Small change or all change: S G Warburg has lost the restless spark that fired its growth. Now it's too big to sit tight and too small to make a world-sized footprint. Where does it go from here? Jason Nisse asks

THE RIGHT HONOURABLE the sixth Earl Cairns, chief executive and deputy chairman of S G Warburg, is few people's idea of the head of a parvenu merchant bank. He is tall, aristocratic and dapper, with the kind of relaxed charm you would expect of a man who runs one of the City's most venerable merchant banks. Warburg, however, is anything but venerable.

Its history stretches back only 40 years. 'We do not see ourselves as part of the Establishment,' Lord Cairns says. The bank cannot compare in pedigree with the likes of N M Rothschild or Baring Brothers, each of which has a couple of centuries of history behind it.

Lord Cairns is only the third hand to take the tiller at Warburg since the bank was founded. He arrived in 1979 from the now defunct stockbrokers J A Scrimgeour & Co - then one of the City's most solid blue-chip firms. A hereditary peer, he was the sort of person Warburg took business from, rather than the sort of person it hired. For his part, it was a culture shock.

'Between working at a stockbroking partnership and a relatively Johnny-come-lately merchant bank, everything was different,' Lord Cairns explains. 'I suppose one of the most important distinguishing marks at Warburg was the lack of self-confidence, a lack of belief that the system owed it a living. This helped to create a restless energy.'

The irony is that although most people at Warburg still subscribe to this corporate mythology, the truth is quite different. Thanks to an astonishing run of success in the 1980s, the bank has come in from the cold. It has moved from being outside the Establishment to being at its very centre. The presence at the helm of Lord Cairns, the embodiment of the system Warburg once thought it was fighting, is evidence of this. And Sir David Scholey, his predecessor as chief executive and still the chairman, was recently a strong contender for the governorship of the Bank of England.

With its corporate self-image so much at odds with reality, Warburg is suffering from something of an identity crisis. Now that it has conquered the City Establishment, it has to figure out what it is trying to achieve and what kind of institution it wants to be.

Success has made it the biggest, most powerful and most feared of the City merchant banks. It is the only serious British contender against the big US investment banks, such as Goldman Sachs and Morgan Stanley, on a global scale. The problem now is how to stay at the top of the City tree. Cracks are appearing in the once dauntingly smooth Warburg edifice, damaging the bank's formidable self-esteem. It wants to expand internationally, but is finding it hard to get from A to B.

None of these problems confronted the bank in its early days, when sheer survival was the only issue. Sir Siegmund Warburg came from a highly respected family of German and American bankers - a distant cousin, Paul Warburg, was credited with creating the US Federal Reserve system. Siegmund fled to London from Nazi Germany in 1933, and set up a financial services company with his partner, Henry Grunfeld. In 1946 they gained a banking licence.

Siegmund used the principles of German banking - frugality, lack of ostentation, discretion and hard work. Grunfeld, who is nearly 90, still turns up at Warburg's offices, and apologises if he leaves before 6pm.

The fledgling S G Warburg found it hard to break into the traditional merchant banking areas, such as discounting bills of exchange and financing foreign trade for British companies, and so was forced to be innovative. It advised on the UK's first hostile corporate takeover, masterminding Reynolds Metal's aggressive bid for British Aluminium in 1959. It issued the first Eurobond, for the Italian group Autostrade.

Its client list featured the new breed of entrepreneur emerging in the Sixties - Charles Clore of Sears, Arnold Weinstock of GEC, Alex Jarrett, Cecil King and Don Ryder of Reed. By the Seventies Warburg was the merchant bank of choice for the aspirant middle classes.

Sir Siegmund did not want Warburg to be seen as an exclusively Jewish bank. He groomed David Scholey, the expansive upper-middle- class graduate of Wellington and Oxford who began his career as a Lloyd's broker, as his successor. Although the bank would deny it, under Scholey (now Sir David) its culture has changed radically.

In a rare interview, Sir Siegmund said he would be unhappy if the bank employed more than 600 people. But under Sir David it took over Rowe & Pitman, founded in 1894; Akroyd & Smithers, one of the two leading stock jobbers before Big Bang, and Mullens, the Government broker with a history which went back to 1742. The mergers pushed Warburg's staff up to the present 6,000.

In some respects, the neurotic emigre culture of Sir Siegmund is still apparent - all mail to directors is opened centrally and circulated to all other directors; a graphologist is still used to process job applications; press contacts are usually maintained on an 'off the record' basis. But the power of the stockbrokers - such as Lord Cairns and Nick Verey, who are anything but parvenus - is growing. The hunger and the lack of self-confidence of the early years has vanished, to be replaced, in the view of some former Warburg clients, with arrogance.

In Sir Siegmund's day, Warburg did not even have its name on the door of its modest offices at 33 King William Street. But with its expansion in the mid-Eighties came a move to a chrome and marble monstrosity in Finsbury Avenue, next door to that graveyard of City ambition, Broadgate.

The entrance is an imposing atrium, and visitors are shepherded to the seventh floor, where Warburg has two sets of meeting rooms. Cold, austere and modern for the bank, intimate and old-fashioned for the broking side, with the names of the original firms above the doors.

The bank's client list, however, is second to none in the City. It boasts such names as ICI, GEC, Reuters Holdings and Reed Elsevier - and its stockbroking operation is eclipsed only by Cazenove in corporate relationships, and Smith New Court in share of market-making.

The bank has been given valuable help in the past few years by the Government, handling a series of big privatisation deals, including the pounds 5.5bn British Telecom share issue last year. This appears to have been part of an official policy to build Warburg, as the most promising of the City merchant banks, into a real competitor to the US and Japanese investment banks on world markets.

By the late Eighties Warburg's position in London was so powerful it was in danger of becoming complacent. Its clients seemed to hang on its every word, its touch in the corporate and capital markets seemed infallible.

Then things began to go wrong. The pounds 2.2bn takeover of Gateway Group by Isosceles brought pounds 25m of fees for Warburg, but Isosceles is now on its third refinancing and questions are being asked of Warburg's role; the Warburg- inspired merger of the leasing companies CLF and Yeoman International has brought a pounds 120m lawsuit against the bank, which comes to court next year; its sloppy work in advising William Low on the failed merger with Budgen brought a ticking off from the takeover panel.

It also lost several large clients - both Granada and Asda abruptly switched to the rival Lazard Brothers last year. They privately accused the bank of arrogance and insensitivity in the way it was advising them.

Its reputation took a further lurch downward when one of its most profitable inventions, the convertible equity bond, began to cause horrendous problems for clients. The problem of repaying its outstanding convertibles nearly proved the coup de grace for Saatchi & Saatchi when the agency was in financial straits two years ago. Next and London International Group suffered similar problems.

The last half-year results showed up Warburg's fallibility - a 35 per cent fall to pounds 51.2m. The main problems were the losses from ecu trading and an ill-fated German leasing venture. The fact that Warburg never breaks down its profits means there is no clue how its core activities of advising and stockbroking fared. But Acquisitions Monthly's analysis of UK takeovers gives some clue. While Warburg led the field last year, the total value of bid in 1992 was just pounds 7.5bn, compared with pounds 10bn in 1991 and a record of pounds 55bn in 1989.

The bank is falling far short of its own ambitions. Lord Cairns says he aims for a 20 per cent return on its pounds 1bn capital, excluding its Mercury fund management business. This year, however, it is unlikely to make more than half that. It still returns more profit than any other British merchant bank, but in comparison with its main international competitors - Goldman, Morgan Stanley, Salomon - it is far behind. And in comparison with them, it has glaring weaknesses.

One is its skill in dealing on the financial markets. Warburg cannot yet equal the Americans in the art of proprietary trading - the technique of betting its own money profitably in the markets. Sometimes its dealing is horribly inept. For example, Warburg lost more than pounds 10m 'facilitating trades for clients' in the ecu market, ahead of the Danish referendum on Maastricht. Rivals in the bond market say Warburg was left with a large holding of ecu bonds at the time of the referendum. After the 'no' vote, the ecu market collapsed and trading all but died, leaving Warburg nursing heavy losses.

Its other problem on the international stage is size. It lacks the capital to compete with its US rivals, it is weakly represented in Tokyo's markets and lacks penetration in New York.

Nicholas Verey, the deputy chairman of S G Warburg Securities, is the man responsible for dealing with these headaches. A partner of Rowe & Pitman, he was sent to sort out Warburg's US operations in 1990, and came back to London in September last year, causing much speculation about his role. 'They've brought Nick Verey back from New York,' people would say in City wine bars. 'Something must be going on.'

What has been going on is what Verey calls the modernisation of the securities business. 'We have reorganised it in the last six months, drawing together the fixed-interest business and the treasury and the money markets operations . . . We have not done fixed-interest business broadly very well in the past,' he admits. 'We went through a stage when we were off the pace.'

Warburg has decided to increase its proprietary trading. The lesson of recent years is that clients will not pay enough for pure broking business to make it worth the brokers' while. As Lord Cairns says: 'We have spent a lot of time, and a significant part of our profits, facilitating business for clients, which has lost us money.'

The move across the spectrum from broker to proprietary trader is not without its pitfalls. The most obvious is the management of conflicts of interest - a live issue in an organisation which will soon have to juggle a corporate finance department advising corporate clients, a securities broker and market maker selling shares to investors and a team, probably made up of the same brokers and market makers, trading on the bank's own behalf.

But this does not worry Warburg unduly, partly because such potential conflicts do not seem to concern clients much After all, the US houses have been successfully juggling several balls for years.

There is a more important question. Will Warburg be any good at trading on its own account? The essence of how US firms trade on their own behalf is through arbitrage - taking advantage of a situation, such as a takeover or a discrepancy between the values of two classes of securities, to generate a profit as close to risk- free as is practical. US firms are expert in hedging - insuring against - risks in the cash markets by using derivatives - futures and options whose value varies with the cash markets.

But if there is any business area where Warburg could be called weak, it is in derivatives, as Nick Verey admits. Potentially the group should be much better. Warburg, Verey says, is one of only two firms which regularly trades all the shares which make up the FT-SE index of the top 350 companies.

One thing holding Warburg back is its credit rating. Investors purchasing futures or options contracts like to deal with the most creditworthy counterparty available. Unfortunately, partly because of its inferior size, Warburg has a lower credit rating than many of its closest rivals, including J P Morgan in the US and Barclays de Zoete Wedd in Britain.

The most plausible solution is for Warburg to raise more capital. This would also help it in other respects. It could, for example, undertake larger proprietary trading operations, and it could put more resources into expanding into the US or Japanese markets.

There is, however, no agreement at the top of Warburg about what to do. The bank currently has capital of close to pounds 1.1bn (including long- term loan stock), which is adequate for the amount of business it does at present. Verey argues that the group needs little capital for its international mergers and acquisitions (M & A) business, and has enough capital to fulfil its underwriting obligations. 'The application of intelligent brain-power does not require huge amounts of capital,' he says.

Lord Cairns is not so sure. 'I don't believe that, until now, we have been constrained by capital. But it is not beyond the wit of man to think that if more capital was needed there would be a way we could get capital.' One way may be to form a joint company with some institutional investors. Cazenove, the City's most blue-blooded stockbroker, successfully took this route several years ago.

The solution most touted in the City , however, is a merger between Warburg and a US firm. The favourite candidates for this marriage have been J P Morgan - a suggestion dismissed by Lord Cairns as nonsensical - and Morgan Stanley. (Donaldson Lufkin & Jenrette or Alex Brown & Co are sometimes mentioned as candidates for a straight takeover.)

The rationale for such a merger goes like this: Warburg is strong in the UK and Europe but its presence in the US is limited, lacking depth in distribution of securities, the M & A presence to ensure the European clients wishing to buy or sell in the US use it, and the presence in the domestic US markets that would give it access to the potential profit streams that stem from the US. A merger would give it that exposure and give an American firm access to Warburg's European presence.

However, Warburg has spent a great deal of time and money building up a US presence. It has hired, among others, Tom Wyman, the former chief executive of CBS and one of the best-connected businessmen in the US, as its chairman.

In his two years in New York, Nick Verey attempted to build a Warburg team which had the samereach as the biggest US houses. Warburg, though, has lacked the reputation to deliver business. 'Our capability is still ahead of our credibility,' is how Verey describes it. Warburg needs to have what Americans call a footprint. 'A purchase would instantly give us a footprint, but do you break all the bones in the foot while doing it?'

The basic problem is culture. Whereas Warburg has assimilated a series of British securities firms over the past seven years, it is not convinced it could perform the same trick in the US. 'Given where we are in the US, it is not easy to find a company where there is no overlap,' says Lord Cairns. 'We will go on building organically in the US unless we can see a better way of doing it.'

If it fails to tap into the wealth of the US market to supplement its rather meagre income from the UK, Warburg has another plan - to make Europe its 'domestic' base.

To that end it has, in Bacot Allain, the largest foreign-owned securities firm in France. It also has a strong Swiss business in Warburg Soditic, a useful position in Spain and a growing joint venture in Italy. The one weakness would be in Germany, where Warburg misjudged where the heart of German finance would be, setting up in Munich when most other firms gravitated towards Frankfurt. Now it is relocating its operations to Frankfurt, but the mistake may leave it lagging in an increasingly important and sophisticated securities market.

Warburg makes much of following its clients overseas, and in recent years some of its largest deals have come from European clients looking to London for advice - such as the massive banking mergers in the Netherlands and electricity mergers in Spain.

The concept of 'Europe is our home', therefore, makes some sense. But it is not the whole solution. 'Does all this add up to an equivalent home market of a major US firm? Frankly no,' admits Lord Cairns. 'Anybody who starts off with an outstandingly profitable domestic base, like the Americans, can afford to spend more time developing long-term businesses.' Europe will never provide that base for Warburg.

The bank's position in Japan is even more problematic. The woes of the domestic economy caused Warburg last July to pull out of making markets in Japanese stock and cut a quarter of its staff. But it is still losing money, and Warburg needs the Japanese market to show some recovery. The group has suffered, relative to US firms, because of its lack of expertise in the kind of hi- tech arbitrage operations that have enabled such firms as Salomon and Goldman Sachs to show astounding profitability in a falling market.

Warburg now finds itself in a quandary. However much it clings to its traditions, it has to realise that the unique selling-point that powered its growth - its advantage due to cultural disadvantage - has disappeared. The 'restless energy' has gone. Warburg needs to decide what type of culture should replace it, but how can it find a culture with the strength to hold together 6,000 staff in more than a dozen locations, when it is fighting firms as powerful as Goldman Sachs and Morgan Stanley?

Warburg sees itself as Europe's bank. But Europe is still fragmented and homogenisation is taking longer than anyone expected. It wants to be an international force and can see where it wants to be. But it is not sure how to get there and may be starting from the wrong place.

There is no question that Warburg will remain the UK's foremost merchant bank. It may even become the foremost merchant bank in Europe. But it faces a difficult task living up to its global ambitions.-