Interbank lending woes or...

Derivatives Traders Signal Bank Woes Likely to Worsen (Update3)

By Liz Capo McCormick

June 4 (Bloomberg) -- Interest-rate derivatives traders are betting banks' difficulties obtaining cash to fund holdings and shore up balance sheets will worsen.

The difference, or spread, between the three-month dollar London interbank offered rate and the overnight index swap rate on contracts beginning in three months and trading now in the forwards market is greater than spreads on those starting this month, according to data tracked by Credit Suisse Holdings Inc.

``The movement in the forward Libor-OIS spreads is telling you that the market is concerned that things can get even worse before they get better,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of the 20 primary dealers of U.S. government securities that trade with the Federal Reserve. ``Until all banks' balance sheets are cleaned up and they've re-capitalized, there is going to be funding pressure.''

Derivatives trades show that while global markets have rebounded since March, the worst may not be over for banks after racking up $387 billion of losses and writedowns from mortgage- related securities since the start of last year. Lehman Brothers Holdings Inc. has tumbled about 19 percent this week on concern it needs outside funding to shore up its balance sheet.

The three-month Libor-OIS spread traded forward to June 16, the date the June Eurodollar futures contract expires, is 68.5 basis points, while the forward spread corresponding to the September Eurodollar expiration is 70 basis points, or 0.7 percentage point. Eurodollar futures are priced at expiration to three-month dollar Libor.

Availability of Funds

Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar swaps, the floating rate is the daily effective federal funds rate.

The difference between Libor, which is an average rate based on a daily survey of 16 banks by the British Bankers' Association, and the OIS rate indirectly measures the availability of funds in the money market. Forwards give expectations for the future.

Wider Libor-OIS September spreads may reflect traders exiting ``soon-to-expire'' positions earlier than usual, given potential volatility in Libor amid questions over its veracity, according to Laurence Mutkin, London-based head of European fixed-income strategy at Morgan Stanley, another primary dealer.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.

Widening Forward Spreads

The market has grown more pessimistic since April 30, when the September spread was 6 basis points less than June, according to Credit Suisse.

The spot three-month dollar Libor-OIS spread is 67 basis points today, after ranging from 24 basis points to 90 basis points this year and peaking last year at 106 basis points in December. The spread averaged 11 basis points for the 10 years prior to August, when the global credit crunch began.

Concern institutions are having difficulty accessing financing increased this week after Standard & Poor's lowered credit ratings for Morgan Stanley, Merrill Lynch & Co. and Lehman Brothers on June 2, citing the possibility that the investment banks will have further writedowns on devalued assets.

Lehman Options

Lehman, the fourth-biggest U.S. securities firm, may report this month its first quarterly loss since going public in 1994, increasing pressure on the company to raise capital, according to analysts at Oppenheimer & Co. and Bank of America Corp. Lehman may be forced either to sell all or part of itself to a bigger financial firm or sell a large quantity of new shares to bolster its finances, the Wall Street Journal reported today.

Options trading shows bearish positions on Lehman exceeded bullish ones by 1.6-to-1 yesterday, a two-month high. The cost of protecting debt sold by Lehman from default rose to 240 basis points from 150 basis points in the credit-default swaps market during the past week, data compiled by UniCredit SpA show.

The British Bankers' Association has been under fire since the Bank for International Settlements said in March the banks that set Libor understated their borrowing costs to avoid speculation they were in financial straits as losses in credit markets mounted.

Libor Oversight

The London-based BBA completed a review of Libor on May 30, saying it will strengthen ``oversight'' of the system. Details will be revealed ``in due course,'' it said.

Three-month Libor-OIS forward spreads through December maturities are in line with each other, indicating the problems with Libor will be longer lasting, according Mustafa Chowdhury, head of U.S. interest-rate research in New York at Deutsche Bank AG, also a primary dealer.

``Instead of being an immediate bank-liquidity problem, Libor is now being affected by a longer-term capital problem,'' Chowdhury said. The market ``had previously expected the liquidity problems that had boosted the Libor-OIS spread to dissipate relatively quickly.''

The Libor-OIS forward spread that corresponds with the Dec. 15 Eurodollar futures expiration date was 67.5 basis points.

Getting creative in accounting -- Decrease in expected liabilties --> Gains (booked as profit)

Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math

By Bradley Keoun

June 2 (Bloomberg) -- Leave it to Wall Street to profit from its own distress.

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

The new math, while legal, defies common sense. Merrill, the third-biggest U.S. securities firm, added $4 billion of revenue during the past three quarters as the market value of its debt fell. That was the result of higher yields demanded by investors spooked by the New York-based company's $37 billion of writedowns from assets hurt by the collapse of the subprime mortgage market.

``They can post substantial gains as a result of a decline in their own creditworthiness,'' said James Cataldo, a former director of treasury risk management for the Federal Home Loan Bank of Boston and now an assistant professor of accounting at Suffolk University in Boston. ``It's completely legitimate, but it doesn't make sense by any way we currently have of thinking of net income.''

The paper profits have helped offset more than $160 billion of writedowns taken by U.S. financial-services companies during the past year. Now some investors and analysts say the winnings are illusory and may have to be reversed.

``The piper will have to paid eventually,'' said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst who left the New York-based firm earlier this year to become an independent consultant.

Statement 159

The debate over what is known as Statement 159 adds to the number of accounting techniques called into question as the U.S. debt market unravels. Investors have criticized banks for booking some writedowns in an accounting category called ``other comprehensive income'' that bypasses their income statements. Accounting rulemakers are now proposing changes to standards that let banks use off-balance-sheet vehicles to juice earnings without tying up precious capital.

Statement 159, formally known as the ``Fair Value Option for Financial Assets and Financial Liabilities,'' was issued in February 2007 by the Financial Accounting Standards Board, or FASB, which sets U.S. accounting rules. It was adopted by most large Wall Street firms in the first quarter of last year and becomes mandatory for all U.S. companies this year, although they have wide latitude in how to apply it, if at all.

Lobbying Effort

The rule was enacted after lobbying by New York-based companies, led by Merrill, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup, which wrote letters to FASB arguing that it wasn't fair to make them mark their assets to market value if they couldn't also mark their liabilities.

``We do not believe it would be appropriate'' to let investors consider creditworthiness when valuing bonds if the issuing company couldn't do the same, wrote Matthew Schroeder, managing director of accounting policy at Goldman, the largest U.S. securities firm by market value, in an April 2006 letter.

Companies are allowed to decide for themselves which of their outstanding bonds, loans and other liabilities will get mark-to- market treatment. That's an unprecedented degree of leeway, said Willens, who is also an adjunct professor at Columbia University in New York.

``It's kind of a dumb rule,'' Willens said. ``In the entire panoply of accounting, this is the most flexible and elective and optional rule that we have.''

The Fed Objects

Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''

Split at FASB

The regulators remain so skeptical that they refuse to let banks apply the phantom revenue toward minimum capital requirements, according to reporting rules posted on the Web site of the Federal Financial Institutions Examination Council. Deborah Lagomarsino, a Washington-based spokeswoman for the Federal Reserve, declined to comment.

Not even the FASB was united on the new standard. Two of its seven board members -- Thomas Linsmeier and Donald Young -- voted against it, according to the February 2007 statement. Linsmeier said the rule ``will provide an opportunity for entities to report significantly less earnings volatility than they are exposed to,'' according to the statement.

The FASB tried to limit abuses by forcing companies to designate their ``fair value'' liabilities when they adopt the new standard. Subsequently, they can't change their minds. Liabilities added after adoption can only be designated at inception.

``The statement was thoroughly discussed with users and preparers'' in advance of its publication, said Neal McGarity, a spokesman for Norwalk, Connecticut-based FASB. A March survey by the CFA Institute, a Charlottesville, Virginia-based group that administers a financial-analyst designation program, showed that 74 percent of investors believe the standard ``has improved market integrity,'' he said.

Merrill's Liabilities

Merrill designated about $166 billion of liabilities, or 17 percent of its total, as fair-value instruments subject to mark- to-market accounting at the end of 2007, according to its annual report. Included in the amount were $76.3 billion of long-term borrowings and $89.7 billion of payables under securities- financing transactions.

Prices for the firm's bonds tumbled over the past year: Its floating-rate notes due in January 2015 are trading at about 87 cents on the dollar, compared with about 100 cents last June.

Merrill has said its gains from the liabilities don't add to true earnings power. In a spreadsheet posted on its Web site, Merrill says that investors who want a ``more meaningful period- to-period comparison'' should exclude the $2.1 billion of revenue recorded in the first quarter.

Merrill spokeswoman Jessica Oppenheim declined to comment. The company owns a passive 20 percent stake in Bloomberg LP, the parent of Bloomberg News.

Lehman to Goldman

Lehman, the fourth-biggest securities firm, has reported $1.9 billion of gains related to a widening of its own bond spreads. Citigroup, the largest U.S. bank by assets, has booked $1.7 billion; Morgan Stanley $1.7 billion; JPMorgan Chase & Co., the third-biggest bank, $1.7 billion; and Goldman Sachs $550 million.

There may be more to come, JPMorgan analyst Kenneth Worthington wrote in a May 28 report. Lehman may book $325 million for the second fiscal quarter ended in May, and Morgan Stanley, the second-biggest U.S. securities firm, may report $470 million, Worthington estimates.

Spokesmen for Lehman, Morgan Stanley, Goldman, Citigroup and JPMorgan in New York declined to comment.

`Shell Game'

So far, most banks' writedowns are ``unrealized,'' meaning they've been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.

The same is true for the liabilities. Companies can't ``realize'' the mark-to-market gains on their debt unless they buy it back at the discounted price. They're unlikely to do so, because the deterioration in creditworthiness means they'd have to replace the debt with higher-cost borrowings, Willens said.

``No one's going out in the market and actually retiring this debt,'' Willens said. ``It's a shell game.''

David Moser, Merrill's managing director for accounting policy, acknowledged that concern in an April 10, 2006, letter to the FASB.

``It seems counterintuitive that when a company's credit spreads are widening, it would recognize a gain in earnings,'' Moser wrote. ``The amounts are typically not realizable and therefore less relevant.''

He nevertheless supported the new accounting standard because it ``mitigates some of the uneconomic volatility in earnings'' that results from marking assets to market without doing the same for liabilities.

Market Reversal

Bear Stearns Cos., which adopted the new standard this year, reported a $305 million windfall in the fiscal first quarter, which ended in February, as bond spreads widened on concerns the company might face a funding shortage. Then in March, after the New York-based securities firm was forced to sell itself to JPMorgan, Bear Stearns's bond spreads tightened, resulting in a $372 million loss, according to a regulatory filing in April.

Worthington estimates that similar tightening of bond spreads at Merrill, Morgan Stanley, Lehman and Goldman Sachs may cause them to reverse $5.96 billion of revenue by the end of the year.

``It could very well hurt earnings,'' said Jeffery Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, in an interview. On the flip side, a recovery may result in asset write- ups, he said.

Standard & Poor's, which relies on banks' financial statements to issue credit ratings, said in April 2006 that the new rule might lead to ``diminished analytical transparency.''

``Equity may be overstated as a result of these illusory gains that may never be realized, hindering the analysis of the equity cushion to absorb losses,'' S&P Chief Accountant Neri Bukspan wrote in a letter to the FASB.

If and when the ``illusory'' revenue is reversed as losses, the banks and brokers may have to work harder to convince investors to ignore them, Willens said.

Lying about LIBOR

Libor Cracks Widen as Bankers Struggle With Reforms (Update2)

By Gavin Finch and Ben Livesey

May 27 (Bloomberg) -- Few companies have suffered from the subprime mortgage collapse more than UBS AG, which has taken $38 billion of writedowns and losses, replaced its chief executive officer and chairman and saw its stock tumble 60 percent.

Yet on 85 percent of the days between July and mid-April, the Zurich-based bank told the British Bankers' Association that it could borrow in the money markets at lower interest rates than its rivals. Not even the U.K.'s Lloyds TSB Group Plc, which only wrote down $1.4 billion, could obtain the rates UBS said it was able to get, according to data compiled by Bloomberg.

``Even when the market knew UBS was massively exposed and Lloyds wasn't, that was not reflected in Libor,'' said Antony Broadbent, an independent banking consultant and former analyst at Sanford C. Bernstein & Co. in London.

Such discrepancies are creating a crisis of confidence in the London interbank offered rate published daily by the London- based BBA and taken from the contributions of UBS, Lloyds TSB and 14 other banks. Rates on corporate bonds, leveraged buyouts loans, derivatives and even U.S. mortgages are pegged to Libor.

The criticism has prompted the BBA to accelerate a review of the 24-year-old system of setting rates. The findings, due May 30, may determine how fast the banking industry recovers from the credit crisis.

`People Get Hurt'

``You've got to fix Libor,'' said Tim Bond, head of asset allocation strategy in London at Barclays Capital, a unit of Barclays Plc, one of the banks that provide quotes to the BBA. ``You don't ever want to be in a situation like this again, where people can get away with quoting whatever rate they like. Real people get hurt like this.''

Libor is a benchmark for about $350 trillion of debt- related securities and derivatives, according to the Bank for International Settlements in Basel, Switzerland. The rate that San Antonio-based AT&T Inc., the biggest U.S. phone company, pays on $2 billion of notes it sold on March 27 floats at three- month Libor plus 0.45 percentage point.

``Libor is baked into the global financial system,'' analysts at JPMorgan Chase & Co. led by Terry Belton, global head of fixed-income and foreign-exchange research, wrote in a May 16 report. ``The question of whether a benchmark could be designed that is less flawed than Libor is debatable; whether such a benchmark could effectively replace Libor is not.''

Libor Exposed

Every morning the BBA, an unregulated trade group, asks member banks how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them at about 11:30 a.m. in London. Three-month dollar Libor was set at 2.64 percent today.

Libor was thrust into the spotlight in August as the subprime-mortgage contagion spread and banks were suddenly wary of lending to each other because of mounting losses that reached $383 billion as of last week, data compiled by Bloomberg show.

Three-month Libor soared to 2.40 percentage points above yields on Treasury bills on Aug. 20, the widest margin since December 1987 and up from 0.39 percentage point a month earlier. The figure was 0.80 percentage point today.

The credit crisis exposed Libor's flaws, according to Peter Hahn, a London-based research fellow for Cass Business School and a former managing director at Citigroup Inc. That's because the BBA publishes the names of contributors and their rates, giving lenders an incentive to underestimate borrowing costs to keep from appearing like they are in financial straits.

Rates `a Lie'

In the first four months of 2007, the difference between the highest and lowest rates for three-month Libor didn't exceed 0.02 percentage point, according to JPMorgan. In the same period this year, it was as wide as 0.17 percentage point.

The BIS said in a March report that some lenders may have ``manipulated'' rates. Strategists such as Bond at Barclays went as far as calling the reported rates a ``lie.''

The BBA said on April 16 that any member deliberately understating rates would be banned. The cost of borrowing in dollars for three months rose 0.18 percentage point to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze in August.

Lesley McLeod, a BBA spokeswoman in London, would only say the association's review is ``ongoing'' and a ``robust process.''

Libor would be more reliable if banks offered rates anonymously, removing the stigma of appearing like they are having trouble accessing capital, said Bond at Barclays.

More U.S. Banks

For Brian Yelvington, a strategist at bond research firm CreditSights Inc. in New York, the solution is for the BBA to insist on proof that the rates quoted are based on real transactions. That way, there would be ``no way to hide since it goes from being a poll of sorts to a confirmed trade,'' he said.

The discrepancies wouldn't have been so pronounced if Libor were set at 10 a.m. New York time, making it less skewed toward Europe, JPMorgan wrote May 16. Only three U.S. banks contribute rates to the BBA: Citigroup, Bank of America Corp. and JPMorgan.

Any changes may be little more than cosmetic as a wholesale restructuring would disrupt the global financial system, said Barry Moran, a money-market trader at Bank of Ireland in Dublin.

``But the last thing you want to be doing in the middle of a financial crisis is implementing massive changes in the way the world's benchmark rate is set,'' Moran said.

UBS, the world's biggest wealth manager, and Lloyds TSB, the U.K.'s largest provider of checking accounts, underscore the wide range in rates quoted to the BBA since July.

HSBC, RBS

UBS's three-month offered rate in dollars averaged 1.3 basis points less than Libor from July through April 15. By contrast, Lloyds TSB quoted rates that were 0.04 basis point above Libor on average. A basis point is 0.01 percentage point.

In that period UBS ousted Peter Wuffli, 50, as chief executive officer after subprime-related losses at a hedge fund run by the bank, and Chairman Marcel Ospel, 58, who helped form UBS through a merger a decade ago, stepped down. UBS has slumped to 25.84 Swiss francs in Zurich from last year's high of 77.05 francs on Feb. 9, 2007. Dominik von Arx, a UBS spokesman in London, declined to comment.

HSBC Holdings Plc, Europe's largest bank by market value, gave rates that averaged 1.4 basis points less than Libor. The London-based bank has taken $19.5 billion in writedowns and charges. Royal Bank of Scotland Group Plc, the U.K.'s second- biggest bank, submitted rates that averaged 0.9 basis point below Libor. It has reported $15.3 billion in losses and writedowns.

HSBC spokesman Patrick McGuinness in London and RBS spokeswoman Carolyn McAdam in Edinburgh declined to comment.

Older article on appeal of SPACs

BLANK CHECK COMPANIES
In a chilly IPO market, blank check companies are hot
By Robert Elder
AMERICAN-STATESMAN STAFF
Sunday, March 02, 2008

It's been a rocky year for initial public offerings, but investors can't get enough of companies that have no assets, no operating history and no business plan.

They are called special-purpose acquisition companies —shell companies that aim to acquire a business, usually within two years after it has raised money in an IPO. Investors don't know what kind of business a company will acquire or whether it will complete a deal, that's why they are also called blank-check companies.

Austin media entrepreneur R. Steven Hicks is the latest big-name investor to announce plans for a special-purpose company, joining the likes of his brother Dallas billionaire Thomas Hicks and activist investor Nelson Peltz, each of whom has raised hundreds of millions of dollars in special-purpose company IPOs.

Steven Hicks plans to raise a more modest $186 million for his blank-check company, Austin-based Capstar Acquisition Corp. The IPO was expected to launch this month, but Hicks said Thursday that the offering would be delayed three months until the financial markets settle down.

The delay in Capstar's offering, though, appears to be an anomaly.

"I hate to use the word 'bubble,' but clearly there's a stampede going on to get SPACs to the (IPO) market," said Steven Davidoff, a law professor at Wayne State University who has written extensively on the capital markets.

This year, 11 of the 19 companies that have raised money in IPOs have been special-purpose companies. Overall it's been a down year for IPOs: 19 companies have priced, a 49 percent decline from the same period in 2007.

But 11 of those 19 have been special-purpose companies.

The reason for the stampede by investors is more of a mystery. The structure of a special-purpose company is heavily tilted in favor of its executives, who typically end up with 20 percent of a newly acquired company, essentially for free.

In a new paper, Davidoff says special-purpose companies are part of a surge in what he calls black market capital, investments that "attempt to mimic the characteristics of hedge funds or private equity."

Average investors are effectively shut out of hedge funds and private equity, which are restricted to wealthier individuals. So they instead seek investments such as special-purpose companies they think can provide the outsized returns sometimes earned by private equity.
A special-purpose company, though, doesn't resemble a buyout fund, which may buy dozens of businesses, spreading the risk. A special-purpose company buys one company and usually has two years to do it.

Patience is a virtue in private equity, said Keith Garrison, a private-markets specialist at the Texas Christian University endowment and the former head of private equity at the $107 billion Teacher Retirement System of Texas pension fund.

At the teacher fund, Garrison said, "We had buyout groups that didn't invest capital for two years, just because the market was terrible."
"That was fine with us," he said. "We would not want them to be on a timelime. If they were, they would maybe be compelled to do things that don't make sense."

Davidoff said it's a no-brainer why managers are lining up to form special-purpose companies: They can raise money in a single IPO, rather than through endless fundraising meetings with potential private investors.

There are some protections for shareholders, a result of some blank-check companies failing in the 1980s and losing investors' money.
First, investors must approve the acquisition of a company.

Capstar says it will require 80 percent of shareholders to approve a deal, while other special-purpose companies have put the bar as low as 60 percent.

Second, if a company isn't acquired by the deadline, investors get close to 100 percent of their money returned. The only risk is the money an investor foregoes by having tied up funds in a special-purpose company for two years.

Investors are largely betting on the ability of a management team to find a business.

Someone who buys into Capstar is betting that Hicks can find another hugely profitable deal. Capstar's securities filings say its executives will try to buy a company in the media or entertainment business, but it doesn't have to limit itself to those industries.

Hicks and his brother Tom rode the consolidation wave in the radio industry in the 1990s. With financing from Tom Hicks' buyout firm, Steven Hicks and longtime associate John Cullen built Capstar Broadcasting Corp. into an industry giant.

They sold Capstar to Chancellor Media for $4.1 billion in 1999.

Cullen is president of DMX Inc., a programmed digital music company controlled by Hicks' private investment firm.

Hicks also runs Harden Healthcare, which is acquiring nursing facilities and home health and hospice agencies.

Special-purpose companies as a whole don't have a record investors can judge. Since 2003, about 47 of the 151 companies that have formed have completed deals, according to SPAC Analytics. In the majority of those cases, it's too soon to tell how investors have fared.
As of Feb. 22, there were 25 companies that had deals pending and 73 — with about $13 billion in capital — were looking for deals.
The scramble to make a deal can resemble a scavenger hunt. Endeavor Acquisition Corp., a New York-based special-purpose company, bought American Apparel in 2007, but only after it failed to buy other businesses.

Endeavor said it unsuccessfully tried to acquire two restaurant chains, a national chain of weight-loss centers and an ethanol producer in the Midwest.

So how did Endeavor settle on American Apparel?

In a filing with the U.S. Securities and Exchange Commission, Endeavor said its chairman and chief executive, Jonathan Ledecky, got the idea after he asked a consultant what kinds of products he liked. The consultant, Martin Dolfi, said he liked American Apparel clothes, and based on that Ledecky ordered research into the company, which led to the acquisition.

"Not all of these SPACs are going to work out," Davidoff said. "In the end, you're creating a race for everyone to cash in before it all pops."

Companies' workings
Special purpose acquisition companies, also called blank-check companies, are flooding the market for initial public offerings. Here's how they work:

Directors and executives get stock in the company at vastly discounted prices.

The company raises money from investors in an IPO and places the money in a trust.

It has 24 months to invest the proceeds.

If deadline isn't met, investors receive about 98 percent of their money back.

Stockholders must approve the company's first proposed investment, which must use at least 80 percent of company's capital.
Management ends up with 20 percent of the acquired company — essentially for free.

Investors can exercise their warrants to acquire additional shares in the acquired company.

The Big Mac (New York Times Article)

The Big MAC
The Deal Professor by Steve M. Davidoff
March 10, 2008, 11:00 am

(Dealbook) We are now a good nine months into the market turmoil that began early last summer. The crisis has left a host of dead deals and tarnished companies in its wake — not to mention scores of scarred merger arbitrageurs who were repeatedly blindsided by cratered transactions.

Material adverse change clauses have played a critical role in these disputes. They have been the lever by which a number of buyers have sought to escape from takeover agreements. In Genesco, HD Supply, SLM and Accredited Home Lenders, among others, buyers have asserted MAC clauses to justify not completing their deals.

That’s a fair number of data points, and so it’s time to take stock of what we’ve learned.

A MAC Invocation is the First Step in a Negotiation
The historical notion of MAC disputes as a renegotiation tool has once again been borne out.

The reason is inherent in the way these clauses are structured. A MAC (also called a material adverse event/effect, or MAE) clause is a way for parties to allocate risk. When a company agrees to be acquired, there will almost always be a period of time between when the original acquisition agreement is executed and the transaction is completed. A MAC clause is a means for the parties to contractually allocate who will bear the risk of adverse events during this interim period. One formulation is “an effect, event, development or change that, individually or in the aggregate, is materially adverse to the business, results of operations or financial condition of the company and its subsidiaries, taken as a whole.” This is a qualitative test and not phrased in dollar terms.

The reason the parties don’t use dollar figures is bargaining leverage. A buyer can invoke a MAC to drive the price of an acquisition down by taking advantage of either changed market conditions or adverse events affecting the company to be purchased. Conversely, even though the buyer may utilize a MAC clause in this manner, a seller may also prefer a qualitative MAC clause to provide it with leeway to argue that an adverse event does not constitute a MAC. In both cases, the MAC clause works for the parties to settle typically at a lower price. The impetus towards settlement is compounded by the lack of substantial case-law on what constitutes a MAC. This is a self-fulfilling loop.
This is what we have seen in the recent wave. All of the MAC cases have been ultimately resolved through settlement rather than a determinative judicial judgment, though one difference has been that only a few deals, such as Accredited Home Lenders/Lone Star, have actually been renegotiated at a lower price; most have settled for a payment by the buyer to the seller, with deal itself being terminated.
And so, despite the relatively large number of MAC disputes, we thus far have only one judicial opinion further defining the scope of a MAC. This was the opinion of the Tennessee Chancery court in Genesco v. Finish Line. Unfortunately, the opinion of that court is not likely to be precedential or particularly useful because of its unique posture under Tennessee law and somewhat flawed reasoning.

Private Equity Buyers Can’t be Trusted with MAC Clauses
The negotiating balance between buyers and sellers that a MAC clause creates has been upset by the structure of private equity transactions.

Private equity deals typically have had a reverse termination fee structure that permits the buyer to exit the deal for any reason by paying a lump sum, typically about three percent of the transaction value. In these circumstances, sellers often rely partially on “soft” factors such as reputation to ensure a deal closing.

The problem with this structure is that it sets an upper bound for maximum damages, and mitigates the risk to a private equity firm in invoking a MAC compared to strategic deals, where the buyer can be forced to complete the deal if no MAC is found. Moreover, a private equity firm may be more incentivized to invoke a MAC to “cover” for the reputational issue.

This is what appeared to happen in a host of deals in the fall. One example is the failed Acxiom transaction. In those deals, a MAC was invoked, but a settlement was reached along the lines of the reverse termination fee, but for slightly less.

So where does that leave us? In private equity deals, parties may want to rethink the inclusion of a MAC clause. Given the continued use of the reverse termination fee structure in private equity deals, the inclusion of a MAC clause provides the private equity firm cover to invoke the MAC clause to “completely” walk from the transaction. Given the damage a MAC claim inflicts on a company, the company will be heavily incentivized in such circumstances to settle out at a lower figure, setting the reverse termination fee as an upper bound of payment.

While we are seeing anecdotal evidence that MAC clauses are getting more seller-friendly, it still does not fully address this issue. If private equity firms are going to obtain the optionality they want, preserving compensation for the seller in a busted deal is an equally worthy goal. This is particularly true since private equity firms are most likely to invoke the reverse termination fee structure in MAC-type situations. Strike a blow for seller rights: Kill the MAC in private equity deals.

The MAC Exclusions Matter
There is also a renewed focus on the carve-outs in every MAC clause. These carve-outs define events that, while materially adverse, are excluded from the definition of a MAC clause. As such, they are the principal place in a MAC clause where buyers and sellers allocate closing risk. The parties can agree any carve-out they wish, but generally parties negotiate carve-outs that allocate market and systemic risk to the buyer and allocate closing risk to the seller for adverse events that particularly and disproportionately affect it.

The SLM and Genesco disputes in particular brought renewed focus on the wording in these carve-outs. There, the parties were seemingly surprised at the exclusions they had negotiated. In SLM’s case it was the scope of the meaning of “disproportional” in a MAC exclusion for changes in laws related to the student lending industry. The Genesco dispute highlighted the potentially wide out an economic industry exclusion could provide a seller in a MAC. The lesson is that these exclusions may be wider than you think and that they are the heart of a MAC clause. Pay attention.

A new MAC strategy has also emerged. In the Genesco case, Finish Line did not initially invoke a MAC. Rather it claimed that the merger agreement among the parties required Genesco to provide Finish Line further information to make such a determination. Despite Genesco’s cries that this was a fishing expedition, the court ordered that Genesco provide such information. Sure enough, Finish Line subsequently claimed a MAC.

Wachovia is following a similar strategy in its litigation to escape financing the Clear Channel/Providence transaction. Wachovia is claiming that it needs further information to make a determination of whether a MAC to the Clear Channel television station business has occurred. This is a claim that, at a minimum, will delay a transaction.

But this strategy is already getting a cold reception in Delaware. Last week, at a hearing on the Clear Channel/Providence/Wachovia litigation, Vice Chancellor Leo Strine Jr. stated to Wachovia’s counsel:

I’m saying is I don’t know what claims you’ve made yet. If what you’re
claiming is that there was some sort of breach of covenant by your client
whereby they were supposed to have been providing certain types of information,
then I understand that there may well be a relationship between that failure to
provide information and your ability to claim an MAE if the information that you
did not get would justify such a call.

But, on the other hand, if you basically already have it, or you really
haven’t been able to call it, then, again, we’re not in that business, and I
don’t think that’s the law of contracts, that you go get to hit and hope.

Translated: Delaware is likely to be less friendly to fishing expeditions or other claims that this is information not in your possession.

And an Example
Let’s conclude by giving an example of an actual MAC clause, the one in the Countrywide’s merger agreement with Bank of America. That agreement defines a material adverse change as:

a material adverse effect on (i) the financial condition, results of operations or business of such party and its Subsidiaries taken as a whole (provided, however, that, with respect to this clause (i), a “Material Adverse Effect” shall not be deemed to include effects to the extent resulting from (A) changes, after the date hereof, in GAAP or regulatory accounting requirements applicable generally to companies in the industries in which such party and its Subsidiaries operate, (B) changes, after the date hereof, in laws, rules or regulations of general applicability to companies in the industries in which such party and its Subsidiaries operate, (C) actions or omissions taken with the prior written consent of the other party, (D) changes, after the date hereof, in global or national political conditions or general economic or market conditions generally affecting other companies in the industries in which such party and its Subsidiaries operate or (E) the public disclosure of this Agreement or the transactions contemplated hereby, except, with respect to clauses (A) and (B), to the extent that the effects of such change are disproportionately adverse to the financial condition, results of operations or business of such party and its Subsidiaries, taken as a whole, as compared to other companies in the industry in which such party and its Subsidiaries operate) or (ii) the ability of such party to timely consummate the transactions contemplated by this Agreement.

This is a middle-of-the-road MAC clause. (For a more seller-friendly one, see the Penn Gaming/Fortress merger agreement.)
Consider recent reports that the FBI is conducting a criminal inquiry into Countrywide: Would that be a MAC, thereby triggering a walk right by Bank of America? Hard to say — a walk right is only triggered if there is a breach of a representation and warranty that rises to the level of a MAC. This investigation certainly might cause such a breach of Countrywide’s representations as to no legal action or compliance with laws.

But to be a MAC, the investigation would have to be something that was not disclosed on the disclosure schedules to the merger agreement that qualify this representation. It would also have to have had or would reasonably be expected to have a MAC on Countrywide.
The disclosure schedules are not public, so we don’t know the answer to the first question. As for the second, a mere investigation is hard to be a MAC; one view is that unless the actual investigation itself causes the MAC, then there is none.

So right now, we just simply don’t know — though it seems not to be one.

Anchoring in auctions

Why Things Cost $19.95

What are the psychological "rules" of bartering?

By Wray Herbert

(Scientific American) One of Alfred Hitchcock’s most enduring bits of cinematic comedy is the auction scene in the espionage thriller North by Northwest. Cary Grant plays Roger Thornhill, a businessman who has been mistaken for a CIA agent by the ruthless Phillip Vandamm. At a critical juncture, Thornhill is cornered by his enemies inside a Chicago auction house, and the only way he can escape is by drawing attention to himself. When the bidding on an antique reaches $2,250, Thornhill yells out, “Fifteen hundred!” When the auctioneer gently chides him, he loudly changes his bid: “Twelve hundred!” When the bidding on a Louis XIV chaise longue reaches $1,200, Thornhill blurts outs, “Thirteen dollars!” The genteel crowd is outraged, but Thornhill gets precisely what he wants: the auctioneer summons the police, who “escort” him past Vandamm’s henchmen to safety.

Clever thinking and good comedy. It is funny for a lot of reasons, and one is that Thornhill violates every psychological “rule” for how we negotiate price and value with one another. So much of life involves “auctions,” whether it is buying a used car or making health care choices or even choosing a mate. But, unlike Roger Thornhill, most of us are motivated by the desire for a fair deal, and we employ some sophisticated cognitive tools to weigh offers, fashion responses, and so forth—all the to-and-fro in getting to an agreement.

But how does life’s dickering play out in the brain? And is it a trustworthy tool for getting what we want? Psychologists have been studying cognitive bartering for some time, and several basics are well established. For example, an opening “bid” of any sort is usually perceived as a mental anchor, a starting point for the psychological jockeying to follow. If we perceive an opening bid as fundamentally inaccurate or unfair, we reject it by countering with something in another ballpark altogether. But what about less dramatic counter offers? What makes us settle on a response?

University of Florida marketing professors Chris Janiszewski and Dan Uy suspected that something fundamental might be going on, that some characteristic of the opening bid itself might influence the way the brain thinks about value and shapes bidding behavior. In particular, they wanted to see if the degree of precision of the opening bid might be important to how the brain acts at an auction. Or, to put it in more familiar terms: Are we really fooled when storekeepers price something at $19.95 instead of a round 20 bucks?

Janiszewski and Uy ran a series of tests to explore this idea. The experiments used hypothetical scenarios, in which participants were required to make a variety of “educated guesses.” For example, they had subjects think about a scenario in which they were buying a high-definition plasma TV and asked them to guesstimate the wholesale cost. The participants were told the retail price, plus the fact that the retailer had a reputation for pricing TVs competitively.

There were three scenarios involving different retail prices: one group of buyers was given a price of $5,000, another was given a price of $4,988, and the third was told $5,012. When all the buyers were asked to estimate the wholesale price, those with the $5,000 price tag in their head guessed much lower than those contemplating the more precise retail prices. That is, they moved farther away from the mental anchor. What is more, those who started with the round number as their mental anchor were much more likely to guess a wholesale price that was also in round numbers. The scientists ran this experiment again and again with different scenarios and always got the same result.

Why would this happen? As Janiszewski and Uy explain in the February issue of Psychological Science, people appear to create mental measuring sticks that run in increments away from any opening bid, and the size of the increments depends on the opening bid. That is, if we see a $20 toaster, we might wonder whether it is worth $19 or $18 or $21; we are thinking in round numbers. But if the starting point is $19.95, the mental measuring stick would look different. We might still think it is wrongly priced, but in our minds we are thinking about nickels and dimes instead of dollars, so a fair comeback might be $19.75 or $19.50.

The psychologists decided to check these lab findings in the real world. They looked at five years of real estate sales in Alachua County, Florida, comparing list prices and actual sale prices of homes. They found that sellers who listed their homes more precisely—say $494,500 as opposed to $500,000—consistently got closer to their asking price. Put another way, buyers were less likely to negotiate the price down as far when they encountered a precise asking price. Furthermore, houses listed in round numbers lost more value if they sat on the market for a couple of months. So, bottom line: one way to deal with a buyer’s market may be to pick an exact list price to begin with.

This isn’t all about money, however. Medical information, Janiszew­ski and Uy note, can also be offered in either precise or general terms: a physician might say that your chance of responding to a medication is “good” or that your chance of responding is 80 percent. The percentage is more precise, but many studies have shown that patients prefer vague generalities like “good,” so doctors tend to use them. But remember that life is an auction. In his mind, the patient is dickering with the doctor, so why not negotiate “good” up to “excellent”? When treatment choices are on the line, the auction house can indeed be a perilous place.

Falling public equity markets make SPACs look compelling

SPAC Attack
Posted on March 20, 2008

(The Deal) The IPO window is all but closed, while the SPAC door looks wide open.

SPACs, or blank-check public offerings, are here to stay, having represented 21% of cash raised in the IPO market in 2007, notes Deal contributor Joseph Bartlett. "The SPACs phenomenon is based on fundamental shifts in the U.S. financial markets, the first being the extended closure (since 2001) of the IPO window in the U.S. for small- and midcap companies."

So what are they, exactly? The Deal's Vyvyan Tenorio offers a primer:

As blind pools, SPACs don't have an operating business when they raise money in public markets. But they have 18 months from an IPO to complete a deal using about 80% of net assets. Up to 95% of the money raised is held in a third-party trust. Once a SPAC has identified a target, it has to notify shareholders and submit documentation to the SEC. Shareholders can approve it and sell or redeem their shares. If the SPAC fails to successfully make an acquisition, the trust is liquidated and the cash returned.

SPACs are an investment favorite of hedge funds (Amaranth Advisors LLC loved 'em before its spectacular implosion) and, of late, large institutional investors like mutual funds. She writes:

Clearly there's an appetite for SPACs among sponsors whose access to capital may be limited, and among hedge funds that hope to profit from arbitrage opportunities. SPACs have also opened avenues for well-heeled financiers such as Texas private equity pioneer Tom Hicks. In June, Hicks filed to raise $400 million through an IPO for a SPAC. [He wound up raising $552 million in October.] Hedge funds, too, are exploiting these vehicles to take themselves public. GLG Partners LP, one of Europe's largest hedge funds, went public in 2006 through a reverse $3.4 billion takeover of Freedom Acquisitions Holdings Inc., which raised $528 million late in the year.

And they're also a popular exit route for private equity firms, notes The Deal's John Morris. (For other ways PE firms can capitalize, see below.) Eleven SPACs have bought private equity-controlled U.S. companies since mid-2006, he says, citing a SPAC tracker.

THE GOOD, THE BAD AND THE FIXES

More generally, SPACs seek to overcome some of the problems involved in the back-door route -- reverse merger into a public shell. It's a two-step process, Sonnenschein Nath & Rosenthal LLP's Bartlett notes: An underwritten IPO followed by an acquisition, effectively a back-door IPO but with built-in safeguards, promising shareholders get a say in choosing the target. He lays out the plusses, particularly when compared to shells, and the minuses:

• It affords retail investors access to many advantages of private equity. While hedge funds typically buy the stock, any average investor can too.
• Investors buy what the SPAC has set out to do; whereas investors in a shell are bystanders.
• And shareholders can vote for a deal or against it and recoup much of their investment, which is far less common with shells.
• All told, a SPAC deal is still a reverse IPO, so if a company is to float successfully, why not use the traditional avenue? The road is shorter, cheaper and less risky. But the window, for now, is closed.
• Further, many deals involve proceeds that fall short of the amount deemed advisable to escape orphanage, a problem that can be countered with rollups.

The remaining issues are tougher, he notes:

• How attractive is a company willing to hang around an average of 218 days for a yes vote that may or may not come? "If it is any good, it should be snapped up quickly by financial and/or strategic investors."
• And a no vote can be catastropic. "Take a look at the stock price nosedive of targets left at the altar by LBO funds reneging at the last minute." (For more on buyouts gone bust, see a related Dealwatch.)
• Further, once proxy materials go out, anyone can take a peek: competitors as well as customers.
• The 18-month deadline imposes tremendous pressure to cut a deal.

So what are the fixes?

• For SPACs themselves, a team-up with a PE fund may be the best model. (See below.) Potential conflicts of interest surrounding the role of private equity investors in SPACs can also arise, but the shareholders always have the cash-out option.
• Meanwhile the SEC needs to regulate to prevent market manipulation (one SEC rule is that SPACs can't predetermine acquisition targets, a contested point because they're often industry-specific) and the average 218-day delay (also aimed at preventing abuse) from sign to close needs to be shortened.
• Finally, reliable data on post-closing stock performance is essential, he notes, to help investors decide which SPACs and targets will withstand the after market.

GAME PLAN

SPACs are trying to differentiate from the checkered past of blind pools, note William F. Griffin Jr. and Andrew D. Myers, shareholders with Davis, Malm & D'Agostine PC. There are investor protections: the aforementioned shareholder vote on acquisitions and cash-out option; management and frequently underwriters have skin in the game via stock and warrant purchase agreements and deferred fees, respectively; a relatively small amount of offering proceeds go toward working capital to consummate an acquisition.

So for a private equity investor, there are three ways to go about getting into the SPAC game, notes the SPAC lady herself, Tina Pappas, a managing director with boutique investment bank Morgan Joseph & Co.:

• Sponsoring a SPAC as an issuer: PE firms that have done so include: MBF Healthcare Partners LP, Steel Partners, LLM Capital Partners LLC, Camden Partners Holdings LLC and GSC Group, while several others are in registration.
• Exits for existing investments: 72 SPACs have more than $12.3 billion in capital looking for acquisitions. She calls a reverse merger one of the most compelling options.
• Co-investing in a SPAC acquisition: In an arrangement where an existing consortium of SPACs just need some more cash to complete a transaction, a firm could come in and perhaps be entitled part of the founders' 20% ownership right and warranty options.

A DIFFERENT ANIMAL

And in a then-recent twist, Tenoiro noted in July:

SPACs have now tapped the Rule 144A [under which an issuer can offer a private sale of securities to qualified institutional buyers, or QIBs, without government oversight] market for privately issued, unregistered securities, which coincidentally is an increasingly popular alternative for private equity firms looking to go public.

It affords more flexibility, she writes, as QIBs are perceived as sophisticated institutional buyers who don't need the same protections as individual or smaller investors. They're not subject to the long SEC review process (drawn out to guard against potential abuses). And how many 144A SPACs there have been is hard to say, given that they're private placements, she writes. "Not surprisingly, sources say investors in these offerings are essentially the same community of hedge funds that invest in SPACs."

And after the IPO come the mergers. McDermott Will & Emery LLP's Joel L. Rubinstein and Dennis J. White weighed in on the nuances in September. Unsurprisingly, competition for the listings is fierce. As The Deal's Donna Block noted Feb. 21: Nasdaq's move to institute new listing standards for special purpose acquisition vehicles is an attempt to capture American Stock Exchange listings. - Carolyn Murph

Programmers free thyselves

You weren't meant to have a boss
March 2008
http://www.paulgraham.com/boss.html

A few days ago I was sitting in a cafe in Palo Alto and a group of programmers came in on some kind of scavenger hunt. It was obviously one of those corporate "team-building" exercises.They looked familiar. I spend nearly all my time working with programmers in their twenties and early thirties. But something seemed wrong about these. There was something missing.And yet the company they worked for is considered a good one, and from what I overheard of their conversation, they seemed smart enough. In fact, they seemed to be from one of the more prestigious groups within the company.So why did it seem there was something odd about them?I have a uniquely warped perspective, because nearly all the programmers I know are startup founders. We've now funded 80 startups with a total of about 200 founders, nearly all of them programmers. I spend a lot of time with them, and not much with other programmers. So my mental image of a young programmer is a startup founder.The guys on the scavenger hunt looked like the programmers I was used to, but they were employees instead of founders. And it was startling how different they seemed.So what, you may say. So I happen to know a subset of programmers who are especially ambitious. Of course less ambitious people will seem different. But the difference between the programmers I saw in the cafe and the ones I was used to wasn't just a difference of degree. Something seemed wrong.I think it's not so much that there's something special about founders as that there's something missing in the lives of employees. I think startup founders, though statistically outliers, are actually living in a way that's more natural for humans.I was in Africa last year and saw a lot of animals in the wild that I'd only seen in zoos before. It was remarkable how different they seemed. Particularly lions. Lions in the wild seem about ten times more alive. They're like different animals. And seeing those guys on their scavenger hunt was like seeing lions in a zoo after spending several years watching them in the wild.TreesWhat's so unnatural about working for a big company? The root of the problem is that humans weren't meant to work in such large groups.Another thing you notice when you see animals in the wild is that each species thrives in groups of a certain size. A herd of impalas might have 100 adults; baboons maybe 20; lions rarely 10. Humans also seem designed to work in groups, and what I've read about hunter-gatherers accords with research on organizations and my own experience to suggest roughly what the ideal size is: groups of 8 work well; by 20 they're getting hard to manage; and a group of 50 is really unwieldy. [1]Whatever the upper limit is, we are clearly not meant to work in groups of several hundred. And yet—for reasons having more to do with technology than human nature—a great many people work for companies with hundreds or thousands of employees.Companies know groups that large wouldn't work, so they divide themselves into units small enough to work together. But to coordinate these they have to introduce something new: bosses.These smaller groups are always arranged in a tree structure. Your boss is the point where your group attaches to the tree. But when you use this trick for dividing a large group into smaller ones, something strange happens that I've never heard anyone mention explicitly. In the group one level up from yours, your boss represents your entire group. A group of 10 managers is not merely a group of 10 people working together in the usual way. It's really a group of groups. Which means for a group of 10 managers to work together as if they were simply a group of 10 individuals, the group working for each manager would have to work as if they were a single person—the workers and manager would each share only one person's worth of freedom between them.In practice a group of people never manage to act as if they were one person. But in a large organization divided into groups in this way, the pressure is always in that direction. Each group tries its best to work as if it were the small group of individuals that humans were designed to work in. That was the point of creating it. And when you propagate that constraint, the result is that each person gets freedom of action in inverse proportion to the size of the entire tree. [2]Anyone who's worked for a large organization has felt this. You can feel the difference between working for a company with 100 employees and one with 10,000, even if your group has only 10 people.Corn SyrupA group of 10 people within a large organization is a kind of fake tribe. The number of people you interact with is about right. But something is missing: individual initiative. Tribes of hunter-gatherers have more freedom. The leaders have a little more power than other members of the tribe, but they don't generally tell them what to do and when the way a boss can.It's not your boss's fault. The real problem is that in the group above you in the hierarchy, your entire group is one virtual person. Your boss is just the way that constraint is imparted to you.So working in a group of 10 people within a large organization feels both right and wrong at the same time. On the surface it feels like the kind of group you're meant to work in, but something major is missing. A job at a big company is like high fructose corn syrup: it has some of the qualities of things you're meant to like, but is disastrously lacking in others.Indeed, food is an excellent metaphor to explain what's wrong with the usual sort of job.For example, working for a big company is the default thing to do, at least for programmers. How bad could it be? Well, food shows that pretty clearly. If you were dropped at a random point in America today, nearly all the food around you would be bad for you. Humans were not designed to eat white flour, refined sugar, high fructose corn syrup, and hydrogenated vegetable oil. And yet if you analyzed the contents of the average grocery store you'd probably find these four ingredients accounted for most of the calories. "Normal" food is terribly bad for you. The only people who eat what humans were actually designed to eat are a few Birkenstock-wearing weirdos in Berkeley.If "normal" food is so bad for us, why is it so common? There are two main reasons. One is that it has more immediate appeal. You may feel lousy an hour after eating that pizza, but eating the first couple bites feels great. The other is economies of scale. Producing junk food scales; producing fresh vegetables doesn't. Which means (a) junk food can be very cheap, and (b) it's worth spending a lot to market it.If people have to choose between something that's cheap, heavily marketed, and appealing in the short term, and something that's expensive, obscure, and appealing in the long term, which do you think most will choose?It's the same with work. The average MIT graduate wants to work at Google or Microsoft, because it's a recognized brand, it's safe, and they'll get paid a good salary right away. It's the job equivalent of the pizza they had for lunch. The drawbacks will only become apparent later, and then only in a vague sense of malaise.And founders and early employees of startups, meanwhile, are like the Birkenstock-wearing weirdos of Berkeley: though a tiny minority of the population, they're the ones living as humans are meant to. In an artificial world, only extremists live naturally.ProgrammersThe restrictiveness of big company jobs is particularly hard on programmers, because the essence of programming is to build new things. Sales people make much the same pitches every day; support people answer much the same questions; but once you've written a piece of code you don't need to write it again. So a programmer working as programmers are meant to is always making new things. And when you're part of an organization whose structure gives each person freedom in inverse proportion to the size of the tree, you're going to face resistance when you do something new.This seems an inevitable consequence of bigness. It's true even in the smartest companies. I was talking recently to a founder who considered starting a startup right out of college, but went to work for Google instead because he thought he'd learn more there. He didn't learn as much as he expected. Programmers learn by doing, and most of the things he wanted to do, he couldn't—sometimes because the company wouldn't let him, but often because the company's code wouldn't let him. Between the drag of legacy code, the overhead of doing development in such a large organization, and the restrictions imposed by interfaces owned by other groups, he could only try a fraction of the things he would have liked to. He said he has learned much more in his own startup, despite the fact that he has to do all the company's errands as well as programming, because at least when he's programming he can do whatever he wants.An obstacle downstream propagates upstream. If you're not allowed to implement new ideas, you stop having them. And vice versa: when you can do whatever you want, you have more ideas about what to do. So working for yourself makes your brain more powerful in the same way a low-restriction exhaust system makes an engine more powerful.Working for yourself doesn't have to mean starting a startup, of course. But a programmer deciding between a regular job at a big company and their own startup is probably going to learn more doing the startup.You can adjust the amount of freedom you get by scaling the size of company you work for. If you start the company, you'll have the most freedom. If you become one of the first 10 employees you'll have almost as much freedom as the founders. Even a company with 100 people will feel different from one with 1000.Working for a small company doesn't ensure freedom. The tree structure of large organizations sets an upper bound on freedom, not a lower bound. The head of a small company may still choose to be a tyrant. The point is that a large organization is compelled by its structure to be one.ConsequencesThat has real consequences for both organizations and individuals. One is that companies will inevitably slow down as they grow larger, no matter how hard they try to keep their startup mojo. It's a consequence of the tree structure that every large organization is forced to adopt.Or rather, a large organization could only avoid slowing down if they avoided tree structure. And since human nature limits the size of group that can work together, the only way I can imagine for larger groups to avoid tree structure would be to have no structure: to have each group actually be independent, and to work together the way components of a market economy do.That might be worth exploring. I suspect there are already some highly partitionable businesses that lean this way. But I don't know any technology companies that have done it.There is one thing companies can do short of structuring themselves as sponges: they can stay small. If I'm right, then it really pays to keep a company as small as it can be at every stage. Particularly a technology company. Which means it's doubly important to hire the best people. Mediocre hires hurt you twice: they get less done, but they also make you big, because you need more of them to solve a given problem.For individuals the upshot is the same: aim small. It will always suck to work for large organizations, and the larger the organization, the more it will suck.In an essay I wrote a couple years ago I advised graduating seniors to work for a couple years for another company before starting their own. I'd modify that now. Work for another company if you want to, but only for a small one, and if you want to start your own startup, go ahead.The reason I suggested college graduates not start startups immediately was that I felt most would fail. And they will. But ambitious programmers are better off doing their own thing and failing than going to work at a big company. Certainly they'll learn more. They might even be better off financially. A lot of people in their early twenties get into debt, because their expenses grow even faster than the salary that seemed so high when they left school. At least if you start a startup and fail your net worth will be zero rather than negative. [3]We've now funded so many different types of founders that we have enough data to see patterns, and there seems to be no benefit from working for a big company. The people who've worked for a few years do seem better than the ones straight out of college, but only because they're that much older.The people who come to us from big companies often seem kind of conservative. It's hard to say how much is because big companies made them that way, and how much is the natural conservatism that made them work for the big companies in the first place. But certainly a large part of it is learned. I know because I've seen it burn off.Having seen that happen so many times is one of the things that convinces me that working for oneself, or at least for a small group, is the natural way for programmers to live. Founders arriving at Y Combinator often have the downtrodden air of refugees. Three months later they're transformed: they have so much more confidence that they seem as if they've grown several inches taller. [4] Strange as this sounds, they seem both more worried and happier at the same time. Which is exactly how I'd describe the way lions seem in the wild.Watching employees get transformed into founders makes it clear that the difference between the two is due mostly to environment—and in particular that the environment in big companies is toxic to programmers. In the first couple weeks of working on their own startup they seem to come to life, because finally they're working the way people are meant to.

Notes[1] When I talk about humans being meant or designed to live a certain way, I mean by evolution.[2] It's not only the leaves who suffer. The constraint propagates up as well as down. So managers are constrained too; instead of just doing things, they have to act through subordinates.[3] Do not finance your startup with credit cards. Financing a startup with debt is usually a stupid move, and credit card debt stupidest of all. Credit card debt is a bad idea, period. It is a trap set by evil companies for the desperate and the foolish.[4] The founders we fund used to be younger (initially we encouraged undergrads to apply), and the first couple times I saw this I used to wonder if they were actually getting physically taller.

Thanks to Trevor Blackwell, Ross Boucher, Aaron Iba, Abby Kirigin, Ivan Kirigin, Jessica Livingston, and Robert Morris for reading drafts of this.

Lower P/Es now may mean... lower P/Es in the future

MARKET MOVER

Are Low P/Es A Valid Reason To Buy Stocks?

With Earnings Shaky And Inflation Climbing, More Declines Possible

By TOM LAURICELLA
March 10, 2008

(WSJ) With the economy showing clear signs of recession and the credit markets in turmoil, the floor under stock prices seems to be getting thinner. Here is another reason to worry: Stock prices aren't as cheap as they seem, and based on other periods when inflation was accelerating and the economy weak, the market can struggle for prolonged periods.

Some argue stocks are attractively priced after a 17% decline in the Standard & Poor's 500-stock index since October. Based on earnings forecasts for 2008 collected by Reuters Estimates, the S&P 500 is trading at 13.2 times projected earnings, compared with an average of 16.5 times going back to 1989, according to data compiled by Morgan Stanley.

Price-to-earnings ratios reflect the amount investors are willing to pay for future earnings. When these ratios fall below long-term trends, conventional wisdom is that stocks are cheap and it is time to buy.

Until 2000, investors feasted on the combination of rising P/E ratios and rising stock prices. At the end of the 1980-82 bear market, S&P stocks changed hands at a price-to-earnings ratio of 8.7, according to Morgan Stanley's data. In the next 17 years, the ratio moved higher, topping out just shy of 30 in the spring of 1999. During that time, when the S&P rose an average of about 17% a year, roughly one-third of returns on the S&P 500 were the result of rising P/E multiples, according to Ibbotson Associates.

That period also featured a long downtrend in inflation and interest rates, which generally lead directly to higher multiples. Now, inflation is quickening, and interest rates, while heading down, can't fall much further. This suggests an environment less conducive to rising stock multiples.

That was the case in the most recent bull market, when price-to-earnings multiples actually fell even as the market rose. When the bull market began in early October 2002, the S&P 500 had finished the previous month at a P/E ratio of 17.6 when measured against the previous 12 months earnings. This past September, just before the market began its descent, the ratio was 16.8.

It is a similar story when looking at expected earnings, the basis on which stocks currently look cheap. At the end of September 2002, the S&P 500 was priced at 14.5 times the coming 12 months expected earnings, according to Morgan Stanley. This past September, after a five-year run in which the S&P 500 rose an average of more than 15% a year, the P/E on the index was 14.8 times the coming year's expected earnings.

"The growth in stock returns came mostly from earnings growth," says Peng Chen, chief investment officer at Ibbotson Associates.

Morgan Stanley analysts contend that stubborn inflation means investors won't be willing to pay big premiums for future earnings. Goldman Sachs Group strategists say that based on typical declines in P/E ratios in the past four recessions, stock multiples can go much lower.

Nicholas Bohnsack, of Strategas Research Partners, says it is a mistake for investors to assume multiples will head higher. There have been extended periods in which multiples went down or were flat, most recently in the 1970s, he notes. Today, he says, "We're in a secular period of multiple contraction," which features lots of "sideways, grinding of multiples."

Part of the problem is that the earnings side of the equation is looking shaky. Wall Street analysts predict a double-digit increase in corporate profits for 2008, but forecasts have been pared back. As of Friday, S&P 500 stocks are expected to generate $98.25 in earnings a share this year, down from the $101.87 a share predicted at the end of last year, according to Reuters.

Analysts have taken an especially sharp knife to estimates of first-quarter earnings, which now are expected at $22.58 a share, compared with the $23.64 forecast at the end of December. That means instead of rising at a 5.1% rate, first-quarter earnings are expected to be basically flat.

Another problem is inflation. In a number of recent sessions, the stock market has reacted positively to higher commodity prices on the theory that it will boost profits of energy and materials companies. But if inflation stays stubbornly high despite the U.S. economic slowdown, it would be a negative for multiples, because it reduces the value of future earnings.

Abhijit Chakrabortti, Morgan Stanley's chief global and U.S. equity strategist, says inflation is running about 0.8 percentage point above the long-term trend of 3.5%, and value for the S&P 500 should be reduced by the same amount. With that factor taken into consideration, he argues that current fair value for the index is about 17 times trailing earnings, not much above its present reading.

Ed Easterling, president of Crestmont Research, argues that record increases in earnings and profit margins in recent years make prices look artificially cheap. He prefers to look at the 10-year trends in earnings, from which he removes the impact of inflation and smooths out the short-term ups and downs in profit margins. That, he contends, provides a cleaner picture of stock valuations.