The Second Generation

The Daily Deal - July 3, 2003

by Joshua Jaffe

Investment bankers in San Francisco call it "the void." That's the vacuum created by the disappearance of the city's first generation of homegrown boutique investment banks and the retreat of New York's bulge-bracket securities firms and their global rivals from all but the commanding heights of the technology investment banking business.

A decade or more ago the legendary Four Horsemen - Robertson Colman & Stephens (which later became San Francisco-based Robertson Stephens Inc.), Hambrecht & Quist, also of San Francisco, C.E. Unterberg, Towbin of New York and Baltimore-based Alex. Brown - would have filled the void. But those four boutique banks and their closest rival, San Francisco's Montgomery Securities, were acquired or dismantled (or both, in succession) by larger East Coast or European interlopers as the tech bubble of the late-20th century picked up steam.

And in their place? Well, no one's in their place today, at least not yet, but a score or more small-to-medium-size investment banks are angling to become the latest Four Horsemen of Silicon Valley. "There's a void, that's obvious," says Richard Osgood, CEO of Pacific Growth Equities Inc., one of the new firms that counts itself among the rising generation of San Francisco boutique banks. "As for who's going to fill it, that isn't obvious."

Contenders include high-profile bankers such as Thomas Weisel, the founder of Montgomery who launched Thomas Weisel Partners LLC in 1999 after Montgomery's acquisition by Bank of America Corp. But the list also includes less familiar bankers, among them former Montgomery executive Ron Lissak, managing partner of 2-year-old Catapult Advisors LLC, an M&A and private placement boutique focused exclusively on the software industry.

Challenging Weisel's eponymous full-service investment bank at one end of the spectrum and Catapult Advisors at the other are boutique shops scattered across San Francisco and into Silicon Valley. Some of them are well known to the larger investment banking world, including William Hambrecht's WR Hambrecht + Co. or regional rivals with a foothold in California, such as New York-based Needham & Co. or William Blair & Co. of Chicago.

Others are recognizable only to tech banking cognoscenti, and even then perhaps not by many. They range from boutiques offering full-service banking, such as Joseph Jolsen's JMP Securities LLC and Osgood's Pacific Growth Equities, to local firms with a far narrower focus, among them Alliant Partners, Venturi & Co. LLC and Neveric Capital Inc.

But all of them recognize the opportunity today. There are more than 3,500 publicly traded companies on the Nasdaq, 70% of which have market capitalizations below $250 million. Almost 60% of these companies boast no research coverage whatsoever. The lack of attention from Wall Street - combined with the compliance burden of Sarbanes-Oxley and daunting business environments - are forcing many of these companies to consider mergers, restructurings or privatizations to survive. Nearby venture capitalists are facing their own set of challenges; thousands of privately held portfolio companies are simply incapable of going public, forcing their financial backers to consider mergers or recapitalizations to improve these startups' chances for initial public offerings.

In short, "the void" is ripe for exploitation. "We're in a target-rich environment," quips William Wisialowski, a partner at Seven Hills Group LLC, a San Francisco-based M&A and private placement firm.

Indeed, the investment banks with connections to promising growth companies and viable small-to-medium-size public tech companies will be the ones able to eke out a living in today's tough times. Boutique banks with a good reputation among VCs for research (and a following among institutional investors) will garner private placement and sell-side merger acquisition engagements from their portfolio companies. And impressive underwriting and after-market trading skills will draw the attention of neglected publicly traded companies seeking sponsors.

Replicating what was achieved by the Four Horseman in an earlier era won't work today. Tougher competition, new regulations and the explosion of the information technology and life sciences industries have changed the rules of the game. "Now, technology isn't in the closet, it's out there," notes Michael Kelly, vice chairman and senior managing director of Broadview International LLC. "The [ bulge bracket] may not like what they see in terms of cyclicality, but they believe it's a market."

Today, "the void" is where local competitors will prove their staying power. Which players from San Francisco's second generation will emerge as winners, however, won't be known for years.

The largest local player on the San Francisco scene would beg to differ. "The old world of the Four Horsemen is now one horsemen," argues TWP's Blake Jorgensen, Weisel's director of investment banking. With 500 employees and more than $200 million in capital, TWP is three times larger than its nearest rival this side of the bulge bracket.

From his perch at the top of the old Pacific Telesis headquarters on the south side of the city's financial district, Jorgensen views the New York investment banks as the firm's main rivals. In his eyes, the local niche players have assumed the role that smaller San Francisco investment banks such as Volpe Brown Whelan & Co. once played.

TWP, he notes, participated in the only two technology IPOs of 2003: Livermore, Calif.-based semiconductor equipment testing company FormFactor Inc. and Nashville-based credit card payment processor iPayment Inc. He says TWP is getting through the downturn by generating about $850,000 per day in trading revenue, management fees from its private equity business and expanding beyond technology.

But in these lean times, how can a small full-service bank turn a profit? Jorgensen points as an example to the firm's profitable position as sole lead underwriter of Select Comfort Corp.'s $80 million follow-on financing in May. TWP landed the assignment from St. Paul Venture Capital, a Boston-based VC firm with which Weisel had previously built a relationship and which held most of Select Comfort's shares. "The VCs are still creating companies, and they need a partner to take them to market," he says. "That's the role the Four Horsemen played. That's the role we're going to play."

Five blocks north, near the center of San Francisco's small financial district, Jolson, CEO of JMP Securities, has adopted a different approach. The 3-year-old firm has built a full-service offering that includes an asset management group headed by 10-time Institutional Investor All-America analyst Jolson himself. And he's proud JMP was the 24th- ranked lead underwriter last year, with seven deals accounting for 0.9% of the U.S. market.

Unlike Weisel, which ranked 14th, Jolson is not aiming for the top 10. By providing strong research in a few select sectors, such as financial services, where he made his name, and in technology, where he's hired experienced analysts and bankers, Jolson hopes the firm can continue its steady growth rate and expand the $22 million in revenue it recorded last year to $30 million this year. He has put former Montgomery partner Craig Johnson in charge of investment banking while he focuses on running the hedge fund.

Jolson expects to record $15 million in revenue in the second quarter, due in part to apartment lender Arbor Realty Trust's $105 million 144A equity offering, which JMP sole lead-managed last month. Jolson's known and kept in touch with the Arbor CEO for a decade.

Jolson notes that TWP started out with a valuation of $500 million when it was established four years ago. "We hope to be there in three to four years," he says. "We're definitely the tortoise."

Another terrapin-like firm run by a Montgomery veteran with his own special twist is Pacific Growth Equities. No upstart, Osgood's full-service boutique is among the only sizable San Francisco-based investment banks not acquired during the boom. The firm never ratcheted up in the late 1990s and has grown quickly amid the technology downturn by remaining profitable, picking off talented research analysts and increasing its annual trading volume on the Nasdaq by 50% from 2001 to 2002.

"We have the luxury of doing now exactly what we've been doing for 12 years," he says. "It's evolutionary, not revolutionary." Indeed, Osgood doesn't even aspire to be a lead IPO underwriter. Instead, he uses a co-manager position as an entree, builds a relationship with the company and waits for the larger firms to lose interest before muscling in on the position as the firm's main market maker, M&A adviser and underwriter.

Other out-of town competitors are targeting this same market segment. Take Needham & Co., the 18-year-old New York investment bank with West Coast offices in Silicon Valley's power center, 3000 Sand Hill Road. Needham's point man at the office, Chad Keck, says his bank is winning business by offering a full suite of products to companies that have been ignored or abandoned by larger firms. Keck even believes Needham can make research pay by creating sales and trading revenue, using it for its asset management activities and for its investment bankers to better understand industry trends.

Other regional banks practicing this full-service investment banking approach and now plying their talents on the West Coast are New York-based Wit Soundview Group Inc., Boston-based Adams, Harkness & Hill Inc., Baltimore-based Legg Mason Inc., William Blair, and Arlington, Va.-based Friedman Billings & Ramsay & Co. And, of course, on the M&A side, Fort Lee, N.J-based Broadview remains a serious competitor with global reach. "These firms will address the midmarket more effectively than guys starting now," says Keck.

Merriman Curhan Ford & Co. believes it should be included in this list since it has the distinction of being the only publicly traded investment bank in San Francisco. Located across the street from the Transamerica Building in the heart of the financial district, MCF inherited the public listing of a bandwidth-trading outfit that was eventually shuttered. Gregory Curhan says the public listing allows the firm to recruit employees with options.

MCF's public face also helps it market the 60-person firm's services to companies facing the same challenges it has already wrestled with, such as completing their own private-investment-in-public-equity transaction. "The playing field is truly wide open right now," Curhan argues. "While there is competition, it's not like three investment banks will win and the other 20 will go out of business."

ThinkEquity Partners, a full-service investment banking boutique founded by former Montgomery and Merrill Lynch & Co. research analyst Michael Moe, is making a bolder bet than most of his competitors. By opening offices in Chicago, New York and Minneapolis and hiring 60 people, the firm has expanded quickly in only two years.

Moe is trying to differentiate his firm with dedicated research expertise in healthcare, technology, media and communications. He hopes his research will impress institutional investors and carry the firm into the ranks of the top 15 Nasdaq market makers by 2007.

In the past 10 months, ThinkEquity has tripled its trading volume to 39 million shares per month, rising to 42nd from 55th. But critics - and there are many in this close-knit but highly competitive banking community - charge that firms such as MCF and Think- Equity can only play niche roles no matter what their ambitions. But does that matter?

Brodie Cobb, managing director at Presidio Financial Partners, doesn't think so, at least not completely. He notes that margins in institutional trading are being compressed by decimalization just as institutional investors are trying to do more with less. Investors now favor brokers that can provide capital, trade flow and anonymity. "The firms that aren't getting cut out are the Goldmans, Merrills and Morgans of the world," he says.

His firm has thus eschewed research and trading in favor of M&A advisory services, such as buy- and sell-side transaction work and fairness opinions, as well as private equity services such as private capital recapitalizations.

Presidio markets its services to the more than 65 individuals who have entrusted Presidio's wealth management division with at least $20 million each. Since many of these individuals are entrepreneurs, they often ask the firm's investment banking division for help, too.

"When these guys want to sell their business, we often get the first and only call," says Sam Wilkins, the head of investment banking. Of the nine active engagement letters the firm is working on, four have been sourced from its wealth management division.

Connections of another sort are key to Seven Hills' boutique ambitions. In office space leased from downsized TWP, Cabot Brown, the founder of Seven Hills, says he and his four partners set up shop in October 2001, targeting small technology, life sciences and business processes companies in need of M&A expertise. The firm's edge, he says, is its connections to industry executives. Seven Hills has professionals who hale from Cowen & Co., ING Furman Selz, Volpe Brown Whelan and Robertson Stephens.

The firm has completed nine transactions since its founding in October 2001, enough to keep it in business. Says Brown: "There's no reason we can't be a dominant force in M&A. The main thing is the quality of the team, and I'd put our team up against anyone."

Other bankers are counting on different sets of expertise. Clay Corbus, senior managing director of corporate finance at WR Hambrecht, may be the only investment banker in San Francisco who thinks the tougher regulatory environment might actually help his firm. With its so-called Dutch auction IPO process, which allows the market to determine a fair opening price for a new listing, and its public company research provided free to retail and institutional users, WR Hambrecht is bucking the practices at other investment banks. The company does offer M&A advisory services, trading and traditional underwriting services, but it's best known for its embrace of the Dutch auction.

Another test of the concept will come in a few months when the proposed IPO of San Francisco-based e-commerce company RedEnvelope Inc. comes to market.

Venturi & Co.'s Matthew Venturi is taking the niche approach to its extreme. The Houlihan Lokey Howard & Zukin veteran based his eponymous firm in the bedroom community of Burlingame, midway between San Francisco and Palo Alto, Calif., to leverage his contacts with law firms and investment banks in need of specific financial engineering skills. He says he's picked up a steady stream of restructuring work. His latest mandate: the May restructuring of Los Angeles-based conference organizer Key3Media Group Inc.

Then there's Catapult Advisors LLC, which specializes in the software sector to gain M&A and private placement assignments. Founder Ron Lissak believes that by interviewing top corporate executives at big public companies, his firm can figure out exactly what public buyers are looking for and which startups can provide it. Formerly the head of Banc of America Securities LLC's private placement business, Lissak says that in a down market, deep knowledge of the software industry will pay off when VC or corporate clients need to identify appropriate buyers or investors.

So which of these firms will survive and then thrive? In the end, only a handful offering varied services in different cities will likely emerge as the go-to firms for growth companies.

"The same basic services are needed," says Pacific Growth Equities' Osgood. "The business models that work are geared toward small to midcap companies that fall below the threshold of the bulge-bracket firms."

The original Four Horsemen and Montgomery filled this niche profitably before more lofty aspirations in the late 1990s led to their demise. The winners among the new generation will be the ones that remember that lesson but adapt to today's very different circumstances.

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