Chase Banks On Tech In buying Hambrecht & Quist, the giant bank hopes to create a New Economy juggernaut. It may well succeed where others have failed.
By Andy Serwer

(FORTUNE Magazine) – It was a big-time meeting that couldn't have happened just six months ago. Here were key bankers from Chase Manhattan pitching to John Zeglis, president of AT&T, trying to win a spot as underwriter for the spinoff AT&T is planning for its wireless business. While the disposition of this mid-January sit-down is still up in the air, it's likely that Chase will get a significant piece of the hallmark deal. That is remarkable considering that as of last summer, Chase had no equity bankers, no equity products, no equity business at all.

So how did Chase get into this business so quickly--and so successfully? Well, last September, you may recall, Chase swooped into San Francisco and announced it was buying Hambrecht & Quist, the small, blue-chip technology investment bank, for $1.35 billion. Though many at the time failed to recognize it, Chase's purchase of H&Q was a signature transaction. The deal brings together two worlds, the FORTUNE 500 clientele of Chase and the red-hot business of technology IPOs. In a sense, Chase may be creating the world's first full-scale, New Economy investment banking practice.

Chase H&Q, as the newly combined business is now called, has an almost unlimited arsenal of capital and a mandate to focus on emerging technology and the explosive economy of Silicon Valley. Quite the combination. Others have tried to cobble together similar alliances, but melding two such pieces together has proven to be a lot tougher than it looks. The Chase H&Q deal may be the one that succeeds.

Why? Well, for one thing, Chase's business and H&Q's business are suddenly converging. The walls that used to divide the raising of capital for the old economy and for the New Economy are beginning to disappear. Traditional companies like AT&T are plunging headfirst into tech and e-commerce and looking to spin these businesses off to unlock their value. LBO firms are doing technology deals. And the new Internet giants are developing huge appetites for capital. With its purchase of H&Q, Chase, led by its pedal-to-the-metal capital markets chief, Jimmy Lee, hopes to ride and indeed shape this convergence.

H&Q, for its part, needed the merger even more than Chase did. Led by the angular and urbane Dan Case (the older brother of AOL's Steve), H&Q was the last of the so-called HARMs (an acronym that stands for Hambrecht & Quist, Alex. Brown, Robertson Stephens, and Montgomery Securities) to lose its independence. The HARMs--a group of smallish, technology-oriented investment banks--were vibrant businesses, but they had come under pressure over the years as big New York investment banks tried to invade their turf. One by one, they sold out. The problem from Case's perspective was that while he, too, needed to partner up, the experiences of the other HARM mergers had so far been pretty negative. With Chase, though, Case has higher hopes. That's because Chase is an institution built on a series of mergers done right.

For instance: Nothing is more important in a merger of this kind than wooing the acquired company's best customers. Which is why mid-December finds Case and Jimmy Lee on a mini road show to meet and greet CEOs of Valley tech companies, as well as the venture capitalists of Sand Hill Road. It's a full couple of days and at each stop, Case begins by explaining why Chase and H&Q have decided to join forces and how this new partnership could prove useful to those in Silicon Valley's inner circle.

Then Lee--who makes no allowances for Silicon Valley decorum and sports power Wall Street suspenders, French cuffs, and slicked-back hair--launches into a story: "You know we run one of the biggest high-yield businesses on Wall Street, and I'm sitting at my desk one day in New York, doing some work for Barnes & Noble, and all of a sudden I hear that is going to do a $500 million high-yield deal and I didn't even know about it," he says incredulously. "That's when I knew that I had better do something."

Case nods his head. The deal was troubling to him too, but for a different reason. H&Q, you see, helped take Amazon public back in 1997. And while Case knew all about the coming transaction, his firm was unable to pitch the business, never mind win it, because H&Q had no junk bond desk. So, like Chase, H&Q was shut out of the Amazon deal, but while Chase was excluded by virtue of being out of the loop, H&Q was a no-show because it didn't have the expertise. (The Amazon deal, by the way, was handled by a little full-service outfit known as Morgan Stanley.)

Some of the folks that Lee and Case meet on their road show wonder if H&Q is really big enough to matter for Chase. After all, H&Q is hardly a bet-the-ranch proposition for the giant bank. "Bite sized" is how Merrill Lynch analyst Judah Kraushaar described the deal when it was first announced back in September. There's some irony in Kraushaar's comment, of course. Going back a couple of years now, rumors of Chase's buying Merrill have swept across the Street with great regularity. And Chase executives--from former CEO Walter Shipley, the architect of the modern Chase, to current CEO William Harrison--have made no secret of their desire to build a global investment bank a la Morgan Stanley and Goldman Sachs. It's also no secret that H&Q hardly puts them in that league. Seated in his muted Park Avenue offices, Harrison, a lanky, soft-spoken son of North Carolina who played basketball for Dean Smith's Tar Heels, makes it clear that H&Q is not necessarily his final investment banking foray: "We are always exploring our options and keeping an open mind," he says.

A quick glance at the numbers and you can see just how small H&Q is relative to Chase. H&Q's $1.35 billion price tag (that doesn't include a $200 million bonus pool to retain key personnel) represents only about 2% of Chase's market cap. (Chase paid for H&Q in cash.) While H&Q has about 1,000 employees, Chase has close to 75,000. Analysts had expected an independent H&Q to generate more than $800 million in revenues this year. Chase is expected to earn over $1.5 billion in net income in each quarter. But H&Q has something money can't buy: a Silicon Valley pedigree. Founded in 1968 by Bill Hambrecht--who left the firm in 1998 and now runs his own eponymous online investment bank--and George Quist, who died in 1982, H&Q took Apple and Genentech public in 1980 and did Netscape's IPO 15 years later.

"We bought H&Q because we needed a footprint in the technology space," says Lee. "It's no more complicated than that." But how can Lee and the Chase bankers launch a significant equities business off such a relatively small platform? Well, for one thing Chase has a huge venture capital business in Chase Capital Partners (see follow-ing story), which does early rounds of financing for companies. Before, when one of these fledglings wanted to go public, the Chase bankers had to pass the deal on to Goldman or some other investment bank, which would likely develop a relationship with the new company and take it through a string of fee-generating transactions. (Major teeth-gnashing here.) Now Chase can take the company public through Chase H&Q and be in the driver's seat to compete for secondary offerings, debt financing, and M&A deals that come down the pike.

But why did Chase do it piecemeal and wager only $1 billion-plus on H&Q to get just a slice of the equities business, instead of spending $30 billion to $40 billion to buy Merrill Lynch and get the whole pie? "Actually we spent $1.35 billion and got 50% of the equity market," says Julie Richardson, a senior banker at Chase (technology and health care account for about half the U.S. stock market). And of course, to complete her thought, it's far and away the more attractive half of the market. With a Merrill, sure, you get the whole enchilada, but that includes metals and mining, commodity chemicals, forest products, and all that stuff. Who needs it?

It's true, though, that we've heard this tune before. Mega-money-center bank buys one of the HARMs to create an equity business off a one-burner hot-plate. And the results range from jury's out to dog's breakfast. Excluding Alex. Brown--a Baltimore firm founded in 1800--the HARMs were all San Francisco-based firms that swapped founders and other personnel almost incestuously but competed fiercely. Along the way, with their VC partners down the peninsula, they helped build the economy of Silicon Valley. That is, until the big boys from New York--most notably Morgan Stanley and then Goldman Sachs--took notice and went west for a piece of the action in the mid-1990s. The HARMs' exclusive playing field quickly became crowded. Growth rates, market shares, and margins fell under pressure, and these feisty firms soon felt compelled to partner up. Meanwhile large commercial banks, bereft of any equity businesses, had their eyes on these little guys. And with the demise of the Glass-Steagall Act in 1996 and 1997, the big banks made a flurry of moves.

The couplings sometimes seemed as if they were out of a junior high school dance. In April 1997 Bankers Trust announced it was buying Alex. Brown. In early June of that year, BankAmerica bought Robertson Stephens. Later that month, Hugh McColl's NationsBank bought Montgomery Securities. Now that would have been fine and dandy except it was just the first go-round. In April 1998, Nations bought BankAmerica (and took the name Bank of America), throwing Montgomery and Robbie Stephens under the same roof. That state of affairs lasted exactly one month before McColl sold Robertson Stephens to BankBoston. Meanwhile Montgomery's co-founder and CEO, Tom Weisel, clashed with McColl and left to start up his own firm, Thomas Weisel Partners, poaching Montgomery bankers and forcing McColl to hire costly replacements. And finally, in November of 1998, Deutsche Bank bought Alex. Brown's parent, Bankers Trust. Got that?

And what was H&Q doing during all of the Sturm und Drang? Well, it went public in 1996. And, like Chase, it had serious marriage talks with Merrill Lynch, though of course it would have been the seller, not the buyer. Case, who sees the technology banking landscape as well as anyone, would insist publicly that H&Q was content to go it alone, but inside the firm it was becoming clear that H&Q would have to find a partner. True, H&Q was growing nicely in the 1990s--revenues were up over eightfold between 1991 and 1999--but that was deceptive, because the pie of technology deals was exploding. In terms of market share, the picture was not rosy. According to Securities Data Corp, H&Q's dollar share of technology IPOs fell from 9% in 1995 to 4.4% last year. "We could either stay in our niches and become a real boutique or we could find a partner and go big," Case now says. "We chose growth."

Maybe that's why Case is happy to explain why he thinks his deal will work when the other HARM deals are still flopping around on the dock. "There are so many reasons," says Case, taking a break from the Lee road show at a Palo Alto coffee bar. "We fit well together. There is no overlap of businesses." And Case says his firm isn't cashing out as the other firms were. Another critical reason: Mergers are deeply embedded in the genetic code of Chase. Remember, this is an institution that is the product of three significant deals; the original entity being the old Chemical Bank, which bought Manufacturers Hanover in 1991. Five years later Chemical bought Chase, then under attack by Michael Price, and took the more prestigious bank's name. (Earlier it picked up Texas Commerce Bancshares.) The man behind the deals, Walter Shipley, was adamant about doing them quickly and right. This was a very personal mission for Shipley, who just stepped down as chairman of the bank at year-end: "I started out in a small bank which Chemical bought," he says. "For years, I was the new guy. No one would talk to me. I knew if I ever put two banks together, I would do it differently."

Apparently Shipley's ways are still practiced, even when it comes to smaller deals like H&Q. "This is not a buyout," insists Lee. "It is a merger." Public consumption material? Sure, but at least Lee is backing it up. Almost as soon as Lee and Case walked out of the press conference--held in San Francisco, not New York--to announce the deal last September, Lee was organizing a series of sit-downs and get-togethers. "At our off-site, what I thought was amazing was that you couldn't really tell who worked at H&Q and who worked at Chase," says Richardson. No small thing that.

And of course the people part of the deal is really the only piece that matters in a service business like this. The job of making the people meld rests first and foremost with Lee, whose veins seem to course with dealmaking matter. A Connecticut Yankee by birth--his family owned the Lee Hat company in Danbury, as well as the local newspaper and radio stations--Lee counts AOL's Bob Pittman and fellow Williams College grad Herbert Allen, CEO of Allen & Co., among his closest buddies. Ask anyone on Wall Street, and he will tell you Lee is as hard-nosed as they come, but he's also a consummate salesman. He sent the spouse of every H&Q managing director a fruit basket for Christmas. "No one had ever done that at H&Q before," says one insider. And so how are the H&Q brass taking to their new boss? "I love him," says Cristina Morgan, H&Q's affable co-head of investment banking. "He doesn't have an administrative bone in his body."

Of course it'll take more than fruit baskets to keep the troops happy. There is the matter of compensation. It is a subject that Chase, not surprisingly, paid close attention to. First there is that $200 million comp pool, out of which top bankers were given generous packages, twice as much as what they had previously made, which puts them close to the top of the industry. The packages are structured not to pay out too soon, however, so that bankers won't cash out and leave. "It's as if Chase is saying, 'Give us a shot,' " says one source. " 'Let us prove to you guys that we can make this work.' " And Case, along with top lieutenants such as Morgan and the other co-head of investment banking, David Golden, are driven to do just that. "Christina and David are very loyal to Dan," says an insider. "They'll stick by him, even though with the pace they're going everyone's getting tired. None of them have to work. They only work because they're sick." Stock options for H&Q employees will now be paid in Chase stock, which pays a dividend. ("I've never had a stock that paid a dividend before," marvels one senior H&Q banker.) Still, retaining smart, ambitious bankers is a huge challenge for any banking firm in the Bay Area, what with the temptations of riches on Sand Hill Road. Recently, for instance, H&Q's high-profile Internet analyst, Danny Rimer, left to join Jim Barksdale's venture group.

Countering that, Case says, is the attraction of building something really big, of finally going toe to toe with Morgan and Goldman and winning. It's not an implausible scenario. "I think adding H&Q's client base to Chase's debt products makes sense," says Kleiner Perkins partner Will Hearst (yes, relation). "I know a couple tech companies that might be interested in adding a layer of debt."

True to the Chase merger playbook, bankers from H&Q and Chase began making calls together almost immediately. Probably the most fruitful immediate synergies will be in telecom, where Jimmy Lee and his people have built up a monster business. Chase has helped jump-start an entire industry of next-gener-ation telcos, providing huge convertible and high-yield debt financings for Alex Mandel's Teligent, as well as RCN and Global Crossing. Now, with H&Q, Chase can do their equity deals too. To help there, Lee recently hired a new, topnotch telco analyst, Tom Lee (no relation), away from Salomon Smith Barney.

Another staple of Jimmy Lee's business has been raising capital for top LBO firms, such as KKR, Forstman, and Hicks Muse. LBO firms used to avoid tech like the plague, but lately there has been a rush to do tech deals by the likes of Silver Lake and Texas Pacific Group. In private banking, Chase and H&Q folks have also been traipsing around together. Traditionally, when H&Q took a company public, its personal bankers would prospect the company top to bottom. After all, everyone in an IPO is a potential customer, because even a secretary can end up with a million bucks. But as these folks (gulp) age, H&Q would have been underserving them. "We really had no trusts and estates products," said Gary Patterson, an H&Q managing director. Which, of course, Chase has a century of experience in. And of course Chase would love to get its hands on a young wealthy New Economy client base.

"I really think that the potential is greater than either side imagines and the challenges are greater than either side imagines," says Jim Davidson, former co-head of M&A at H&Q and now one of Silver Lake's four principals. Already the potential is being realized. Even though H&Q's numbers were only included in the last three weeks of the quarter, its contribution was significant. But the challenges are there too. Lee is clearly not yet completely comfortable in the ways of Silicon Valley. Then there is the question of how long Case and Morgan and Golden et al. will stick around. On the other hand, it just may be that Lee and Case will make this thing so big that buying a Merrill Lynch becomes less compelling by the quarter. If they start landing deals like the AT&T spinoff, why bother?