Even the mighty are falling. The last two major independent investment banks on Wall Street, Goldman Sachs (GS) and Morgan Stanley (MS), have received permission from the Federal Reserve to convert from traditional investment banks into commercial banks or bank holding companies. Plenty of ink, digital or otherwise, has been spilled about the disappearance of investment banks so I won’t dwell much on that. We’ve seen the collapse of Lehman Brothers (LEH) and Bear Stearns. Still somehow, I’m sure there were some who sentimentally held out hope that the two shiniest of white shoe firms in investment banking would survive relatively unchanged. Disappointingly, Goldman Sachs and Morgan Stanley will now join the ranks of Bank of America (BAC) and Wachovia (WB) as large commercial money center banks serving the retail masses.

It remains to be seen what will happen to the investment banking businesses of Goldman and Morgan. Other commercial money center banks like Bank of America and Citigroup (C) have been able to operate smaller investment banking divisions within the corporate umbrella. While the market is caught up in short-term financial myopia (worthwhile because some fear a total meltdown), I’m more interested in the long term strategic implications.

Survival – It is clear that the decision to convert to a commercial bank was spurred in part by a need to raise capital and survive. Becoming commercial banks allows Goldman and Morgan to tap the emergency funds that the Fed has made available. Goldman has also reached an agreement to secure private funding as well from Warren Buffett, the head honcho at Berkshire Hathaway (BRK-A). Morgan has agreed to sell a piece of itself to Mitsubishi UFJ Financial Group (MTU), in a move reminiscent of the Japanese shopping spree of the 1980s. In the panicked rush to shore up our faltering financial system and institutions, have we given enough thought to these combinations and their future implications?

Initial Public Offerings – Goldman Sachs and Morgan Stanley consistently topped the league tables as the best bulge bracket firms with the power and reach to handle large IPOs. No one is thinking of going public in this market environment but there will come a time when all is right again and innovative businesses will want to go public. Who will be there to sell the hype and coordinate the logistics?

Pure Investment Banks – Will there be a changing of the guard? The investment banking divisions within commercial bank holding companies have never been able to win more business than the Goldmans and Morgans and Lehmans that focused deeply on investment banking and merchant banking. Is it reasonable to assume that Goldman and Morgan will maintain their dominance of investment banking while converting into commercial banks? I think there is merit in the focus of pure investment banking. It will be interesting to watch if other players like Jefferies Group (JEF), Greenhill & Company (GHL), and Stifel Financial (SF) can aggressively move to fill the void. I think these stocks will perform well over the long term as they jockey to become the next white shoe firm (so long as they haven’t gotten involved with all the toxic financial instruments floating out there).

Talent Exodus – Look to the Yahoo! (YHOO) saga to see that Talent (with a capital T) goes where the opportunity is best and where it can operate with the least restraint. Goldman and Morgan will see their cream of the crop flee to hedge funds or the remaining smaller, albeit pure play, investment banks to ply their trade. Goldman’s proprietary traders generated a majority of the firm’s profits so I expect those guys will find happy homes at hedge funds. Why would any truly good trader want to be a part of Goldman Sachs now? On the other hand, I’ve rarely seen a guy from the sell side of investment banking be able to withstand the ruthless performance pressures of the buy side though so I expect there will be a ton of unemployed investment bankers. My how MBA programs will be flooded with applications. Brush up on those GMATs cause you’re going to be competing against a horde of former ibankers. Why would any truly good trader want to be a part of Goldman Sachs now?

There is a lot of knee-jerk anger and many hyperventilating voices calling for change and placing blame on government, government officials, greedy business executives, mindless consumers, etc. I’m over that already, in fact, I’ve never been there in the first place. I’m only interested in profiting from what the future will bring and what we can learn from history. In that light, let me end by quoting one of the great Founding Fathers.

“All human situations have their inconveniences. We feel those of the present but neither see nor feel those of the future; and hence we often make troublesome changes without amendment, and frequently for the worse.” – Benjamin Franklin (1706 – 1790)

These recent events highlight the lucrative nature of infrastructure investments and the persistent and controversial trend of foreign companies and sovereign wealth funds acquiring huge infrastructure assets in the United States. The political environment grows increasingly hostile as national and local politicians, including the presidential candidates, look to explain Americans’ economic struggles with a cornucopia of reasons including free trade agreements like NAFTA, a “corrupt sitting president,” and globalization generally.

This issue of foreign investment in public infrastructure has been on my radar since late 2006. Below is an essay I wrote for an investment newsletter published in January 2007 distributed to high net worth clients.

Public Infrastructure Sales: Samurais, Jihadists, and Masters of the Universe

“The Japanese are coming!” Remember when modern-day Paul Reveres shouted this refrain in the 1980s? Honda (HMC), and Toyota (TM) earnestly began their conquest of the American driver and, resultantly, Detroit’s mammoth metal benders. Would-be samurais from a nation of diminutive conformists threatened our towering sense of American exceptionalism by snatching up national treasures from our private sector like Pebble Beach, Columbia Pictures, Universal Studios, and Rockefeller Center. Although the apocalyptic visions of Japanese dominance and American indentureship have faded, the “buying of America” continues today.

Only now, the purchasers hail from different shores and their acquisition targets are of a more public flavor. In January 2006, a plan to privatize the Indiana Toll Road came to fruition when the State of Indiana entered into an agreement with Cintra (a Spanish construction firm) and Macquarie Bank (an Australian bank). The Spanish-Australian partnership paid the Indiana State Government $3.85 billion for a 75-year lease to operate and maintain the toll road. The same consortium recently entered into a $1.83 billion lease to operate the Chicago Skyway Toll Bridge. As these foreign entities begin to exact payments from beleaguered commuters, resistance to foreign ownership of public infrastructure grows.

Free trade and free markets be damned. Early this year, public sentiment derailed the proposed Dubai Ports World acquisition of U.S. ports facilities in New York, New Jersey, Philadelphia, Baltimore, New Orleans, and Miami. In a cacophonic display of bipartisan zealousness, Republican and Democratic members of Congress questioned the wisdom of selling strategic infrastructure assets to not only a foreign country, but one which two members of the 9/11 hijackers called home. The overall tone could be summed up by the mordant one-sentence letter Representative Sue Myrick (R-NC) sent to President Bush that read, “Dear Mr. President: In regards to selling American ports to the United Arab Emirates, not just NO – but HELL NO!”

Being neither knee-jerk nationalists nor adherents to Ricardian economic orthodoxy, the editors of this publication acknowledge the merits of both the free market argument and the argument for excluding strategic infrastructure from the free market. One of the tenets of free trade asserts that private industry is more efficient at delivering services than government, and experience has confirmed that theory. But, when does that precious efficiency bump up against national sovereignty and security? Pragmatic protectionists should point out that ports and roads are different species in the genus of public infrastructure; that roads are strategic but ports are more strategic.

Do we as a nation make distinctions between domestic private players and foreign entities? How do we respond to foreign companies that are not entirely private, being controlled by foreign governments? In the case of Dubai Ports World, the United Arab Emirates government owns a stake in the port operator. How do our reactions at home affect the ability of our own private companies to venture abroad and invest in and own foreign assets?

Through all this brouhaha, the editors of this publication see an opportunity for the many domestic leveraged buyout firms within our own borders. With over $175 billion raised in 2006 alone, the industry is flush with liquidity. At the risk of sounding cliché, we echo the industry’s mantra that there is “too much capital chasing too few deals.” With all the largest funds finding themselves in highly contested auction environments for companies suitable for buyouts, even the most sanguine investors admit that future returns will lag past performance. Public infrastructure as an asset class represents a potential opportunity to deploy some of that excess liquidity and to diversify LBO or private equity portfolios.Some questions beg consideration. This asset class will no doubt offer lower returns than traditional private equity investments; does the stability of returns compensate for that shortfall? What are the reasonable exit opportunities? What consequences might arise from shifting concepts of private and public property? How can the public be safeguarded from the specter of crony capitalism?

Questions notwithstanding, infrastructure investments with their super-stable revenue and profit streams offer the possibility of smoothing out the volatility of returns in portfolios otherwise dependent on the ever shifting environment for initial public offerings, mergers, and acquisitions. The promise of stable returns is causing some financial masters-of-the-universe to contemplate establishing investment pools to capture this opportunity. Goldman Sachs (GS), the Carlyle Group and other top institutions are all rumored to be pitching this idea to limited investors. We’re quite sure that hedge funds will want to get into this game too.We suspect there might even be an inefficiency here for domestic buyout firms to exploit. Public sentiment against encroachment by foreign firms might allow for lowball bids by domestic buyout firms. This compromise between public and private could placate the citizenry. The Golden Gate Bridge anyone?

Another report by the National Venture Capital Association found that only five venture-backed startups achieved an IPO in Q1 2008. We’ve never seen levels this low since the bottom of the bear market in Q2 2003. A public market with a healthy appetite for new issues is essential for the venture capital industry. It drives the lucrative exits that VCs are looking for and also, in a roundabout way, cycles money back into venture fund coffers for the next generation of startups. In a market wary of IPOs, the only remaining exit opportunity is acquisition by strategic buyers.

We know that VCs are frustratingly lemming-like in behavior. As with all investment activities and fields, it is much safer to follow the crowd or herd than to venture out, pardon the pun. But as with all investment activities and fields, it is much more profitable to invest with a contrarian framework.

Bull market vintage funds usually pay top dollar in terms of valuations. It is notoriously difficult to time the markets, but a good or lucky venture fund could exit handsomely on a few investments while valuations are still rising. However, most investments will have been made at the most expensive valuations. This is not usually a recipe for success.

Bear market vintage funds usually buy equity in startups at favorable valuations. It is still notoriously difficult to time the markets, but the depressed valuations paid by venture funds make it more likely their exits will be profitable. Investments made now while we are in a bear market will take several years to harvest. When portfolio companies are ripe, if history is any guide, the markets will have turned for the better and exit opportunities will abound.

What would I do if I wore the shiny shoes of a VC? As I said before, I would resolutely shun the second-tier ideas that are social networking apps built by self-styled “social networking gurus” or “social app gurus” because these toy ventures will never achieve noticeable success. If I had to play in the Web 2.0 playground, I would concentrate on “primary platforms” that will compete directly against existing social networks like Myspace (NWS-A) and Facebook in a unique way. I’m sure there are entrepreneurs frantically trying to figure out different ways to address the social networking space. I would not fund any social networking apps that would need to exist within Myspace, Facebook, OpenSocial (GOOG), or other platform ecosystems. In the big picture, the cost to build a primary platform versus a secondary web application, or even networks of secondary web applications, differs little. The reduced cost of building consumer Web 2.0 businesses means perhaps we should be allocating less capital to this space anyway.

Of course, not everything is Web 2.0 – let’s not be myopic here. Enterprise 2.0 looks promising as it actually has a potential revenue model around it. I’m crossing my fingers that the clean tech guys will launch something truly revolutionary and world-changing. The already significant attention given to that space by VCs will pale in comparison to the resultant capital flooding to clean tech if some genius scores a big hit.

What would I do if I wore the worn-out sneakers of an entrepreneur? I would try and do what Marc Andreessen did with Ning and raise more money than I need to weather the coming slowdown. Giving up a bit more equity in this environment makes sense in order to ensure that my startup makes it through alive. This is exactly what I’m trying to do with my new stealth mode startup. Now I’m no Andreessen and my deal is so new, but I’ll just have to keep pitching to see how far we get.

What really surprised me from the article was that many startups were putting their cash in ARSs without the knowledge of their venture investors. I’ve always believed that early stage ventures should outsource their CFO functions. Good chief financial officers are difficult to find and oftentimes startups’ finances are not complex enough to warrant a full time CFO. Spending decisions should absolutely remain the domain of the entrepreneurs and executives that are closest to the market and know at an intimate level the costs of competing. But investing and financing activities can be handled by an outside expert, at least until the enterprise meets success and its finances become more complicated. Most technology entrepreneurs, especially the ones in software, are not necessarily well-versed in finance.

My previous startup, a venture-backed software company called mediaFORGE, employed an outfit called CFO Solutions. Many venture funds have hired the folks at CFO Solutions to help manage the financing activities of their portfolio companies. I think Silicon Valley Bank (SIVB) provides some of these services but could do better advertising.

Of course, I’m sure few could have predicted the credit crisis and its damage to the ARS market. The concomitant recession fears will also put a damper on the availability of venture funding. The current market environment will not be very receptive of initial public offerings, one of the major exits for venture-funded companies and their venture investors. Startups currently in fundraising mode should try and raise more than they think they need because VCs are going to be rather tight in the near term future. It’s a strategy the PayPal (EBAY) guys implemented when they foresaw the need to ride out the dotcom crash. I have yet to decide if we’re going into fundraising mode at my new startup, SocialOptimize.