Japan M&A: growing, but from a low base

Positive developments only marginally outweigh negative outcomes for M&A deals in Japan this year, yet participants remain upbeat about the future.

Two steps forward, one step back seems an apt description of Japan’s M&A market. For every positive development, which seems to propel the market forward towards a more active M&A arena, another development moves it back. “There is a lot of head room in Japan for M&A volumes to continue to grow on a sustained basis,” says Shunichiro Tsunokawa, a managing director in Morgan Stanley’s M&A division in Tokyo. That’s not surprising given the small base. M&A activity in Japan during 2006 is estimated at around $103 billion, compared to record volumes of $1.6 trillion in the US alone and $3.8 trillion worldwide. Global M&A volume rose around 38% year on year compared to 2005. The US and Europe broadly mirrored the consolidated rate of growth while Asia ex Japan exceeded it at 40%. But in the world’s second largest financial market M&A activity declined 36%. While the overall market size may still be small, it is undeniable that recent M&A activity in Japan is re-shaping the existing landscape. And despite the slowdown in 2006, market participants remain bullish on the current year and the future. “The Japanese M&A market, in general, is at its most vibrant and diverse ever,” remarks Matthew Hanning, head of M&A and corporate advisory for Asia Pacific at UBS. “Our sense is that pipelines remain filled with deals, indicating that activity will remain busy into 2008 and beyond.” A takeover launched by Oji Paper for Hokuetsu Paper in 2006, the first ever hostile bid by one Japanese company for another, captures the change. The deal was unsuccessful for Oji, but still successful in changing prevailing perceptions of hostile deals. “The idea that a company would talk of going unfriendly if their negotiated overtures were rebuffed was unspeakable earlier,” says Morgan Stanley’s Tsunokawa. “But that has changed.” Now Japanese companies themselves suggest exploring all available avenues if there is a strong strategic rationale underlying their pursuit of a target. Indeed, two cross-border deals that Japanese companies pursued in 2007 capture the degree of change. In May Japanese technology company Fujitsu offered a $563 million takeover bid for French application services vendor, GFI Informatique. GFI had already announced plans to induct Apex Partners, a private equity firm, as a financial investor. Fujitsu termed its overture “friendly” and in April initiated dialogue with GFI management but Fujitsu may have been galvanised into action by the impending shareholder vote on the Apax investment. The GFI board did not share Fujitsu’s view. The proposed price was too low and the offer was “unsolicited and hostile and highly unusual in the information technology services industry where human capital is a company’s main asset” said GFI to shareholders while asking them to vote against the Fujitsu proposal. Not surprisingly Fujitsu could not achieve the minimum 67% shareholding it needed and the bid failed. Then, in July Japan’s Fast Retailing locked horns with Dubai investment vehicle Istithmar for US department store chain, Barneys. Jones Apparel Group, the owners of Barneys, had already announced in June, a deal to sell the asset to the Middle Eastern sovereign fund for $825 million. After Fast Retailing entered the fray the asset was bid up and Istithmar finally paid $942 million to emerge as the winner. Advisers are not surprised at the outcomes. Companies that make unsolicited bids, especially those termed hostile by the target, or enter the fray for an asset already in play know the odds are stacked against them. The willingness of Fujitsu and Fast Retailing to embark on these bids, knowing the low likelihood of success, suggests a considerable change in the mindset of Japanese companies. “Japanese companies are being driven to look outwards by the demographics in Japan,” says Morgan Stanley’s Tsunokawa. “Growth rates, especially for consumer and healthcare businesses, are dwindling and to continue to grow companies will have to pursue new avenues and target new markets.” And Japanese companies are being helped in their aspirations by liquidity in the local banking system. “Japanese local banks are in relatively better shape than many of their counterparts elsewhere in the world and, despite fundamentally taking a conservative approach, have the appetite and willingness to fund the cross-border aspirations of their clients,” explains Morgan Stanley’s Tsunokawa. Increasing shareholder activism is also driving change. The idea that shareholders could question deals seemed to have permeated the consciousness of corporate Japan as a result of some high-profile deals that shareholder-led resistance thwarted this year. After Ichigo Asset management led the first-ever shareholder resistance to a proposed merger, resulting in Tokyo Kotetsu shareholders voting down a pair up with Osaka Steel, a merger between Hoya and Pentax was abandoned as Pentax shareholders felt the deal under-valued the company. Then in June, shareholders of Bull-Dog Sauce approved a “poison pill” scheme to block a proposed takeover attempt by Warren Lichtenstein’s fund, Steel Partners. Steel Partners ownership was whittled down to 3% of Bull-Dog, from the 10% it had accumulated, by a fresh issuance of shares to all shareholders other than the US hedge fund. Steel Partners took the case all the way to Japan’s Supreme Court before conceding defeat. Like the Oji-Hokuetsu case, the Bull-Dog one has supporters in both camps. Some right-wingers term the outcome a setback for the ability of activist-led reform to succeed. But others are more sensitive to the nuances of the specific situation. “The court observed, while upholding the poison pill, that Steel Partners was not constructive enough in explaining its plans for Bull-Dog,” comments a specialist. “This suggests a window for activist shareholders to effect change still exists if they engage management and other stakeholders in productive dialogue before they take further action.” And it is also well-accepted that hedge fund-sponsored activism suffers from greenmail type perceptions – or buying a company’s stock and using the perceived threat of a takeover to either sell the shares back at a premium or force change on the management. Obviously, this is not something corporate Japan is likely to endorse in a hurry. Companies with strong underlying strategic motivations for our acquisition will go back to the drawing board and try again to put together a deal. This is what Hoya, represented by UBS, did. It tabled a revised offer for Pentax that this time contemplated a takeover via a tender offer bid – and declared in August that it had been successful in making Pentax a Hoya subsidiary. Another positive development for inbound Japanese M&A activity is recent legislation permitting triangular mergers. Japan’s new company law, which went into effect May 1, lets foreign corporations use shares to acquire Japanese targets. On October 2 Citi announced it would pioneer the use of triangular mergers in the country to effect its acquisition of Japanese brokerage firm, Nikko Cordial. Earlier this year Citi paid $8 billion to acquire 68% of Nikko. It will acquire the remaining 32% for $4.6 billion via a triangular merger by which Nikko Cordial’s minority shareholders will receive Citigroup shares. The tax treatment governing the structure is complex and this has led to some rumblings of discontent from advisers about how many companies will actually adopt this route. But this is still a positive change for foreign companies. “The new legislation surrounding triangular mergers is a welcome development as this provides one more alternative on deal structuring,” says Morgan Stanley’s Tsunokawa. Some recent deals have been driven by the desire to wholly own a Japanese subsidiary, to either drive growth or change. In April Polo Ralph Lauren offered to acquire the 80% of Impact 21, its Japanese sub-licensee that Polo did not own. Polo simultaneously acquired the 50% interest in its Japanese master licensee from its partner. Polo spent $370 million to gain 100% ownership in a market that it entered in 1978 and which is currently its second largest country in terms of sales of Polo products after the US. “The Polo Ralph Lauren case illustrates well how companies which may have entered Japan with one foot in the door now want to squarely place two feet inside,” elaborates Tsunokawa, who advised Polo on the transaction. “The strategic rationale for the deal was compelling.” More recently in October Wal-Mart offered $878 million to buy the 49% of Japanese retail chain Seiyu that it does not own. Seiyu has been loss-making for five consecutive years since Wal-Mart entered the Japanese market via a partnership with the Japanese retailer in 2002. “Wal-Mart sees Japan as a top strategic priority, based on the significant size and structure of the market and economy,” explains a source. “Wal-Mart considers it can best leverage this opportunity with Seiyu under its full control.” UBS, along with Citi and Dresdner, is advising Wal-Mart on the deal. Taking one step back still means reaching nearer your destination with every move. As UBS’s Hanning summarises: “M&A in Japan has shown some definite green shoots; we feel confident this is a sign of more to come over the next 12 months”. This story first appeared in the Japan supplement which was published with FinanceAsia’s November issue.

Korean Corporations’ Limited Presence in Global M&A Landscape

Korean Corporations’ Limited Presence in Global M&A Landscape

Amid fierce M&A wars waged worldwide, seven in ten chief domestic conglomerates were investigated to be ignorant of global M&As, clearly illustrating the limited scope of their management strategies. Maeil Business Newspaper conducted a joint survey with BCG on global M&A against 103 key Korean corporations (by sales), including Samsung Electronics and Hyundai Motor, to find that 70 companies were not considering merger or acquisition of foreign companies. Only 21 enterprises answered that global M&A was being examined or planned. Meanwhile, 12 corporations had actually acquired overseas companies during the recent three years. As the greatest reason for not pursuing M&A solutions with foreign enterprises, 46.2 percent replied a lack of suitable candidates. 28.4 percent also answered post-merger challenges concerning different corporate cultures, human resources and systems. The most feared post-acquisition factor was opposition within the organization, responded by 46.7 percent, followed by various policies (29.3 percent) and fund raising (14.1 percent). To the question whether Korean companies’ currently passive M&A activity will boom with foreign M&A contracts in the future, a surprising 94 percent answered “yes.” Among corporations that were considering global M&As, 34 percent opted for Southeast Asia and Vietnam as desirable regions, followed by China (23 percent). As chief M&A reason, 80 corporations answered ‘securing of new market’ and 14 said ‘securing new technology’. [Dong-eun Lee / KHS] [ⓒ Maeil Business Newspaper & mk.co.kr, All rights reserved] 08-27, 2007 19:33:30

Half the New Names in Top 500 Global Companies Exploit M&A

Half the New Names in Top 500 Global Companies Exploit M&A

Research suggests that M&A (merger and acquisition) is an effective way for companies to boost their global competitiveness. According to a report released by the LG Economic Research Institute on Oct. 28, among the 203 firms that have been newly added to the top 500 global companies list – during the last 10 years from 1997 to 2006 – 101 of them (49 percent) have raised their stature in the global business arena via M&A activity of larger than $500 million. Among the 397 companies that have maintained themselves in the list for the past 10 years, 58 percent exploited M&A. On the other hand, among those companies that were not ranked in the 500 list, only 27 percent have done M&A. The report also showed that the increase rate of sales was better for M&A-savvy companies. Among the 397 companies that have posted their names in the 500 list for 10 consecutive years, the average annual sales increase of those with M&A experience was 8.7 percent while those without only recorded 5.6 percent. Among the newly added companies, the average annual sales increase of those with M&A experience recorded 15.9 percent while those without only recorded 13.6 percent. [Min-jeong Lee / KHS] [ⓒ Maeil Business Newspaper & mk.co.kr, All rights reserved] 10-28, 2007 20:05:00

Citigroup’s Head of M&A – Businessweek Interview 2004

Citigroup’s Magner on the Art of M&A

Sandy Weill’s protégé explains the secrets of a successful acquisition: A clear mission, no customer disruptions, and a lot of employee support

With recession a fading memory and some giant companies flush with cash again, mergers and acquisitions seem to be coming back in vogue. Witness J.P. Morgan’s (JPM ) recent takeover of Bank One for $58 billion in stock or the effort by Cingular Wireless to buy AT&T Wireless (AWE ) for $41 billion in cash (the largest all-cash deal in history), or Comcast’s (CMCSA ) $54 billion hostile bid for Walt Disney (DIS ). The hunt is on for deals that can squeeze more profits and better efficiencies from industry consolidation. Yet, economic and academic studies have long shown that one out of every two ultimately fail to achieve their expected results, often miserably.The most common symptom of merger mania is indigestion, in which one or both companies fail to successfully incorporate their business models, goals, or cultures into an integrated whole. The promised payoffs never materialize. Eventually, investors flee, and stock values go down. The most prominent example in recent corporate history was 2001 AOL-Time Warner (TWX ) deal.

One company that has been successful with acquisitions, however, is Citigroup (C ). In 1998, Citibank’s $70 billion merger with Travelers Group, which established the world’s largest financial-services firm, was the biggest in history until the AOL-Time-Warner deal.

AT SANDY’S RIGHT HAND.  Since then, under the reign of Chairman Sanford “Sandy” Weill, Citigroup has been a lean wolf on the hunt, snapping up dozens of companies. Yet, through it all, Citigroup increased its annual earnings more than 700 times, Weill likes to boast. No one disputes the outfit’s success with M&A.

Marge Magner is a Weill protégé who first worked for him back in 1987. She has held many executive positions at Citi, including chief operating officer. For the past eight months, she has headed Citigroup’s Global Consumer Group (GCG). As such, she’s a key architect and executor of the company’s acquisition strategy and has directly negotiated and implemented Citicorp’s buys of European American Bank (EAB), Washington Mutual Finance (WMF), Golden State Bancorp, Sears’ credit and financial products business, and Banamex-Banacci.

Last year, incomes from Magner’s operations totaled $9.6 billion of Citigroup’s total $17.85 billion profit, accounting for 55% of the corporation’s earnings, with a 17% growth rate. If Magner’s group were an independent entity, it would be the seventh-largest corporation in the world. Her latest foray: GCG made a $2.73 billion cash offer to buy Koram Bank, South Korea’s sixth-largest, in February.

How does Citigroup do so well with mergers? And why do so many others’ fail? I asked Magner for some answers. Here are edited excerpts from our conversation:

Q: When should a company consider a merger or acquisition?
A: It depends on your vision for the business. You have to understand what the dynamics are that are uniquely driving your industry. It also always depends on whether you’re in a consolidating industry, which creates opportunities for mergers and acquisitions.

Consolidation takes place because of scale. You’re either doing consolidation or receiving it. You will be involved one way or another. Generally, people would rather decide their own fate and determine whether to acquire, not the other way around.

Ideally, you’re looking to acquire products, a distribution method, or something that you don’t have now that clearly moves you forward in terms of your business strategy or provides greater leverage for your overall business platform. Maybe the acquisition allows you to bring costs down or to distribute your products to an expanding consumer base.

Q: O.K., so when isn’t a good time to merge?
A: [You should never do it just] because everyone else is merging and acquiring. Just because it’s right for some other company in your industry or in another industry doesn’t mean it’s right for you. Two companies that are weak players in their respective markets can’t merge to cover up their individual problems. One will end up pulling the other down.

Q: How do you determine a specific target for acquisition?
A: You can spend lots of time thinking about what business is a perfect fit. You can look at factors ranging from geography, product line, distribution systems, and information technology. What strategic advantage does that target bring you? Where are you trying to take your business?

At the end of the day, that potential target company must be available. That takes investment-banking help. You can also pick up the phone and call that company’s CEO and have a casual chat. A lot in the business world happens because of relationships.

Q: How is Citigroup’s search different from other companies?
A: We know what we want to do. Our objective is to expand the business by product line and geography. The first thing we do after identifying a company is to look at the numbers. This is, of course, easier if you’re talking about a public company.

We then approach these companies — our investment bankers will come to them. In some cases, the company is looking for a strategic sale and will put itself up for sale. This can help a company to negotiate terms. You have to get a sense of how much you are willing to pay or bid for the company.

Due diligence is the most critical aspect of M&A, and one of the most important aspect of the entire process. For us, we typically have the people responsible for the integration do the due-diligence work. Some companies have analysts go in. Our preference is to rely on the line people who are going to have to deliver the results. [They have] to plan the execution as they perform due-diligence work.

From there, the process is to develop a formal agreement between the two companies, to work through regulatory review on a federal or state level. But you plan integration from the time you start the due-diligence process.

Nothing good happens between the signing of a formal agreement and the closing of the deal. The longer it takes, the more difficult things become. Any organization struggles with uncertainty and ambiguity. Delays detract from effective execution. Identifying all the issues for integration up front is the key. We don’t do a deal unless [Citigroup Chief Operating Officer] Bob Willumstad or I understand every aspect of the deal. We don’t buy anything unless we have spent a lot of time with the sellers of a company.

Q: How about an example?
A: With the [2002] CalFed deal [Golden State Bancorp was the holding company of California Federal Bank], both Bob and I were in California for due-diligence work from the time we had a basic agreement in place. We were meeting people and talking to the CalFed staff about what they could expect to see in the transition.

We had to make quick decisions and determine who’s in charge of various aspects of the operation and who’s doing what. If we see ways to consolidate operations and that people won’t be needed for certain jobs or that there’s duplication of positions, we act as quickly as we can to make any necessary changes in staffing.

The reality is that if you’re respectful of people and you work to help them find other jobs, employees are comforted because they know that interest and involvement in employment issues at a senior level will make things happen. Senior management in the corporation know what my priorities are concerning employees. Wherever possible we work to find opportunities for existing staff to work in different locations. We have job fairs and remind people that we do business all over the world.

Q: What about the tough calls?
A: The transaction should either be really easy [once you've done your homework] or for a very good price to justify taking more risk. At the end of the day, you have to determine what the new entity will look like, how it will perform, and how investors and consumers will judge it. You may have to walk away. There may be limits from a pricing standpoint. Just because you can do a deal doesn’t mean you should.

You always have to remember that you’re investing the shareholders’ money and that you have to give them a good return. There are limits. [Sometimes,] when you look at the business 3, 5, 10, or 20 years out, if it looks like it’s important for the strategic long-term value of the company, you may decide that this deal is important and that you have to do it. There may be more of a strategic impact than a financial impact.

For Citigroup, we look for our deals to be more accretive than dilutive. The worst potential deals are those that dilute earnings per share. We will look at all deals in terms of the opportunity to increase EPS for our stockholders.

Q: How do you properly integrate a company into your own? What are the primary considerations?
A: The No. 1 consideration is the customer. What’s the customer seeing and experiencing? How are they able to get to the quality of service they’re expecting during this transition period? It all starts from maintaining a consistent experience for the customer with no fire drills.

The No. 2 consideration is the [acquired company's] employees. Determining how to match commission plans, salaries, benefits, and other human-resource issues. Employees need to have their roles clarified as quickly as possible.

Q: What are the primary considerations for successful technology and systems integration? How do you monitor progress? What are the biggest obstacles to overcome?
A: Band-Aids only work for a short period of time. For example, WorldCom did an awful lot of acquisitions, but they didn’t really integrate their information-technology systems effectively. Technology integration must be a priority and must be done properly. This has to be the first order of business. Technology must be used to ensure that the customer has a positive experience with no disruption.

Q: What is the proper mix of growth — acquisition vs. organic?
A: The answer will vary from organization to organization. From our experience, the proper mix of growth over time is two-thirds organic and one-third through acquisition.

Q: What’s the most important lesson you have learned?
A: The importance of execution. Doing this well and doing it thoroughly. You need people who understand how your organization must be focused. Having people who are experienced with the process is critical. For the CalFed merger, we merged 350 branches into our system of 3,100 branches and 9,800 branches worldwide. You have to have people on the ground to make things work, to make sure that the customer is well served, and that your employees are calm.

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Meet the PayPal Mafia

By Jeffrey M. O’Brien, Fortune senior editor

November 14 2007: 2:24 PM EST

(Fortune Magazine) — A door opens, and a blond man appears in a white jacket with large buttons. “Good morning,” he says. “Peter’s in back. Make yourself comfortable in the dining room. I’ll be serving breakfast shortly.”

Holy cannoli. Peter Thiel has a butler. The 40-year-old entrepreneur runs a $3 billion hedge fund. He’s the founder of a new venture capital firm that’s the talk of Silicon Valley. He’s got an early $500,000 stake in Facebook that’s now worth about $1 billion on paper. The man has bankrolled everything from restaurants to movies and is lauded by many as some kind of free-market genius. He drives a half-million-dollar McLaren supercar. And now a butler.

Just back from a morning run, Thiel emerges into the dining room of his home in the shadow of San Francisco’s Palace of Fine Arts. Wearing a powder-blue T-shirt wet with sweat, he displays the relaxed self-confidence of Michael Corleone. Perhaps it comes with the butler. “I’m Peter,” he says, extending his hand and smiling before thanking me for agreeing to such a late breakfast meeting. It’s 7:30 A.M. “It was nice to sleep in.”

The doorbell rings, and in walks a scruffy, sleepy-eyed Max Levchin, 32, who has trekked over from his new $5 million-plus home a few blocks away in Pacific Heights. Every garment on Levchin’s unwashed body is a freebie – University of Illinois zip jacket, mismatching shorts, bright orange T-shirt with some Hebrew lettering.

Levchin runs one of the hottest companies on the web, a photo-sharing site called Slide that draws 134 million users a month. Making neither eye contact nor conversation, he presses his lips together, nods to indicate that he is, as ever, ready for business, and sits.

It’s been nine years since Thiel and Levchin first dined together at Hobee’s, near Stanford University. Levchin had an idea for a company, and Thiel wanted to invest. In short order Thiel joined as a co-founder, and together they set out to “create the new world currency.”

Their brainchild would change the course of the Internet. They’d bring on several hundred employees to what would become PayPal. They’d sign up more than 20 million users and burn $180 million in funding before breaking even and selling out to eBay (Charts, Fortune 500) for $1.5 billion.

And then things got interesting. The eBay deal, remarkable only because it happened in the bleakness of 2002, wasn’t so much an exit as an explosion. Most of PayPal’s key employees left eBay, but they stayed in touch. They even have a name for themselves: the PayPal mafia. And the mafiosi have been busy.

During the past five years they’ve been furiously building things – investment firms, philanthropies, solar-power companies, an electric-car maker, a firm that aims to colonize Mars, and of course a slew of Internet companies. It’s amazing how many hot web properties can trace their ancestries to PayPal.

Besides Facebook and Slide, there’s Yelp, Digg, and YouTube. Thiel and Levchin, the don and consigliere of the mafia, figure that all told, there are dozens of enterprises worth a total of roughly $30 billion – and that value is growing rapidly, as evidenced by Thiel’s good fortune with Facebook.

This group of serial entrepreneurs and investors represents a new generation of wealth and power. In some ways they’re classic characters of Silicon Valley, where success and easy access to capital breed ambition and further success. It’s the reason people come to the area from all over the world. But even by that standard, PayPal was a petri dish for entrepreneurs. The obvious question is, Why?

Maybe it comes back to the early hires. After their first breakfast, Thiel and Levchin began recruiting everyone they knew at their alma maters. “It basically started by hiring all these people in concentric circles,” Thiel remembers. “I hired friends from Stanford, and Max brought in people from the University of Illinois.”

They were looking for a specific type of candidate. They wanted competitive, well-read, multilingual individuals who, above all else, had a proficiency in math. Levchin’s original idea for PayPal was to beam money between PalmPilots, but Thiel has a way of seeing the bigger picture.

A staunch libertarian, Thiel figured a web-based currency would undermine government tax structures. Getting there, however, would mean taking on established industries – commercial banking, for instance – which would require financial acumen and engineering expertise.

Thiel and Levchin also wanted workaholics who were not MBAs, consultants, frat boys, or, God forbid, jocks. “This guy came in, and I asked what he liked to do for fun,” Levchin recalls. “He said, ‘I really enjoy playing hoops.’ I said, ‘We can’t hire the guy. Everyone I knew in college who liked to play hoops was an idiot.’”

In other words, they were looking for people like themselves. A bilingual immigrant from Kiev, Ukraine, Levchin is the hypercompetitive son of a playwright father and a physicist mother. He’s numerate in the extreme and is an accomplished clarinetist whose athletic pursuits don’t typically take him beyond table tennis. He lives to work.

Born in Germany, Thiel has a J.D. from Stanford and did some time as a corporate lawyer. But finance has always been more his thing - Institutional Investor named his hedge fund, Clarium Capital, “global macro fund of the year” in 2005. (He was once ranked among the top under-21 chess players in the country, but he gave up playing competitively.

“Taken too far, chess can become an alternate reality in which one loses sight of the real world,” he says. “My chess ability was roughly at the limit. Had I become any stronger, there would have been some massive tradeoffs with success in other domains in life.”)

“All of this is about self-selecting for people just like you,” says Levchin. “He thinks like me, he’s just as geeky, and he doesn’t get laid very often. Great hire! We’ll get along perfectly.”

Recruiting underclassmen from the middle of the country assured Levchin that his charges would have few preconceived notions and fewer social distractions. “Most of them were very introverted anyway,” Levchin recalls. “They’d come in, eat crappy food all day, and sleep under their desks.”

Early on, disagreements sometimes broke out into wrestling matches, and on at least one occasion Levchin worried that he had a serious fight on his hands. As with the real Mob, PayPal wasn’t exactly welcoming toward women.

When it came time to hire a high-ranking female engineer, she turned out to be bad at Ping-Pong. Levchin took that as a lack of competitive fire but grudgingly hired her anyway. She quit within six months. “Peter never fails to rub that in,” he grumbles.

Of course Google (Charts, Fortune 500) is also famous for a relentless pursuit of brainiacs. But PayPal was no Google. “The difference between Google and PayPal was that Google wanted to hire Ph.D.s, and PayPal wanted to hire the people who got into Ph.D. programs and dropped out,” says Roelof Botha, PayPal’s onetime CFO who went on to become a general partner at one of the nation’s most powerful VC firms, Sequoia Capital, and put the first venture money into YouTube. “It’s a different temperament.”

The PayPal-ers who didn’t possess Thiel’s anti-establishment streak as new hires had it by the time they left. The PayPal culture wasn’t just antigovernment. It was anti–mainstream thought.

Thiel, ever the freethinker, has donated $3.5 million to the Methuselah Foundation, a life-extension-research organization run by the controversial academic Aubrey de Grey, who believes humans will one day live to 1,000.

Thiel sits on the board of the Singularity Institute for Artificial Intelligence, which concerns itself with the coming merger of man and machine. In the early days at PayPal, he even discussed establishing cryogenic storage as an employee benefit.

Thiel’s leadership style is as unconventional as his worldview. His hallmark management MO at PayPal (at least, pre-IPO) was the all-hands open-book session. Customer logs, revenue flow, fraud losses, burn rate: He’d display it all for every employee to see. This access to information, coupled with the lack of offices, created a flat structure where any idea could win the day.

“Good decision-making flows out of details,” says former COO David Sacks, who now runs both the online genealogy startup Geni and the Hollywood production studio Room 9 Entertainment, which made Thank You for Smoking. “We did not subscribe to the idea that managers are this special class of employee.”

Sacks himself almost didn’t get hired by PayPal – perhaps because of a short stint at McKinsey. But Thiel recognized him as an important dissenting voice, someone who could sharpen the company’s focus.

Once he came on, McKinsey taint notwithstanding, Sacks further opened the culture by establishing a no-unnecessary-meetings policy. He became a meeting cop. Anytime he’d see a closed-door discussion happening, he’d sit in for three minutes. If he considered the meeting to be valueless, he’d call it adjourned.

Sacks, in his office on Sunset Boulevard in West Hollywood, recalls how the lack of meetings helped create a culture of many workers and few managers. “You didn’t measure where you were in the organization by how many people you’re managing,” he says. Prestige was measured “by how few people there were above you who could prevent you from doing what you wanted to do.”

Back in Silicon Valley, Reid Hoffman, a former executive VP, sits in his own office at the social networking site he started, LinkedIn. Hoffman is one of the Valley’s most prolific angel investors, with stakes in more than 60 startups, including Facebook and Digg.

Like Sacks, he loved PayPal’s meritocracy. “The group was very analytical,” says Hoffman. “It was all about, ‘Here are my arguments; here’s my perspective.’ You could never say, ‘In my experience,’ because experience wasn’t there as a variable.”

Not everyone liked the PayPal vibe. Chief among the dissenters is Elon Musk.

It’s free-lunch Friday at the space-exploration company SpaceX, down the road from Los Angeles International Airport. The massive fuselage of a rocket ship dominates the ground floor. In its shadow, dozens of employees sit cramped at a handful of foldout tables.

There are no seats to be had, not even for the man who invested $100 million of his own money to start the company. So Musk and I retreat to his desk. I’ve just asked him what it was like to be the victim of a coup led by Sacks, Levchin, and Thiel. “It was like unicorns and rainbows, flower-filled meadows,” he says with a smirk.

Musk came to PayPal not through Levchin/Thiel’s regime but during the company’s merger with his Internet bank, X.com. Born and raised in South Africa, Musk sold his first company, Zip2, to AltaVista at age 28 for more than $300 million. Now 36, he’s running SpaceX, which plans to send people into space and eventually colonize Mars, and serves as chairman of Tesla Motors (electric cars) and Solar City (solar-panel installation).

Despite having perhaps the greatest entrepreneurial streak of all the PayPal mafia, Musk was purged from PayPal like some kind of toxin. Soon after the merger, Thiel resigned.

Musk became CEO of the combined company and decided it was time for a technological overhaul. Specifically, he wanted to toss out Unix and put everything on a Microsoft platform.

That may sound innocent enough to laypeople but not to Unix zealots like Levchin and his team. A holy war ensued. Musk lost. The board fired him and brought back Thiel while Musk was on a flight to Australia for his first vacation in years. “That’s the problem with vacations,” Musk deadpans.

Musk still contends he didn’t deserve his fate, that his biggest flaw was being cut from different cloth. “Peter, Max, and I are not directly aligned philosophically,” he says. “Peter’s philosophy is pretty odd. It’s not normal. He’s a contrarian from an investing standpoint and thinks a lot about the singularity. I’m much less excited about that. I’m pro-human.”

It wasn’t just Musk; anyone who didn’t mesh with the Levchin/Thiel culture ran into trouble. X.com had a number of people from the banking industry who didn’t last long. “We had been rivals, so it was awkward,” remembers Jeremy Stoppelman, who was an engineer at X.com, stuck it out after the merger, and is now the CEO of Yelp, a fast-growing restaurant- and bar-review site.

“And that awkwardness turned into total dysfunction and warfare. Most X employees ended up leaving or getting fired. The culture was really an intellectual pissing contest, and some people didn’t like that.”

The infighting eventually stopped. It had to, because there were too many other enemies to deal with – eBay, for example. Before buying PayPal, the auction giant tried in various ways to kill it – by purchasing a competing service, for example.

Meanwhile, PayPal losses were multiplying. It battled Russian fraudsters who were filching millions by cribbing credit card numbers. Customer-service complaints flooded the phone lines and in-boxes and were often dealt with by simply not answering the phone or doing a mass deletion. Louisiana temporarily banned PayPal from doing business in the state; MasterCard (Charts) threatened to pull the plug because of the high number of chargebacks.

“Peter Thiel didn’t know what a chargeback was,” says Jawed Karim, an early engineer who went on to found YouTube with fellow alumni Chad Hurley and Steve Chen – and then sell it to Google for $1.65 billion. “That’s one of the fundamental things of any credit card payment system. Chargebacks almost killed the company.”

But the executive team made up for nonmastery of details with unwavering vision, which inspired the troops. At his San Bruno, Calif., office, YouTube CEO Hurley remembers his PayPal days as an education in business. When he arrived in California with a degree in art from Indiana University of Pennsylvania, building a successful company seemed like something other people did.

“You never think it could happen to you,” says Hurley. “But seeing Peter and Max and the guys come up with ideas and seeing how to make things work gave me a lot of insight. You may not have a business degree, but you see how to put the process into effect. The experience helped me realize the payoff of being involved in a startup.”

After 11 revisions to the prospectus, PayPal pulled off its IPO on Feb. 15, 2002. The stock closed that day at $20 a share and rose for the next nine months, even as Nasdaq cratered, until the sale to eBay. Thiel walked away on the day of the acquisition; Levchin and Sacks followed. Botha considered sticking around – “Meg Whitman made me a terrific offer,” he says – but left for Sequoia to stay in the startup game.

For those who remained in the name of a paycheck, the culture shock was profound. Premal Shah, a former product manager at PayPal and now president of Kiva.org, was put in charge of eBay’s developing-world strategy. He went to India for three months – a dream assignment. But when he got back, it seemed that every day meant another PowerPoint presentation for yet another layer of management. “I quit after a year,” he says.

By then, the PayPal mafia was well established. Today they call upon one another when they need money or advice – and when they need both, they go to Thiel, who seems to be at the center of it all. Among his many investments, Thiel has money in Slide, Yelp, and LinkedIn.

He helped his former assistant start Laïola, one of San Francisco’s hottest new restaurants. His venture capital startup, the Founders Fund, invested the first $1.5 million in Sacks’ Geni.com, where five of the 29 employees are from PayPal.

Levchin invested in IronPort systems, which was founded by early PayPal investor Scott Bannister and acquired by Cisco (Charts, Fortune 500) for $830 million. He put the first $1 million into Yelp and serves as its chairman.

He’s also got money with Botha at Sequoia (even while Sequoia has a stake in Slide’s rival, RockYou) and was an executive producer of Thank You for Smoking, along with Sacks, Thiel, and Musk. That last name may come as a surprise, but Musk has made peace with his mutineers.

He has invested in Room 9, Geni, Botha’s Sequoia fund, and Clarium Capital. (But he won’t let Thiel reciprocate. “We don’t need the money,” says Musk with a wry smile.)

As for the impact of PayPal’s culture, that varies. At some places, like Slide, Levchin’s work ethic lives on- though his hiring practices seem to have softened. His head of engineering, for example, was on the Stanford water polo team. “He probably likes to play hoops,” Levchin jokes.

At other places there’s nary an intellectual pissing match in sight. YouTube’s quiet San Bruno office might be taken for a division of a large corporation (which it is).

At Yelp, Stoppelman has become a regular on the San Francisco party circuit, and these days spends little time sleeping under his desk. But both YouTube and Yelp learned a valuable lesson from PayPal: The first idea isn’t always the best. Yelp was a convoluted e-mail referral service before becoming a top review site. YouTube started as a video dating play. Now it’s at the center of the zeitgeist.

The mafia doesn’t often convene in a physical place- they don’t have a Bada Bing, where Tony Soprano and his crew would hang out. But they do have a sense of humor, and so at FORTUNE’s request, the capos are gathered in Tosca, the legendary San Francisco watering hole, for a group photo.

Frank Sinatra is here, crooning from the Wurlitzer. So are Thiel, Levchin, Sacks, Botha, and many others. Musk wanted to come, but he’s in Chicago to receive an “innovator of the year” award. Hurley and Chen bowed out after their Google handler objected to the gangster motif.

The group is decked out in gold chains and tracksuits, smoking cigars, drinking Maker’s Mark. It’s a happy moment, even if the lack of Wi-Fi makes Levchin antsy. Looking at the group laughing and joking, you’d never guess they’re all supercompetitive hyperintellectuals- or that some don’t like each other very much. But when you get to know them a bit, it’s not all that surprising. As Stoppelman puts it, “We’re all a little weird.”

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