KKR Outspends Blackstone, Instills Profit-First Creed (Update1)
By Richard Teitelbaum
June 29 (Bloomberg) -- It's a great time to be Henry Kravis, as he's quick to remind people.
In April, the buyout mogul is standing in a ballroom of the Waldorf-Astoria hotel in New York, telling AIDS researcher Dr. David Ho, architect Maya Lin and Yahoo! Inc. co-founder Jerry Yang that the private equity industry he helped invent is hotter than ever.
``We're in, right now, the golden age,'' Kravis, 63, tells a gathering of prominent Chinese-Americans and Wall Street executives.
In May, Kravis is up in Halifax, Nova Scotia, saying, again, that the takeover arena has never looked better.
``The private equity world is in its golden era right now,'' Kravis tells a conference of bankers and investors. ``The stars are aligned.''
It's certainly a gilded moment for Henry Roberts Kravis. Almost two decades after his $31.4 billion takeover of RJR Nabisco Inc. rewrote the rules of leveraged buyouts, Kravis is buying companies at a record clip.
Fueled by cheap money that's now getting more expensive, private equity has ripped through public companies and ushered in what George David Smith, business historian at New York University's Stern School of Business, calls a new era of capitalism.
From Jan. 1, 2006, to June 27, Kohlberg Kravis Roberts & Co., the buyout firm Kravis co-founded in 1976 with his cousin George Roberts and one-time mentor Jerome Kohlberg, has announced deals worth $215 billion to acquire all or part of 30 companies, according to data compiled by Bloomberg.
$107 Billion Empire
In that time, KKR, with U.S. offices in New York and Menlo Park, California, outspent rivals Blackstone Group LP, Carlyle Group and TPG Inc.
Behind all of the dealmaking, Kravis and Roberts, also 63, now lord over an industrial empire that dwarfs some of the world's mightiest public corporations. As of May 31, the firm had a hand in 36 companies that together generated about $107 billion of revenue in 2006, according to figures KKR posted on its Web site. That's more than Coca-Cola Co., Microsoft Corp. and Walt Disney Co. put together.
These companies employed 560,000 people, more than either Citigroup Inc. or General Electric Co. In fact, more people work for KKR companies than live in Atlanta, Miami or St. Louis. Now that Blackstone has gone public, KKR may try to do the same, opening Kravis's realm to stock-market investors.
Kravis's Realm
After several of the firm's acquisitions began to sour in the late 1990s, Kravis and Roberts changed direction and tightened their grip on the companies they buy.
Nowadays, New York-based Capstone Consulting LLC, a consulting firm that works exclusively for KKR, measures company performance. KKR demands its managers sink their own money into the companies they run, works its contacts to find pros who can help them, sets performance standards -- and fires people who fail.
``Any fool can buy a company,'' Kravis said at a private equity conference in Frankfurt in February 2006. ``The hard and important part of our job was what we did with the company to create shareholder value once we acquired it.'' KKR executives declined to be interviewed for this story.
From his aerie 42 floors above 57th Street in midtown Manhattan, Kravis straddles the corporate and financial worlds. He's played a role in more than a fifth of the $545.5 billion in buyouts announced this year through June 27.
Setting Records
During that period, Kravis set records on both sides of the Atlantic. After KKR and TPG agreed to buy Dallas-based electric utility operator TXU Corp. in February in a record $45 billion LBO, Kravis and Italian billionaire Stefano Pessina in April agreed to buy British drugstore chain Alliance Boots Plc for 11.1 billion pounds ($22.2 billion) in the largest LBO in Europe.
Today, Kravis's reach extends from North Carolina, where KKR controls mattress maker Sealy Corp.; to Turin, Italy, where KKR owns FL Selenia SpA, which makes automotive lubricants; to Rotterdam, where KKR owns AVR Bedrijven NV, the largest waste management company in the Netherlands. In Europe, KKR owned stakes in or controlled 15 companies as of May 31.
At the center of this empire is an investment committee that meets regularly in KKR's New York headquarters high above Central Park. The group includes Kravis, Roberts and Capstone CEO Dean Nelson and vets proposed deals.
The KKR Way
A second gathering, called the portfolio management committee, also convenes to review KKR's collection of companies and reports from so-called deal teams that put buyouts together.
Twenty-five partners, or members, and more than 65 managing directors, directors, principals and associates are divided into nine industry groups. They split their time between finding takeover targets, working on deals and making sure KKR companies are being run well.
KKR usually assigns two or more of its executives to the board of a company. It deploys Capstone consultants to find ways to cut costs and boost sales.
KKR's 2006 annual review lists 14 senior advisers, including former CEOs Edwin Artzt of Procter & Gamble Co., Paul Hazen of Wells Fargo & Co. and George Fisher of Eastman Kodak Co. and Motorola Inc., who counsel dealmakers and managers and sometimes serve on boards and the portfolio committee. Former Agere Systems Inc. CEO Richard Clemmer joined in June.
RJR Excesses
``KKR is now the best private equity firm at buying companies and then making them better,'' says former partner Scott Stuart, who now runs Sageview Capital LLC, based in Greenwich, Connecticut, and Palo Alto, California, with Ned Gilhuly, another KKR veteran.
It may surprise some people that KKR cares about running companies. Its ill-fated takeover of RJR Nabisco, memorialized in the best seller ``Barbarians at the Gate: The Fall of RJR Nabisco'' (Harper Row, 1990) and a 1993 HBO movie of the same name, made Kravis a poster boy for the ``greed is good'' '80s.
The book recounts how Kravis threw a closing dinner in the ballroom of New York's Pierre hotel, where 400 investment bankers, lawyers and friends dined on lobster, veal with morel sauce and a 3-foot-high (0.9-meter-high) cake adorned with replicas of Nabisco products. The RJR LBO turned out to be a flop, generating an internal rate of return of less than 1 percent, according to a 2001 KKR valuation report.
Buyout Binge
KKR raises money from investors, typically public and corporate pension funds, and then leverages that cash with borrowed money to make acquisitions and magnify returns. For example, KKR may invest $1 of equity for every $9 it borrows.
Buying companies is the easy part. The harder part is improving them so they pay down debt more quickly and then cashing out at a profit by selling them to someone else, usually the public, in the form of an initial stock offering, or directly to another company or group of investors.
Hardly a day goes by without another marquee brand getting gobbled up by private equity these days.
From Jan. 1, 2006, to June 27, 21 companies in the Standard & Poor's 500 Index announced their sale to private equity firms. Private equity buyouts accounted for $1.2 trillion, or 20.5 percent, of the record $6.1 trillion in mergers and acquisitions announced worldwide during that period.
Now, with interest rates climbing, life could get tougher for the private equity crowd, which borrows heavily to finance acquisitions. Benchmark 10-year U.S. Treasury rates climbed to 5.08 percent on June 27 from 4.54 percent in mid-March.
Fear and Greed
A sustained rise in rates or a decline in stock prices would turn up the heat on KKR -- and the managers who run its companies.
Buyout firms have already hit a rough patch. Blackstone stock, initially priced at $31, fell as low as $29.13 on June 27. The stock was trading at $30.03 in New York today. Carlyle Group this week cut the size and price of an IPO of a fund that invests in bonds backed by mortgages as damage from the U.S. real-estate slump spread.
How KKR manages its companies is more important than ever. The firm usually lines up top people and makes them scared to fail. Joseph Welch, chief executive officer of electric utility company ITC Holdings Corp., says KKR ensures its managers stay focused on the bottom line by making them invest in their own companies.
When KKR bought Novi, Michigan-based ITC in 2003, it offered Welch a chance to run it -- provided he put about $1.5 million into it. Welch ended up emptying his savings account, mortgaging his house and taking out a loan.
``KKR didn't want to have trouble sleeping at night,'' Welch, 58, says. ``They did that by making sure I had trouble sleeping at night.''
No Losers
KKR sets benchmarks for everything from the amount of scrap produced to safety records and then holds managers accountable.
At Princeton, New Jersey-based Rockwood Holdings Inc., which makes specialty chemicals and advanced ceramics, CEO Seifi Ghasemi, 62, used such benchmarks to turn around the company during the 2001 U.S. recession. He fired 10 percent of Rockwood's workforce.
``We are trying to make people rich -- and rich people even richer,'' Ghasemi says.
KKR has zero tolerance for money losers. Eckard Heidloff, CEO of Paderborn, Germany-based Wincor Nixdorf AG, which manufactures automated teller machines, discovered that when Gilhuly told him the firm was considering selling a Wincor division that was in the red.
Kravis's team makes sure managers understand that customers -- not KKR -- will pay down debt.
The Capstone Edge
Marc Tellier, CEO of Montreal-based Yellow Pages Group, which distributes telephone directories across Canada, says Capstone helped improve a system that employs the Canadian consumer price index and a half dozen other variables to better price ads and stoke sales.
Power grids, advanced ceramics, ATMs, Ottawa telephone directories -- it's all a long way from the world of Henry Kravis. He and his wife, economist Marie-Josee Kravis, form one of New York's ultimate power couples.
A regular at black-tie galas, Henry serves on the boards of the Metropolitan Museum of Art, Mount Sinai Medical Center, Columbia University's Graduate School of Business and Rockefeller University. Marie-Josee, a senior fellow at the Washington-based Hudson Institute, is president of the Museum of Modern Art. Roberts, whose wife of 35 years died in 2003, keeps a lower profile than his cousin. Kohlberg, 81, left after a falling-out in 1987.
30 Percent Returns
The private equity boom that Kravis and Roberts are fueling has implications not just for Wall Street but increasingly for every executive, investor and retiree. U.S. public and corporate pension funds are looking to boost returns so they can keep their promises to aging workers.
Kravis's aim is to earn his investors fatter returns than they could get in the stock market.
The $245 billion California Public Employees' Retirement System says on its Web site that from its start in 2001, KKR European Fund LP generated a 30.7 percent internal rate of return through December 2006. KKR Millennium Fund, which was started in 2002, posted a 39 percent internal rate of return.
Back in the '80s, private equity firms produced most of their investment returns via the leverage they employed to acquire companies. Now, they're making more of their money by overhauling business practices and improving productivity.
For their efforts, buyout firms collect fees in all shapes and sizes. Firms such as KKR typically charge management fees of 1-2 percent and collect 20 percent of any capital gains when they sell a company.
Fees, Fees, Fees
On top of that, KKR collects fees from its companies for advice on mergers and acquisitions as well as for management consulting and other services.
When KKR bought Sealy from a group led by Boston-based Bain Capital LLC in 2004, for example, Kravis's firm and Bain shared $31.8 million of M&A advisory fees.
Do private equity firms earn their money? NYU's Smith, co- author of ``The New Financial Capitalists: Kohlberg, Kravis Roberts and the Creation of Corporate Value'' (Cambridge University Press, 1998), says well-run buyouts have helped liberate companies from the rubber-stamp boards that have long dominated much of corporate America.
``Most boards at public companies have been captives to the CEO,'' he says.
Michael Chu, a former executive and limited partner at KKR, says managers at public companies can muddle along, even prosper, simply by not rocking the boat. That doesn't work at KKR companies.
The LBO Effect
``You don't have the luxury of managing issues at the margin,'' says Chu, a founder of Buenos Aires-based Pegasus Venture Capital.
``If the market changes, you change the strategy,'' he says. ``If the CEO doesn't work out a year into the deal, you never shy away from the tough questions. You change the CEO.''
Measured by stock performance, LBOs have made many companies better, according to a 2006 study by Jerry Cao, a doctoral candidate at Boston College, and Josh Lerner, a professor of investment banking at Harvard Business School.
The pair examined almost 500 companies that went private in LBOs and subsequently went public again from 1980 to 2002. They found that these companies beat their IPO peers in the stock market: Companies that had undergone LBOs posted an average, cumulative three-year return of 57.9 percent compared with 20.5 percent for conventional IPOs and 33.4 percent for the Standard & Poor's 500 Index.
Who Gets Hurt
Lerner says the disciplining power of an LBO forces managers to make tough decisions.
``There is a process of refocusing the company, disposing of divisions that aren't central to its mission,'' he says.
Even so, when KKR pulls the levers, someone usually gets ground up in the gears. By leveraging companies, KKR encourages managers to cut costs and, often, that means jobs.
KKR bought Evansville, Indiana-based Accuride Corp., which makes truck parts, in 1997 and sold the last of its shares in early June. In April, the International Brotherhood of Teamsters agreed to lay off 64 of about 350 workers at Accuride's Plant No. 1 in Elkhart, Indiana.
Matt Sandefur, a machine operator who works on brake drums for big rigs at the plant, says managers have frozen his pay for 2007, doubled health insurance deductibles and cut coverage. He's looking for a new job.
New Concern
``I say KKR hates unions,'' Sandefur, 41, says. ``I used to feel secure in my job.''
Workers aren't the only ones worrying these days. As private equity deals get bigger and bigger, some investors see trouble brewing. Wall Street, after all, tends to get carried away. The LBO boom of the '80s ended with an implosion in the junk bond market and a wave of corporate bankruptcies.
``Everybody thinks private equity is the panacea,'' says Jim Leech, senior vice president of Teachers' Private Capital, part of the Ontario Teachers' Pension Plan. ``In our opinion, it's getting scary.''
Lately, acquisition prices have been rising along with borrowing costs. Competition for deals pushed the average price paid for companies in LBOs to 8.5 times cash flow in the fourth quarter of 2006 from 6.4 times in 2001, according to S&P.
``It's a case of a lot of money chasing after deals,'' Chu says. Ultimately, private equity returns are likely to falter, he says. ``Maybe you don't get 25 percent returns; you get 12 percent or 10 percent,'' he says.
Regal Debacle
Kravis and Roberts have been through rocky times. Starting in the late '90s, KKR stumbled as a string of its companies began to fail, most notably Knoxville, Tennessee-based Regal Cinemas Inc., which filed for Chapter 11 in 2001.
It was a costly mistake that changed the way Kravis and Roberts operate. KKR had led a buyout of the movie theater chain in 1998 for $1.58 billion, only to see its value plummet amid a glut of multiplex theater construction.
``George Roberts and I sat down and said, `Look, we've got to change the way we're doing business,''' Kravis said in April at the Waldorf-Astoria, where he was addressing the Committee of 100, a group of Chinese-American leaders that includes cellist Yo-Yo Ma and architect I.M. Pei.
After the Regal Cinemas debacle, KKR created its investment and portfolio management committees, organized its dealmakers into industry groups and formalized 100-day business plans: playbooks that spell out what actions are supposed be completed by specific dates in the early months of a buyout.
Harnessing Greed
Kravis tapped Nelson, a senior vice president of Boston Consulting Group Inc., to build Capstone in 2000.
To run its companies, KKR harnesses the forces that drive financial markets: fear and greed. At ITC, all of the executives that Welch hired also had to invest their own money in the company.
The son of a Kansas laborer, Welch joined Detroit-based DTE Energy Co.'s predecessor, Detroit Edison, in 1971, fresh out of the University of Kansas, where he earned a bachelor's degree in electrical engineering.
When he was put in charge of DTE's power transmission infrastructure in 1999, Welch discovered that it was dilapidated. Transmission corridors were overgrown with vegetation, generators were leaking fuel and breakers were rusted, he says.
``The thing had been lost in the amorphousness of the parent, and it had been run ad hoc,'' Welch says of ITC. Underinvestment in the power grid is a national disgrace, he adds.
ITC Vision
Welch had a vision: A separate ITC would have the incentives to invest in the grid, improve reliability -- and help solve America's energy crisis by enabling renewable energy to be transmitted efficiently. He urged DTE to establish ITC as a separate unit. DTE did, and decided to sell it.
KKR, New York-based Trimaran Capital Partners, the state of Michigan and ITC management teamed up to buy ITC for $610 million. The $650 million financing package consisted of 35 percent in cash and $425 million of term loans.
Regulators wanted ITC to be untangled from its parent in 12 months. At first, Welch had a steel desk -- and no chair or corporate checking account. The local OfficeMax wouldn't even let him buy paper clips on credit.
Welch and KKR set to work. Their first task was to hire 17 executives. KKR required all of them to sink their own money into ITC. Welch offered Edward Rahill, director of planning and corporate development at DTE, a job as chief financial officer - - and gave him less than 24 hours to think it over.
`Long-Term Story'
Rahill, 54, says he ultimately joined for the opportunity to help fix America's crumbling power grid.
``It's the greatest team-building exercise you can have,'' Welch says. ``And that, fundamentally, in my mind, is why KKR is so damned successful: They invest in and motivate people -- they align people.''
Stuart, the former KKR partner, was Kravis's point man on ITC. His job was to explain the company's business plan to state and federal regulators.
``It was a great long-term story,'' says Stuart, 48. ``The grid in the U.S. needs a lot of investment to handle the demands.''
KKR put its contacts to work. Deloitte & Touche USA LLP, KKR's preferred accounting firm, helped ITC set up a new accounting system within four months. London-based Willis Group Holdings Ltd., a former KKR company, arranged insurance for ITC transmission lines.
Top of the List
Law firm Simpson Thacher & Bartlett LLP, whose chairman, Richard Beattie, worked with Kravis on the RJR Nabisco buyout, provided legal advice.
``When you're a KKR company, people come in and put you at the top of their lists,'' Welch says.
Rahill agrees. ``You get the A teams, no if's, and's or but's about it,'' he says.
ITC went public at $23 a share in July 2005. According to a May supplement to KKR's 2006 annual review, the firm initially invested $128.7 million. By the time KKR sold its last shares in February for $316.7 million, it had generated gross proceeds of $664.4 million, or five times its invested capital.
ITC shareholders have made money, too. Through June 27, the stock had posted an annualized return of 40.4 percent since the IPO. Welch's stake, 1.7 percent as of May 14, was worth $30 million as of June 27.
Like Welch, Heidloff at Wincor Nixdorf, the ATM maker, sees KKR as a liberator.
Wincor Buyout
Heidloff joined a predecessor of Wincor Nixdorf in 1983, after graduating from the University of Paderborn with a degree in business administration.
During the '90s, the company missed out on international growth opportunities as part of Munich-based Siemens AG, Heidloff says. While Wincor had 60 percent of the German ATM market, its global share was 8 percent, he says.
Because Siemens was organized by geography and along product lines, country managers could reject Wincor proposals to expand outside Germany.
``I spent two days a week convincing headquarters and country managers to get approval to grow the business,'' Heidloff, 50, says.
In 1999, Heidloff, then CFO, and Karl-Heinz Stiller, CEO at the time, drafted a plan with Siemens's management to set Wincor free. Siemens put Wincor on the block.
KKR teamed up with Goldman Sachs Group Inc. to buy Wincor Nixdorf for 736 million euros ($789 million) in late 1999.
Flying to Frankfurt
As a condition, KKR demanded Heidloff and Stiller stay on. KKR bought 71.3 percent, Goldman Sachs bought 17.8 percent and more than 100 Wincor executives purchased a total of 10.9 percent.
``We didn't want a situation where just two or three people got rich,'' says Heidloff, who became CEO when Stiller retired this year.
In the beginning, KKR's Gilhuly and Johannes Huth, then a managing director, flew weekly to Frankfurt to check on the progress. It was impressive from the start, with cash flow rising 11.2 percent annually between fiscal 2000 and fiscal 2003.
When it became clear that Wincor's retail computer unit was losing money, Gilhuly, Huth and their counterparts at Goldman Sachs told Heidloff it was time to consider a sale or other options.
``They really wanted to be in that business,'' Gilhuly says. ``We turned up the heat.''
Model LBO
The Wincor unit sharpened its focus on high-margin software components and emphasized consulting services. The division, which had a 7.6 million euro loss on a cash flow basis in 2000, earned 12.8 million in 2002.
``They turned out to be an exceptional team,'' Gilhuly, 47, says.
Heidloff says it was a model LBO. ``If you do a budget and deliver every quarter, your life is very easy,'' he says.
Wincor Nixdorf went public in a May 2004 IPO that valued the company at about 1 billion euros. KKR reduced its stake to 28.8 percent.
Heidloff and other Wincor executives largely held on to their stock, figuring KKR was selling too early. They were right. Through June 27, Wincor stock had posted an annualized return of 47.9 percent since its IPO.
Even in the post-Regal Cinemas era, KKR has run into trouble. When acquisitions go sour, KKR steps in -- fast.
Changing Tack
After KKR bought Rockwood Holdings from Laporte Plc in November 2000 for $1.18 billion, putting down $282 million in cash and financing the rest with a mix of loans, a U.S. recession sent prices of Rockwood's chemicals sinking. By late 2001, the company was losing money.
KKR tore up its business plans for Rockwood's various units and drew up new ones. It dispatched Capstone's Eric Daliere and Nelson to set new benchmarks and improve productivity at scores of factories around the world.
KKR was running Rockwood with what it considered interim management. Kravis wanted a new CEO and zeroed in on Ghasemi, who was a former executive director at National Iranian Steel Industries, the country's state-run steel company under the late shah. Ghasemi fled Iran after the 1979 Islamic Revolution and eventually went to work for Redditch, U.K.-based GKN Plc, a maker of car and airplane parts.
Shaking Up Rockwood
When Ghasemi walked into Rockwood's Princeton headquarters in October 2001, a fellow executive apologized for not having prepared an office for him.
``I don't need an office,'' Ghasemi recalls saying.
Then the executive told him that Rockwood hadn't lined up a secretary for its new CEO either.
``I don't need a secretary -- and neither do you,'' Ghasemi said.
Before long, the executive, and his secretary, were gone.
Ghasemi, who has a master's degree in mechanical engineering from Stanford University, says he spent as many as 28 days a month on the road. He visited Rockwood plants around the world to find ways to squeeze costs and boost efficiency.
At a factory in Gonzalez, Texas, he went through plant schematics and figured out that the company could rearrange production lines to operate with fewer people. He ultimately fired 400 people companywide, or 10 percent of the workforce.
``I'm not too shy to say Rockwood exists to make money,'' says Ghasemi, who wears a lapel pin inscribed with Rockwood's motto: ``Cash, Customers, Commitment.''
Ghasemi knew how to fire up a sales force.
Darwinian Management
He offered them a 10 percent cut of any price increases they negotiated on Rockwood chemicals. Lo and behold, prices stopped falling.
The overall strategy was Darwinian. The company would unload any division that wasn't No. 1, No. 2 or No. 3 in its field.
Ghasemi freely tapped into KKR's brain trust. KKR had explored acquiring Frankfurt-based engineering company MG Technologies AG. Ghasemi and KKR used that knowledge when deciding to buy MG Technologies' Dynamit Nobel chemicals unit in 2004 for $1.98 billion. Rockwood and KKR then worked to unload part of that company in 2006.
With Capstone's help, Ghasemi devised spreadsheets so plant managers could keep track of which customers bought what chemicals as well as customer complaints and product returns.
Each month, Ghasemi now thumbs through a thousand-page printout comprising such stats from every plant around the world.
KKR Clout
``That's how you know what's going on at a company,'' Ghasemi says. In all, KKR poured $572.6 million into Rockwood in exchange for common and preferred stock, much of that going to bankroll the purchase of Dynamit Nobel.
In Rockwood's August 2005 IPO, KKR garnered $36.7 million of the proceeds from the redemption of convertible preferred stock it held, plus sundry fees. It also shared $131.9 million with Credit Suisse Group's DLJ merchant bank unit, which had invested $159.4 million in the Dynamit Nobel purchase.
The offering left KKR with 51 percent of the company, which was worth $1.37 billion on June 27. As of that date, the stock had returned an annualized 38.1 percent since the IPO.
KKR uses its clout to help its companies recruit executives in a hurry. After KKR and the Ontario Teachers' Pension Plan bought 90 percent of Yellow Pages Group in November 2002 for 3 billion Canadian dollars ($1.92 billion), KKR's Joseph Bae and Alexander Navab retained Marc Tellier as CEO.
KKR bought Yellow Pages from BCE Inc., Canada's largest telephone company, where Tellier had spent his entire career.
Luring Executives
In late June, three separate groups of investors, one of which included KKR, had either submitted bids for BCE or were considering doing so.
Tellier, 38, says he relied on Capstone and KKR to fix Yellow Pages.
``This was not a well-run business,'' Tellier says. One obvious sign: The Yellow Pages directories bore blue covers because blue was BCE's corporate color.
``The critical element was to get the management team in place,'' says Tellier, whose father, Paul, served as CEO of Bombardier Inc. and Canadian National Railway Co.
Tellier needed a head of sales, a chief information officer, a chief financial officer, a general counsel and a head of human resources. Bae and Navab, members of KKR's communications team, gave five executive search firms one week to come up with plans to find the executives.
Tellier and KKR reviewed the proposals and hired Toronto- based Caldwell Partners International. Four weeks later, Yellow Pages Group had its executives.
Spurring Sales
Tellier says Capstone's Nelson and other consultants helped the company zero in on its customers, set prices for Yellow Pages advertisements and ramp up sales.
Nelson suggested Tellier use a range of variables, from the Canadian CPI to the directories' market penetration in a given region, to help set ad prices. Capstone helped upgrade management software so executives could track sales more effectively.
Today, Tellier can monitor weekly sales by province, sales manager or salesperson. With a click of his computer mouse, he can locate the person who can tell him why sales are up or down in a particular area or category.
Salespeople also began tracking how customers responded to pitches over time. Yellow Pages urged sales reps to push larger ads, which cost $156 a month, rather than smaller ones, which cost $24.
Another IPO
Tellier increased the proportion of salespeople who make face-to-face pitches rather than phone calls. Reps who used to sell six area directories sometimes had the number cut to, say, three. That way they'd be less likely to let sales lag in any one sales region.
Once a week, Tellier parks his GMC Yukon at a local coffee shop and hits the road with one of his 500 salespeople.
``You've got to understand the psyche of a small-business owner,'' Tellier says. ``One hundred percent of the dialogue is helping the customer be more successful.''
Yellow Pages Group went public in July 2003, selling its equity via Yellow Pages Income Fund, an income trust. The structure is similar to that of a real estate investment trust and enables companies to pass on earnings untaxed. The deal took advantage of investors' hunger for high-yielding securities at the time and valued Yellow Pages at C$4.7 billion. Through June 27, Yellow Pages units had returned an annualized 14.4 percent since trading began.
`Having a Ball'
Kravis and Roberts, each man now in his seventh decade, are more powerful than they've ever been. Stuart, the KKR veteran, says his former bosses show no sign of slowing down.
``My sense is, they're having a ball,'' he says.
No party lasts forever. Kravis captured the euphoria of his golden age last November, before financing costs began rising, when he addressed newly minted partners of Goldman Sachs.
At the Ritz-Carlton hotel in lower New York, Kravis told the crowd that KKR and Goldman had worked together and made money together for three decades. Their lucrative partnership would endure, he said.
Kravis paused. ``Just don't do anything to screw it up,'' he added. The partners laughed. As the deals -- and potential dangers -- of the private equity boom keep multiplying, Kravis might want to heed his own advice.
Saturday, June 30, 2007
Friday, June 29, 2007
Emissions news
Emission Permits Rise to Week's High on Expected German Demand
By Mathew Carr
June 28 (Bloomberg) -- European Union emission permits rose to their highest in a week, on speculation demand from proposed German power stations will exceed the permits set aside by the national government, a Deutsche Bank AG analyst said. Rising power prices helped push permits higher.
EU carbon dioxide emission permits for December 2008 gained 93 cents, or 4.3 percent, to close at 22.36 euros ($30.11) a metric ton on the European Climate Exchange in Amsterdam. They earlier traded as high as 22.60 euros a ton, their highest since June 21.
Demand for permits from yet-to-be-built power plants may reach 33 million tons a year in the five years through 2012, said Mark Lewis, a Paris-based emissions analyst at Deutsche Bank. That's 15 million tons a year more than the 18 million tons a year Germany has set aside for new plants, Lewis said today by telephone.
Emission permits sometimes follow German electricity because higher electricity prices make it more profitable for power plants to burn fossil fuels. Germany is the largest electricity market in the EU, home to the biggest greenhouse-gas trading program.
Baseload German power for next year, a European benchmark, rose 20 cents, or 0.4 percent, to 56.30 euros a megawatt hour, according to prices from ICAP Plc.
By Mathew Carr
June 28 (Bloomberg) -- European Union emission permits rose to their highest in a week, on speculation demand from proposed German power stations will exceed the permits set aside by the national government, a Deutsche Bank AG analyst said. Rising power prices helped push permits higher.
EU carbon dioxide emission permits for December 2008 gained 93 cents, or 4.3 percent, to close at 22.36 euros ($30.11) a metric ton on the European Climate Exchange in Amsterdam. They earlier traded as high as 22.60 euros a ton, their highest since June 21.
Demand for permits from yet-to-be-built power plants may reach 33 million tons a year in the five years through 2012, said Mark Lewis, a Paris-based emissions analyst at Deutsche Bank. That's 15 million tons a year more than the 18 million tons a year Germany has set aside for new plants, Lewis said today by telephone.
Emission permits sometimes follow German electricity because higher electricity prices make it more profitable for power plants to burn fossil fuels. Germany is the largest electricity market in the EU, home to the biggest greenhouse-gas trading program.
Baseload German power for next year, a European benchmark, rose 20 cents, or 0.4 percent, to 56.30 euros a megawatt hour, according to prices from ICAP Plc.
Thursday, June 28, 2007
SEC investigates link between hedge fund and private equity
Strange... why is this a big deal? Isn't it already public knowledge that buyout firms often have a separate trading arm operating much likea hedge fund. PE firms are not as regulated as investment banks, so is it any surprise if they make more from hedge fund arm than the actual buyouts?
However that being said, hedging is an integral part of mitigating credit risks for the entire firm. Only thing is... for whom does it ultimately benefits?
SEC Investigating Insider Trading in Credit-Default Swaps
By David Scheer
June 22 (Bloomberg) -- The U.S. Securities and Exchange Commission is examining cases of suspected insider trading in credit-default swaps, expanding the scope of a crackdown on investors' illegal use of confidential information.
``There are investigations looking into that market,'' Walter Ricciardi, a deputy enforcement director at the SEC, said in an interview in New York today. It would be a ``mistake'' to assume U.S. regulators aren't pursuing a case, even if they've never done one like it before, he said.
Prices on credit-default swaps, which insure investors against bond defaults, have surged before leveraged buyouts in the past year, fueling speculation that illegal profiteers are turning to credit derivatives. Federal Reserve Chairman Ben S. Bernanke urged regulators last month to take action to prevent abuses in those markets from undermining investor confidence.
Ricciardi declined to say how long the SEC has been monitoring credit-default swaps and wouldn't identify anyone under investigation.
``Insider trading, in particular in that space, is a priority for us,'' SEC Chairman Christopher Cox said in an interview June 15. Cox stopped short of saying which U.S. regulator, the SEC or the Commodity Futures Trading Commission, has authority to bring a lawsuit.
Prices for contracts linked to Las Vegas-based Harrah's Entertainment Inc. and Nashville, Tennessee-based HCA Inc. rose last year ahead of announcements or news reports that those companies were takeover targets.
In March, prices for swaps based on First Data Corp.'s bonds climbed 62 percent in the two weeks before Kohlberg Kravis Roberts & Co. bid for the company on April 2.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. The contracts, typically expiring after five years, pay if a borrower fails to meet its obligations on time.
Hedge funds and other investors have turned to the contracts to make bets because they're cheaper and easier to trade than the securities on which they're based.
However that being said, hedging is an integral part of mitigating credit risks for the entire firm. Only thing is... for whom does it ultimately benefits?
SEC Investigating Insider Trading in Credit-Default Swaps
By David Scheer
June 22 (Bloomberg) -- The U.S. Securities and Exchange Commission is examining cases of suspected insider trading in credit-default swaps, expanding the scope of a crackdown on investors' illegal use of confidential information.
``There are investigations looking into that market,'' Walter Ricciardi, a deputy enforcement director at the SEC, said in an interview in New York today. It would be a ``mistake'' to assume U.S. regulators aren't pursuing a case, even if they've never done one like it before, he said.
Prices on credit-default swaps, which insure investors against bond defaults, have surged before leveraged buyouts in the past year, fueling speculation that illegal profiteers are turning to credit derivatives. Federal Reserve Chairman Ben S. Bernanke urged regulators last month to take action to prevent abuses in those markets from undermining investor confidence.
Ricciardi declined to say how long the SEC has been monitoring credit-default swaps and wouldn't identify anyone under investigation.
``Insider trading, in particular in that space, is a priority for us,'' SEC Chairman Christopher Cox said in an interview June 15. Cox stopped short of saying which U.S. regulator, the SEC or the Commodity Futures Trading Commission, has authority to bring a lawsuit.
Prices for contracts linked to Las Vegas-based Harrah's Entertainment Inc. and Nashville, Tennessee-based HCA Inc. rose last year ahead of announcements or news reports that those companies were takeover targets.
In March, prices for swaps based on First Data Corp.'s bonds climbed 62 percent in the two weeks before Kohlberg Kravis Roberts & Co. bid for the company on April 2.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. The contracts, typically expiring after five years, pay if a borrower fails to meet its obligations on time.
Hedge funds and other investors have turned to the contracts to make bets because they're cheaper and easier to trade than the securities on which they're based.
Wednesday, June 27, 2007
Yen correction may be temporary as carry trades prevail
Hot money bounded for emerging market equities and other assets.
Weakening yen and dollar contributes to growth of M3 in emerging markets. A temporary boon for equities?
Yen Rises Most in 10 Weeks as Investors Reduce Carry Trades
By David McIntyre and Kosuke Goto
June 27 (Bloomberg) -- The yen rose the most in 10 weeks against the dollar as investors pared holdings of emerging market bonds and stocks funded by loans in the currency.
Japan's yen gained against the Indonesian rupiah and Malaysian ringgit after Finance Minister Koji Omi yesterday stressed the risk of one-way foreign-exchange bets. It also climbed against the New Zealand dollar after that nation's central bank Deputy Governor Grant Spencer echoed Omi's comments and said traders should expect further market intervention.
``Concern about declines in Asian equities are a good chance to unwind bets for yen weakness,'' said Nobuo Ibaraki, deputy general manager of foreign exchange at Nomura Trust & Banking Co. Ltd., a unit of Japan's largest brokerage. ``Traders are wary of selling the yen following comments from Japanese officials.''
The yen rose to 164.92 per euro at 6:56 a.m. in London from 165.83 late in New York yesterday. Japan's currency climbed to 122.70 per dollar from 123.26, its biggest one-day gain since April 17. It may rise to 165 per euro and 122.70 against the dollar today, Ibaraki said.
Japan's currency increased the most in three weeks against New Zealand's dollar to 93.84 yen from 94.41 yen yesterday.
Not One-Way Bet
``The exchange rate is not a one-way bet,'' Deputy Governor Grant Spencer said in an article prepared for publication and e- mailed to Bloomberg News today. ``Foreign exchange intervention is an ongoing process.''
The yen appreciated 1 percent against Australia's dollar, its biggest gain since April 19, to trade at 103.47 after reaching as high as 103.38, the strongest since June 15.
Investors' confidence to put on so-called carry trades, in which they borrow at Japan's low interest rates to buy higher- yielding assets elsewhere, may ebb as the Morgan Stanley Capital International Asia-Pacific index of leading regional shares fell by the most in almost three weeks. The Standard & Poor's 500 Index is set for the biggest monthly loss in more than a year.
Gains in the yen may be limited by speculation fund managers will convert it into foreign currencies as they prepare to launch investment trusts composed of overseas assets.
Finance companies will market more than 1 trillion yen ($8.1 billion) of foreign-currency investment trusts before the end of June, according to data compiled by Bloomberg. Japan's benchmark rate is the lowest in the industrialized world, reducing the appeal of domestic assets.
``We're going to see carry trades for a long time,'' Gabriel de Kock, chief currency economist in New York at Citigroup Global Markets, said at a conference on foreign exchange in Singapore. ``The yen will be a dog.''
The yen will drop to 125 per dollar by year-end as Japan's 0.5 percent rate encourages investor outflows, said Daisaku Ueno at Nomura Securities Co.
Narrow Range
The narrowest monthly trading range in more than six years in April will prompt Japanese investors to seek higher-yielding foreign assets, pushing down the yen, Ueno said.
The yen that month traded within the smallest band since Oct. 2000, according to data tracked by Bloomberg. The spread between the high of 117.41 yen on April 2 and the low of 119.87 yen on April 16 was 2.46 yen. The range in May was 2.90 yen. The currency this month has had the range of 3.36 yen. The monthly trading range has averaged 4.8 yen since Jan, 2000.
`Likely to Prevail'
``Dollar-yen doesn't move as it used to,'' said Ueno, who in March was named best foreign-exchange analyst in the 19th annual Nikkei analyst rankings. ``In such a situation, the yen carry trade is likely to prevail. The yen's weak trend won't change.''
The dollar also declined against the yen on a report that's likely to show U.S. durable goods orders fell 1 percent last month, the most since January, after rising a revised 0.8 percent in April, according to the median forecast of 73 economists surveyed by Bloomberg.
``There's a real risk that we continue to see U.S. data disappoint,'' said Jonathan Cavanagh, a currency strategist at Westpac Banking Corp. in Sydney. ``The dollar has further to go on the downside.''
The euro's rally from a June 13 low may stall, according to technical charts traders use to predict currency movements, said Yuji Saito, head of the foreign-exchange sales department at Societe Generale SA in Tokyo.
The failure of the euro to sustain a break above so-called resistance at $1.3470 for the three previous days suggests further gains may be limited, Saito said. Resistance is a level where sell orders may be clustered.
``The euro looks bearish on the charts,'' he said. ``The euro may pull back to $1.3400 today,'' from $1.3439.
The $1.3470 level represents a 50 percent retracement of the euro's fall to the June 13 low from the April 27 high of $1.3681, based on a series of numbers known as the Fibonacci sequence.
Weakening yen and dollar contributes to growth of M3 in emerging markets. A temporary boon for equities?
Yen Rises Most in 10 Weeks as Investors Reduce Carry Trades
By David McIntyre and Kosuke Goto
June 27 (Bloomberg) -- The yen rose the most in 10 weeks against the dollar as investors pared holdings of emerging market bonds and stocks funded by loans in the currency.
Japan's yen gained against the Indonesian rupiah and Malaysian ringgit after Finance Minister Koji Omi yesterday stressed the risk of one-way foreign-exchange bets. It also climbed against the New Zealand dollar after that nation's central bank Deputy Governor Grant Spencer echoed Omi's comments and said traders should expect further market intervention.
``Concern about declines in Asian equities are a good chance to unwind bets for yen weakness,'' said Nobuo Ibaraki, deputy general manager of foreign exchange at Nomura Trust & Banking Co. Ltd., a unit of Japan's largest brokerage. ``Traders are wary of selling the yen following comments from Japanese officials.''
The yen rose to 164.92 per euro at 6:56 a.m. in London from 165.83 late in New York yesterday. Japan's currency climbed to 122.70 per dollar from 123.26, its biggest one-day gain since April 17. It may rise to 165 per euro and 122.70 against the dollar today, Ibaraki said.
Japan's currency increased the most in three weeks against New Zealand's dollar to 93.84 yen from 94.41 yen yesterday.
Not One-Way Bet
``The exchange rate is not a one-way bet,'' Deputy Governor Grant Spencer said in an article prepared for publication and e- mailed to Bloomberg News today. ``Foreign exchange intervention is an ongoing process.''
The yen appreciated 1 percent against Australia's dollar, its biggest gain since April 19, to trade at 103.47 after reaching as high as 103.38, the strongest since June 15.
Investors' confidence to put on so-called carry trades, in which they borrow at Japan's low interest rates to buy higher- yielding assets elsewhere, may ebb as the Morgan Stanley Capital International Asia-Pacific index of leading regional shares fell by the most in almost three weeks. The Standard & Poor's 500 Index is set for the biggest monthly loss in more than a year.
Gains in the yen may be limited by speculation fund managers will convert it into foreign currencies as they prepare to launch investment trusts composed of overseas assets.
Finance companies will market more than 1 trillion yen ($8.1 billion) of foreign-currency investment trusts before the end of June, according to data compiled by Bloomberg. Japan's benchmark rate is the lowest in the industrialized world, reducing the appeal of domestic assets.
``We're going to see carry trades for a long time,'' Gabriel de Kock, chief currency economist in New York at Citigroup Global Markets, said at a conference on foreign exchange in Singapore. ``The yen will be a dog.''
The yen will drop to 125 per dollar by year-end as Japan's 0.5 percent rate encourages investor outflows, said Daisaku Ueno at Nomura Securities Co.
Narrow Range
The narrowest monthly trading range in more than six years in April will prompt Japanese investors to seek higher-yielding foreign assets, pushing down the yen, Ueno said.
The yen that month traded within the smallest band since Oct. 2000, according to data tracked by Bloomberg. The spread between the high of 117.41 yen on April 2 and the low of 119.87 yen on April 16 was 2.46 yen. The range in May was 2.90 yen. The currency this month has had the range of 3.36 yen. The monthly trading range has averaged 4.8 yen since Jan, 2000.
`Likely to Prevail'
``Dollar-yen doesn't move as it used to,'' said Ueno, who in March was named best foreign-exchange analyst in the 19th annual Nikkei analyst rankings. ``In such a situation, the yen carry trade is likely to prevail. The yen's weak trend won't change.''
The dollar also declined against the yen on a report that's likely to show U.S. durable goods orders fell 1 percent last month, the most since January, after rising a revised 0.8 percent in April, according to the median forecast of 73 economists surveyed by Bloomberg.
``There's a real risk that we continue to see U.S. data disappoint,'' said Jonathan Cavanagh, a currency strategist at Westpac Banking Corp. in Sydney. ``The dollar has further to go on the downside.''
The euro's rally from a June 13 low may stall, according to technical charts traders use to predict currency movements, said Yuji Saito, head of the foreign-exchange sales department at Societe Generale SA in Tokyo.
The failure of the euro to sustain a break above so-called resistance at $1.3470 for the three previous days suggests further gains may be limited, Saito said. Resistance is a level where sell orders may be clustered.
``The euro looks bearish on the charts,'' he said. ``The euro may pull back to $1.3400 today,'' from $1.3439.
The $1.3470 level represents a 50 percent retracement of the euro's fall to the June 13 low from the April 27 high of $1.3681, based on a series of numbers known as the Fibonacci sequence.
Popular institutional small-caps investment strategy revealed!
Now you can be a fund manager too.
Noticed this part of this strategy in play during my time in equities. Established brokerages like Merrill Lynch usually pick their stories from the ramblings of less established local brokerages. Small local brokerages could be touting the stock to the skies, but if the Merrills do not pick up the story, price appreciation remains controlled. Cover stories are picked up with great timing, when it becomes apparent that the small caps have been awarded large contracts which would no doubt be a positive catalyst for appreciation.
Finally, small caps stocks are really a derivative of large caps, abeit an imperfect one.
There are greater rewards (and risks) because of their exposure to the fortunes of larger companies from which they derive their business. Sudden spikes in business dramatically improves utilization and ASPs for small caps.
However as a result of this imperfection, movements are largely unpredictable to the general public.
Mobius, Gordon-James Focus on `Small Caps' in Emerging Markets
By Alexander Ragir
June 26 (Bloomberg) -- David Semple recalls sweating in the Singapore sun as he lugged his briefcase through the streets, looking for Ezra Holdings Ltd.'s office building.
Semple, whose Van Eck Emerging Markets Fund had the second- best performance of any U.S.-based emerging market stock fund in the past three years, was pounding the pavement to make up for the lack of published research on Singapore's less-traded stocks. He found the bargain he was seeking in Ezra Holdings, a shipping- service provider for oil companies whose shares are up fivefold since he bought them in July 2005.
``They were ready for my questions, they had the answers, they knew what I needed to know,'' Semple, 43, said as he leaned back in the chair in his New York office. ``That was a classic case of a company where you saw it when it was relatively small and it hit the sweet spot.''
Investors Mark Mobius at Templeton Asset Management Ltd. and Mark Gordon-James at Aberdeen Asset Management are employing Semple's strategy. They have set up funds in the past year to invest in stocks with capitalization of less than $2.5 billion, which may have greater potential for gains than the bigger companies that make up developing countries' equity benchmarks.
Kenneth L. Fisher, chairman of Fisher Investments in Woodside, California, says he is skeptical of the strategy because the shares are likely to lose the most in an economic slowdown.
``You don't want to have much in this,'' said Fisher, who oversees $41 billion. ``If you have more than a couple of percent in this, it's too much. This is just a return kicker in a bull market, which will be a return killer in the next bear market.''
Markets in Transition
Merrill Lynch said in a June 1 report that emerging markets are in a ``transition,'' during which profits of smaller companies will rise the fastest. Shares of 100 so-called small cap emerging market companies in a Merrill Lynch index surged 40 percent this year, more than double the gains of the Morgan Stanley Capital International emerging market index.
MSCI Barra, a unit of Morgan Stanley that provides the MSCI regional indexes, plans to introduce an Emerging Market Small Cap gauge next June, focusing on companies with market values of less than $2 billion.
For Semple, who helps manage $5 billion at Van Eck Associates, the ``sweet spot'' comes when larger investors and brokerages pick up coverage of a stock he owns, enabling him to ``make an awful lot of money, very quickly.''
Semple bought Ezra Holdings for S$1.08 a share when only one analyst covered the company, on July 22, 2005. Since then, four investment banks have initiated coverage, including JPMorgan Chase & Co., and the stock trades at S$5.55.
Track Record
About half of Semple's $94 million Van Eck Emerging Markets Fund is invested in shares of companies with a market value of less than $1 billion. The fund rose 70 percent in the past 12 months.
Semple's fund returned an average of 46 percent in the past three years, the second-best performance of 100 U.S.-based emerging market equity funds. Santa Monica, California-based Dimensional Fund Advisor's DFA Emerging Markets Value Fund was the best performer, with an average yearly gain of 48 percent. Karen Umland, who manages this fund, declined to comment on her investment strategies, a spokesman said.
Gordon-James, who helps manage $8.7 billion in emerging market stocks, started his $200 million Aberdeen Global Emerging Markets Smaller Companies Fund in March to invest in companies with a market value less than $2.5 billion. Mobius, who oversees $30 billion in emerging markets stocks, began his $44 million Templeton Emerging Market Small Cap Fund last October, to buy shares of companies with up to $1 billion in market value.
Biggest Holdings
South African goods wholesaler Massmart Holdings Ltd., Mexican homebuilder Sare Holding SAB and Hungarian hotel chain Danubius Hotel and Spa Nyrt are the largest holdings in the Aberdeen smaller-company fund.
The risk of the strategy is that emerging market countries are more prone to political and economic risk, because they lack established democratic institutions, said Bill Fries, who helps manage $43 billion at Thornburg Investment Inc. in Santa Fe, New Mexico, and has 25 percent of his holdings in emerging markets.
``It's easy getting into some of these names, but if ever there's a problem, getting out is very, very difficult,'' said Marc Halperin, who helps manage $2 billion at Federated Global Investment in New York. ``The resources and finances just to get out there and see these companies is also too much.''
Aberdeen has 27 emerging market fund managers, Gordon-James said. The small caps have less debt and are more insulated from fluctuations in the global economy than larger emerging market companies, he said. `
``It doesn't have to be more risky,'' he said. ``What's the point of narrowing yourself to large caps where, by definition, you're forced to invest in many global industries like mining, oil and technology?''
Profit Outlook
Earnings growth for companies likely to be in the new MSCI small-cap index will be 30 percent in 2008, almost twice the estimate for the MSCI Emerging market index, according to the Merrill Lynch report titled ``Bullish on EM small cap.'' Shares in both indexes trade at about the same price, at 12 times 2008 earnings, Merrill said.
``Small caps are like a farmer's crop,'' said Don Elefson, at U.S. Trust Co. of New York, whose $1.2 billion Excelsior Emerging Markets fund holds 20 percent to 30 percent in shares of companies with a market value of less than $2.5 billion. ``If the soil is bad, they're not going to grow; if there are severe storms coming in, they're going to wreck the crop.''
The stocks currently present an opportunity, he said.
``Firms that get into this early will do very well,'' he said. ``Emerging market small-caps will be one of the single best asset classes we've ever seen.''
Noticed this part of this strategy in play during my time in equities. Established brokerages like Merrill Lynch usually pick their stories from the ramblings of less established local brokerages. Small local brokerages could be touting the stock to the skies, but if the Merrills do not pick up the story, price appreciation remains controlled. Cover stories are picked up with great timing, when it becomes apparent that the small caps have been awarded large contracts which would no doubt be a positive catalyst for appreciation.
Finally, small caps stocks are really a derivative of large caps, abeit an imperfect one.
There are greater rewards (and risks) because of their exposure to the fortunes of larger companies from which they derive their business. Sudden spikes in business dramatically improves utilization and ASPs for small caps.
However as a result of this imperfection, movements are largely unpredictable to the general public.
Mobius, Gordon-James Focus on `Small Caps' in Emerging Markets
By Alexander Ragir
June 26 (Bloomberg) -- David Semple recalls sweating in the Singapore sun as he lugged his briefcase through the streets, looking for Ezra Holdings Ltd.'s office building.
Semple, whose Van Eck Emerging Markets Fund had the second- best performance of any U.S.-based emerging market stock fund in the past three years, was pounding the pavement to make up for the lack of published research on Singapore's less-traded stocks. He found the bargain he was seeking in Ezra Holdings, a shipping- service provider for oil companies whose shares are up fivefold since he bought them in July 2005.
``They were ready for my questions, they had the answers, they knew what I needed to know,'' Semple, 43, said as he leaned back in the chair in his New York office. ``That was a classic case of a company where you saw it when it was relatively small and it hit the sweet spot.''
Investors Mark Mobius at Templeton Asset Management Ltd. and Mark Gordon-James at Aberdeen Asset Management are employing Semple's strategy. They have set up funds in the past year to invest in stocks with capitalization of less than $2.5 billion, which may have greater potential for gains than the bigger companies that make up developing countries' equity benchmarks.
Kenneth L. Fisher, chairman of Fisher Investments in Woodside, California, says he is skeptical of the strategy because the shares are likely to lose the most in an economic slowdown.
``You don't want to have much in this,'' said Fisher, who oversees $41 billion. ``If you have more than a couple of percent in this, it's too much. This is just a return kicker in a bull market, which will be a return killer in the next bear market.''
Markets in Transition
Merrill Lynch said in a June 1 report that emerging markets are in a ``transition,'' during which profits of smaller companies will rise the fastest. Shares of 100 so-called small cap emerging market companies in a Merrill Lynch index surged 40 percent this year, more than double the gains of the Morgan Stanley Capital International emerging market index.
MSCI Barra, a unit of Morgan Stanley that provides the MSCI regional indexes, plans to introduce an Emerging Market Small Cap gauge next June, focusing on companies with market values of less than $2 billion.
For Semple, who helps manage $5 billion at Van Eck Associates, the ``sweet spot'' comes when larger investors and brokerages pick up coverage of a stock he owns, enabling him to ``make an awful lot of money, very quickly.''
Semple bought Ezra Holdings for S$1.08 a share when only one analyst covered the company, on July 22, 2005. Since then, four investment banks have initiated coverage, including JPMorgan Chase & Co., and the stock trades at S$5.55.
Track Record
About half of Semple's $94 million Van Eck Emerging Markets Fund is invested in shares of companies with a market value of less than $1 billion. The fund rose 70 percent in the past 12 months.
Semple's fund returned an average of 46 percent in the past three years, the second-best performance of 100 U.S.-based emerging market equity funds. Santa Monica, California-based Dimensional Fund Advisor's DFA Emerging Markets Value Fund was the best performer, with an average yearly gain of 48 percent. Karen Umland, who manages this fund, declined to comment on her investment strategies, a spokesman said.
Gordon-James, who helps manage $8.7 billion in emerging market stocks, started his $200 million Aberdeen Global Emerging Markets Smaller Companies Fund in March to invest in companies with a market value less than $2.5 billion. Mobius, who oversees $30 billion in emerging markets stocks, began his $44 million Templeton Emerging Market Small Cap Fund last October, to buy shares of companies with up to $1 billion in market value.
Biggest Holdings
South African goods wholesaler Massmart Holdings Ltd., Mexican homebuilder Sare Holding SAB and Hungarian hotel chain Danubius Hotel and Spa Nyrt are the largest holdings in the Aberdeen smaller-company fund.
The risk of the strategy is that emerging market countries are more prone to political and economic risk, because they lack established democratic institutions, said Bill Fries, who helps manage $43 billion at Thornburg Investment Inc. in Santa Fe, New Mexico, and has 25 percent of his holdings in emerging markets.
``It's easy getting into some of these names, but if ever there's a problem, getting out is very, very difficult,'' said Marc Halperin, who helps manage $2 billion at Federated Global Investment in New York. ``The resources and finances just to get out there and see these companies is also too much.''
Aberdeen has 27 emerging market fund managers, Gordon-James said. The small caps have less debt and are more insulated from fluctuations in the global economy than larger emerging market companies, he said. `
``It doesn't have to be more risky,'' he said. ``What's the point of narrowing yourself to large caps where, by definition, you're forced to invest in many global industries like mining, oil and technology?''
Profit Outlook
Earnings growth for companies likely to be in the new MSCI small-cap index will be 30 percent in 2008, almost twice the estimate for the MSCI Emerging market index, according to the Merrill Lynch report titled ``Bullish on EM small cap.'' Shares in both indexes trade at about the same price, at 12 times 2008 earnings, Merrill said.
``Small caps are like a farmer's crop,'' said Don Elefson, at U.S. Trust Co. of New York, whose $1.2 billion Excelsior Emerging Markets fund holds 20 percent to 30 percent in shares of companies with a market value of less than $2.5 billion. ``If the soil is bad, they're not going to grow; if there are severe storms coming in, they're going to wreck the crop.''
The stocks currently present an opportunity, he said.
``Firms that get into this early will do very well,'' he said. ``Emerging market small-caps will be one of the single best asset classes we've ever seen.''
Tuesday, June 26, 2007
International trade faces capacity challenge from ports and intermodel infrastructure
The gist of the article suggests that developing new port capacity may not come easily in Europe and US with regulatory constraints. Rail infrastructure and freight constraints in the US may be limiting faster growth in international trade.
Are ports the choke point in the supply chain?
by John Fossey
(Containerization International) Could ports be the catalyst for a change in the supply chain as we know it today? At the most extreme could ports actually lead to a reversal in the globalisation process and lead to companies sourcing goods from nearer to home?
The latter scenario would be dream come true for the environmentalists who blame globalisation and therefore, indirectly, containerisation, for rising levels of pollution.
Port congestion is nothing new. But until 2004, the problems were largely confined to the developing world and countries throughout Africa, South America and southern Asia.
Poor investment, inefficient terminal management systems, which were largely geared to the conventional cargo era rather than containers, plus inferior customs clearance procedures, meant cargo would sit on the docks for ages and ships would have to wait at the anchorage. Waiting times could run to several weeks.
Then in 2004, ports such as Los Angeles and Long Beach in the US, Rotterdam and Antwerp in Europe and even Singapore – all bastions of ongoing and huge capital investment programmes and use of the most modern equipment – suffered the unmentionable; congestion.
At times, vessels were forced to wait outside of the two California ports for more than a week before they could be handled, retailers started to see their shelves empty of goods and manufacturers had to reschedule some of their production programmes.
The situation was blamed on several factors:
· The phasing in of the first super generation post-panamax ships (8,000TEU plus), which meant a significant increase in import/export exchanges at the terminal
· Poor cargo forecasting by the ports which affected terminal management efficiency
In fact all analysts/economists were guilty of underestimating just how much cargo would be shipped out of China and the role that the country would play in global commerce, following its joining of the WTO in November 2001.
Pure and simply the ports were not prepared for the surge in cargo volumes and everybody involved in the supply chain suffered. The experience served to illustrate just what an important ‘cog’ in the supply chain the marine terminal is.
Although the situation has improved as a result of new handling equipment being purchased, additional terminal capacity developed and extra labour recruited, many ports are on a ‘knife edge’ when it comes to congestion.
Moreover, vessels, one of the causes of the 2004 bottlenecks, are getting bigger. MSC, CMA CGM, Zim Integrated Shipping Service and Hanjin Shipping will all take delivery of vessels loading in excess of 9,500TEU over the next three years. And there are still more of Maersk’s E-class 11,000TEU monsters to be delivered.
Principally, this new tonnage is aimed at moving those expanding Chinese exports more quickly to consumer markets in Europe and North America.
However, this is something that the authors of a new report published by the Boston Consulting Group say will become increasingly challenging. They suggest that Congestion at North America's West Coast ports and continuing capacity problems at major European ports have complicated the China sourcing equation to such an extent that companies need to consider alternatives.
In a report entitled ‘Surviving the China Riptide: How to Profit from the Supply Chain Bottleneck’, George Stalk Jr and Kevin Waddell, write: ‘Companies in both regions need to look closely at the effects transportation bottlenecks can have on their profits and re-evaluate their manufacturing and distribution assumptions.
‘With no solution in sight, many US companies may be better off manufacturing in Mexico or at home, though labor and other costs are significantly higher than in China. Similarly, West European companies that now source from China may want to switch all or part of their manufacturing operations to central and eastern Europe. In their rush to source from China, many companies are blindly walking into a strategic risk.’
Stalk and Waddell add: ‘The risk is thinking that sourcing from China will result in lower product costs, when in reality the supply chain dynamics will, in many cases, drive up overall costs and reduce profitability.’
In particular, the analysts were concerned about the situation in the US, which they claimed was a landside infrastructure issue too. ‘Existing rail infrastructure to disperse the flood of goods from China is also being strained, with freight out of Los Angeles and Long Beach [America's busiest ports] already very near capacity and freight out of Oakland, Seattle and Tacoma expected to reach capacity in the next couple of years,’ said Stalk and Waddell. ’With no major projects to expand US rail capacity currently on the drawing board, this problem will worsen over time.’
Indeed, they referred to the problems in the US to be the equivalent of ‘a giant non-tariff trade barrier.’
In part, the report appears quite alarmist, particularly as other consultants, including teams at Global Insight have suggested that this year’s transpacific eastbound peak season period should pass without incident with plenty of container-handling capacity in place at US west coast ports.
However, it must be borne in mind that new container terminals can take years to build because of the increasingly onerous planning and environmental permits that are needed. In Europe and the US it can take as long as eight, even 10 years, to develop a new cargo-handling facility, for instance. Hence, unlike a ship where the lead time between ordering and delivery is three years, there is no quick fix to the problems being outlined by Stalk and Waddell.
Clearly, there are some recent incidents that highlight just how tight the situation is. Strikes last year and earlier this year in Rotterdam caused backlogs at ports all over northern Europe and resulted in ocean carriers’ schedules being heavily disrupted.
Interruptions like this are a further cost to companies and another reason why outsourcing does not necessarily save all the costs it is supposed to do. Moreover, it can damage client/customer relationships and affect future business opportunities.
Outsourcing to China, or for that matter to India and/or Vietnam, is, therefore, not just a simple case of looking at labour savings of 20 to 30 times that of western Europeans or Americans, but increasingly in taking into account costs associated with a malfunctioning supply chain.
It is for this reason that Stalk and Waddell suggest companies consider a different set of options in the future, including:
· Bring manufacturing home.
· Build ‘land-side’ capacity at ports not yet overwhelmed by congestion (a solution that is probably more applicable in Europe than the US, where environmentalists routinely lobby against the expansion of existing facilities).
· Aggressively manage their China-based supply chain, ‘looking for ways to squeeze time from it that competitors haven't identified or exploited.’
· Explore shipping alternatives, such as air freight, ‘that may appear costly but may actually lower overall expenditures by reducing hidden costs.’
· Invest in ‘premiums’ and ‘capabilities’ - paying higher prices, for example, for priority service improving the company's own abilities to move goods quickly and efficiently past or around congestion.
· Diversify supply with ‘multiple suppliers and supply points’ or produce critical components and products domestically, accepting higher production costs as a tradeoff for lower supply-chain costs and reliable delivery schedules.
Clearly, for US-based manufacturers/buyers, Mexico and the Caribbean/Central America might offer some options, whereas in Europe, Hungary, the Czech Republic, Poland and the Baltic States (Estonia, Lithuania and Latvia) could prove attractive. In addition, to manufacturing costs being on average only a third to a fifth of those in the US and western Europe, transit times are significantly faster (just two to four days) and those congested ports can be avoided.
Stalk and Waddell concluded: ‘Success depends on providing customers what they want and when they want it.’
For the liner shipping and ports’ sectors the future looks exceptionally challenging, but failure to deal with the issues and ensure that sufficient capacity is available at the heart of the supply chain could threaten global trade itself.
Are ports the choke point in the supply chain?
by John Fossey
(Containerization International) Could ports be the catalyst for a change in the supply chain as we know it today? At the most extreme could ports actually lead to a reversal in the globalisation process and lead to companies sourcing goods from nearer to home?
The latter scenario would be dream come true for the environmentalists who blame globalisation and therefore, indirectly, containerisation, for rising levels of pollution.
Port congestion is nothing new. But until 2004, the problems were largely confined to the developing world and countries throughout Africa, South America and southern Asia.
Poor investment, inefficient terminal management systems, which were largely geared to the conventional cargo era rather than containers, plus inferior customs clearance procedures, meant cargo would sit on the docks for ages and ships would have to wait at the anchorage. Waiting times could run to several weeks.
Then in 2004, ports such as Los Angeles and Long Beach in the US, Rotterdam and Antwerp in Europe and even Singapore – all bastions of ongoing and huge capital investment programmes and use of the most modern equipment – suffered the unmentionable; congestion.
At times, vessels were forced to wait outside of the two California ports for more than a week before they could be handled, retailers started to see their shelves empty of goods and manufacturers had to reschedule some of their production programmes.
The situation was blamed on several factors:
· The phasing in of the first super generation post-panamax ships (8,000TEU plus), which meant a significant increase in import/export exchanges at the terminal
· Poor cargo forecasting by the ports which affected terminal management efficiency
In fact all analysts/economists were guilty of underestimating just how much cargo would be shipped out of China and the role that the country would play in global commerce, following its joining of the WTO in November 2001.
Pure and simply the ports were not prepared for the surge in cargo volumes and everybody involved in the supply chain suffered. The experience served to illustrate just what an important ‘cog’ in the supply chain the marine terminal is.
Although the situation has improved as a result of new handling equipment being purchased, additional terminal capacity developed and extra labour recruited, many ports are on a ‘knife edge’ when it comes to congestion.
Moreover, vessels, one of the causes of the 2004 bottlenecks, are getting bigger. MSC, CMA CGM, Zim Integrated Shipping Service and Hanjin Shipping will all take delivery of vessels loading in excess of 9,500TEU over the next three years. And there are still more of Maersk’s E-class 11,000TEU monsters to be delivered.
Principally, this new tonnage is aimed at moving those expanding Chinese exports more quickly to consumer markets in Europe and North America.
However, this is something that the authors of a new report published by the Boston Consulting Group say will become increasingly challenging. They suggest that Congestion at North America's West Coast ports and continuing capacity problems at major European ports have complicated the China sourcing equation to such an extent that companies need to consider alternatives.
In a report entitled ‘Surviving the China Riptide: How to Profit from the Supply Chain Bottleneck’, George Stalk Jr and Kevin Waddell, write: ‘Companies in both regions need to look closely at the effects transportation bottlenecks can have on their profits and re-evaluate their manufacturing and distribution assumptions.
‘With no solution in sight, many US companies may be better off manufacturing in Mexico or at home, though labor and other costs are significantly higher than in China. Similarly, West European companies that now source from China may want to switch all or part of their manufacturing operations to central and eastern Europe. In their rush to source from China, many companies are blindly walking into a strategic risk.’
Stalk and Waddell add: ‘The risk is thinking that sourcing from China will result in lower product costs, when in reality the supply chain dynamics will, in many cases, drive up overall costs and reduce profitability.’
In particular, the analysts were concerned about the situation in the US, which they claimed was a landside infrastructure issue too. ‘Existing rail infrastructure to disperse the flood of goods from China is also being strained, with freight out of Los Angeles and Long Beach [America's busiest ports] already very near capacity and freight out of Oakland, Seattle and Tacoma expected to reach capacity in the next couple of years,’ said Stalk and Waddell. ’With no major projects to expand US rail capacity currently on the drawing board, this problem will worsen over time.’
Indeed, they referred to the problems in the US to be the equivalent of ‘a giant non-tariff trade barrier.’
In part, the report appears quite alarmist, particularly as other consultants, including teams at Global Insight have suggested that this year’s transpacific eastbound peak season period should pass without incident with plenty of container-handling capacity in place at US west coast ports.
However, it must be borne in mind that new container terminals can take years to build because of the increasingly onerous planning and environmental permits that are needed. In Europe and the US it can take as long as eight, even 10 years, to develop a new cargo-handling facility, for instance. Hence, unlike a ship where the lead time between ordering and delivery is three years, there is no quick fix to the problems being outlined by Stalk and Waddell.
Clearly, there are some recent incidents that highlight just how tight the situation is. Strikes last year and earlier this year in Rotterdam caused backlogs at ports all over northern Europe and resulted in ocean carriers’ schedules being heavily disrupted.
Interruptions like this are a further cost to companies and another reason why outsourcing does not necessarily save all the costs it is supposed to do. Moreover, it can damage client/customer relationships and affect future business opportunities.
Outsourcing to China, or for that matter to India and/or Vietnam, is, therefore, not just a simple case of looking at labour savings of 20 to 30 times that of western Europeans or Americans, but increasingly in taking into account costs associated with a malfunctioning supply chain.
It is for this reason that Stalk and Waddell suggest companies consider a different set of options in the future, including:
· Bring manufacturing home.
· Build ‘land-side’ capacity at ports not yet overwhelmed by congestion (a solution that is probably more applicable in Europe than the US, where environmentalists routinely lobby against the expansion of existing facilities).
· Aggressively manage their China-based supply chain, ‘looking for ways to squeeze time from it that competitors haven't identified or exploited.’
· Explore shipping alternatives, such as air freight, ‘that may appear costly but may actually lower overall expenditures by reducing hidden costs.’
· Invest in ‘premiums’ and ‘capabilities’ - paying higher prices, for example, for priority service improving the company's own abilities to move goods quickly and efficiently past or around congestion.
· Diversify supply with ‘multiple suppliers and supply points’ or produce critical components and products domestically, accepting higher production costs as a tradeoff for lower supply-chain costs and reliable delivery schedules.
Clearly, for US-based manufacturers/buyers, Mexico and the Caribbean/Central America might offer some options, whereas in Europe, Hungary, the Czech Republic, Poland and the Baltic States (Estonia, Lithuania and Latvia) could prove attractive. In addition, to manufacturing costs being on average only a third to a fifth of those in the US and western Europe, transit times are significantly faster (just two to four days) and those congested ports can be avoided.
Stalk and Waddell concluded: ‘Success depends on providing customers what they want and when they want it.’
For the liner shipping and ports’ sectors the future looks exceptionally challenging, but failure to deal with the issues and ensure that sufficient capacity is available at the heart of the supply chain could threaten global trade itself.
Monday, June 25, 2007
BIS expects global interest rates to rise amidst inflationary concerns
Interest Rates Will Rise in `Golden Age' of Growth, BIS Says
By Gabi Thesing
June 25 (Bloomberg) -- Central banks will need to continue raising interest rates to quell inflation as the ``golden age'' of global economic expansion continues, the Bank for International Settlements said.
``Inflationary pressures might turn out to be more significant than anticipated,'' BIS General Manager Malcolm Knight told a press conference in Basel, Switzerland, yesterday. ``Authorities should continue gradually to normalize the level of policy interest rates'' as the global economy extends what ``may well go down in history as a `golden age.'''
The world's major central banks have raised borrowing costs over the past year to contain inflation, marking the first synchronized tightening of monetary policy since 2000. Policy makers are concerned that the longest streak of sustained global growth in 30 years will fuel wage and price increases as companies operate at full capacity and unemployment drops.
``Economic growth has been much stronger than expected,'' said Thorsten Polleit, chief Germany economist at Barclays Capital in Frankfurt. ``That's stoking inflation, so central banks will have to keep raising interest rates.''
The European Central Bank, the Bank of Japan, the People's Bank of China and the Bank of England have all indicated that further rate increases may be in the pipeline this year, while economists at Merrill Lynch & Co. and Goldman Sachs Group Inc. now expect the U.S. Federal Reserve to leave rates at a six-year high rather than cut them.
China, Europe
Companies appear to be ``regaining pricing power'' while ``rapidly rising wages in countries such as China'' suggest ``the tailwinds of globalization may have abated, at least temporarily,'' Knight said.
Chinese central bank Governor Zhou Xiaochuan said on the weekend he can't rule out raising rates a third time this year to curb inflation and take the steam out of a surging stock market.
The ECB raised its benchmark rate to a six-year high of 4 percent this month and President Jean-Claude Trichet left the door open for another move.
``We have never said that the tightening cycle has ended,'' ECB council member Guy Quaden told reporters in Basel yesterday. ``Central banks have to closely monitor risks for inflation, which seem to be oriented upwards.''
Globally, ``inflation continues to be a concern,'' said Mexican central bank governor Guillermo Ortiz. ``The latest data and information certainly point to a stronger global economy.''
Bankers Meet
Trichet, Zhou, Bank of Japan Governor Toshihiko Fukui and U.S. Federal Reserve Vice Chairman Donald Kohn were among more than 100 central bankers attending the annual general meeting of the BIS in Basel over the weekend.
Known as the central banks' central bank, the BIS holds currency reserves on behalf of its members, produces research on everything from derivatives to inflation-targeting and provides policy makers with a forum for discussion.
The International Monetary Fund forecasts global economic expansion of 4.9 percent this year after 5.4 percent growth in 2006. That will mark five consecutive years of growth above 4 percent, the longest streak since the early 1970s.
``It is not clear whether inflationary pressures have been contained,'' the BIS said in its annual report, published yesterday. ``Economic slack has more or less been used up in the major advanced economies'' and ``vanishing slack might have increased inflationary risks.''
New Zealand, Sweden
Central banks may also have ignited inflation by keeping borrowing costs ``so low for so long,'' the BIS said. In the period under review, to May 2007, interest rates ``remained highly accommodative in the industrial countries'' after being raised only ``moderately.''
New Zealand unexpectedly increased its key interest rate to a record 8 percent earlier this month and Sweden's central bank last week raised borrowing costs for the eighth time in 18 months. It said further increases are in store.
``The next few years could continue to produce good global economic performance,'' BIS's Knight said. ``We are confident that central banks will strive to meet the challenges they face in pursuing price stability.''
By Gabi Thesing
June 25 (Bloomberg) -- Central banks will need to continue raising interest rates to quell inflation as the ``golden age'' of global economic expansion continues, the Bank for International Settlements said.
``Inflationary pressures might turn out to be more significant than anticipated,'' BIS General Manager Malcolm Knight told a press conference in Basel, Switzerland, yesterday. ``Authorities should continue gradually to normalize the level of policy interest rates'' as the global economy extends what ``may well go down in history as a `golden age.'''
The world's major central banks have raised borrowing costs over the past year to contain inflation, marking the first synchronized tightening of monetary policy since 2000. Policy makers are concerned that the longest streak of sustained global growth in 30 years will fuel wage and price increases as companies operate at full capacity and unemployment drops.
``Economic growth has been much stronger than expected,'' said Thorsten Polleit, chief Germany economist at Barclays Capital in Frankfurt. ``That's stoking inflation, so central banks will have to keep raising interest rates.''
The European Central Bank, the Bank of Japan, the People's Bank of China and the Bank of England have all indicated that further rate increases may be in the pipeline this year, while economists at Merrill Lynch & Co. and Goldman Sachs Group Inc. now expect the U.S. Federal Reserve to leave rates at a six-year high rather than cut them.
China, Europe
Companies appear to be ``regaining pricing power'' while ``rapidly rising wages in countries such as China'' suggest ``the tailwinds of globalization may have abated, at least temporarily,'' Knight said.
Chinese central bank Governor Zhou Xiaochuan said on the weekend he can't rule out raising rates a third time this year to curb inflation and take the steam out of a surging stock market.
The ECB raised its benchmark rate to a six-year high of 4 percent this month and President Jean-Claude Trichet left the door open for another move.
``We have never said that the tightening cycle has ended,'' ECB council member Guy Quaden told reporters in Basel yesterday. ``Central banks have to closely monitor risks for inflation, which seem to be oriented upwards.''
Globally, ``inflation continues to be a concern,'' said Mexican central bank governor Guillermo Ortiz. ``The latest data and information certainly point to a stronger global economy.''
Bankers Meet
Trichet, Zhou, Bank of Japan Governor Toshihiko Fukui and U.S. Federal Reserve Vice Chairman Donald Kohn were among more than 100 central bankers attending the annual general meeting of the BIS in Basel over the weekend.
Known as the central banks' central bank, the BIS holds currency reserves on behalf of its members, produces research on everything from derivatives to inflation-targeting and provides policy makers with a forum for discussion.
The International Monetary Fund forecasts global economic expansion of 4.9 percent this year after 5.4 percent growth in 2006. That will mark five consecutive years of growth above 4 percent, the longest streak since the early 1970s.
``It is not clear whether inflationary pressures have been contained,'' the BIS said in its annual report, published yesterday. ``Economic slack has more or less been used up in the major advanced economies'' and ``vanishing slack might have increased inflationary risks.''
New Zealand, Sweden
Central banks may also have ignited inflation by keeping borrowing costs ``so low for so long,'' the BIS said. In the period under review, to May 2007, interest rates ``remained highly accommodative in the industrial countries'' after being raised only ``moderately.''
New Zealand unexpectedly increased its key interest rate to a record 8 percent earlier this month and Sweden's central bank last week raised borrowing costs for the eighth time in 18 months. It said further increases are in store.
``The next few years could continue to produce good global economic performance,'' BIS's Knight said. ``We are confident that central banks will strive to meet the challenges they face in pursuing price stability.''
Even hedge funds seek public equity as cost of debt rises
GLG Partners to List Shares Through Reverse Takeover (Update1)
By Andrei Postelnicu
June 25 (Bloomberg) -- GLG Partners LP, Europe's third-largest hedge fund manager, agreed to be taken over by Freedom Acquisition Holdings Inc. for $3.4 billion in cash and stock to gain U.S. investors and a Wall Street listing.
Freedom, a special purpose vehicle which went public on the American Stock Exchange last year, will borrow as much as $570 million to finance the takeover and use the $512 million raised in its stock sale, GLG said in a statement today.
The transaction will make GLG, whose bets on emerging markets, bonds and European stocks helped its funds return twice as much as rivals last year, the first U.S.-listed asset manager exclusively focused on hedge funds, following Fortress Investment Group LLC, which also manages private-equity funds.
``This strategic transaction is an important step in building GLG's global business, affording us the opportunity to increase brand awareness and expand in major targeted markets, including the U.S., Middle East and Asia,'' Noam Gottesman, GLG's founder, managing director and co-chief executive officer, said in the statement.
GLG, Europe's third-largest hedge fund manager according to Institutional Investor's Alpha magazine, says it's the continent's biggest independent hedge fund manager, running about 40 funds. It was founded in 1995 by Gottesman, Pierre LaGrange and Jonathan Green as a unit of Lehman Brothers Holdings Inc.
GLG's $2.5 billion Market Neutral fund, which uses arbitrage and fixed-income investments to limit its correlation with stocks, returned 9.5 percent for this year's first four months, according to its April 30 update for clients. That compares with 2.9 percent for the average hedge fund investing in bonds, according to Hedge Fund Research Inc.
New Listing
The combined company, to be called GLG Partners Ltd., will transfer its listing to the New York Stock Exchange upon completion of the deal, expected in the fourth quarter.
Hedge funds are mostly private and unregulated pools of capital where managers can buy or sell any assets, participating substantially in the profits of the money invested. Special-purpose vehicles are companies set up for specific transactions such as acquisitions.
The world's over 9,000 hedge funds manage about $1.6 trillion in assets, more than double the amount five years ago. They tend to charge investors a 2 percent management fee and keep 20 percent of any money they make.
Perella Weinberg Partners advised GLG on the deal and Citigroup Inc. advised Freedom. Chadbourne & Parke LLP were GLG's lawyers while Greenberg Traurig PA were Freedom's.
By Andrei Postelnicu
June 25 (Bloomberg) -- GLG Partners LP, Europe's third-largest hedge fund manager, agreed to be taken over by Freedom Acquisition Holdings Inc. for $3.4 billion in cash and stock to gain U.S. investors and a Wall Street listing.
Freedom, a special purpose vehicle which went public on the American Stock Exchange last year, will borrow as much as $570 million to finance the takeover and use the $512 million raised in its stock sale, GLG said in a statement today.
The transaction will make GLG, whose bets on emerging markets, bonds and European stocks helped its funds return twice as much as rivals last year, the first U.S.-listed asset manager exclusively focused on hedge funds, following Fortress Investment Group LLC, which also manages private-equity funds.
``This strategic transaction is an important step in building GLG's global business, affording us the opportunity to increase brand awareness and expand in major targeted markets, including the U.S., Middle East and Asia,'' Noam Gottesman, GLG's founder, managing director and co-chief executive officer, said in the statement.
GLG, Europe's third-largest hedge fund manager according to Institutional Investor's Alpha magazine, says it's the continent's biggest independent hedge fund manager, running about 40 funds. It was founded in 1995 by Gottesman, Pierre LaGrange and Jonathan Green as a unit of Lehman Brothers Holdings Inc.
GLG's $2.5 billion Market Neutral fund, which uses arbitrage and fixed-income investments to limit its correlation with stocks, returned 9.5 percent for this year's first four months, according to its April 30 update for clients. That compares with 2.9 percent for the average hedge fund investing in bonds, according to Hedge Fund Research Inc.
New Listing
The combined company, to be called GLG Partners Ltd., will transfer its listing to the New York Stock Exchange upon completion of the deal, expected in the fourth quarter.
Hedge funds are mostly private and unregulated pools of capital where managers can buy or sell any assets, participating substantially in the profits of the money invested. Special-purpose vehicles are companies set up for specific transactions such as acquisitions.
The world's over 9,000 hedge funds manage about $1.6 trillion in assets, more than double the amount five years ago. They tend to charge investors a 2 percent management fee and keep 20 percent of any money they make.
Perella Weinberg Partners advised GLG on the deal and Citigroup Inc. advised Freedom. Chadbourne & Parke LLP were GLG's lawyers while Greenberg Traurig PA were Freedom's.
Barbarians Strike Back
Blackstone Sparks Lobbying `Battle Royale' in Congress on Taxes
By Ryan J. Donmoyer and Elizabeth Hester
June 25 (Bloomberg) -- Stephen Schwarzman, the founder of Blackstone Group LP, stood beaming before 600 Champagne-sipping investors in the baroque ballroom of New York's Pierre Hotel, transformed into a black and white palace for the occasion.
At that moment, on June 14, Schwarzman was the master of the financial universe, fresh from a blitz of media attention and about to launch the most anticipated initial public offering of the year. An hour later, his victory lap was thrown off course by word of a bill in the U.S. Senate to more than double Blackstone's tax burden -- the first of what are likely to be a slew of proposals and regulations aimed at hedge funds and private-equity firms.
Now Wall Street's new elite is fighting back, rapidly assembling an army of high-powered lobbyists to block the efforts of the Democrats who control Congress -- and some Republicans as well -- to assault their profits.
The lobbying ``will pick up like wildfire, especially with a presidential election year in the very near future,'' says Steven Howard, a partner at the New York law firm Thacher Proffitt & Wood LLP who advises investment firms. ``This will be a battle royale in Congress, where you'll have representatives and senators who view themselves as populists against the financial industry's giants.''
Another Salvo
House Democrats fired a new salvo on June 22, when Ways and Means Chairman Charles Rangel of New York and Financial Services Chairman Barney Frank of Massachusetts introduced legislation that would tax all fund managers' share of profits at the 35 percent corporate rate, instead of the 15 percent capital-gains rate they currently pay.
``They've got their teeth into it and they'll continue to pursue it,'' says former Texas Representative Bill Archer, who was the Republican chairman of the House Ways and Means Committee between 1995 and 2001. ``It's a no-lose situation politically.''
Industry leaders have made themselves ready targets thanks in part to annual payouts that sometimes reach more than $1 billion and extravagant displays of wealth such as Schwarzman's 60th birthday party in New York on Feb. 13, which featured a performance by Rod Stewart and a video greeting from President George W. Bush.
``The publicity is definitely working against them,'' says John Chapoton, a partner at Brown Investment Advisers and Trust in Washington and a former Treasury Department official in the Reagan administration.
Market Enthusiasm
The legislation introduced last week by the Senate Finance Committee -- which, unlike the Rangel-Frank measure, would apply only to private-equity firms that go public -- didn't damp investor enthusiasm for the Blackstone IPO.
The company's shares rose $4.06, or 13 percent, on June 22 in their first day of trading. Schwarzman planned to sell about 5.7 percent of his stake for $449.2 million, according to a June 21 filing with the SEC. His remaining 23 percent stake in the company is worth $8.76 billion.
Lawmakers are searching for new revenue sources to offset the cost of their spending plans. The government may lose $4 billion to $6 billion a year in revenue because of financial firms' favorable tax treatment.
That figure may even be too low, congressional aides say: Billions more may be lost because many investments are routed through offshore tax havens such as the Cayman Islands, where 8,134 active hedge funds are registered. That's an increase of 123 percent over the past five years, according to the Cayman Islands Monetary Authority.
Lobbying
To help defend their profits, Blackstone, the Carlyle Group and Apollo Management LP helped found a Washington trade group, the Private Equity Council, which in turn hired three powerhouse lobbying firms to promote their interests: Capitol Tax Partners; Brownstein Hyatt Farber Schreck and Akin Gump Strauss Hauer & Feld LLP.
Among those registered to lobby for the council are former Democratic Representative Vic Fazio of California and former Assistant Treasury Secretary Jonathan Talisman. Blackstone is also represented by Washington-based Ogilvy Government Relations, whose lobbyists include Wayne Berman, a top fundraiser for Bush.
Ken Mehlman, former Republican National Committee chairman and White House political director, is also working on the issue at Akin Gump, the third-biggest lobbying firm by revenue in 2006.
`No Guarantee'
Blackstone spokesman John Ford declines to comment. Robert Stewart, a spokesman for the Private Equity Council, says the current tax system is appropriate because it recognizes that ``private-equity investments are in fact investments that can produce a profit or a loss, and there's no guarantee about them.''
The industry also has poured millions of dollars into lawmakers' campaign coffers. Employees and spouses at the top 10 firms ranked by fund size, including Blackstone and Carlyle, donated at least $461,050 to federal candidates, parties, and political action committees in the first three months of this year.
Excluding the 2008 presidential donations, giving almost doubled to $207,700, compared with $111,348 in donations by the same 10 funds in the first three months of 2005, according to Federal Election Commission figures. Democrats have received most of the money, bringing in $259,800, or 56 percent of the total from the top 10 firms, according to FEC figures.
Presidential Candidates
Private-equity firms or hedge funds were among the top donors to at least four presidential candidates in the first quarter of 2007, according to the Center for Responsive Politics, a Washington-based group that tracks money in politics. Former North Carolina Senator John Edwards received $182,250 from the employees of New York-based Fortress Investment Group LLC, making the hedge fund where he once worked his biggest backer.
Fortress's taxes would also increase under the Senate legislation proposed last week. Democratic Senator Christopher Dodd of Connecticut's biggest backers are employees of Stamford, Connecticut-based SAC Capital Advisors LLC, who gave $207,300.
Among Republicans, the biggest donors to former New York Mayor Rudy Giuliani -- with $195,800 -- are the employees of the New York-based hedge fund Elliott Management Corp. Former Massachusetts Governor Mitt Romney received $99,800 from Boston- based Bain Capital LLC, making the company he founded his third- largest donor.
Support From Dodd
The industry has already found some support in Congress. Last week, Dodd, who is chairman of the Banking Committee and whose state is home to thousands of hedge funds, asked the Securities and Exchange Commission to review the Senate's Blackstone legislation, saying it raised questions ``about its impact on the capital markets.''
Still, the increased lobbying is unlikely to quiet the growing clamor in Congress for a revision of the carried- interest benefit, which saves fund managers as much as 20 percentage points on their income taxes and also exempts them from the 2.9 percent payroll tax for Medicare.
Congressional aides say the huge wealth generated by the firms is an attractive source of revenue as Congress struggles to stave off a $30 billion increase in the alternative minimum tax on 30 million middle-income families that is scheduled to take effect this year.
Howard says the success of Blackstone's IPO may embolden lawmakers to pursue the industry by making it easier for them to counter arguments that Congress is interfering with the financial markets by raising taxes. ``The greater the IPO, the greater their temerity,'' he says.
By Ryan J. Donmoyer and Elizabeth Hester
June 25 (Bloomberg) -- Stephen Schwarzman, the founder of Blackstone Group LP, stood beaming before 600 Champagne-sipping investors in the baroque ballroom of New York's Pierre Hotel, transformed into a black and white palace for the occasion.
At that moment, on June 14, Schwarzman was the master of the financial universe, fresh from a blitz of media attention and about to launch the most anticipated initial public offering of the year. An hour later, his victory lap was thrown off course by word of a bill in the U.S. Senate to more than double Blackstone's tax burden -- the first of what are likely to be a slew of proposals and regulations aimed at hedge funds and private-equity firms.
Now Wall Street's new elite is fighting back, rapidly assembling an army of high-powered lobbyists to block the efforts of the Democrats who control Congress -- and some Republicans as well -- to assault their profits.
The lobbying ``will pick up like wildfire, especially with a presidential election year in the very near future,'' says Steven Howard, a partner at the New York law firm Thacher Proffitt & Wood LLP who advises investment firms. ``This will be a battle royale in Congress, where you'll have representatives and senators who view themselves as populists against the financial industry's giants.''
Another Salvo
House Democrats fired a new salvo on June 22, when Ways and Means Chairman Charles Rangel of New York and Financial Services Chairman Barney Frank of Massachusetts introduced legislation that would tax all fund managers' share of profits at the 35 percent corporate rate, instead of the 15 percent capital-gains rate they currently pay.
``They've got their teeth into it and they'll continue to pursue it,'' says former Texas Representative Bill Archer, who was the Republican chairman of the House Ways and Means Committee between 1995 and 2001. ``It's a no-lose situation politically.''
Industry leaders have made themselves ready targets thanks in part to annual payouts that sometimes reach more than $1 billion and extravagant displays of wealth such as Schwarzman's 60th birthday party in New York on Feb. 13, which featured a performance by Rod Stewart and a video greeting from President George W. Bush.
``The publicity is definitely working against them,'' says John Chapoton, a partner at Brown Investment Advisers and Trust in Washington and a former Treasury Department official in the Reagan administration.
Market Enthusiasm
The legislation introduced last week by the Senate Finance Committee -- which, unlike the Rangel-Frank measure, would apply only to private-equity firms that go public -- didn't damp investor enthusiasm for the Blackstone IPO.
The company's shares rose $4.06, or 13 percent, on June 22 in their first day of trading. Schwarzman planned to sell about 5.7 percent of his stake for $449.2 million, according to a June 21 filing with the SEC. His remaining 23 percent stake in the company is worth $8.76 billion.
Lawmakers are searching for new revenue sources to offset the cost of their spending plans. The government may lose $4 billion to $6 billion a year in revenue because of financial firms' favorable tax treatment.
That figure may even be too low, congressional aides say: Billions more may be lost because many investments are routed through offshore tax havens such as the Cayman Islands, where 8,134 active hedge funds are registered. That's an increase of 123 percent over the past five years, according to the Cayman Islands Monetary Authority.
Lobbying
To help defend their profits, Blackstone, the Carlyle Group and Apollo Management LP helped found a Washington trade group, the Private Equity Council, which in turn hired three powerhouse lobbying firms to promote their interests: Capitol Tax Partners; Brownstein Hyatt Farber Schreck and Akin Gump Strauss Hauer & Feld LLP.
Among those registered to lobby for the council are former Democratic Representative Vic Fazio of California and former Assistant Treasury Secretary Jonathan Talisman. Blackstone is also represented by Washington-based Ogilvy Government Relations, whose lobbyists include Wayne Berman, a top fundraiser for Bush.
Ken Mehlman, former Republican National Committee chairman and White House political director, is also working on the issue at Akin Gump, the third-biggest lobbying firm by revenue in 2006.
`No Guarantee'
Blackstone spokesman John Ford declines to comment. Robert Stewart, a spokesman for the Private Equity Council, says the current tax system is appropriate because it recognizes that ``private-equity investments are in fact investments that can produce a profit or a loss, and there's no guarantee about them.''
The industry also has poured millions of dollars into lawmakers' campaign coffers. Employees and spouses at the top 10 firms ranked by fund size, including Blackstone and Carlyle, donated at least $461,050 to federal candidates, parties, and political action committees in the first three months of this year.
Excluding the 2008 presidential donations, giving almost doubled to $207,700, compared with $111,348 in donations by the same 10 funds in the first three months of 2005, according to Federal Election Commission figures. Democrats have received most of the money, bringing in $259,800, or 56 percent of the total from the top 10 firms, according to FEC figures.
Presidential Candidates
Private-equity firms or hedge funds were among the top donors to at least four presidential candidates in the first quarter of 2007, according to the Center for Responsive Politics, a Washington-based group that tracks money in politics. Former North Carolina Senator John Edwards received $182,250 from the employees of New York-based Fortress Investment Group LLC, making the hedge fund where he once worked his biggest backer.
Fortress's taxes would also increase under the Senate legislation proposed last week. Democratic Senator Christopher Dodd of Connecticut's biggest backers are employees of Stamford, Connecticut-based SAC Capital Advisors LLC, who gave $207,300.
Among Republicans, the biggest donors to former New York Mayor Rudy Giuliani -- with $195,800 -- are the employees of the New York-based hedge fund Elliott Management Corp. Former Massachusetts Governor Mitt Romney received $99,800 from Boston- based Bain Capital LLC, making the company he founded his third- largest donor.
Support From Dodd
The industry has already found some support in Congress. Last week, Dodd, who is chairman of the Banking Committee and whose state is home to thousands of hedge funds, asked the Securities and Exchange Commission to review the Senate's Blackstone legislation, saying it raised questions ``about its impact on the capital markets.''
Still, the increased lobbying is unlikely to quiet the growing clamor in Congress for a revision of the carried- interest benefit, which saves fund managers as much as 20 percentage points on their income taxes and also exempts them from the 2.9 percent payroll tax for Medicare.
Congressional aides say the huge wealth generated by the firms is an attractive source of revenue as Congress struggles to stave off a $30 billion increase in the alternative minimum tax on 30 million middle-income families that is scheduled to take effect this year.
Howard says the success of Blackstone's IPO may embolden lawmakers to pursue the industry by making it easier for them to counter arguments that Congress is interfering with the financial markets by raising taxes. ``The greater the IPO, the greater their temerity,'' he says.
Sunday, June 24, 2007
Pragmatism in the Public and Private Sector
Bloomberg: The CEO Mayor
How New York's Mike Bloomberg is creating a new model for public service that places pragmatism before politics
by Tom Lowry
(BusinessWeek - 14 June 2007) The American businessman-politician has a long and storied history. From Alexander Hamilton (industrialist) to Herbert Hoover (mining consultant) to New Jersey Governor Jon Corzine (CEO, Goldman, Sachs (GS)), wealthy and connected executives have, for better or worse, tried to bring corner-office management to the public arena. With the arrival of George W. Bush, MBA, we began to hear a lot about the so-called CEO President who was supposed to muster a greater degree of executive decisiveness and accountability. But four years of war and the Katrina debacle have blunted that talk.
Which brings us to New York City Mayor Michael R. Bloomberg. This forthright and prosaic 65-year-old billionaire just may have the right combination of managerial, risk-taking, and political skills to create a new model for public service—possibly even at the national level should Bloomberg run for President.
Applying lessons from an early career on Wall Street and from two decades building his eponymous financial-information and media empire, the mayor is using technology, marketing, data analysis, and results-driven incentives to manage what is often seen as an unmanageable city of 8 million.
Bloomberg sees New York City as a corporation, its citizens as customers, its sanitation workers, police officers, clerks, and deputy commissioners as talent. He is the chief executive. Call him a technocrat all you want; he's O.K. with that. "I hear a disparaging tone, like there's something wrong with accountability and results," he says. "What was I hired for?"
Yes, Bloomberg has endured setbacks. His failed attempt to build a football stadium in Manhattan gobbled up time and energy for much of his first term. And while his takeover of city schools five years ago from the state has led to dramatically improved test scores, there is a long way to go before the mayor can declare victory. Plus, some of his ideas—including his suggestion to pay kids for good grades—grate on educators.
Yet his checklist-obsessed operating style has resonated with New York's famously cynical citizenry—70% approval ratings attest to that—and well beyond Gotham. "People see that this can be done in a place like New York, effectively managing something so large and complex," says Time Warner CEO Richard D. Parsons, a Bloomberg friend and someone mentioned as a possible mayoral candidate himself. "And they think, 'Hey, this can be done elsewhere.'"
The City Is a Brand
Put yourself in Bloomberg's size 9½ loafers on Jan. 1, 2002, the day he was sworn in as New York's 108th mayor. The city was grappling with the psychological and financial impact of the terrorist attacks. It faced a budget gap of nearly $6 billion. On Wall Street, there was talk of abandoning Manhattan for the safer precincts of New Jersey or Connecticut.
Bloomberg had three options: cut services, raise taxes, or both. He did what no mayor had dared to do in more than a decade: He jacked up property taxes. And he didn't agonize over the decision a bit. "It [was] easy to make that choice," he recalls.
Some of his aides tried to talk him out of it, fearing the move amounted to political suicide. And by the following summer, Bloomberg's approval ratings had plunged, to 31%. But the novice mayor was undeterred. Where most politicians would have seen only a fiscal solution to the budget gap, he spotted a marketing opportunity. He was protecting the New York City "brand." Bloomberg saw a low crime rate, good public transportation, and clean streets as indispensable to selling New York. Cutting back on services, he felt, would send the wrong message to the business community and the outside world.
At the same time, Bloomberg boosted New York's promotional efforts. First, he consolidated three existing operations under a not-for-profit entity called NYC & Co. He tripled the city's contribution to the annual marketing budget, to $22 million. Then he went out and hired as CEO a veteran ad man, George Fertitta, whose branding and marketing firm had handled the likes of Coca-Cola (KO), Perry Ellis (PERY), and Walt Disney. All cities have marketing arms. But Fertitta's operation is essentially an advertising agency with an in-house creative services unit that uses various media, from bus shelters to the city's cable channel, to help sell the Big Apple.
Ever the metric junkie, Bloomberg set a goal for NYC & Co.: lure 50 million visitors a year by 2015. And knowing that foreign tourists spend three times as much as U.S. visitors, he ordered Fertitta to open more branch offices around the world. Today, NYC & Co. has a presence in 14 cities, with new offices set to open in Seoul, Tokyo, and Shanghai in coming months.
Since 2003, New York says it has added 151,100 new private sector jobs, boosting the economy and fueling a construction boom. And last year, partly owing to a weak U.S. dollar, the city reports attracting 44 million visitors, up from 35 million in 2002. As for that 18.5% property tax hike, it got a whole lot easier to swallow when the average value of a single family home surged by 55%. Now, with the city in surplus, Bloomberg plans to hand out $1.3 billion in tax cuts not only to homeowners but also to businesses and shoppers.
The Voters Are Customers
Bloomberg the executive was obsessive about catering to his customers, establishing 24-hour call lines, collecting data to help develop new products, and sending his executives out into the field to solicit feedback directly from clients. "Good companies listen to their customers, No.1," he says. "Then they try to satisfy their needs, No.2. But don't let [them] drive the internal decisions of the company."
As daunting as it may sound in a city never shy about complaining, Bloomberg decided New York needed its own 24-hour customer-service line. Yes, other cities had deployed 311 numbers, but never on such a grand scale. The benefit, beyond giving the public a new outlet to vent, would be making city government more efficient.
One month after being sworn in, Bloomberg proposed a 311 line that would allow New Yorkers to report everything from noise pollution to downed power lines. More important, 311 would give the mayor unprecedented access to what was on his constituents' minds. Bloomberg sees the weekly reports and gets a sense of the citizenry's angst—and whether problems are getting solved and how quickly.
Since it launched in March, 2003, at a startup cost of $25 million, 311 has received 49 million calls. The service employs 370 round-the-clock call takers. And New York has done an impressive job of data-mining the calls and quickly responding, says Stephen Goldsmith, the former mayor of Indianapolis and now a professor at Harvard's Kennedy School of Government. "Something special is going on in New York," he says. As far as the mayor is concerned, the numbers tell the story. Emergency 911 traffic is down by 1 million calls since 311's inception, meaning first responders are being called to fewer non-emergencies. The Buildings Dept. uses 311 to streamline the permit process and the review of plans by inspectors. The average wait time for an appointment with a building inspector has dropped from 40 days to less than a week. Two years after 311 launched, inspections for excessive noise were up 94%; rodent exterminations, 36%.
Heather Schwartz, a 30-year-old graduate student, is a regular user of the 311 line and says she became a big fan last year when she called about graffiti in a northern Manhattan subway station. Within days, the walls were painted over. Each time the graffiti artists returned, the city would paint over their handiwork. Finally the vandals gave up. Now Schwartz calls 311 for everything from elevator inspections to trash in the streets. "I am thrilled with it," she says. "It professionalizes the city."
The More Light, the Better
Earlier this year, during a morning meeting with top staffers, Bloomberg noticed the large doors to the ornate conference room in City Hall. They were wooden. How could that be? Bloomberg thought he'd made City Hall "see-through." All meeting rooms had glass windows, so you could look inside. His desk and those of his staff were clustered in a room without walls to facilitate better and faster communication. By week's end the room had glass doors.
Bloomberg has tried to make the government and its agencies more open, too. In a task that previously fell to city budget directors, Bloomberg himself each year makes three budget presentations in the same day: one to city council, another for other elected officials, and one to the press. He uses easy-to-follow charts and tables, much like a CEO's Power Point presentation to analysts. His hope is that, by explaining the forces shaping the city's economy, a better understanding of his tax and spending priorities will emerge. The approach has not only helped him in budget negotiations with city council but also fostered a smoother relationship with civic and advocacy groups, says Mitchell Moss, an urban policy and planning professor at New York University.
What's more, citizens can get a closer look at their city government than ever before. The semiannual mayor's management report once exceeded 1,000 pages in three printed volumes. Today, the report—which reviews the delivery of city services—is 186 pages, available online, and includes many more features than before, including neighborhood data and five-year trends that allow New Yorkers to compare past and present. In addition, the city plans and budget, once convoluted fiscal documents with only summaries available online, are now fully accessible on the city's Web site. Before, a New Yorker could never see a specific agency's overhead costs—its pensions and legal claims, say. The costs were pooled as a single number. Now each agency breaks them out.
Hire Smart and Delegate
The first thing most politicians do upon winning office is fill top jobs with people to whom they owe their support or who have long-standing ties to the political Establishment. Bloomberg arrived at City Hall with no such debts. That's partly because he financed his own campaign. But even if he hadn't, Bloomberg says, he still would have recruited his lieutenants based on their ability to set targets and hit them.
And by and large, that is what he has done. Not surprisingly, he reached into the business community, appointing a former partner of private equity firm Oak Hill Capital Partners named Daniel Doctoroff to run New York City's economic development office. And he brought over four of his executives from Bloomberg itself. One of them was Katherine Oliver. Bloomberg had a turnaround mission in mind for her at the city's Office of Film, Theatre & Broadcasting.
Oliver was working in London, overseeing Bloomberg global radio and television operations, when she got the call. Her marching orders from the mayor were simple: build a customer-service organization. She wasn't prepared for how much the film office needed modernizing and refocusing. Toronto and Louisiana, among other places, were stealing business from New York. Production companies were required to visit the office and fill out permit applications on paper. And to Oliver's astonishment the agency had only one computer. Most staff were tapping away on electric typewriters.
Within a month of her arrival, her 22 employees had new Dell (DELL) flat-screens, and production companies were able to file for permits online. Approvals have since surged to 200 a day, up from 200 a week in 2002. Oliver also put a photo library on the Web site, letting producers scout locations from their desks. She began offering a combined 15% tax credit to film and tv productions that complete at least 75% of their stage work in the city. Oliver says the program has generated $2.4 billion in new business and 10,000 new jobs since 2005. She offered filmmakers free advertising space on public property. And she set up a dedicated team of 33 police officers to ease shoots in the city. "We tried to look at this as B to B," says Oliver. "This is a microcosm of what Michael wanted to do for the entire city."
The movie industry isn't complaining. Veteran producer Michael Tadross says the city's film office is much more efficient. "You get maps, diagrams, and suggestions of where to shoot during one-on-one meetings with folks in the office," says Tadross, who just completed filming a remake of The Omega Man, I Am Legend, in New York. "I have always felt big cities should be run by businesspeople, not politicians."
Be Bold, Be Fearless
"A major part of the CEO's responsibilities is to be the ultimate risk-taker and decision-maker. Truman ('The buck stops here') had it right." So wrote Bloomberg in his 1997 autobiography Bloomberg By Bloomberg. The mayor has embraced risk with an almost reckless disregard for political repercussions. Sometimes it has worked out: His controversial smoking ban in bars and restaurants is being replicated in other cities. Sometimes it hasn't: In a crushing defeat, he lost the 2012 Olympics bid to London.
Bloomberg recently reflected on the rare setback. "In business, you reward people for taking risks. When it doesn't work out, you promote them because they were willing to try new things. If people come back and tell me they skied all day and never fell down, I tell them to try a different mountain." He adds: "I have always joked that [the difference between] having the courage of your convictions and being pigheaded is in the results."
Bloomberg has two and a half years left in his second term, so it's a little early to talk about legacy. But the influence of this self-made billionaire will be felt by generations of politicians. One is Adrian Fenty. Washington's 36-year-old mayor has adopted the newsroom-style office, or bullpen, that Bloomberg brought from his company, and is now seeking a Bloomberg-style overhaul of his city's own chronically underperforming schools.
What has Bloomberg learned as mayor? "The real world, whether in business or government, requires that you don't jump to the endgame [or] to success right away," he says. "You do it piece by piece. Some people get immobilized when they come to a roadblock. My answer is, 'you know, it's a shame it's there, but now where else can we go? Let's just do it.'"
How New York's Mike Bloomberg is creating a new model for public service that places pragmatism before politics
by Tom Lowry
(BusinessWeek - 14 June 2007) The American businessman-politician has a long and storied history. From Alexander Hamilton (industrialist) to Herbert Hoover (mining consultant) to New Jersey Governor Jon Corzine (CEO, Goldman, Sachs (GS)), wealthy and connected executives have, for better or worse, tried to bring corner-office management to the public arena. With the arrival of George W. Bush, MBA, we began to hear a lot about the so-called CEO President who was supposed to muster a greater degree of executive decisiveness and accountability. But four years of war and the Katrina debacle have blunted that talk.
Which brings us to New York City Mayor Michael R. Bloomberg. This forthright and prosaic 65-year-old billionaire just may have the right combination of managerial, risk-taking, and political skills to create a new model for public service—possibly even at the national level should Bloomberg run for President.
Applying lessons from an early career on Wall Street and from two decades building his eponymous financial-information and media empire, the mayor is using technology, marketing, data analysis, and results-driven incentives to manage what is often seen as an unmanageable city of 8 million.
Bloomberg sees New York City as a corporation, its citizens as customers, its sanitation workers, police officers, clerks, and deputy commissioners as talent. He is the chief executive. Call him a technocrat all you want; he's O.K. with that. "I hear a disparaging tone, like there's something wrong with accountability and results," he says. "What was I hired for?"
Yes, Bloomberg has endured setbacks. His failed attempt to build a football stadium in Manhattan gobbled up time and energy for much of his first term. And while his takeover of city schools five years ago from the state has led to dramatically improved test scores, there is a long way to go before the mayor can declare victory. Plus, some of his ideas—including his suggestion to pay kids for good grades—grate on educators.
Yet his checklist-obsessed operating style has resonated with New York's famously cynical citizenry—70% approval ratings attest to that—and well beyond Gotham. "People see that this can be done in a place like New York, effectively managing something so large and complex," says Time Warner CEO Richard D. Parsons, a Bloomberg friend and someone mentioned as a possible mayoral candidate himself. "And they think, 'Hey, this can be done elsewhere.'"
The City Is a Brand
Put yourself in Bloomberg's size 9½ loafers on Jan. 1, 2002, the day he was sworn in as New York's 108th mayor. The city was grappling with the psychological and financial impact of the terrorist attacks. It faced a budget gap of nearly $6 billion. On Wall Street, there was talk of abandoning Manhattan for the safer precincts of New Jersey or Connecticut.
Bloomberg had three options: cut services, raise taxes, or both. He did what no mayor had dared to do in more than a decade: He jacked up property taxes. And he didn't agonize over the decision a bit. "It [was] easy to make that choice," he recalls.
Some of his aides tried to talk him out of it, fearing the move amounted to political suicide. And by the following summer, Bloomberg's approval ratings had plunged, to 31%. But the novice mayor was undeterred. Where most politicians would have seen only a fiscal solution to the budget gap, he spotted a marketing opportunity. He was protecting the New York City "brand." Bloomberg saw a low crime rate, good public transportation, and clean streets as indispensable to selling New York. Cutting back on services, he felt, would send the wrong message to the business community and the outside world.
At the same time, Bloomberg boosted New York's promotional efforts. First, he consolidated three existing operations under a not-for-profit entity called NYC & Co. He tripled the city's contribution to the annual marketing budget, to $22 million. Then he went out and hired as CEO a veteran ad man, George Fertitta, whose branding and marketing firm had handled the likes of Coca-Cola (KO), Perry Ellis (PERY), and Walt Disney. All cities have marketing arms. But Fertitta's operation is essentially an advertising agency with an in-house creative services unit that uses various media, from bus shelters to the city's cable channel, to help sell the Big Apple.
Ever the metric junkie, Bloomberg set a goal for NYC & Co.: lure 50 million visitors a year by 2015. And knowing that foreign tourists spend three times as much as U.S. visitors, he ordered Fertitta to open more branch offices around the world. Today, NYC & Co. has a presence in 14 cities, with new offices set to open in Seoul, Tokyo, and Shanghai in coming months.
Since 2003, New York says it has added 151,100 new private sector jobs, boosting the economy and fueling a construction boom. And last year, partly owing to a weak U.S. dollar, the city reports attracting 44 million visitors, up from 35 million in 2002. As for that 18.5% property tax hike, it got a whole lot easier to swallow when the average value of a single family home surged by 55%. Now, with the city in surplus, Bloomberg plans to hand out $1.3 billion in tax cuts not only to homeowners but also to businesses and shoppers.
The Voters Are Customers
Bloomberg the executive was obsessive about catering to his customers, establishing 24-hour call lines, collecting data to help develop new products, and sending his executives out into the field to solicit feedback directly from clients. "Good companies listen to their customers, No.1," he says. "Then they try to satisfy their needs, No.2. But don't let [them] drive the internal decisions of the company."
As daunting as it may sound in a city never shy about complaining, Bloomberg decided New York needed its own 24-hour customer-service line. Yes, other cities had deployed 311 numbers, but never on such a grand scale. The benefit, beyond giving the public a new outlet to vent, would be making city government more efficient.
One month after being sworn in, Bloomberg proposed a 311 line that would allow New Yorkers to report everything from noise pollution to downed power lines. More important, 311 would give the mayor unprecedented access to what was on his constituents' minds. Bloomberg sees the weekly reports and gets a sense of the citizenry's angst—and whether problems are getting solved and how quickly.
Since it launched in March, 2003, at a startup cost of $25 million, 311 has received 49 million calls. The service employs 370 round-the-clock call takers. And New York has done an impressive job of data-mining the calls and quickly responding, says Stephen Goldsmith, the former mayor of Indianapolis and now a professor at Harvard's Kennedy School of Government. "Something special is going on in New York," he says. As far as the mayor is concerned, the numbers tell the story. Emergency 911 traffic is down by 1 million calls since 311's inception, meaning first responders are being called to fewer non-emergencies. The Buildings Dept. uses 311 to streamline the permit process and the review of plans by inspectors. The average wait time for an appointment with a building inspector has dropped from 40 days to less than a week. Two years after 311 launched, inspections for excessive noise were up 94%; rodent exterminations, 36%.
Heather Schwartz, a 30-year-old graduate student, is a regular user of the 311 line and says she became a big fan last year when she called about graffiti in a northern Manhattan subway station. Within days, the walls were painted over. Each time the graffiti artists returned, the city would paint over their handiwork. Finally the vandals gave up. Now Schwartz calls 311 for everything from elevator inspections to trash in the streets. "I am thrilled with it," she says. "It professionalizes the city."
The More Light, the Better
Earlier this year, during a morning meeting with top staffers, Bloomberg noticed the large doors to the ornate conference room in City Hall. They were wooden. How could that be? Bloomberg thought he'd made City Hall "see-through." All meeting rooms had glass windows, so you could look inside. His desk and those of his staff were clustered in a room without walls to facilitate better and faster communication. By week's end the room had glass doors.
Bloomberg has tried to make the government and its agencies more open, too. In a task that previously fell to city budget directors, Bloomberg himself each year makes three budget presentations in the same day: one to city council, another for other elected officials, and one to the press. He uses easy-to-follow charts and tables, much like a CEO's Power Point presentation to analysts. His hope is that, by explaining the forces shaping the city's economy, a better understanding of his tax and spending priorities will emerge. The approach has not only helped him in budget negotiations with city council but also fostered a smoother relationship with civic and advocacy groups, says Mitchell Moss, an urban policy and planning professor at New York University.
What's more, citizens can get a closer look at their city government than ever before. The semiannual mayor's management report once exceeded 1,000 pages in three printed volumes. Today, the report—which reviews the delivery of city services—is 186 pages, available online, and includes many more features than before, including neighborhood data and five-year trends that allow New Yorkers to compare past and present. In addition, the city plans and budget, once convoluted fiscal documents with only summaries available online, are now fully accessible on the city's Web site. Before, a New Yorker could never see a specific agency's overhead costs—its pensions and legal claims, say. The costs were pooled as a single number. Now each agency breaks them out.
Hire Smart and Delegate
The first thing most politicians do upon winning office is fill top jobs with people to whom they owe their support or who have long-standing ties to the political Establishment. Bloomberg arrived at City Hall with no such debts. That's partly because he financed his own campaign. But even if he hadn't, Bloomberg says, he still would have recruited his lieutenants based on their ability to set targets and hit them.
And by and large, that is what he has done. Not surprisingly, he reached into the business community, appointing a former partner of private equity firm Oak Hill Capital Partners named Daniel Doctoroff to run New York City's economic development office. And he brought over four of his executives from Bloomberg itself. One of them was Katherine Oliver. Bloomberg had a turnaround mission in mind for her at the city's Office of Film, Theatre & Broadcasting.
Oliver was working in London, overseeing Bloomberg global radio and television operations, when she got the call. Her marching orders from the mayor were simple: build a customer-service organization. She wasn't prepared for how much the film office needed modernizing and refocusing. Toronto and Louisiana, among other places, were stealing business from New York. Production companies were required to visit the office and fill out permit applications on paper. And to Oliver's astonishment the agency had only one computer. Most staff were tapping away on electric typewriters.
Within a month of her arrival, her 22 employees had new Dell (DELL) flat-screens, and production companies were able to file for permits online. Approvals have since surged to 200 a day, up from 200 a week in 2002. Oliver also put a photo library on the Web site, letting producers scout locations from their desks. She began offering a combined 15% tax credit to film and tv productions that complete at least 75% of their stage work in the city. Oliver says the program has generated $2.4 billion in new business and 10,000 new jobs since 2005. She offered filmmakers free advertising space on public property. And she set up a dedicated team of 33 police officers to ease shoots in the city. "We tried to look at this as B to B," says Oliver. "This is a microcosm of what Michael wanted to do for the entire city."
The movie industry isn't complaining. Veteran producer Michael Tadross says the city's film office is much more efficient. "You get maps, diagrams, and suggestions of where to shoot during one-on-one meetings with folks in the office," says Tadross, who just completed filming a remake of The Omega Man, I Am Legend, in New York. "I have always felt big cities should be run by businesspeople, not politicians."
Be Bold, Be Fearless
"A major part of the CEO's responsibilities is to be the ultimate risk-taker and decision-maker. Truman ('The buck stops here') had it right." So wrote Bloomberg in his 1997 autobiography Bloomberg By Bloomberg. The mayor has embraced risk with an almost reckless disregard for political repercussions. Sometimes it has worked out: His controversial smoking ban in bars and restaurants is being replicated in other cities. Sometimes it hasn't: In a crushing defeat, he lost the 2012 Olympics bid to London.
Bloomberg recently reflected on the rare setback. "In business, you reward people for taking risks. When it doesn't work out, you promote them because they were willing to try new things. If people come back and tell me they skied all day and never fell down, I tell them to try a different mountain." He adds: "I have always joked that [the difference between] having the courage of your convictions and being pigheaded is in the results."
Bloomberg has two and a half years left in his second term, so it's a little early to talk about legacy. But the influence of this self-made billionaire will be felt by generations of politicians. One is Adrian Fenty. Washington's 36-year-old mayor has adopted the newsroom-style office, or bullpen, that Bloomberg brought from his company, and is now seeking a Bloomberg-style overhaul of his city's own chronically underperforming schools.
What has Bloomberg learned as mayor? "The real world, whether in business or government, requires that you don't jump to the endgame [or] to success right away," he says. "You do it piece by piece. Some people get immobilized when they come to a roadblock. My answer is, 'you know, it's a shame it's there, but now where else can we go? Let's just do it.'"
Wednesday, June 20, 2007
CDS may be the financial innovation that will reduce credit spreads permanently
Credit default swaps are fast becoming a cost-effective means of transferring credit risk as well as leveraged financing hedging strategy.
Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita
June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.
Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.
``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.
Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.
The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.
The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.
First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.
Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.
``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.
$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.
The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.
The funds might leave the U.S. loan market should investors reverse these trades, Calder said.
``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''
`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.
``The size associated with that potential flow is enough to move the market,'' he said.
Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.
That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.
Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.
``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''
Loan Credit-Default Swaps May Exceed Loan Trades (Update2)
By Patricia Kuo and Junko Fujita
June 20 (Bloomberg) -- Credit-default swaps linked to loans will be more actively traded in the U.S. than the loans themselves within a year, according to analysts at Citigroup Inc., the largest U.S. bank.
Trading of loan credit-default swaps now accounts for 50 percent of the volume of loan trades handled by Citigroup, New York-based Jonathan Calder, head of the U.S. bank's loan sales and trading, told a conference yesterday in Tokyo.
``It's an easy bet that over next year, loan credit-default swaps will exceed cash loan trades volume by at least two times,'' Calder said at the conference organized by New York- based Loan Syndications and Trading Association.
Credit-default swaps on loans, used to speculate on the ability of companies to repay the debt, are luring investors such as hedge funds and fund managers as a lower-cost alternative to investing in loans. They also provide arbitragers with opportunities to profit from the gap in risk premium between loans, derivatives and bonds.
The amount of loan credit-default swaps outstanding has ballooned to more than $85 billion from $31.6 billion last year and $6.3 billion in 2005, according to estimates from Goldman Sachs Group Inc. and Markit Group Ltd., administrator of the LCDX index, the first tradeable index contract tied to the loan market.
The amount traded on the LCDX index, based on the loans of 100 companies, reached $25 billion in its first two weeks, according to Markit. Goldman estimates that about $60 billion in credit swaps tied to individual companies were outstanding before the index started trading.
First Data
Arrangers of the non-investment grade loans that Kohlberg Kravis Roberts & Co. is seeking for its takeover of First Data Corp., the world's largest card payment processor, may start selling the debt in the next few weeks. Credit-default swaps on the loans, which haven't yet been sold, are already actively traded, Calder said.
Greenwood Village, Colorado-based First Data said in a regulatory filing in May that New York-based KKR will seek $16 billion of loans to fund the acquisition.
``This is not just an evolution. This is something that will significantly change the way we do business,'' Calder said.
$40 Billion Trade
Traders have bought an estimated $40 billion of loan credit- default swaps as part of what is called a negative basis trade, Calder said. In such a trade, investors can profit from holding both a loan and its protection against default when the cost of the derivative contract is less than the interest income they get from the loan.
The loan's yield premium over the cost of protection -- which ranged between 30 basis points and 120 basis points in the U.S. this year -- will probably disappear once the commercial lending departments of banks start purchasing credit-default swaps based on loans they've made, he said. A basis point is 0.01 percentage point.
The funds might leave the U.S. loan market should investors reverse these trades, Calder said.
``At the moment, cash is flowing into loans to do the negative basis trade,'' Calder said. ``At some point in the future, cash may flow out of loans.''
`Move the Market'
Even loan investors who don't use credit derivatives should learn about this trade because it is big enough to affect the loan market, Calder said.
``The size associated with that potential flow is enough to move the market,'' he said.
Credit-default swaps tied to corporate bonds, which were conceived about a decade ago, more than doubled in 2006 to cover $34.5 trillion in securities, according to the International Swaps and Derivatives Association. That's almost 10 times the amount of senior unsecured bonds outstanding. Credit swaps were conceived to protect bondholders against default and pay the buyer face value in exchange for the underlying securities.
Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.
The record amount of money sought to finance buyouts may cause borrowers in the U.S. to pay more for non-investment grade loans by the end of the year, Calder said. Standard & Poor's Leveraged Commentary & Data unit estimates that companies will seek about $197 billion of junk-rated loans in the next 12 months.
That concern is reflected in the LCDX index. The index fell for a seventh day, declining 0.30 to 99.74 at 4:03 p.m. in New York. The index is below 100 for the first time since May 22, according to Markit Group. A decline in the index signals deteriorating perceptions of creditworthiness.
Leveraged Loans
Leveraged loans in the U.S. grew 85 percent to $550 billion this year compared with the same period of 2006, Bloomberg data show.
``With the large size of individual deals and large aggregate calendar, we expect there will be some backup in the rates in the U.S. leveraged loan market as we go through the summer,'' Calder said. ``We're going to have the busiest summer and I will be very surprised if we don't see coupons expand a little bit.''
Invention of credit derivatives
This is an old article on how the credit derivatives innovation has mushrooomed into its present state. Also interesting is the environment in which ideas could be translated to reality, and how such financial innovations tend to be short-lived.
The dream machine: invention of credit derivatives
By Gillian Tett
(FT 24 Mar 2006) The first time I ran into the “Morgan mafia” - or, more accurately, the ex-JPMorgan mafia - was at a banking conference in Nice last year. It was, I later learned, the type of ritual typical of high finance: around a plush, darkened lecture theatre and well-stocked bar, a gaggle of suited men (and the occasional woman) earnestly muttered about “delta hedging”, “correlation risk” or “CDO squared”.
For all I could tell, they might have been discussing nuclear physics or ancient Chinese. What distinguished this meeting from those topics, however, was the whiff of money: these people might have looked like nerds, but they sported very expensive watches, and their chat was peppered with casual references to billions of dollars.
Uneasily, I tried to work out what was going on. A few weeks earlier I had started reporting on the capital markets and heard that something called “credit derivatives” was revolutionising global finance. Just five years ago the sector was a tiny niche business. Now the volume of all the outstanding credit-derivatives deals in the world is estimated at $12 trillion. However, like most people, I had little idea what a number that big actually meant (for reference, it is about the size of the American economy, or almost four times the total value of all the shares on the London Stock Exchange). So I had flown to Nice hoping to get some bearings in this strange land.
“Who’s that?” I whispered to a banker next to me, pointing to a platform where two men and two women were discussing whether investors “really understand the full ramifications of CDO risk”. (Their conclusion seemed to be: “not always”, which didn’t surprise me, given how little of the jargon anyone might have understood.) My neighbour furtively whispered that he worked for one of the biggest US banks and was therefore forbidden to talk to journalists, “since you guys keep writing that crap about derivatives blowing up the world”. But then he relented: the speakers, he said, were apparently consultants or partners in hedge (big private investment) funds; but almost all used to work for JPMorgan, the big US bank.
Why JPMorgan? I asked. Why not Goldman Sachs or Morgan Stanley? Or a British, French - or Chinese - bank, come to that?
“It’s the Morgan mafia - they sort of created the whole credit derivatives thing,” he chuckled, and then clammed up as if he had revealed a sensitive commercial secret.
As I sat watching slick PowerPoint presentations, I wondered how this had come about. Every year, the anonymous eggheads who work on Wall Street and in the City of London produce a stream of bright ideas that push money around the world in an ever more efficient way (and make the banks they work for, and themselves, richer in the process). Most of these ideas simply vanish; but every so often a few - such as credit derivatives - mushroom with extraordinary speed.
To anyone outside finance, these concepts generally seem so complex that such innovation might exist in a parallel universe. But that is only half true. For if the oil of high finance does not keep lubricating the wheels of the global economy, the world as we know it would quickly slow down. Moreover, we live in such an inter-connected economic system that every time you convert money at a foreign exchange till, pay your mortgage to a bank or use your ATM card, you are plugging into a giant web of capital flows that is being continually rewoven by these innovations.
But where, I wondered as I sat in the lecture theatre, do these ideas come from? And why do some fail and others blossom into a $12 trillion business? And what does that tell us about the way that financial innovation really works and shapes all our lives?
In the months that followed the conference in Nice, I started to track down some of this “Morgan mafia” in an effort to understand the credit derivatives tale. It was not an easy task: traders live in a world in which information costs money, numbers speak louder than words and journalists are - at best - viewed with extreme distrust. But, as it turns out, one place to start this story is not on the dealing floors of London or New York, but on the humid coast of Florida. For it was there, at the plush holiday resort of Boca Raton, that about 80 JPMorgan bankers working in their derivatives department assembled about a decade ago, to hold a so-called “weekend offsite”.
By now you might be feeling like I did when I showed up at that banking conference in Nice, wondering what everyone was talking about. First you need to understand what a derivative is. And to do that, you might as well start with the literal meaning: a derivative is something whose nature is derived, or comes, from something else. In the financial world, where we are interested in the value of something, the value of a derivative depends on the value of something else. So far so simple.
There are many things in the financial world that have value: shares, bonds, currencies, commodities, cash, loans. The secret of the derivative is that it makes it possible for you to have some of the value of one of those assets, even if you don’t actually own it. Why would anyone want to do that? Part of the answer is that it acts a bit like an insurance policy. If you think you might have an accident in your car, you don’t have to set aside the entire value of a new car. You can pay a premium that will cover the cost only if you crash. If you think your shares are going to fall, you don’t have to sell them. You can take out a contract to sell them at a certain price if indeed they do fall. If they don’t fall, you won’t have sold. That’s how you build stability and predictability into your finances. It’s the same in business. Let’s say you make tyres: you can contract to buy rubber at a certain price without actually buying it and having to stash it in a warehouse before you need it. That way you build stability into your tyre business. Perhaps you know you will need to borrow money in six months. You don’t have to do so now at today’s interest rate and sit on the money for half a year. You can take out a contract to borrow in six months at a rate that you can then build into your budget. And so on. Useful things, derivatives.
However, there is a second aspect to derivatives that also makes them occasionally dangerous. Some investors use them to make “speculative” bets on how the markets will move. Imagine, for example, that you were absolutely sure rubber prices were going to surge: you might borrow money to buy a derivative that lets you benefit from a rubber price increase, even if you never owned any rubber at all (or never needed to own it). However, if such bets go wrong (say rubber prices actually fall), or you misunderstand the complex mathematics behind the contract, you can lose an awful lot of money, particularly if you have borrowed heavily to make your bet. It is this second, “speculative” feature that makes derivatives Manichean in nature, capable of producing both negative and positive outcomes.
Now, back to Boca Raton. The “offsite weekend” was part of a well-worn ritual in the banking world, designed to let the bankers celebrate and let off steam. On this occasion, the young JPMorgan bankers (and they were mostly young) were determined to have fun. Boca Raton has golden sands, a swanky tennis club and a sparkling marina, and in the early 1990s the bank had plenty of money to splash around: some of the bankers flew in by Concorde, stayed in smart, pink Spanish-style villas and drank heavily at the bank’s expense. Indeed, by the end of the weekend, the party spirit was running so high that the bankers started throwing each other into the swimming pool fully clothed.
“There was a great group spirit - we worked hard, but we also had a lot of fun,” recalls Bill Winters, an American banker with a straight-talking manner and debonair features, who was one of those who ended up dripping wet. These days Winters, 45, is a man who exudes gravitas: his current job is co-chief executive of JPMorgan’s entire investment bank, which makes him one of the most powerful people in investment banking today. But back at Boca Raton he was just an up-and-coming derivatives expert who, like the rest of his ilk, was hungry for opportunity - and fun.
But partying aside, Boca Raton also had a very serious agenda. For it came as JPMorgan was confronting an odd paradox that haunts the banking world. While laws exist to protect people from stealing brilliant inventions from each other in areas such as industry or design, in the apparently frighteningly powerful world of modern finance, there is nothing to prevent someone from pinching a rival’s ingenious inventions and replicating them (if they can get the resources in place). Or as Peter Hancock, then a JPMorgan banker who was in charge of the Boca Raton meeting, explains: “All ideas in the financial world can be copied pretty quickly - financial innovation does not enjoy patent protection like other fields of engineering.”
Hancock knew the problems this posed perhaps better than anyone else. At that time he was running JPMorgan’s derivatives team. It was not a job anyone might have associated with Hancock if they were meeting him for the first time: a highly intellectual man, with an amiable face, he exudes the courteous manner of an English country doctor rather than a Wall Street financier. Initially he had had little ambition to become a banker. His dream was to be an inventor, and with this in mind he studied science at Oxford. But he drifted into derivatives because he sensed that it was one thing in the banking world that came close to offering the thrill of scientific research. More specifically, at that time - in the late 1980s - the concept of derivatives was so new that it was largely untested, and thus offered plenty of scope to be creative.
At first, this was a rarefied business that few people understood. However, Hancock was one of those who spotted the potential, and when he took over the derivatives department (then known as the “swaps” team) at JPMorgan, at the age of 29, he quickly built it up into a global operation. However, by the time the team came to meet in Boca Raton, Hancock had sensed that this triumph was starting to carry the seeds of potential decline. In the early days of the “swaps” business, it had seemed so exotic that relatively few clients wanted to buy the services - but those who did would pay high fees. Then, as demand mushroomed, profits boomed and a new wave of competitors was attracted into the markets. They were able freely to copy this technology - and undercut the bank on price. What had started as the banking equivalent of the couture dress design trade was becoming a mass market clothing fashion game.
That meant JPMorgan needed a new idea - one that its rivals could not copy too fast. As the bankers assembled in a hotel conference room, close to the Boca Raton marina, Hancock tried to prod them through their hangovers and jetlag into some brainstorming. “The idea was that we should think about how to take forward this large swaps business we had built... and apply it to other areas,” Hancock says.
(One of his colleagues remembers: “Hancock is like an ideas machine - throws a thousand thoughts on to the wall. Most never fly at all, but every so often one does.”)
The idea that attracted most excitement was the concept of mixing derivatives with credit. One of the pernicious problems that have always dogged business is so-called “credit risk” - or the danger that a loan (or bond) might turn sour. And as they sat in their conference room in Boca Raton, some of the bankers started to wonder if there was a way to create derivatives that could bet on whether bonds or loans would default.
After the meeting ended, the bankers flew back from Florida and started hunting for ways to put these ideas into practice. One was Robert Reoch, a young British banker who had recently joined JPMorgan’s London derivatives desk, which was tucked in a former boys’ school on Victoria Embankment. At that time, this derivatives team was very busy in Europe doing its “usual” business of trading currency and interest rate “swaps”. But at the time, JPMorgan also had another booming business in London - trading government bonds. And in the months after Boca Raton, Reoch and his colleagues started to work on the idea of a credit derivative.
No one on the team knew how to price this type of contract, let alone create the paperwork needed to keep the lawyers happy. But Reoch found an investor willing to buy such a deal, and one day he quietly sold a contract that placed bets on whether three European bonds would default. “It was the first time we had done a transaction like that,” Reoch proudly recalls.
What was it they did? The trade was what is known as a “first to default” swap. At that time JPMorgan was heavily involved in trading European government bonds and bond derivatives that left it exposed to losses if any bonds suddenly went into default (not an irrational fear in the pre-euro mid-1990s). However, the bank created a contract which effectively insured itself against such a default for a basket of bonds (say, that of Sweden, Italy and Belgium). It stipulated that if any of these bonds went into default, an investor would pay JPMorgan compensation. If that default never occurred, the investor would make money because they were receiving a fee to take this risk; but if any bonds defaulted, JPMorgan was covered. Thus as long as a price could be found that kept everyone happy, it was a win-win deal: JPMorgan reduced its risk, and the investors could earn nice returns. It took another three months for the team to sort out the paperwork for this experiment. And it didn’t at first make waves in the financial markets. At that time, other banks were also experimenting in this way - and groups such as Bankers Trust and Credit Suisse were considered more innovative and aggressive in this area than JPMorgan. Yet, as 1994 turned into 1995, JPMorgan moved out in front.
Quite why remains a matter of debate. JPMorgan’s rivals say it was a simple matter of business expediency - and, above all, accounting pressure. International banking laws place strict limits on how much risk a bank can take before it has to stop doing new business, and the bank was hitting those limits. This meant JPMorgan had a strong incentive to look at credit in an innovative manner, because it had a bigger loan book than rivals.
This does not explain the whole story - or at least not as the JPMorgan’s bankers now tell it. They say it was corporate culture: the bank’s background as a blue-chip lender meant that it prided itself on having a more gentlemanly ethos than some of its Wall Street competitors. Hancock placed a heavy emphasis on recruiting individuals willing to work within a strong team ethos.
He started by recruiting a loyal deputy, Bill Demchak, a practical young American who was skilled at turning Hancock’s abstract musings into concrete plans. (”Without Demchak, half of Hancock’s idea would have probably just stayed on another planet,” laughs one colleague.) Then they pulled a group of young, highly ambitious - and all exceedingly numerate - wannabe bankers into their orbit, sometimes from unlikely quarters.
In London, the team included an American, Bill Winters, and Tim (”Frosty”) Frost, who hailed from Nottingham and sported an economics degree from the London School of Economics. (”A lot of people in this [credit derivatives business] came from the LSE,” he says today, speaking with the flattened vowels from his Midlands childhood.) Over in New York, Demchak and Hancock pulled in Andrew Feldstein, an ambitious and articulate young trader. Another recruit was Terri Duhon, a vivacious, dark-haired woman, who had grown up in humble circumstance in rural Louisiana, but then won a scholarship to study maths at Massachusetts Institute of Technology, where - like many of her generation - she succumbed to the intellectual and pecuniary lure of finance. “I had read Liar’s Poker and thought that trading derivatives sounded sexy and fun,” she recalls.
Another - more unlikely - young wannabe was a well-spoken, horse-mad British woman called Blythe Masters. She had grown up in the south-east of England, where she attended the exclusive King’s public school in Canterbury on a scholarship before completing an economics degree at Cambridge university. From an early age, Masters decided that she wanted a career in derivatives. It was an unusual choice for a middle-class Englishwoman at the time. And even today she does not look like the usual stereotype of a Wall Street hotshot. When I met her recently in JPMorgan’s London offices she was sporting a well-cut blonde bob and an elegant candy pink suit, with matching shoes and bag. As if explaining this to me, she said: “I have a quantitative background, but really derivatives appealed to me because they require so much creativity.”
At first she joined JPMorgan’s commodities desk. But after she attended the Boca Raton meeting she - like “Frosty” and the others - sensed an opportunity. So she moved across to New York and started hunting for ways to use the credit derivatives idea. Around this point, in her mid-twenties, she also had a baby (in an early marriage that did not last). This apparently did not put her off her stride: when she went into labour, she kept monitoring her financial trades from the hospital. She also kept brainstorming with colleagues about how to turn the credit derivatives idea into tangible profit. “We had a culture created by people such as Peter Hancock and Bill Demchak which emphasised teamwork and where no single individual could own a product,” says Masters. “That is quite different from the turf-driven environment of many investment banks. You cannot produce this type of innovation if you are too narrowly focused on... personal profits and losses.”
By 1997, Demchak and Masters came up with their Big Idea: a product known as Bistro, short for Broad Index Secured Trust Offering. (Bankers who work in the world of derivatives love creating odd names out of complex acronyms - it appeals to their problem-solving skills, no doubt.) What Bistro did was to use credit derivatives to “clean up” a bank’s balance sheet. The scheme started by taking a basket of bank loans and separating out - in accounting terms - the theoretical risk that these loans would turn sour from the loans themselves. This default risk was usually then sold to a “paper” company, known as a special purpose vehicle, which then issued bonds that investors could buy. If lots of loans went into default, the value of these bonds would fall, of course; but if the loans were honoured, the bonds would be a safe bet for the investors. Either way, the point was this: anyone buying such bonds was essentially betting on the risk of loan default. And as long as the deal was structured in a way that made the bonds look cheap, relative to the risk of default, then investors would think they had got a good deal. The pricing itself was based on what had happened to banks’ loan books in recent years (together with some complex number crunching).
The deal looked even better for the original bank. For the act of selling the default risk on to new investors had crucial regulatory implications. International banking rules say that banks have to hold a certain level of spare funds (or reserves) to protect themselves from the danger that their loans might turn bad. However, since the banks had sold the risk of default on to somebody else, they could now argue that they did not need to hold these funds.
To anybody outside the world of finance, this might look odd (after all, the banks were still making loans); but the regulators accepted this argument, since the risk had moved, in accounting terms. And that let the banks free up funds to make even more loans. It was the financial equivalent of calorie-free chocolate: almost too good to be true.
Hancock’s group started using Bistro to clean up JPMorgan’s own portfolio of loans. Then they started offering it to other banks. And within the space of a few months, they were handling not just billions of dollars of loans, but tens of billions, and then hundreds of billions. It was an intoxicating time for the young bankers. Many had been impoverished graduates just a few years earlier; now they were earning bonuses bigger than most had ever dared to imagine. Not that they had any time to spend the cash: as demand swelled, JPMorgan’s tiny team - which still numbered just a few dozen - found themselves almost every waking hour in each others’ company. “The business we were doing grew exponentially,” recalls Duhon. “We went out and ‘Bistro-ed’ everything we could.”
By the end of the decade, Hancock had been promoted to chief financial officer of the bank - and the success of Bistro had left Masters running the credit derivatives group. But soon, in 2000, JPMorgan merged with one of its giant rivals, Chase Manhattan. Such mergers are common on Wall Street, but they rarely occur without internal fights or defections. And this was no exception: Hancock resigned, later followed by Demchak. And with these men gone, a team that had held together with unusual loyalty for almost a decade (or a lifetime in investment banking) started to crumble.
These days, some of this original JPMorgan “dream team” - as they were dubbed by specialist financial magazines - remain at the bank. There is Winters, of course, and Masters recently became chief financial officer of the investment bank at the age of just 35 - which makes her one of the most powerful women on Wall Street and almost certainly the most senior British female there. (She remains horse-mad to this day: in what little spare time she has from her career and daughter, and a new fiance, she also owns an equestrian business.)
But most of the JPMorgan team have scattered to the winds. Some are running credit derivatives businesses at other investment banks. Others have moved to the fast-expanding world of hedge funds. The British banker “Frosty”, for example, recently co-founded Cairn Capital, a hedge fund based in Mayfair; Feldstein co-founded BlueMountain Capital Management, a New York-based hedge fund; the would-be inventor Hancock co-runs Integrated Finance Ltd, an advisory group; Demchak is vice-chairman of PNC Financial Services Group; Reoch, the British banker who did JPMorgan’s first credit derivatives trade, is a consultant based in the pleasant climes of Dorset; and Duhon - the banker from rural Louisiana - has created a consultancy in Mayfair.
These days banks such as Deutsche Bank, Citigroup, Morgan Stanley and Goldman Sachs are also big in credit derivatives. Thus the dispersion of the JPMorgan innovators has helped to transform a niche product into a vast industry with extraordinary speed. Indeed, JPMorgan itself, having at first tried to keep its products to itself, decided in this decade to collaborate with its rivals to build the type of industry-wide infrastructure that could make the overall market as big as possible.
But that success has come at a cost. As credit derivatives have spread, they have also become another, lower margin, mass market game - just like the swaps business when the JPMorgan bankers met at Boca Raton. Indeed, everyone agrees that the innovation cycle is now speeding up dramatically, as technology integrates markets more closely. A decade or two ago, a new idea could stay “secret” for a year or two; now it can leak from New York to Tokyo - and back - in the press of a button or two. That makes it harder than ever to protect profitable inventions - and creates even more pressure for innovation.
Most bankers insist that these new instruments make the financial world a safer place. After all, for the first time, institutions making loans now have an effective way to insure against defaults; so does anyone investing in bonds (including, perhaps, your pension fund). Moreover, the fact that loan risks are now being traded means they are now spread among a much wider pool of people. That should make the financial system more resilient to shocks. If a cataclysmic event ever hits (say, 10 large companies suddenly collapse) the blow will be spread around in millions of tiny pieces, not concentrated on just one spot.
There is also a downside: spreading risk around makes it much harder for bankers, central bankers - or anybody else - to predict what might happen if a cataclysm did hit. For the whole credit derivatives world has exploded at such a dizzy pace that nobody is exactly sure where the loan risk has gone. Have all the investors who have bought credit derivatives contracts checked the fine print to see what losses they could sustain? Does anybody understand the chain reaction that might be triggered by such losses? Could the world’s trading systems cope? And what would happen to all those hedge funds that have been jumping into the credit derivatives world?
And what of the future? Some of the leading figures, such as Masters, think there is room for more innovation in the credit derivatives world. For while the basic ideas are now so widely dispersed that they are almost “mass-market” for traders, she believes that “the point about that process is that when something becomes commoditised it lets you create second- or third-generation products”. That should make it easier for bankers to reassemble these derivatives in new and more complex ways - in much the same way that it becomes possible to create more complex computers when there is mass-market production of circuit boards. The next round of innovation, in other words, will be derivatives of credit derivatives, or even “derivatives cubed”.
None of the ideas that are around at the moment is entirely new: on the contrary, most were on the list of concepts that Hancock tried to “throw on the wall” - as his colleagues say - back in Boca Raton in the early 1990s. Yet somehow those concepts never found such fertile business soil as the credit idea. But maybe that is just a matter of time. “Ideas can float around for ages and then suddenly get picked up,” says Hancock.
So perhaps, somewhere out on Wall Street or in the City - or Mayfair - the seeds for fresh innovation are already germinating. Ambitious young bankers are eagerly sniffing for them, just as Masters, Winters and Frosty were a decade ago. But wherever the next brilliant innovation appears, one thing is certain: inside every moment of stunning success on Wall Street and in the City are the seeds of future decline. And by the time humble journalists such as me ever get to know what the next really Big Idea is, the most profitable moment in that cycle will already have occurred.
The dream machine: invention of credit derivatives
By Gillian Tett
(FT 24 Mar 2006) The first time I ran into the “Morgan mafia” - or, more accurately, the ex-JPMorgan mafia - was at a banking conference in Nice last year. It was, I later learned, the type of ritual typical of high finance: around a plush, darkened lecture theatre and well-stocked bar, a gaggle of suited men (and the occasional woman) earnestly muttered about “delta hedging”, “correlation risk” or “CDO squared”.
For all I could tell, they might have been discussing nuclear physics or ancient Chinese. What distinguished this meeting from those topics, however, was the whiff of money: these people might have looked like nerds, but they sported very expensive watches, and their chat was peppered with casual references to billions of dollars.
Uneasily, I tried to work out what was going on. A few weeks earlier I had started reporting on the capital markets and heard that something called “credit derivatives” was revolutionising global finance. Just five years ago the sector was a tiny niche business. Now the volume of all the outstanding credit-derivatives deals in the world is estimated at $12 trillion. However, like most people, I had little idea what a number that big actually meant (for reference, it is about the size of the American economy, or almost four times the total value of all the shares on the London Stock Exchange). So I had flown to Nice hoping to get some bearings in this strange land.
“Who’s that?” I whispered to a banker next to me, pointing to a platform where two men and two women were discussing whether investors “really understand the full ramifications of CDO risk”. (Their conclusion seemed to be: “not always”, which didn’t surprise me, given how little of the jargon anyone might have understood.) My neighbour furtively whispered that he worked for one of the biggest US banks and was therefore forbidden to talk to journalists, “since you guys keep writing that crap about derivatives blowing up the world”. But then he relented: the speakers, he said, were apparently consultants or partners in hedge (big private investment) funds; but almost all used to work for JPMorgan, the big US bank.
Why JPMorgan? I asked. Why not Goldman Sachs or Morgan Stanley? Or a British, French - or Chinese - bank, come to that?
“It’s the Morgan mafia - they sort of created the whole credit derivatives thing,” he chuckled, and then clammed up as if he had revealed a sensitive commercial secret.
As I sat watching slick PowerPoint presentations, I wondered how this had come about. Every year, the anonymous eggheads who work on Wall Street and in the City of London produce a stream of bright ideas that push money around the world in an ever more efficient way (and make the banks they work for, and themselves, richer in the process). Most of these ideas simply vanish; but every so often a few - such as credit derivatives - mushroom with extraordinary speed.
To anyone outside finance, these concepts generally seem so complex that such innovation might exist in a parallel universe. But that is only half true. For if the oil of high finance does not keep lubricating the wheels of the global economy, the world as we know it would quickly slow down. Moreover, we live in such an inter-connected economic system that every time you convert money at a foreign exchange till, pay your mortgage to a bank or use your ATM card, you are plugging into a giant web of capital flows that is being continually rewoven by these innovations.
But where, I wondered as I sat in the lecture theatre, do these ideas come from? And why do some fail and others blossom into a $12 trillion business? And what does that tell us about the way that financial innovation really works and shapes all our lives?
In the months that followed the conference in Nice, I started to track down some of this “Morgan mafia” in an effort to understand the credit derivatives tale. It was not an easy task: traders live in a world in which information costs money, numbers speak louder than words and journalists are - at best - viewed with extreme distrust. But, as it turns out, one place to start this story is not on the dealing floors of London or New York, but on the humid coast of Florida. For it was there, at the plush holiday resort of Boca Raton, that about 80 JPMorgan bankers working in their derivatives department assembled about a decade ago, to hold a so-called “weekend offsite”.
By now you might be feeling like I did when I showed up at that banking conference in Nice, wondering what everyone was talking about. First you need to understand what a derivative is. And to do that, you might as well start with the literal meaning: a derivative is something whose nature is derived, or comes, from something else. In the financial world, where we are interested in the value of something, the value of a derivative depends on the value of something else. So far so simple.
There are many things in the financial world that have value: shares, bonds, currencies, commodities, cash, loans. The secret of the derivative is that it makes it possible for you to have some of the value of one of those assets, even if you don’t actually own it. Why would anyone want to do that? Part of the answer is that it acts a bit like an insurance policy. If you think you might have an accident in your car, you don’t have to set aside the entire value of a new car. You can pay a premium that will cover the cost only if you crash. If you think your shares are going to fall, you don’t have to sell them. You can take out a contract to sell them at a certain price if indeed they do fall. If they don’t fall, you won’t have sold. That’s how you build stability and predictability into your finances. It’s the same in business. Let’s say you make tyres: you can contract to buy rubber at a certain price without actually buying it and having to stash it in a warehouse before you need it. That way you build stability into your tyre business. Perhaps you know you will need to borrow money in six months. You don’t have to do so now at today’s interest rate and sit on the money for half a year. You can take out a contract to borrow in six months at a rate that you can then build into your budget. And so on. Useful things, derivatives.
However, there is a second aspect to derivatives that also makes them occasionally dangerous. Some investors use them to make “speculative” bets on how the markets will move. Imagine, for example, that you were absolutely sure rubber prices were going to surge: you might borrow money to buy a derivative that lets you benefit from a rubber price increase, even if you never owned any rubber at all (or never needed to own it). However, if such bets go wrong (say rubber prices actually fall), or you misunderstand the complex mathematics behind the contract, you can lose an awful lot of money, particularly if you have borrowed heavily to make your bet. It is this second, “speculative” feature that makes derivatives Manichean in nature, capable of producing both negative and positive outcomes.
Now, back to Boca Raton. The “offsite weekend” was part of a well-worn ritual in the banking world, designed to let the bankers celebrate and let off steam. On this occasion, the young JPMorgan bankers (and they were mostly young) were determined to have fun. Boca Raton has golden sands, a swanky tennis club and a sparkling marina, and in the early 1990s the bank had plenty of money to splash around: some of the bankers flew in by Concorde, stayed in smart, pink Spanish-style villas and drank heavily at the bank’s expense. Indeed, by the end of the weekend, the party spirit was running so high that the bankers started throwing each other into the swimming pool fully clothed.
“There was a great group spirit - we worked hard, but we also had a lot of fun,” recalls Bill Winters, an American banker with a straight-talking manner and debonair features, who was one of those who ended up dripping wet. These days Winters, 45, is a man who exudes gravitas: his current job is co-chief executive of JPMorgan’s entire investment bank, which makes him one of the most powerful people in investment banking today. But back at Boca Raton he was just an up-and-coming derivatives expert who, like the rest of his ilk, was hungry for opportunity - and fun.
But partying aside, Boca Raton also had a very serious agenda. For it came as JPMorgan was confronting an odd paradox that haunts the banking world. While laws exist to protect people from stealing brilliant inventions from each other in areas such as industry or design, in the apparently frighteningly powerful world of modern finance, there is nothing to prevent someone from pinching a rival’s ingenious inventions and replicating them (if they can get the resources in place). Or as Peter Hancock, then a JPMorgan banker who was in charge of the Boca Raton meeting, explains: “All ideas in the financial world can be copied pretty quickly - financial innovation does not enjoy patent protection like other fields of engineering.”
Hancock knew the problems this posed perhaps better than anyone else. At that time he was running JPMorgan’s derivatives team. It was not a job anyone might have associated with Hancock if they were meeting him for the first time: a highly intellectual man, with an amiable face, he exudes the courteous manner of an English country doctor rather than a Wall Street financier. Initially he had had little ambition to become a banker. His dream was to be an inventor, and with this in mind he studied science at Oxford. But he drifted into derivatives because he sensed that it was one thing in the banking world that came close to offering the thrill of scientific research. More specifically, at that time - in the late 1980s - the concept of derivatives was so new that it was largely untested, and thus offered plenty of scope to be creative.
At first, this was a rarefied business that few people understood. However, Hancock was one of those who spotted the potential, and when he took over the derivatives department (then known as the “swaps” team) at JPMorgan, at the age of 29, he quickly built it up into a global operation. However, by the time the team came to meet in Boca Raton, Hancock had sensed that this triumph was starting to carry the seeds of potential decline. In the early days of the “swaps” business, it had seemed so exotic that relatively few clients wanted to buy the services - but those who did would pay high fees. Then, as demand mushroomed, profits boomed and a new wave of competitors was attracted into the markets. They were able freely to copy this technology - and undercut the bank on price. What had started as the banking equivalent of the couture dress design trade was becoming a mass market clothing fashion game.
That meant JPMorgan needed a new idea - one that its rivals could not copy too fast. As the bankers assembled in a hotel conference room, close to the Boca Raton marina, Hancock tried to prod them through their hangovers and jetlag into some brainstorming. “The idea was that we should think about how to take forward this large swaps business we had built... and apply it to other areas,” Hancock says.
(One of his colleagues remembers: “Hancock is like an ideas machine - throws a thousand thoughts on to the wall. Most never fly at all, but every so often one does.”)
The idea that attracted most excitement was the concept of mixing derivatives with credit. One of the pernicious problems that have always dogged business is so-called “credit risk” - or the danger that a loan (or bond) might turn sour. And as they sat in their conference room in Boca Raton, some of the bankers started to wonder if there was a way to create derivatives that could bet on whether bonds or loans would default.
After the meeting ended, the bankers flew back from Florida and started hunting for ways to put these ideas into practice. One was Robert Reoch, a young British banker who had recently joined JPMorgan’s London derivatives desk, which was tucked in a former boys’ school on Victoria Embankment. At that time, this derivatives team was very busy in Europe doing its “usual” business of trading currency and interest rate “swaps”. But at the time, JPMorgan also had another booming business in London - trading government bonds. And in the months after Boca Raton, Reoch and his colleagues started to work on the idea of a credit derivative.
No one on the team knew how to price this type of contract, let alone create the paperwork needed to keep the lawyers happy. But Reoch found an investor willing to buy such a deal, and one day he quietly sold a contract that placed bets on whether three European bonds would default. “It was the first time we had done a transaction like that,” Reoch proudly recalls.
What was it they did? The trade was what is known as a “first to default” swap. At that time JPMorgan was heavily involved in trading European government bonds and bond derivatives that left it exposed to losses if any bonds suddenly went into default (not an irrational fear in the pre-euro mid-1990s). However, the bank created a contract which effectively insured itself against such a default for a basket of bonds (say, that of Sweden, Italy and Belgium). It stipulated that if any of these bonds went into default, an investor would pay JPMorgan compensation. If that default never occurred, the investor would make money because they were receiving a fee to take this risk; but if any bonds defaulted, JPMorgan was covered. Thus as long as a price could be found that kept everyone happy, it was a win-win deal: JPMorgan reduced its risk, and the investors could earn nice returns. It took another three months for the team to sort out the paperwork for this experiment. And it didn’t at first make waves in the financial markets. At that time, other banks were also experimenting in this way - and groups such as Bankers Trust and Credit Suisse were considered more innovative and aggressive in this area than JPMorgan. Yet, as 1994 turned into 1995, JPMorgan moved out in front.
Quite why remains a matter of debate. JPMorgan’s rivals say it was a simple matter of business expediency - and, above all, accounting pressure. International banking laws place strict limits on how much risk a bank can take before it has to stop doing new business, and the bank was hitting those limits. This meant JPMorgan had a strong incentive to look at credit in an innovative manner, because it had a bigger loan book than rivals.
This does not explain the whole story - or at least not as the JPMorgan’s bankers now tell it. They say it was corporate culture: the bank’s background as a blue-chip lender meant that it prided itself on having a more gentlemanly ethos than some of its Wall Street competitors. Hancock placed a heavy emphasis on recruiting individuals willing to work within a strong team ethos.
He started by recruiting a loyal deputy, Bill Demchak, a practical young American who was skilled at turning Hancock’s abstract musings into concrete plans. (”Without Demchak, half of Hancock’s idea would have probably just stayed on another planet,” laughs one colleague.) Then they pulled a group of young, highly ambitious - and all exceedingly numerate - wannabe bankers into their orbit, sometimes from unlikely quarters.
In London, the team included an American, Bill Winters, and Tim (”Frosty”) Frost, who hailed from Nottingham and sported an economics degree from the London School of Economics. (”A lot of people in this [credit derivatives business] came from the LSE,” he says today, speaking with the flattened vowels from his Midlands childhood.) Over in New York, Demchak and Hancock pulled in Andrew Feldstein, an ambitious and articulate young trader. Another recruit was Terri Duhon, a vivacious, dark-haired woman, who had grown up in humble circumstance in rural Louisiana, but then won a scholarship to study maths at Massachusetts Institute of Technology, where - like many of her generation - she succumbed to the intellectual and pecuniary lure of finance. “I had read Liar’s Poker and thought that trading derivatives sounded sexy and fun,” she recalls.
Another - more unlikely - young wannabe was a well-spoken, horse-mad British woman called Blythe Masters. She had grown up in the south-east of England, where she attended the exclusive King’s public school in Canterbury on a scholarship before completing an economics degree at Cambridge university. From an early age, Masters decided that she wanted a career in derivatives. It was an unusual choice for a middle-class Englishwoman at the time. And even today she does not look like the usual stereotype of a Wall Street hotshot. When I met her recently in JPMorgan’s London offices she was sporting a well-cut blonde bob and an elegant candy pink suit, with matching shoes and bag. As if explaining this to me, she said: “I have a quantitative background, but really derivatives appealed to me because they require so much creativity.”
At first she joined JPMorgan’s commodities desk. But after she attended the Boca Raton meeting she - like “Frosty” and the others - sensed an opportunity. So she moved across to New York and started hunting for ways to use the credit derivatives idea. Around this point, in her mid-twenties, she also had a baby (in an early marriage that did not last). This apparently did not put her off her stride: when she went into labour, she kept monitoring her financial trades from the hospital. She also kept brainstorming with colleagues about how to turn the credit derivatives idea into tangible profit. “We had a culture created by people such as Peter Hancock and Bill Demchak which emphasised teamwork and where no single individual could own a product,” says Masters. “That is quite different from the turf-driven environment of many investment banks. You cannot produce this type of innovation if you are too narrowly focused on... personal profits and losses.”
By 1997, Demchak and Masters came up with their Big Idea: a product known as Bistro, short for Broad Index Secured Trust Offering. (Bankers who work in the world of derivatives love creating odd names out of complex acronyms - it appeals to their problem-solving skills, no doubt.) What Bistro did was to use credit derivatives to “clean up” a bank’s balance sheet. The scheme started by taking a basket of bank loans and separating out - in accounting terms - the theoretical risk that these loans would turn sour from the loans themselves. This default risk was usually then sold to a “paper” company, known as a special purpose vehicle, which then issued bonds that investors could buy. If lots of loans went into default, the value of these bonds would fall, of course; but if the loans were honoured, the bonds would be a safe bet for the investors. Either way, the point was this: anyone buying such bonds was essentially betting on the risk of loan default. And as long as the deal was structured in a way that made the bonds look cheap, relative to the risk of default, then investors would think they had got a good deal. The pricing itself was based on what had happened to banks’ loan books in recent years (together with some complex number crunching).
The deal looked even better for the original bank. For the act of selling the default risk on to new investors had crucial regulatory implications. International banking rules say that banks have to hold a certain level of spare funds (or reserves) to protect themselves from the danger that their loans might turn bad. However, since the banks had sold the risk of default on to somebody else, they could now argue that they did not need to hold these funds.
To anybody outside the world of finance, this might look odd (after all, the banks were still making loans); but the regulators accepted this argument, since the risk had moved, in accounting terms. And that let the banks free up funds to make even more loans. It was the financial equivalent of calorie-free chocolate: almost too good to be true.
Hancock’s group started using Bistro to clean up JPMorgan’s own portfolio of loans. Then they started offering it to other banks. And within the space of a few months, they were handling not just billions of dollars of loans, but tens of billions, and then hundreds of billions. It was an intoxicating time for the young bankers. Many had been impoverished graduates just a few years earlier; now they were earning bonuses bigger than most had ever dared to imagine. Not that they had any time to spend the cash: as demand swelled, JPMorgan’s tiny team - which still numbered just a few dozen - found themselves almost every waking hour in each others’ company. “The business we were doing grew exponentially,” recalls Duhon. “We went out and ‘Bistro-ed’ everything we could.”
By the end of the decade, Hancock had been promoted to chief financial officer of the bank - and the success of Bistro had left Masters running the credit derivatives group. But soon, in 2000, JPMorgan merged with one of its giant rivals, Chase Manhattan. Such mergers are common on Wall Street, but they rarely occur without internal fights or defections. And this was no exception: Hancock resigned, later followed by Demchak. And with these men gone, a team that had held together with unusual loyalty for almost a decade (or a lifetime in investment banking) started to crumble.
These days, some of this original JPMorgan “dream team” - as they were dubbed by specialist financial magazines - remain at the bank. There is Winters, of course, and Masters recently became chief financial officer of the investment bank at the age of just 35 - which makes her one of the most powerful women on Wall Street and almost certainly the most senior British female there. (She remains horse-mad to this day: in what little spare time she has from her career and daughter, and a new fiance, she also owns an equestrian business.)
But most of the JPMorgan team have scattered to the winds. Some are running credit derivatives businesses at other investment banks. Others have moved to the fast-expanding world of hedge funds. The British banker “Frosty”, for example, recently co-founded Cairn Capital, a hedge fund based in Mayfair; Feldstein co-founded BlueMountain Capital Management, a New York-based hedge fund; the would-be inventor Hancock co-runs Integrated Finance Ltd, an advisory group; Demchak is vice-chairman of PNC Financial Services Group; Reoch, the British banker who did JPMorgan’s first credit derivatives trade, is a consultant based in the pleasant climes of Dorset; and Duhon - the banker from rural Louisiana - has created a consultancy in Mayfair.
These days banks such as Deutsche Bank, Citigroup, Morgan Stanley and Goldman Sachs are also big in credit derivatives. Thus the dispersion of the JPMorgan innovators has helped to transform a niche product into a vast industry with extraordinary speed. Indeed, JPMorgan itself, having at first tried to keep its products to itself, decided in this decade to collaborate with its rivals to build the type of industry-wide infrastructure that could make the overall market as big as possible.
But that success has come at a cost. As credit derivatives have spread, they have also become another, lower margin, mass market game - just like the swaps business when the JPMorgan bankers met at Boca Raton. Indeed, everyone agrees that the innovation cycle is now speeding up dramatically, as technology integrates markets more closely. A decade or two ago, a new idea could stay “secret” for a year or two; now it can leak from New York to Tokyo - and back - in the press of a button or two. That makes it harder than ever to protect profitable inventions - and creates even more pressure for innovation.
Most bankers insist that these new instruments make the financial world a safer place. After all, for the first time, institutions making loans now have an effective way to insure against defaults; so does anyone investing in bonds (including, perhaps, your pension fund). Moreover, the fact that loan risks are now being traded means they are now spread among a much wider pool of people. That should make the financial system more resilient to shocks. If a cataclysmic event ever hits (say, 10 large companies suddenly collapse) the blow will be spread around in millions of tiny pieces, not concentrated on just one spot.
There is also a downside: spreading risk around makes it much harder for bankers, central bankers - or anybody else - to predict what might happen if a cataclysm did hit. For the whole credit derivatives world has exploded at such a dizzy pace that nobody is exactly sure where the loan risk has gone. Have all the investors who have bought credit derivatives contracts checked the fine print to see what losses they could sustain? Does anybody understand the chain reaction that might be triggered by such losses? Could the world’s trading systems cope? And what would happen to all those hedge funds that have been jumping into the credit derivatives world?
And what of the future? Some of the leading figures, such as Masters, think there is room for more innovation in the credit derivatives world. For while the basic ideas are now so widely dispersed that they are almost “mass-market” for traders, she believes that “the point about that process is that when something becomes commoditised it lets you create second- or third-generation products”. That should make it easier for bankers to reassemble these derivatives in new and more complex ways - in much the same way that it becomes possible to create more complex computers when there is mass-market production of circuit boards. The next round of innovation, in other words, will be derivatives of credit derivatives, or even “derivatives cubed”.
None of the ideas that are around at the moment is entirely new: on the contrary, most were on the list of concepts that Hancock tried to “throw on the wall” - as his colleagues say - back in Boca Raton in the early 1990s. Yet somehow those concepts never found such fertile business soil as the credit idea. But maybe that is just a matter of time. “Ideas can float around for ages and then suddenly get picked up,” says Hancock.
So perhaps, somewhere out on Wall Street or in the City - or Mayfair - the seeds for fresh innovation are already germinating. Ambitious young bankers are eagerly sniffing for them, just as Masters, Winters and Frosty were a decade ago. But wherever the next brilliant innovation appears, one thing is certain: inside every moment of stunning success on Wall Street and in the City are the seeds of future decline. And by the time humble journalists such as me ever get to know what the next really Big Idea is, the most profitable moment in that cycle will already have occurred.
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