said his company started working with SoundView on his company's IPO in 1996, and research analyst Kris Tuttle was able to successfully explain to investors the meaning of BEA's e-commerce infrastructure platform when this kind of concept was still unfamiliar. "Kris led the pack," says Coleman.
Now the E*Trade deal
With the costly task of luring and maintaining retail brokerage accounts now turned over to E*Trade, Wit can focus on its underwriting prowess. At the same time, it retains rights to be sole distributor of IPO shares and research to E*Trade's 2.6 million customers as part of a five-year alliance with E*Trade.
"The E*Trade and E*Offering deal was an acknowledgement that if we were going to truly become powerful in the capital-raising process, we needed real individual capability, and 100,000 accounts weren't going to make it," admits Lessin, referring to the much smaller number of retail accounts Wit has managed to line up before the deal. "With E*Trade," he promises, "It starts to get serious."
In the agreement, which was sparked by General Atlantic Partners, investors in E*Trade and E*Offering, Wit signed to take over E*Offering, the struggling investment banking unit and eliminate a competitor in the process.
"We bought E*Offering, but most importantly, we bought an exclusive relationship with E*Trade and an increased West Coast presence," says Readmond. "What you had over a period of 14 to 15 months is two companies advancing very rapidly within their core businesses. They had a set of needs in our core competency, and we had a set of needs in heir core competency."
From a deal structure point-of-view, the cross-equity ownership agreement made sense. "It adds some teeth to the deal structure," notes Matt Vetto, analyst with Salomon Smith Barney. Increasing the number of retail accounts 26 times also helps, he says. "Being able to plug into the E*Trade system improves distribution dramatically."
While Wit may have made a smart move, it also lost some independence as it took on new board members from E*Trade and E*offering, including E*Trade's Chairman and CEO Christos Cotsakos and Bill Ford, a General Atlantic partner. The question is now how will it all play out in the real world: Who will control distribution of IPO shares-Wit or E*Trade?
There's likely to be some change. Wit used to assign IPO shares via lottery and had a rule against flipping. E*Trade, which frowns on selling prior to 30 days but does not forbid it, tells customers that if they flip they'll be restricted from buying IPOs for 60 days. But bankers in the valley wonder how strictly these rules are adhered to, and whether E*Trade and other online brokers end up rewarding those who trade the most and are every CEO's nightmare: day traders.
"This is one dirty little secret" said one banker. "If they are not going to reward their most profitable customers, who are they going to reward?"
Luckily for Wit, the problem is not unique to E*Trade. Wit's newest competitor is Epoch Partners, a West Coast online investment bank backed by Schwab, Ameritrade Holding Corp. Inc., TD Waterhouse Corp. and VCs Benchmark Capital and Kleiner, Perkins, Caufield & Byers. People close to Epoch point out that the number of trades per assets held is greater at E*Trade than Schwab, an indication that day traders prefer E*Trade, with its lower costs. Meanwhile, Schwab customers average assets of about $200,000, versus E*Trade's $26,000. But Epoch will also deal with the customers of Ameritrade, which offers the same low rates as E*Trade.
That's not the only problem, however. Readmond puts the issue quite bluntly: "If we can't bring enough supply to satisfy 100,000 customers of our own, what would lead us to believe we'd get enough supply to satisfy 2.6 million customers?" he asks. "My answer to that is that price ultimately determines the intersection between supply and demand. And to the extent that individual investors can influence the price of the offering rather than the performance of the stock in the after market, two things will happen. Offerings will be priced more fairly than they are today, and the extraordinary demand that spills over from the IPO unsatisfied into the after market and causes astronomical first-day jumps in that market will be minimized."
Talking about the first-day pop in a pop-less world seems a bit arcane these days. But in the recent IPO bull market, it became the issue du jour for the new online investment banks. They pointed out that traditional underwriters set an IPO's price based on demand from a small group of institutional clients, causing a first-day pop when retail investors clamored to buy shares. The pop transferred demand from the IPO to the after market, leaving retail customers holding the bag for the institutions who flipped the shares and made a bundle. Wit, and the other upstarts, promised to take into account retail demand and price the stock higher in the IPO, reducing the pop. Until then, IPO demand and supply are far from synchronized.
"There is grumbling among everybody's customers," says Salomon's Vetto. "It's a cyclical business. Supply and demand ebb and flow. The challenge for E*Trade is to match their customer demand as best they can."
Of course, this won't change until Wit is in the driver seat; i.e., until it can get to lead-manage IPOs. With E*Trade and SoundView under the Wit umbrella, Wit says it is now ready.
But, when the market recovers, will issuers choose Wit over others? "An issuer needs great investment bankers, great research, institutional distribution, individual distribution, and after market support," says Readmond. "Each one of these milestones filled in another piece in the issuer puzzle so that now we have a very compelling offering to the issuer."
At least one client agrees. BEA System's Coleman thinks Wit's chances in getting lead roles are good. He notes that he bumped Wit up from sixth to second position in the five financing events his company has had since 1996. "Wit has moved into the second tier just below Morgan, Goldman and CSFB," he says. "They can start to be considered. Making the final cut is real hard. We moved them up because of the strength of their analysis. There are bigger houses today, but so stretched with the things they cover."
However, the fact remains that equity market share is concentrated in fewer and fewer hands. Never mind lead, Wit is likely to have to work hard for every co-manager role, competing with the likes of Chase H&Q and Robertson Stephens. "Wit's biggest competition will come from competing for a role as co-manager," says Salomon's Vetto.
Indeed, some of the most significant breakthroughs may come in follow-ons, not IPOs. For example, Wit has pretty much decided to not price IPOs in a Dutch auction, even though it would theoretically help match up supply and demand more equitably by allowing individuals and small institutions, now last in priority in the public capital-raising process, the chance to name the price they are willing to pay. Instead, Wit has introduced a Dutch auction into an electronic platform, called Vostock, where indiviuals and institutions have equal access to follow-on offerings. The system, which will first be tried in a live offering later this summer, determines the price electronically within a given time and price window regardless of the order size or origin.
Wit debuted Vostock in April, but instead of part of some pre-meditated strategy, its introduction was more of an intelligent improvisation growing out of an after-hours trading platform that was scheduled to launch in early 2000. Wit scrapped the plan before launch when competitors beat it to it and after-hours trading failed to catch fire. To salvage its operation, Wit changed the after hours system into a Dutch auction follow-on issuance platform in partnership with ITG Technologies Inc.
Still a target?
All these changes don't answer the big question. Will Wit make it on its own? Wit's big sugar daddy, Goldman Sachs, has been flirting-advising Wit on acquisitions but not making the committal phone call.
"I would say that if this is an investment that was fifty-fifty financial and strategic, it's now moved in the direction of more financial and less strategic over the last year," says Joseph Gleberman, the Goldman managing director who has worked closely with Wit since the initial investment was made.
Wit's business is less complementary to and more competitive with Goldman today than it was a year ago, says Gleberman. "The area where Wit is attractive to Goldman Sachs is from the distribution side, not the issuer side," he says.
But the rumors continue. Some say that Goldman, which owns 12% of Wit, at this point wants Wit "to just go away." Others say that Goldman has been advising Wit on both of its recent acquisitions, shaping the company for itself. Goldman has the option to buy 5.6 million Wit shares at $5.57 exercisable in October, which would maintain its current stake as share dilution kicks in.
But if it's true that the larger Wit grows, the less likely that any the top bulge-bracket players will need it, observers suggest that an acquisition would more likely come from a firm such as UBS Warburg, which is rapidly expanding its online capabilities in the U.S. What Wit could offer is a fully developed electronic distribution capability and technology expertise, plus an electronic platform for follow-on offerings.
Butte would not speculate on an acquisition, but points out that regardless of the state of today's market, technology is what all major banks are sinking their resources into. This makes it logical that a bank that needs to strengthen its technology platform may just want to pluck a focused technology group. Moreover, since scale is so important in the tech world, Wit might be an attractive acquisition to anyone wanting to increase its heft.
The wild card? Analysts point out to the fact that Wit may be in the black, but its ally E*Trade burns money. If E*Trade gets acquired, there's concern that Wit might get dragged into the deal in the process and also be acquired, speculate analysts.
Lessin doesn't rule out an acquisition. Nor does he rule out the possibility that Wit will make it on its own. "I have to maximize shareholder value," he says.
That's particularly an acute issue for Wit now, as shareholders have been up in arms over the recent moves. But Lessin says the the E*Trade opportunity was too great to pass up. "I had to do what makes sense for the company strategically," says Lessin. "I can't worry about stock price in the near term. This was a unique opportunity."
In the meantime, the question remains, how bad and how long the slump will last, and whether private placements, advisory work and M&A will be enough to keep Wit going. Lessin is adamant Wit can survive today's malaise, saying that "Wit has sources of revenue that are more balanced than people think." Goldman's Gleberman agrees. "Wit's biggest challenge is to integrate its acquisitions," he says. "This is not about survival."
