How Stan O'Neal transformed Merrill Lynch

IF YOU’RE LOOKING for a sure sign of the rejuvenation of Merrill Lynch under the leadership of Stan O’Neal, look no further than the events of May this year. Speculation had been rife that Merrill was about to make transformational deals in some or all of retail banking, mortgage origination and consumer finance.

Merrill’s share price was suffering as a result. O’Neal needed to calm expectations and make plain the reality. Having spent five years restructuring Merrill Lynch – first through some of the most swingeing cost-cutting the industry has ever seen, then through a transformation of the business through organic growth and selective acquisitions – he did not want to see unfounded rumours unsettle the steady course he had set.

A few meetings with key shareholders and analysts later and the market calmed down.

But it’s the success of the Merrill transformation story, and the pace at which the bank’s results have improved in the past two years as the benefits of the restructuring kick in, that have got the markets excited about Merrill again.

At the very least, such speculation might nail once and for all the patently undeserved reputation heaped on O’Neal during his early years at the Merrill helm – that he was merely a cost-cutter, and not the man to take Merrill forward.

Much of the credit for the turnround has to go to O’Neal himself, who became president of the firm in its darkest days in 2001.

O’Neal, in person, insists on sharing much of the credit with his tightly knit executive committee, which numbers just eight people.

But here’s the take of a very senior member of Merrill’s management group: “When Stan O’Neal took over the firm, he was the only person for the job. Without him, Merrill’s businesses would have survived – only we’d be owned by someone else now.”

The numbers don’t lie, and here’s some headline evidence of the O’Neal effect. Revenues in the first quarter of 2006 totalled $7.96 billion – a 28% increase that outstripped most of its rivals, higher than even in the halcyon days of 2000 when the S&P 500 hit its peak and Merrill was almost a pure equities firm. Revenues in global markets and investment banking (GMI) were $4.55 billion, up 37% from the previous year. In the first quarter of 2003, GMI revenues were little more than $2.5 billion. Debt revenues soared to $2.1 billion in Q1 2006 alone.

Merrill’s mistakes of the past

The Merrill Lynch of 2006 is a very different investment bank to its former incarnation, the legacy of a previous regime that had allowed the firm’s excesses to spiral out of control.

By 2000 and the height of the tech bubble, Merrill Lynch had gone from being a profitable diversified investment bank to pretty much a one-trick pony. It was out of the commodities business, out of private equity, losing money in fixed income, little or nowhere in mortgages and stop/start in foreign exchange. People familiar with management strategy at the time say there was a disproportionate reaction to bad news; as all the good news was in equities, resources were allocated accordingly. At the turn of the millennium about 75% of Merrill’s bottom line came from equity-related business.

“Success is often the route of hubris and maybe indulgence; in many respects it’s loss of discipline on many fronts,” says O’Neal. “Because we’d been so successful doing a number of things, we came to believe that if we just did more things in more places, that we would continue to be equally successful without necessarily thinking about what was required in order to make it a reality, or adequately testing the assumptions that underlie the business thesis.”

In effect, the thundering herd was clapped out.

Merrill Lynch’s senior managers pinpointed a number of areas that needed to undergo fundamental change. The first was operating discipline.

“The facts and figures didn’t lie,” says vice-chairman and chief administrative officer Ahmass Fakahany. “We were, in some cases, feeding businesses with low margins and lower prospects. We had too many specialists. We had too many support people and needed to employ a new discipline around resource allocation. The firm didn’t need three legs. We needed to chop one off.”

And that’s exactly what Merrill did, removing 33% of its workforce in a dramatic cull of 25,000 employees. And it wasn’t just a question of cutting staff numbers. Mother Merrill had become over-generous to her brood: the days of chauffeured cars for middle managers, concierge services for investment bankers and lavish expenses had to go too.

In total, some $7.5 billion of annual costs were removed from the business. 

In addition, O’Neal had to take complete control of the business. Look at his title – chairman, chief executive officer, and president. Not much doubt who is in charge then, is there?

But that wasn’t always the case. For a long-time O’Neal was seen a stop-gap, as a cost-cutter who would go once the cull was over. People had focused too much on his two years as CFO. They’d forgotten about his years as a ruthless and aggressive dealmaker – the real O’Neal to this day.

Meet O’Neal and you can’t help but be impressed with his politeness and easy charm, and his determination not to deal in glib soundbites but to give a full and considered response. He masks his cutting edge well.

But a kid who was born on a cotton farm doesn’t become the 11th CEO of one of Wall Street’s finest without an edge. In 2003 the challenge to his authority duly came. Vice-chairman Tom Patrick and Arshad Zakaria, president of investment banking, were ousted by O’Neal when they attempted to undermine his authority by going behind his back to try to get Zakaria appointed as president of the firm.

O’Neal won’t tolerate dissent – the company line has been agreed by its senior management, and it will be adhered to.

“No one would mistake me for being ambiguous about what I think is the right form of behaviour and the right operating mode and objectives,” he says. “And so I’ve tried to be very clear as we’ve gone through this evolution about what’s expected from our senior leaders. We have made some changes over time, where we’ve had people who just didn’t get it, who couldn’t understand that this was about the enterprise more than it was about them, and it was more about excellence in individual performance as part of team, as opposed to simply distinguishing yourself.”

O’Neal also had to put up with the comments of Winthrop Smith Jr, the scion of a company founder and former senior executive, who said in November 2003: “I am not sure [Stan] has heard or yet fully appreciates the Merrill Lynch stories and may not be able to embrace the culture in the same fashion as his predecessors. Time will tell.”

To prove the likes of Smith wrong, O’Neal simply got on with the job. Once the cost-cutting was complete, and O’Neal has assumed complete control in 2003, the rebuilding of Merrill Lynch could begin in earnest. The new, leaner Merrill had some money to spend on growth.

But it was a steady-as-she-goes approach – O’Neal was determined not to repeat the mistakes of the past. Selected investment in organic growth was the starting point. Merrill had fallen behind its peers in derivatives and trading. From 2003 to 2005, Merrill made 500 hires at managing director or director level – people Fakahany says would not have considered joining the firm two years earlier.

A business close to O’Neal’s heart

Leveraged finance is an asset class that encapsulates the whole Merrill turnaround story. In the early 1990s, when O’Neal was in charge of the business, no other firm could touch Merrill’s leveraged finance franchise. From 1996, the franchise fell victim to Merrill’s obsession with equity markets. As one insider says: “We simply gave the business away.” By 2003, Merrill had sunk to a lowly 12th place in the global league table.

There was a lot of internal discussion about what to do next. Insiders admit that not everyone was keen to reinvest in the business. “We’d blown the business. Why would we stake our credibility and reputation on saying we were going to rebuild it?” says one senior executive. “Stan was determined to do it. But some people thought he was out of his mind.”

The winning factor was the need to be close to financial sponsors – who one Merrill banker describes as “arguably our most important clients today” – and to achieve that the firm had to have a high-yield franchise.

Once the discussions were over the turnaround came. And it has been quick and impressive. Merrill now ranks as one of the world’s top five leveraged finance firms again, and is only beaten by banks with large balance sheets as well as investment banking, such as JPMorgan. It’s strange to hear Merrill executives talk once again about league tables. For a while, the subject was strictly off limits.

Merrill was the bank that, in the 1990s, wanted to be number one at everything. Insiders say that in 1997 and 1998, when Merrill set out its entire stall to be number one in the global bond underwriting league tables, the fixed-income business lost $1 billion. It was the wrong strategy, as O’Neal now admits.

“There was a time when this firm mistakenly defined being number one in a league table as being equivalent to the quality of the franchise. But it’s far more complex than that,” O’Neal says.

As Merrill was rebuilding, and because an obsession with league tables was so closely associated with past failings, it was hard to pin down Merrill’s managers about aims of ranking or market share.

Now a once-more confident Merrill will discuss the dreaded l-word. But there’s a difference: the detail of the discussion has changed.

Greg Fleming, president of global markets and investment banking, says: “League tables do matter. They are critical to client relevance, and they add to a client’s perception of our capabilities in a certain area. Being 12th or 15th doesn’t work. Whether you push to number one depends on each market’s dynamics. In high yield, for example, an incremental move in league tables may not be justified from a risk/return standpoint.”

Back to private equity

O’Neal feels his firm mistakenly abandoned private equity in the 1990s. Now it is back in the business with a bang, investing alongside clients in deals where the firm considers it appropriate.

O’Neal doesn’t feel there is a potential for conflict of interest: “We’ve not been a sell-side adviser and a bidder at the same time, and we don’t plan to be, and I think that is the source of the debate,” he says pointedly. Rather it would be bad news for Merrill and its shareholders if the firm were not involved, according to the man who the private equity business ultimately reports to, Greg Fleming.

Fleming uses Bank of China as a good example of how Merrill looks at private equity. Other notable investments include Debenhams and Hertz. “We’d been involved with Royal Bank of Scotland on many of their transactions over a number of years,” he says. “They wanted other outside investors on the Bank of China trade, and we were able to commit our own capital as well as bring in other investors.”

Fleming says that in private equity Merrill will maintain the cautious approach that it adopted when it entered other new markets.

“We aren’t going to chase deals simply to try to achieve a diversified private equity portfolio quickly – that’s a recipe for making mistakes,” he says. “This business has been in a cyclical high for a couple of years but we’re here for the longer term, building a business for the next 15 or 20 years, not simply racing after deals in a hot market.”

Being everything to the client

M&A has been an area of particular achievement for Merrill in the past two years. Over the past 12 months it has scored noteworthy mandates in many of the largest deals: for example advising UK telco 02 on its sale to Spain’s Telefónica for $31.7 billion; advising UniCredito Italiano on its $22 billion acquisition of Germany’s HVB, just 12 months after it had played a leading role in advising Santander on the first major European cross-border merger, with the UK’s Abbey; advising Procter & Gamble on its $60.8 billion takeover of Gillette; and also UFJ, when it was sold to Mitsubishi Financial in Japan for $59.1 billion.

For Fleming, the success of the M&A business – and in particular the frequency with which Merrill has been winning mandates on the defence side of bids – is a good sign of the strength of the entire firm. “Winning defence mandates is a barometer of the health of our client relationships,” he says. “We don’t just want to be an M&A boutique – we want to provide our clients with every service they need.”

Merrill managers point to a series of mandates for Houston-based energy company Targa Resources as an example of what has become the holy grail in investment banking: get the M&A mandate and then all the financing (and fees) that go with it.

In October last year Targa, which is affiliated with private equity firm Warburg Pincus, paid $2.45 billion for the natural gas gathering, processing and distribution assets of Dynegy.

Merrill was the sole M&A adviser to Targa; it provided commitment for the $2.75 billion debt financing; it was joint lead arranger and joint bookrunner on a $2.5 billion senior secured credit facility; it was joint bookrunner on an issue of $250 million in senior notes; its commodities division provided energy commodity hedges; and Merrill Lynch Global Private Equity invested in the deal. There, in one transaction, is the encapsulation of what modern investment banking has become all about.

A home run in commodities?

As well as concentrating on organic growth, Merrill has made a number of acquisitions over the past three years. Notable deals include buying UK mortgage servicer Mortgages plc, and the acquisition of a 90% stake in Indian investment bank DSP.

But the transaction that gets everyone at Merrill most excited is the acquisition of Entergy-Koch Trading in 2004 in a deal though to be worth about $800 million. Merrill had never been a serious player in the commodities markets. It had been looking to break into the market for some time, and considered bidding for Enron’s old trading business, which eventually was bought by UBS.

EKT was the ideal fit, however; it enabled Merrill to have a large-scale commodities trading business from which it could then roll out investment banking products to clients.

EKT would not come cheap. In the final quarter of 2004 the commodities boom had built up the head of steam it still shows no sign of losing. Other banks, such as Citigroup, Lehman Brothers and JPMorgan, were also keen on EKT. Merrill had to pay top dollar. But speak to people behind the deal and they’ll now say they got a bargain.

“We looked very closely at the build or buy argument,” says Dow Kim, president of global markets and investment banking in charge of secondary business (his co-head Fleming runs origination). “We had to be honest – why would people at Goldman or Morgan Stanley join us when we didn’t have a business to speak of.”

Home run

Kim says Merrill hit a home run with EKT. Merrill would have missed out on the commodity hedging on the Targa trade if the firm had not bought EKT. Now they are aggressively building an oil operation within EKT, hiring 65 people and opening offices in Singapore and Japan – to complement EKT’s traditional expertise in natural gas.

O’Neal is suitably bullish about his acquisition: “We entered that transaction with a high degree of certainty that it would be at least a huge positive, and it’s turned out to be even better than we could have expected. It’s not only that it was good from a pure financial return point of view, it’s been fundamentally important to our ability to continue to serve our clients.”

One legacy of Merrill’s pre-2001 days was that it continued to have one of the best cash equity businesses on the street. But it has little presence in businesses such as electronic trading, portfolio trading or statistical arbitrage. While competitors such as Goldman Sachs and Morgan Stanley had been investing in these areas, Merrill had put all its money in cash. It’s a business, says Fakahany, that might have taken years to build in terms of a team and its relationship. Instead it hired in as head of global equity Rohit d’Souza, and his team, from Morgan Stanley.

Kim says the investment is starting to pay dividends. Equity market-related revenues for the first quarter of 2006 were up 62% on the same period last year. Merrill’s equity prop trading group, which began about 18 months ago, contributed a “nine-figure revenue number” in the first six months of 2006, according to one Merrill banker.

Foreign exchange is another area that Merrill needs to build up. The firm slipped in Euromoney’s latest benchmark survey (see May 2006) from sixth place in overall trading to 10th. In terms of trading with non-financial corporations, it plummeted from fifth place to a lowly 23rd. Perhaps most worrying of all, in the important leveraged funds space Merrill dropped from second to 10th place.

Rival FX bankers say Merrill has slipped recently because of high-profile departures and a perceived lack of investment in technology for its platform.

Kim says that FX is an important business to build up. “We need to concentrate especially on spot/forward in G10 currencies, local currency and exotic trading. We’re adding resources in complex products and local currencies. And we want to leverage our retail franchise with FX structured products.”

The aim is not to be one of the larger liquidity providers, such as a Citigroup or Deutsche Bank, but rather to be sufficiently in the flows to allow Merrill to take part in higher-margin business; and also to make sure it doesn’t miss out on M&A-related FX hedging opportunities for clients.

Prime brokerage is another hole that O’Neal and his team were determined to fill. For Merrill’s management, the question about building a prime brokerage business was not whether it was wise to get into it so late, but rather why hadn’t they been in it before?

O’Neal says: “Do we think we can be competitive and bring something distinctive, versus Bear Stearns, Morgan Stanley, Goldman Sachs? The answer is yes. Because we bring a cash equity business that is second to none, a high quality of service and a research capability and a client orientation that I think is distinctive from all the other firms we compete with.”

Takeover speculation

Despite the strong turnaround in Merrill’s business, and its improving profit and revenue numbers, the firm’s return on equity figures still languish, at around 17%, several points behind its peers, such as Goldman Sachs, Lehman Brothers and Morgan Stanley. This might in part be an effect of its brokerage business. It’s certainly something that O’Neal and his CFO, Jeff Edwards, are looking to rectify. In large part they have done this by using free cashflow to buy back billions of dollars of Merrill stock. Edwards admitted in his Q1 earnings call with analysts that there was “some impatience among senior management” at the poor ROE numbers.

It’s one of the main reasons for the huge amount of speculation about whether Merrill will seek a transformational acquisition. The stock markets got particularly excited about the prospect at the start of the second quarter of this year: depending on who you listened to, Merrill was about to buy a retail bank in North Fork, a global mortgage originator in Countrywide, or a consumer finance business.

The one certain impact of the speculation was that it drove down Merrill’s share price. O’Neal went out on his analyst and investor charm offensive. Morgan Stanley analyst Chris Meyer put out a report saying “concerns about Merrill doing a ‘dumb’ acquisition are misplaced”. He went further, saying that lumping all the rumours together to say Merrill was under pressure to buy a bank “is inaccurate to start with and doesn’t do Merrill justice given their track record of doing ‘smart’ deals over the last three years”.

Meyer says that Merrill’s main problem in terms of improving its ROE discount is not just an excess of capital but also because of low asset turnover. Pushing more assets through its securitization business would be one way of doing this – which is why Merrill is keen to take on incumbents such as Lehman and Bear Stearns in the US and build a mortgage origination platform.

O’Neal has shown in the past that he won’t be rushed into anything that he doesn’t think would be right for the bank.

“We’ve been doing this in a conservative way for about three years now, and I’d say we are 75% of the way towards what we would ideally like to achieve,” says O’Neal. “The only reason we’re not 100% of the way there is because we either haven’t seen the acquisition opportunity, or we haven’t yet been able to add the right people.”

The lessons of the past remain at the forefront of O’Neal’s mind. He won’t repeat the mistakes of his predecessor. Merrill is his firm now. Look at his track record; listen to what he says.