CAHPTER 14
Capital Power
Nothing begins at the beginning. The before, and the before the before, and the before the before the before—all are part of the “beginning.” And so it was in 2009 when a major new direction for Vanguard took shape. Barclays Bank decided to sell all or part of its investment arm, Barclays Global Investors, and BlackRock decided to buy BGI for $13.5 billion. Vanguard astounded industry observers with a multibillion-dollar cash offer for just the ETF part of BGI, leaving BGI’s index mutual funds with Barclays PLC.
Vanguard was not entirely new to acquisitions. A few years earlier, it had briefly considered acquiring TIAA-CREF, the enormous retirement fund for college and university faculty and staff. Both organizations had substantial assets dominated by long-term retirement accounts invested in index funds. That acquisition possibility was quickly dropped, for three major reasons, clarified through rigorous discussion: the cultures of the two organizations, while generally similar, were sufficiently different to raise doubts about the success of integration; achieving the savings advantages that would make the merger financially attractive would depend on terminating a large majority of the TIAA-CREF employees, clearly counter to the core “loyalty up, loyalty down” values of Vanguard; and, as became clear during the senior staff and board discussions, growth in assets was not a primary objective of Vanguard.1 Vanguard’s focus was singular: what was best for each of Vanguard’s present investors over the long term.
What had become Barclays Global Investors had begun as an experimental unit of Wells Fargo Bank’s investment department, led by James R. Vertin, an avid duck hunter who habitually took only enough shells to match the legal limit—and never missed. A serious student of pioneering work on efficient markets, Jim Vertin became convinced of the merits of indexing in the early 1970s and created Wells Fargo Investment Advisors, which later became part of a joint venture with Nikko Securities. The two units continued to operate as separate business units. In 1994, Merrill Lynch came close to acquiring Wells Fargo Investment Advisors but decided against it when, according to Jerry Kenney, then a top Merrill executive, two important investment managers pleaded with CEO Bill Schreyer: “If you acquire this index business, it will kill all we have done or can do to build up Merrill Lynch Asset Management as an active manager.”2 As a result, the way was left open for Barclays Bank to acquire Wells Fargo Nikko, which it did for $400 million as part of its nascent globalization strategy. Barclays merged this combination with the investment management division of Barclays DeZoete Wedd Investors to form BGI in 1995. By 2006, BGI had pre-tax profits of $1.3 billion and a profit margin of 43.9 percent.
In April 2009, a small article in the Wall Street Journal described an offer by the private equity firm CVC Capital to buy the iShares ETF business of Barclays Global Investors, a deal arranged by Lazard, the prior firm of Barclays’ chairman. In the depths of the global recession, Barclays Bank was under pressure from British banking authorities to raise equity capital. Fortunately for Vanguard, the announced CVC deal included a so-called “go shop” provision allowing Barclays to consider other, higher bids for the iShares business, which, if accepted, would entitle CVC to a breakup fee. Brennan, by then Vanguard’s chairman, saw the article and went to Glenn Reed, head of the Strategy and Finance division, and CEO Bill McNabb to ask, “Do you think we should take a look?”3
BGI’s iShares business was large, approximately $350 billion in assets at the time. It was the leading global ETF business in an industry that most analysts felt had a long future growth runway. iShares dominated the American ETF market and had established small but growing market positions in the United Kingdom, Europe, and Asia. Acquiring iShares would immediately establish Vanguard as the leading US provider of ETFs and could jump-start its then modest international business.
Reed soon concluded that Vanguard should engage an investment bank to advise and represent its interests in a possible bid for the iShares business. The obvious initial choice was Goldman Sachs, which had faithfully called on Vanguard for several years, even though Vanguard had always been an unlikely consumer of investment banking services. Here, at last, was an opportunity to reward that firm for its efforts—but Goldman had already been retained by a client interested in the same transaction, so it could not also work for Vanguard.
April 2009 was a low point in Wall Street transaction volume and, in the absence of other activity, the CVC–iShares announcement attracted considerable interest among financial services industry participants and the private equity community.4 As a result, the same conflicted situation prevailed at every major New York investment bank. So Reed, raised in the Midwest himself, suggested that Vanguard hire William Blair, the leading Chicago securities and corporate finance firm. Brennan and McNabb readily agreed.
William Blair put together a stellar team to help Vanguard analyze and evaluate the iShares business. During the initial conversations, there was confusion as to how Vanguard, as a mutual organization—“not for profit” to outsiders—could obtain the enormous capital that would be required to outbid CVC. Reed explained that the Vanguard Group, Inc. could, by the terms of its relationship with the funds, call for capital from the Vanguard mutual funds, up to approximately $2 billion. With $2 billion in equity capital, Vanguard could readily borrow another two or three billion for a total of around $5 billion.
“Wow! How soon could you do that?”
“Virtually overnight.”
The silence on the phone made clear that any confusion had been cleared up. Vanguard had significant capital commitment capabilities. They had just not been widely nor clearly understood.
Reed had known that William Blair had a first-rate relationship with Warren Buffett and Berkshire Hathaway, having introduced the Dairy Queen acquisition to Berkshire several years before. Reed asked Blair to contact Buffett on Vanguard’s behalf, to see if he might have an interest in learning more about Vanguard’s ambitions for iShares.
Buffett confirmed to William Blair’s representative that he had always had a high regard for Vanguard and invited Brennan, McNabb, and Reed to visit Berkshire Hathaway’s headquarters in the Kiewit Building in Omaha. The Vanguard team got there early and decided to wait for time to pass at the building’s first floor coffee shop, where they ordered some food that none of them really wanted. At the appointed time, they took the elevator to the Berkshire Hathaway floor. Getting out of the elevator, however, the three men were unsure which door to enter from the elevator lobby, when Warren Buffett suddenly opened a door and invited them in, taking them down the hall to a modest room with a desk, a sofa, and a couple of high-backed chairs.
After introductions, Brennan, McNabb, and Reed described Vanguard’s interest in iShares, after which Buffett asked, “How can we help?” Moving to his desk, he took out a yellow pad, made some notes with a pencil, and announced that “[we] can lend you $2½ billion,” which was just what Vanguard needed to go with the $2 billion it could raise internally.
After a short tour of the modest Berkshire Hathaway offices, including Buffett’s extensive array of University of Nebraska football memorabilia, Buffett gave the keys to his car to his assistant and asked her to give the three from Vanguard a ride to the Omaha airport. The entire visit took no more than 90 minutes.5
If Vanguard could win iShares, it would benefit from the high brand loyalty of ETF investors: they repeatedly use the one “family” of ETFs they have gotten used to. Vanguard would coordinate, but not combine and integrate, the BGI line of ETFs with its own. Similarly, avoiding layoffs, Vanguard would not try to combine the two organizations, one on the West Coast and one on the East Coast. This would limit the opportunity for “rightsizing” to enhance the economics.
BlackRock, an organization with unusually strong leadership, did have a focus on size and, as a public company, on increasing revenues and earnings to enhance the value of its common stock, a major part of the personal wealth of CEO Larry Fink and his executive team. Having recently completed the integration of a major investment management acquisition, Merrill Lynch Asset Management, some BlackRock executives were unsure their organization had the energy and bandwidth to succeed so soon with another major acquisition.
Barclays Bank needed a capital infusion of £15 billion when chairman Bob Diamond’s Gulfstream landed late in 2008 in Doha, Qatar, as Philip Augar related in his splendid account of Barclays Bank’s travails, The Bank That Lived a Little.6 On October 13, Her Majesty’s government announced that it had taken major stakes in three of the United Kingdom’s largest banks for an enormous total of £37 billion. Barclays Bank announced that it would not need government funding but would be independently raising £4.5 billion, £1.5 billion through management actions and £2 billion by not paying out the year’s final dividend, plus a new money commitment by Qatar of £1 billion; it would also raise around £10 billion in debt.
The idea of Barclays Bank selling BGI, driven by an acute need for equity capital, was originated in London by Hector Sants, the highly regarded head of the Financial Services Authority (FSA), then the City of London’s powerful regulator. The first would-be buyer, CVC, was only interested in the iShares business. Barclays wanted to explore alternative moves and remembered that six years earlier, Bob Diamond, an American and newly named Barclays chairman, had discussed selling the whole BGI organization with BlackRock’s Larry Fink, but discussions had not advanced very far.
Diamond noticed on his bankwide schedule of major meetings that the Barclays Capital team serving BlackRock was hosting its senior people at a Yankees baseball game, the first game in the new Yankee Stadium. While a devoted Red Sox fan himself, he decided this was an important opportunity. He went to Barclays’ private lounge at the stadium and, near the end of the game, went for a walk with BlackRock’s president, Robert Kapito, asking him to arrange a meeting with Fink a few days later.*
At that meeting, Diamond offered an exclusive deal for the whole BGI business, and Fink said he would now buy all of BGI.7 This bold move completely changed the competition. First, it would provide Barclays Bank with all the capital it needed to meet its regulators’ requirements—and would do so in a single transaction. Second, it took Vanguard out of the competition: Vanguard could arrange a $5 billion transaction, but not one for $13 billion—and particularly not when Vanguard had no strategic reason to expand in index fund investing, where it was already the market leader.
BlackRock’s deal was announced in June for $13.5 billion, composed of £4.2 billion in cash and 19.9 percent ownership of BlackRock. Fink was correctly convinced the financial crisis was over. When the deal closed on December 1, 2009, BlackRock’s market capitalization soared by $6.3 billion to $15.2 billion. Barclays Bank’s take was more than 30 times what it had paid to create BGI 14 years earlier, and the bank was in the clear financially.
Bob Diamond received $36 million for stock he had purchased for $10 million just seven years before. With costs cut and assets doubling, profits had risen rapidly—more than fivefold. BGI had decided in early 1999 that while ETFs were superior as a product, establishing a strong market demand would require a full spectrum product line, a major educational program, and a dedicated sales force. BGI hired over 100 salespeople, rebranded its ETFs as iShares, matched each major index with an iShare ETF, budgeted $12 million for print and TV ads, created its own award-winning website, and addressed retail investors. Its sales force focused on three kinds of advisers: Registered Investment Adviser (RIA) firms, national and regional securities firms, and small firms. As its retail business grew, BGI launched a major effort with institutional investors, hedge funds, mutual funds, and wealth managers. By 2006, BGI managed an array of 194 ETFs worldwide and had spent $100 million on market development. BGI was the largest ETF sponsor, with $284 billion in assets under management. State Street Global had $101 billion, Bank of New York had $27 billion, and Vanguard ranked fifth with $22 billion, having begun only in 2002.
Glenn Reed took comfort in his late father-in-law’s sage advice to “never look back and worry about a deal not done.” Many good things came to Vanguard from the iShares deal not done:
• To ensure that Vanguard would not find out later that it had simply been just a stalking horse for other bidders, Vanguard had required Barclays to cover Vanguard’s due diligence costs in the event a deal was completed with someone else. Barclays honored the commitment, and reimbursed substantially all of Vanguard’s nearly $1 million in out-of-pocket expenses. In Reed’s view, “The Vanguard team got a great education in the ways of M&A . . . all on full scholarship.”
• Vanguard reaffirmed its ability to raise large amounts of capital by drawing funds from the Vanguard mutual funds or borrowing from third parties. Vanguard confirmed it could also raise substantial capital by increasing its client fees by merely one basis point, or by not reducing fees by the same tiny amount. As assets under management rose beyond $8 trillion, this financial power became increasingly formidable. Reed said, “This was a defining time for Vanguard and its strategists.”
• Most important, having lost its bid to acquire iShares, Vanguard and its board recommitted to building energetically on what it already had—a formidable ETF business in its own right—by expanding that product line and investing to expand its sales organization.
Vanguard had clarified its decision criteria: a keen interest in acquiring assets in ETFs but no interest in adding by acquisition to its business in index funds; interest only in actions that would benefit its current investors; and extreme caution about culture clash.
While publicly owned competitors like BlackRock would understandably focus on getting bigger in assets, revenues, and profits, Vanguard would not. Vanguard’s focus would always be on getting better—better at serving each investor. Furthermore, the burgeoning financial power of Vanguard, while latent before, was now clear: for the right investment, Vanguard had become a financial powerhouse—and knew it.
As board chairman Alfred Rankin put it to Bill McNabb and Jack Brennan, “Now that you’ve proven you have the ability to raise and deploy $5 billion if the right opportunity comes your way, don’t you have an implicit challenge to go looking for $5 billion opportunities?”8
* In another telling, Kapito bought a scalper’s ticket and went to Barclays’ box to pull Diamond out and urge him to sell all of BGI to BlackRock.