Thursday, January 29, 2015

Is Shake Shack Worth a Half-Billion?

Long lines are commonplace at Shake Shack
Those who argue passionately about their burgers say it's an East Coast-West Coast thing.

Californians and others west of the Rockies boast about their In-n-Out burgers, small bundles of beef sold at reasonable prices with locations darted up and down the Pacific line.  New Yorkers along the I-95 corridor (and others in far-away places like Dubai) brag about Shake Shack, an expensive treat that most say is worth every bite, even if every morsel is worth about a dollar. (Somewhere in between are Five Guys and Smashburger fans, those who argue these burgers offer Shack quality at about three-quarters the price.)

Shake Shack, the growing burger chain started by successful restaurant entrepreneur Danny Meyer in New York, is about to go public.  The company is owned in part by Meyer's restaurant holding company and by private-equity investors. For much of its 13-year history, Meyer insisted the company would expand in a slow, disciplined way.  And Shake Shack did.  For years, Shake Shack burgers were known among an in-the-know crowd ready and willing to pay more for quality, familiar with the actual address of those few locations that sold the meal-time treat.

Now the Shack has opted to go public, issue new shares on the NYSE and raise about $100 million in its offering.  Meyer's team has a 20%-plus ownership, and like many entrepreneurs of our time, has endorsed the company issuing separate voting shares (Class B stock) that will permit him to maintain a controlling interest (in the way Mark Zuckerberg continues to call the shots as a minority shareholder at Facebook). Investment bankers from Morgan Stanley and JPMorgan are valuing the company between $570-670 million.

Financial analysts who follow the food industry like to categorize Shake Shack into the "fast-casual" or "better burger (expensive burger)" sector.  Many say Shake Shack competes in affluent markets, vying for customers willing to spend more than $20/person for a fast-food experience. Chipotle is mentioned often as a competitor.

Some conclude Shake Shack doesn't compete with McDonald's or Burger King, although they all peddle similar menus (burgers, fries, shakes, etc.). Shack fans contend simple menus and stellar food quality attract them to Shack sites. (McDonald's, meanwhile, must grapple with its own problems. The company just announced deplorable 2014 results, continues to tinker with menus and prices, and replaced its CEO Don Thompson in a sudden, late-January announcement.)

Many questions pop up; some will be answered in the weeks to come, as the shares storm out the market gates in late January and start trading actively in the first quarter, 2015.

1.  Why would the company change course, launch a more aggressive expansion plan, and decide to plant its brand in locations around the country and world?

Meyer and his private-equity owners are likely pushing for sustained growth, encouraged by the accelerating popularity of the product and brand. They might have concluded that now is the time to take advantage of such momentum.

With emphasis on quality, with little emphasis on price, the company established a cult-like following in and around Manhattan.  New Yorkers are familiar with Shake Shack's long, snaking lines that  extend outside a store onto the streets, around corners. Impatient New Yorkers have been patient about standing in cold weather to pay double-digits for burgers. In early years, some were known to have driven 40 miles or more to buy the burgers in Westport, Conn.  There are now seven Shacks in New York, including locations in Grand Central Terminal and at Citifield.

Meyer was prudent, careful, proceeding cautiously, as the market and demand for product grew.  The company's board may have concluded that overall growth will not necessarily come from same-store sales, but from the rapid increase in the number of stores.

The company has 63 sites, 34 in the U.S., and a presence in nine countries. Total sales in 2014, when audits are done, will likely reach $100 million--a 21 percent increase. 

The industry assesses food chains by a concept, "AUV," average unit volume per store.  In the New York area, its stores are generating $7 million in sales/year. Non-New York stores are generating sales less than half that. Management believes (and the industry agrees) that same-store sales will likely flatten out (or sag or even decline in some regions). Hence, to increase earnings, the company must add new stores. To add new stores, the company must (a) raise more in private capital (not something current investor-owners will want to accept), (b) raise more debt, (c) increase the number of franchisees (something it hasn't done willingly), or (d) raise funds by going public. It chose (d).

In its IPO, the company will raise about $90-100 million, sufficient enough to build new restaurants in strategic locations.  Industry experts are comfortable Shake Shack will take care not to build new sites too close to others to avoid restaurant cannibalization. To achieve the kind of sales growth it has experienced the past few years, the company can rely on new sales from new sites and assume old sites will maintain the same level of activity.

It could also increase prices, but even with its loyal, well-to-do consumer base, the company can't risk daring to sell a $10 hamburger at prices $12-15, at least not yet. Microeconomics will alert company managers that price increases could cause some customers to run away, even if some analysts say Shake Shack's customer base is not price sensitive ("inelastic demand," professors would say).

Some say the IPO is rationalized in part by Meyer's objective to cash out, boost or "monetize" his holdings. If all goes right, some reports say his stake will top $100 million after the IPO. But he could have "monetized" his holdings, as a private company, just as easily by selling his stake in private markets.

2.  Is now the right time to go public?

Its investment-bank advisers have coached the company's board.  Once Shake Shack made the strategic decision to go public, banks counseled the company on price, timing and execution.  Last year the new-issue market was bustling, as equity markets continued to ride a post-crisis momentum. There have been rollicking, upsetting interludes every other month in stocks, such as the one we are enduring this month.  That would discourage many IPO debuts or sideline them until markets breathe fresh air again.

If the current volatility can be pinpointed by other factors (political uncertainty abroad, a few sluggish corporate earnings announcements, the impact of oil prices on big players in the energy industry, etc.) then bankers and the company's board will likely proceed with confidence.

3.  Is the company worth more than a half-billion?

That's the looming question of the moment.  The company and its bank advisers decided what amount to raise, decided to issue equity (instead of debt), and decided to go public.  Then it needed to determine the market value of the company, a value it will tweak, recalculate and reassess right until the shares are issued.

Market value is based on many factors--revenue and earnings growth, actual cash flow, re-investments to support planned growth, risks and uncertainties of all kinds, and investors' expectations of a return on equity.

Value is also based, in part, on supply and demand for new shares.  Bank syndication units will have already canvassed the market, investors, traders, and favorite client accounts.  Sometimes extraordinary demand may prop up the value, boost it higher than it deserves to be, based on investor perceptions.

Preliminary assessments indicate the company could be valued as high as $670 million. (The stock will launch in the $14-19/share range with some expected "pop" in value in the first week; it will then likely settle into a more realistic range thereafter.) What does that imply for a company with $100 million revenues and reported operating-profit margins of about 20-30%.

Let's assume these numbers imply the company will generate cash from current operations (before taxes and re-investments) of about $20 million in 2015.  Financial wizards can deploy models to infer what growth rates lead to a $600 million-plus valuation.  Rough calculations could show that the current valuation assumes the company will grow cash from operations at a rate of about 8-10%/year indefinitely.

Shake Shack exceeded such growth rates the past few years, as popularity took off, along with consumers' willingness to pay more for a quality burger.  Its track record suggests the company has had a strategy of modest, careful expansion and will achieve growth at least at 8-10% levels over the next few years. This also assumes the company will be able to manage costs efficiently, including, for example, the cost of beef.  (One less-than-confident financial analyst thinks the company is too vulnerable to rising beef costs, because it relies on too few suppliers.)

But what about long-term growth--especially if there is a perceived limit to how high it can price its burgers, a realistic limit to how much in sales one site can generate, and a plausible limit to how many Shake Shack locations the world can digest?

A midtown Manhattan store, already generating volume of about $7 million/year with lines that spill onto the avenues, couldn't possibly increase revenues unless the store expands (not likely) or increases prices (too much of a risk, when there is a Five Guys two blocks away).

But the current valuation implies growth will continue at a 10%-plus/year pace far beyond the next five years. Some analytical reports suggest the company might be aiming for as many as 450 sites in the long term to ensure such growth.

4.  Is the stock a good buy, once the IPO attention wears down?

That will depend on an investor's horizon--short term, medium-term or long term. It will also depend on the analyst or investor's understanding of markets, trends, fads, and competition.

Like Facebook's IPO launch, Shake Shack's opening days could be characterized by some intermittent stumbling out the gates (not  due to technical glitches, but perhaps by some investors lumping its performance with the same struggles of McDonald's or with the way Burger King has bounced from owner to owner). But once it settles into a groove, the stock could be a good 1-2-year buy, capitalizing on growth momentum of the past two years. But long-term questions will loom.

5.   Will the phenomenon (or fad?) dwindle away? Will consumers move on to something else or flee to the next new burger thing? 

Consumer behavior is always fleeting, often unpredictable. But consumers can be loyal to a brand or taste, in this case. If company strategy sticks to prudent expansion and avoids tampering with what has worked well in its restaurants, then there may still be long lines winding around its store corners 10 years from now.

By most corporate-finance standards, the Shake Shack IPO is not gigantic. A modest deal, small by many standards, but one that will garner some attention.  We aren't talking about a Facebook-size offering (billions and billions).

It comes at a pivotal point in Shake Shack's timeline.  The IPO and the periods thereafter could determine whether the company will have expanded too quickly for its market niche or whether the company will have begun to knock down burger-market boundaries and become a quality-burger brand name on both Coasts.

Tracy Williams

See also:

CFN: Facebook IPO: What Went Wrong? 2012
CFN:  Twitter Takes Its Turn with an IPO, 2013
CFN:  Alibaba's IPO in U.S. Territory, 2014
CFN:  Merger Mania, 2013

Sunday, January 18, 2015

On Campus: Always Adapting

Emory Dean Erika James
Business schools evolve and adjust to a rapidly changing business environment.  They adapt and overhaul to prepare another generation of managers, leaders, entrepreneurs, investors, advisers, consultants, teachers and bankers.

Some schools turn themselves inside out to make themselves relevant to the complexities of business today. Most align with other programs (medicine, journalism, engineering and law, e.g.) and consider altering the structure and timetable of degree offerings. Many now require overseas study (usually in the student's second year) and combine courses like finance, marketing and operations to show prospective employers that MBA graduates have depth across disciplines and functions. Sure, they continue to have required content. Students cannot avoid a core curriculum of economics, statistics, marketing, accounting, operations, policy, and finance.

Yet today's MBA students must squeeze in coursework in ethics, entrepreneurship, digital advertising, risk management, social media, derivatives markets, private equity, crisis management and global politics. Business schools offer courses in these areas, but must support scholarship and academic research in the same by hiring the right professors and organizing rigorous curricula.

It's all inevitable. It's normal for business schools to introduce new disciplines, programs and initiatives every year to keep up and stay relevant.  The sample below tells what's going on at many Consortium schools in early 2015.

David Thomas, dean of the Consortium's newest school Georgetown-McDonough, told an audience at a special forum led by Washington, D.C.-area business schools last fall that MBA students today are not going to school to select employers. This post-crisis period is characterized by electronic commerce, digital communications, and innovation.  New industries, products and start-ups emerge every week.

Students, too, still haven't forgotten about how the predictable, safe careers paths of their elders were derailed in the late 2000's. MBA graduates, Thomas said, are choosing "meaning and purpose" in what they want to do. Sometimes what they want to do is not doing what they can to secure a spot at Morgan Stanley or McKinsey.

Last fall, the school hosted a case competition for students to find business solutions for non-profit 
organizations.  Students made presentations on behalf of a foundation that supports families in Nicaragua and made recommendations for improvements in health care and education.

Like many top schools, Georgetown encourages and helps arrange international experience.  It sponsors a "Global Business Experience" program, where students are assigned to a company in a foreign "client" country and recommend solutions in finance, operations and organization structure. 

Students at Dartmouth-Tuck late last year formed a consulting team that worked with the U.S. Olympics Committee to assist in Boston's bid to be chosen as the site of the 2024 Olympic Games. Their project wasn't an academic exercise; it was a real business case, requiring analysis, study, recommendations, implementation and presentation. Boston is still in the running, and the Tuck team's contribution could make a long-term difference. 

The entrepreneurial bug has bitten everywhere, not just among venture capitalists on the West Coast. Major business schools have had programs and courses in entrepreneurship for decades now. For years, they offered a handful of courses, and there were always related student clubs and forums that invited prominent entrepreneurs.

Today, entrepreneurship (via academic study, special institutes, coursework, and student groups) is a major concentration at most schools. They offer a long slate of courses and invite successful alumni  regularly to explain their start-up stories to eager students. Students devote time to start-up ideas or legitimate business plans, and schools arrange for venture funding, sponsor competitions, and organize alumni networks to help students take signficant steps to execute their plans.

USC-Marshall now offers a master's degree in entrepreneurship and innovation. Cornell-Johnson sponsors its version of the "Shark Tank" television program, where students present their ideas and detailed plans to panels of professionals.  (A "Shark Tank" on its campus is scheduled for Feb. 15.)

At the senior levels and in diversity, business schools have begun to walk the walk, while talking the talk.  Some Consortium schools have appointed deans who are women or from under-represented minority groups. The dean at Georgetown (Thomas), for example, is African-American. Emory-Goizueta's dean, Erika James, who starts her second year in 2015, is an African-American woman. 

James, for many years, held senior positions at another Consortium school, Virginia-Darden, before Emory offered her the deanship.  She also has a Ph.D. in organization psychology at yet another Consortium school, Michigan-Ross.

En route to Emory, she and others have done interesting research on women as CEO's of major companies.  They examined what happens to the stock price of a public company when it announces it has appointed a woman CEO.  Research shows that in many cases (all other factors being controlled or acknowledged), the stock price declines.  They tried to explain the cause. Often, the decline might be caused by the market's lack of confidence in the selection or by a perception that investors force women heads to prove themselves before share prices catch up. 

James arrived in Atlanta just in time to help shepherd Emory to the top of a list of schools with the highest rates of offers among MBA graduates last year. Both Emory and Consortium school Dartmouth-Tuck reported offering rates of 98% (through August, for a recent graduating class), along with graduates of Chicago and Penn-Wharton.  Offering rates, the statistics themselves, imply many factors could be in play:  

(a) The schools are doing exceptional jobs in helping graduates find employment by attracting major recruiters and preparing students for the process.

(b) The schools are in regions or have relationships with companies, sponsors, or firms where there are historic pipelines to financially stable employers. (General Motors and General Mills, for example, will consistently turn to Michigan-Ross when it needs to hire financial-management MBA's. Coca-Cola will likely approach Emory year after year to recruit MBA's in marketing and international management, especially since vast contributions of Coca-Cola stock explain much of the university's high endowment.)

(c) Yet offering rates at some schools will be affected by a portion of students who are pursuing non-traditional careers or are contemplating start-ups or small companies, where offers are not timely or formal or offers don't exist. A few graduating students withdraw from the process, while exploring a different kind of opportunity.

Michigan-Ross, in the past year or so, has introduced new research studies called "Positive Business" and "Open-book Finance," based on recent work from some professors.  Open-book finance would aligns the finance function with business-unit management and human resources.  It encourages companies to share details of corporate performance (revenues, costs, profits, profit objectives, growth goals, etc.) with all employees, not just business-unit managers or those working in finance.

Researchers indicate employees are more productive and more committed to job functions when they understand their impact on bottom-line performance and understand what the company must do to reach revenue-profit goals. 

Last month, an opening of relations between the U.S. and Cuba was proclaimed in headlines everywhere. Now even business schools are following the coattails of the major news story. Virginia-Darden didn't wait to find a way for MBA students to have a business experience in the country . This month, 26 second-year students spent a week in Havana studying the culture, politics and history, monitoring a training center for entrepreneurs and visiting other small businesses.

Financial engineering and quantitative finance are disciplines not far removed from the MBA core. In most cases, they are divisions within a business school, an attachment to or an advanced offering in the finance discipline.  Students can take related courses or earn a master's degree in quantitative finance.  Some MBA graduates in years past have specialized in quantitative finance or earned separate degrees. 

Carnegie Mellon-Tepper is widely known to have one of the best programs in quantitative finance. At the business school, students can earn a master's in computational finance. Many of them are preparing for careers in asset management, hedge funds, capital markets and financial products, or academic careers in finance. 

At Tepper, students take familiar business-school courses in accounting and economics, but veer immediately into coursework that will include options pricing, derivatives, risk management, arbitrage, data analytics, asset pricing, and advanced statistics. Tepper likes to distinguish itself from other schools with this special offering and permits MBA students with some interest in these courses to pursue them, if they wish.

Yale School Management ("SOM") moved into its sparkling new quarters, Evans Hall, a year ago, after vowing to follow other schools in building architecturally appealing, state-of-the-art facilities. Yale's large glass structure with blue hues and adorable courtyards is already a popular destination for other schools on campus by hosting events, symposia and conferences. You won't hear anymore a Yale SOM student disparage about having to scamper from old building to old building to attend classes or participate in case-study groups.

In the past year, Yale MBA students launched a group, "RevYale," that encourages MBA students to act as mentors to undergraduate students, particularly those that lead student groups and those interested in starting organizations on campus.  More experienced MBA students act as partners and mentors to undergraduates, whether they are interested in art, music, politics, sciences, or business.

The Yale MBA students provide guidance in leadership, finance, and organization management, based on their experiences and studies. The undergraduates get to have an MBA "big brother or sister" in their midst and learn something about the value of graduate business education. Yale SOM gets to steer smart minds toward an eventual Yale MBA.

Tracy Williams

Tuesday, January 6, 2015

MBA's in Finance: 2015 Opportunities

Now that we've eased into 2015 and had a chance to review 2014 in finance, what opportunities lie ahead for finance professionals, particularly MBA students in finance or recent graduates?

For a moment, at least, let's disregard the uncertainty and apparent confusion running rampant in capital markets in the early days of January.  The outlook is still not as bleak as it sometimes feels.

These aren't tumultuous times, and few, if anybody, will describe 2014 as a bookend to a crisis period.  We still have those sporadic of bouts of upsetting volatility, marked by swoons of uncertainty and inexplicable "corrections."  And nobody dares say we are experiencing the b-word:  "boom."  For professionals in finance, the industry is undergoing a decade-long transformation, a constant re-engineering in some ways with the 2008-10 recession a plaguing memory. Financial institutions proceed on course to execute a daunting, complex game plan in the aftermath. 

Back in the early-mid 2000's, an MBA graduate in finance charting a career (especially an MBA from a "brand" school, one that is popular among big-institution recruiters) might have tapped the default button and headed into investment banking, ready to embark on a career in corporate finance, merger advice or trading an assortment of exotic financial instruments. 

A decade later, an MBA graduate in finance is less likely to tap a default button. A default button may not even exist. Those interested in finance are more apt to evaluate multiple offers across industry lines and weigh options carefully.

Compensation, location, prestige and functional titles might have ruled years ago. Today, MBA graduates will likely have realistic, reasonable criteria.  Compensation and location still count for much, but lifestyle, job flexibility, job function, job growth, career horizon, diversity, and company culture count for a lot, too.  It's easier now for graduates from top schools to turn down offers from Goldman Sachs or Morgan Stanley, if an offer from a smaller, lesser-known organization matches the criteria much better. 

Investment Banking

Opportunities in investment banking depend on the business environment and macro-economics, but they also depend on the financial institution, the bank that is determined to devote resources, times and talent or the bank that is willing to devote capital (to fund lending and investing) to support an all-out effort.

UBS, for example, announced a year ago it was scaling back in investment banking in the U.S. It decided it couldn't compete against other bulge-bracket firms or reasoned it could never generate appropriate revenues and returns or rise to the top of league tables.  It scaled back, but the bank hasn't disappeared from the deal table. It still appears in top-15 rankings in banking fees or deals done.

Opportunities also depend on capital markets or client industries. Banking activity (including equity and debt underwriting and corporate lending) continues to flourish in banking sectors in health care, financial institutions, media and telecommunications.

Across the board, IPO activity is up; improved equity markets kept equity bankers busy in 2014 with new and add-on offerings.  Debt lending and underwriting hasn't sagged, as low interest rates encourage new debt and debt refinancings.

As experienced bankers know too well, when lulls in activity occur, banks tend to shut down, shrink or withdraw from certain industry sectors quickly and often without much warning.

The deal announcements, deal statistics and backlog suggest these might be bustling times in investment banking, although they don't hearken back to explosive periods of the mid-2000's or late 1990's. For the moment, banks worry more these days about attracting top-notch talent (at all levels) than they might about deal flow and demand for services.

Boutique Investment Banking

"Boutique" banking is fashionable now, as it has been intermittently for the past 25 years.  In the early 1990's, names such as Alex Brown, Hambrecht & Quist, and Montgomery Secruities were fashionable names in boutique banking, which is often described as niche banking for niche industries or for start-up and new companies.  Those names disappeared when they were devoured by bigger commercial banks, which wanted to grab the boutiques' expertise, their client lists and top bankers.

Today, Moelis, Weinberg & Perella, and Evercore are top boutique banks. They tend to hire experienced professionals and won't be seen on most MBA campuses. They are thriving and have become legitimate threats to the big banks (in certain specialties and with certain clients). Unless they find ways to survive in the long term (like Lazard, Jefferies, or Greenhill), they are always candidates to be absorbed by large banks trying to fill gaps in talent.

One pattern continues from the 1980's (when Wasserstein Perella was founded by bankers from what was then First Boston).  There will always be groups of top bankers ("star" bankers, the media call them) at large firms who decide they can function better and earn more by going out on their own, by starting their own boutiques.  Hence, it's not unusual, whether it's 1989 or 2014, for a prominent industry banker at, say, Morgan Stanley or Goldman Sachs to decide to leave the industry, only to re-emerge months or a year later with an announcement forming his or her own boutique with others promising to move over eventually. 

Corporate Finance (Non-financial Institutions)

When large corporations do well or are confident that revenues and profits will rise in the periods to come, their finance and treasury units must hustle to support growing balance sheets, business expansion and capital needs.  Many, of course, hire investment bankers for some strategic advice and market intelligence, but most have in-house finance professionals who coordinate related activity and who must manage the specific funding needs and funding costs of business units.

Larger, more established companies will prefer to ponder financial and corporate strategy and make finance decisions themselves, long before they hire investment bankers to manage the mechanics of a prospective transaction (debt offering, e.g.).

Large companies still growing and expanding and still performing well will always have internal corporate-finance opportunities.  

Corporate Banking

Banks, especially the large ones, the ones that have been labeled "systemically important" enough to impose risk on the financial system if they falter, are stifled by growing capital requirements and limited opportunities to make money from lucrative trading.  Many are resorting (or retreating?) to bread-and-butter banking activities:  corporate lending, cash management, custody, securities process, e.g.  Wells Fargo is a prominent example.

Others like JPMorgan Chase and Citi haven't shredded investment banking prowess, but they have a greater appreciation for the value of corporate banking. Corporate banking often results in more stable revenue streams and more consistent returns on equity. A senior-management team at a major bank may conclude that generating 12% returns on capital year after year with the same reliable corporate clients is a realistic, reachable goal. Generating 10% returns in trading might be impossible, given the current regulatory climate. Over the past four or five years, these banks and others (Wells Fargo and Bank of America, etc.) have re-emphasized their corporate-banking roots and heritage.

Opportunities exist, and MBA graduates will be expected to hit the road to cultivate client activity right away.  Many banks, however, have faltered in communicating the story (and important role) of corporate banking well on cmpus or haven't aggressively recruited the best graduates. 

Mergers and Acquisitions

M&A is hot right now.  Last year was one of the best years (with over $3 trillion in deals recorded globally) since 2007.  The leading investment banks were the familiar names:  Goldman Sachs, JPMorgan Chase, Bank of America-Merrill, and Morgan Stanley (with significant, notable activity from boutiques).  Banks advised on big deals among pharmaceuticals, financial institutions, oil and gas companies, and health-care companies.

Activist shareholders are swarming around companies, preaching to board members about the values of their prospective deals.  Large companies, swamped with cash generated from a few years of earnings but too tentative and afraid to make new investments, have once again gained confidence to consider growth and expansion (via acquisitions).

Banks are swamped with deal flow and need a stream of analysts and associates to devote their lives to get deals done within tight deadlines or to help senior bankers present their ideas to company CFO's and CEO's for deals on the table or in concept.

But M&A activity and trends have always fluctuated in frightening ways.  Deal flow can reach extraordinary peaks and then, just a quarter later, can fall into an abyss with an eye blink.  Banks gear up, ramp up for peak flow and then suddenly shrink, often at the expense of junior professionals.

The best banks always maintain a core of expert bankers, even in the toughest times, always ready to pitch the next transaction or convince a company CEO that the best way out of a rut is a corporate combination or a sale of an important subsidiary.

Private Wealth Management and Asset Management

With strenuous (and stressful?) capital requirements, banks will continue to emphasize businesses that generate smooth income streams and that don't require capital support based on calculations of risk. For strong performance, private banking and asset management depend almost entirely on client activity, client demand for services and investment products, and a bank's ability to attract and hold onto client assets ("stickiness," some call it).  If they achieve all of the above for most of the time, banks figure they can generate 12-15% returns.

Such an attractive proposition means banks (from Goldman Sachs to UBS) want to keep the expansion going in these areas (domestically and abroad) and have implemented formal recruiting programs to attract top talent and MBA graduates from brand-name schools.

These areas offer a different kind of experience in banking. But even new bankers will be pressured to attract new clients and more client assets--year after year.  

Financial Regulation

Financial regulation and the enormous reams of new laws and new rules mean enormous amounts of information-gathering, reporting, compliance, and follow-up.  Banks, broker/dealers and even funds and insurance companies (including those like AIG designated as "systemically important") don't want to be perceived or seen as shrugging off rules.  It's a new day, and while banks complain (and even work to roll back rules changes in the way some did in late 2014 with Dodd-Frank and derivatives regulation), they all take compliance seriously now.

They now boast about the vigorous commitment they have made to comply with rules and reporting deadlines. (Steven A. Cohen's newly organized hedge fund, Point72, the descendant of SAC Capital, boasts of having hired former SEC officials to ensure the new fund, Third Point all hints of insider trading.)

This also means significant opportunities in regulatory compliance at financial institutions, which face internal challenges of trying to boost the reputation and attractiveness of what had been one of the least glamorous (and sometimes one of the most under-paid) roles.

Few, if any, financial institutions appear on the campuses of top business schools to recruit hard for roles in compliance. They don't bother and often prefer to recruit lawyers, accountants, or those who've worked in similar positions at other banks.  But the door is wide open for those raise their hands and for those who want to use the experience as a platform to understand the many activities of a bank.

Most agree, however, that no matter how important the role is and no matter how much a bank is willing to support the role and pay handsome compensation, it's often hard to transfer from compliance roles into the trenches of real business activity (banking, investing, lending, trading and research). 

Venture Capital

There actually was a time when major financial institutions like JPMorgan and Morgan Stanley invested some of their capital in new ventures.  Related risks, new regulation and capital requirements discourage that.

Venture capital, while just as lucrative and prominent as ever, is a closed business activity. We know who the leading firms are, know where they reside, and know the deals they do. But there's no easy way to be recruited.  In recent years, many of the large and influential firms in venture capital were started by entrepreneurs themselves who retired from starting and running businesses after they amassed extraordinary wealth. Venture-capital firms have sprouted in Silicon Valley and even in areas a red-eye jet ride from San Francisco (New York, e.g.).

Many of the founders and leaders of venture firms are MBA graduates themselves (from such schools as Stanford, Wharton and Columbia and Consortium schools such as NYU-Stern, Dartmouth-Tuck and others). Venture-capital firms don't broadcast employment opportunities widely and loudly. Their approach is hush-hush, often a tap on the shoulder. Theirs is a stealth, network-oriented form of recruiting.

The firms are flush with capital, ready to fund new companies, as angel investors or in rounds two, three or four.  They need analytical and research support, not to mention senior, experienced professionals with relationships and keen understanding of new products and markets.  How to ferret and unearth any opportunity to get through the door of Kleiner Perkins or some of the other new firms (Andreessen Horowitz, e.g.) has always been a daunting challenge for business-school graduates who want to work in this sector. 

Private Equity

Private equity is not experiencing a boom.  Many firms are digging out from debilitating investments from the recession years, which means restructuring portfolio companies is taking longer than expected and taking them away from hunting down new investments.

Other firms are preparing for better times ahead with improved prospects in the economy. The industry is much about value investing--finding opportunities (established companies that are under-valued or are under-appreciated or require management overhaul) and turning them into growth stories over a 5-7-year period.

Private-equity firms exist in niches, cover most industries, and are big and small.  Many hire MBA graduates, but not as formally and predictably as large financial institutions.  While some of these firms are mired in solving problems in the past, many are hopeful about the years to come and will likely reach out for professional support in certain pockets.

Hedge Funds

All is sour with hedge funds. Yes, some like Cohen's new (family) fund reports healthy returns in 2014, at least from the bits and pieces of information that trickle out about its performance. Activist funds, the funds that chase down corporate boards and shareholders to force them to revamp business strategy or restructure their balance sheets, did well. In aggregate, however, the track record for investing in hedge funds the past couple of years is dismal (2-3% gains when overall equity markets have done much better).

It's not that funds are losing money; it's the scorn they receive (and deserve?) for requiring investors to pay fees on top of fees (management fees, performance-sharing fees, etc.) for mediocre results. While many funds have shut down in 2013-14, opportunities will exist at the best-performing funds and at long-established funds.

Hedge funds and private-equity firms in the past decade have resorted to a round-about way of recruiting.  They tend to permit bulge-bracket banks to dominate campus recruiting and hire and train some of the best graduates.  After those recruits (working as analysts or MBA associates) have gone through training and have mastered spreadsheets, financial analysis, and market analysis (about 2-3 years), they sweep through surreptitiously and pluck analysts and associates from Barclays, UBS, Goldman Sachs, RBC Capital, Morgan Stanley, etc. On Wall Street, it's a rite of passage for analysts to get that first call from a head-hunter representing a fund, less than a year on the job.

They usually promise a swifter rise up the promotion ladder, better compensation, a different kind of experience, and sometimes a more sane lifestyle. 

Fixed-income Trading, Investing, and Research

For those interested in bond trading (whether at banks, dealers or funds), these might be the worst of times.  A number of factors are to blame.  First, banks haven't made money from fixed-income activities for the past year or two for several reasons (low activity, lack of the right kind of interest-rate volatility, regulatory restrictions on trading, and the threat of low margins from the oncoming onslaught of electronic dealing).

Second, banks and the entire investing populace had been preparing for an upsurge of interest rates, which hasn't occurred yet, but which was supposed to cause a nightmare of losses for those who dared to hold substantial fixed-income securities on the balance sheet.

Third, experts and experienced traders know fixed-income markets are transitioning into electronic trading in the way equity trading has led the way the past decade.  For traders, high margins from arranging client trades will disappear; for banks, unless the bond is exotic, complex or unexplainable, they won't need to populate trading desks with armies of humans (brokers and traders).  If the bonds are exotic and unexplainable and if the institution is regulated, regulators will frown on the activity and impose tough capital requirements. And the public will declare banks are using deposits to finance the trading of those unexplainable assets.

MBA graduates interested in fixed-income sectors should be forewarned.

Risk Management

Financial institutions large and small have expanded their risk-management units steadily in the past five years. Risk management has marched to the front row of importance at major financial institutions.

It now encompasses far more than it used to. Decades ago, risk management was mostly about corporate-lending and trading risks. Today, risk management is enmeshed in every activity in the financial institution and now encompasses regulation, reputation, compliance and financial management.

Most banks are still tweaking the risk-management model (how to structure the risk organization, where to put personnel, how to define roles and authorities, and how to capture all forms of risk from credit risk to market risk, liquidity risk, documentaition risk and operations risk, etc.).

While they mold the right model, many banks struggle with determining how to attract competent people into risk-management roles, how to recruit talented entry-level professionals, and how to design a promising career path.

When financial-institution recruiters promote themselves in lavish ways on campus, they are groping to figure out how to sell an MBA student in finance on an exciting, challenging role in risk management. Some banks won't try to recruit at top business schools.  Other banks recruit for risk management internally. Most banks try to convince strong performers on the business lines to transfer into risk management (and many do).

Notwithstanding recruiting issues and challenges, its visibility and importance grow year after year; for recent MBA graduates, it could be the best way to crack the front doors at some prominent institutions without having to settle for an under-cover position far from the front lines.

Electronic Dealers, Exchanges

Capital markets in all asset classes (equities, corporate bonds, government bonds, municipal bonds, commodities, options, derivatives, swaps and currencies) are headed in the direction of  electronic markets. Trades are executed where computers communicate with each other while humans preside on the sidelines. They observe to make sure algorithms run correctly, instructions are input without error, and all market scenarios are covered or hedged.

Many argue there is room for humans on the trading floor (for odd-lot activity, for non-standard trades, for new products, and even for clients who stubbornly prefer to interact with a human voice). But the numbers won't stack up.

The guiding hand of humans won't disappear.  Professionals with keen understanding of markets, regulation, trading rules, and risks need to be present to operate (and implement software for) electronic markets, electronic exchanges, electronic trading schemes, and electronic match-making systems. (These include, for example, such firms as Markit, ICE, Nasdaq, TradeWeb, Knight Capital, and Liquidnet.)

Therein lie opportunities for recent graduates who understand markets and financial products and who understand what can happen when markets collapse, markets become inactive, markets are crushed by pressures from participants, and market pricing spirals out of control.  Opportunities exist for those who will know what to do in these scenarios.

Diversity

The diversity picture is better than it was immediately after the crisis, when diversity initiatives were shelved while banks struggled to survive, literally. Financial institutions, across the board, have renewed commitments to hire under-represented minorities and women. Even venture-capital and private-equity firms, which have had atrocious track records, have promised they will do better.

However, some of the same issues continue to plague most of them. Banks and investment firms recruit, attract and hire minorities and women and pave a way for them to work in high-profile, challenging tracks.

But they can't keep them (in significant numbers).  Many opt out, and many become discouraged by the suffocating dog-eat-dog culture. Others are disappointed that financial institutions fail to fulfill promises related to development and work-life balance (issues that all younger employees, not just minorities and women, have with big banks).

Many don't see mentors (senior managers) like themselves or can't find sponsors who can help them get to the next steps.  Some cling and thrive. Others depart and go where they'll be more comfortable.

Meanwhile, banks and institutions worry there is no pipeline to ensure the ranks are diverse among senior traders and bankers and sector heads. So they continue recruiting efforts to "maintain the numbers" and replenish the desks and cubicles vacated by others.

Transformation, regulation, electronic trading and waiting for interest rates to turn upward (after markets ponder the meaning of sinking oil prices). That defines the opening days of 2015. Somewhere around and in between, there really are scattered opportunities.

Tracy Williams

Friday, December 12, 2014

How Was 2014? Not Bad?

Not glowing, but not bad
This was the year that stayed the course, proceeding along a smooth track with occasional bumps in the road until the bottom nearly fell in early autumn. In the beginning, financial consultants and those who dare to project a year or two down the road reminded us that stock markets couldn't repeat the astounding double-digit returns of 2013. But the markets, they said, could still manage satisfactory returns.

Now there's that bit about our rocky autumn, when markets tumbled and rumbled, and we had begun to wonder whether another crisis or period of turmoil was on the horizon. So in finance, how has the year turned out?

BONDS AND INTEREST RATES: What's Next? 

The year has been eventful, but it won't deserve a long chapter in financial history. For much of the period, we prepared for "tapering," the Federal Reserve's plan to pull back on "QE"(Quantitative Easing, or its efforts to ignite the economy by buying bonds, thus injecting more money into the overall supply and keeping interest rates low.) We braced ourselves (as we have done for a few years now) for the Fed's pull-back and for a sudden rise in interest rates. 

Financial advisers warned about loading up portfolios with fixed-income securities (especially those with longer terms) lest interest-rate increases would cause rampart losses. But soaring interest rates haven't happened yet (at least not in 2014), and bond portfolios haven't plunged as much as many have predicted. 

In corporate bonds, the looming 2014 story is investors' desperation for higher returns in a low-interest environment. In the hunt for a decent return, they have "chased returns" by accepting more risk. Hence, investors that heretofore wouldn't touch a non-investment-grade (or "junk"?) bond are now getting comfortable with purchases with credit grades below BBB+. They reason it's worth the risk of probability of default to get a return much higher than the paltry 1-2% returns on high-rated bonds. 

Risk-management skeptics are watching this trend closely. While the demand for more yield pushes upward the demand to invest in more corporate bonds near "junk" thresholds, it also increases prices higher than they should be on a risk-reward scale. 

This leads to investment portfolios becoming saturated with risky bonds, which, at least right now, don't appear risky, but could become a terrifying albatross in a market downturn. The skeptics say chasing yields too much by taking more risk leads to being insufficiently compensated for the risks accepted. 

Fixed-income departments, meanwhile, at major financial institutions (known in the industry as "FICC" ("CC" refers to currencies and commodities)) continue to languish. Banks have observed declining volume, so much so that they can hardly rationalize supporting FICC departments. 

They suffer, too, from the industry's migration toward electronic trading. (Equity markets and trading have experienced the same migration, too, toward computer trading.) Banks and dealers, especially those that rely on trading volume to generate profits, can no longer justify hiring and paying high compensation for rows of trading desks populated by high-bonused humans. 

Some banks have elected to withdraw from FICC; others, like Goldman Sachs, have decided they have the edge and capital to profit from sheer heft and the  massive volume partly achieved from other banks' paring down FICC units to bare bones.

MERGERS AND ACQUISITIONS: The Trends for the Moment 

Statistics show this has been a banner year in mergers and acquisitions. Big banks and boutiques have thrived. From the flurry of deals, two trends have surfaced: 

a) Activist shareholders have become forces to be dealt with. They have evolved into industry-shapers who confront board members and shareholders and exert financial will-power to get their way regarding strategies to increase a company's share price. No company is off limits, whether it's Apple or Herbalife, as we've seen in the last two years. 

When they "get their way" or successfully convince board members or big shareholders their financial strategy will work, that results in a barnyard of M&A activity--a sale of assets, a sale of divisions, a separate spin-off to existing shareholders, a proposal to acquire another company, or a proposal to sell the entire company. 

b) We appear to be in a financial era where selling off unwanted, lagging, money-losing or unrelated operations (subsidiaries, fixed-assets, product lines, e.g.) seems a viable financial strategy to boost a company's market value (or share value). This would be the antithesis of the momentous era of conglomerates (in the 1960's and certain periods thereafter). (Credit Suisse has identified over 25 global companies that are now considering or have announced spin-offs, asset sales of significant size, or divestitures.) 

Reflect back, for a moment, to those periods in financial history when diversity in product lines, businesses, and investments ruled corporate strategy. Corporate finance theory supported diversifying assets to reduce risks. Management practice stipulated that a struggling, declining business unit could be offset by another less-correlated, growing business unit. 

Now corporate strategists (and M&A advisers) have promoted a different tactic: Get lean, streamline operations, and focus on what you do best--which means, too, become less diverse. The strategy has spurred some M&A activity in the last year, most notably H&P's announcement to split into two smaller companies (a consumer-products company and a cloud-computing, software company for a corporate clientele). The sale of PayPal by eBay was another well-known divestiture during the year. 

Be watchful, however. M&A trends toss and turn. They depend on investment opportunities and cash reserves held by large companies. They also depend on prevailing fads and financial maneuverings, banks' willingness to finance mergers, and regulators who worry from the sidelines that the careless financing of deals might be getting out of hand. 

HEDGE FUNDS: Who's Shutting Down Now? 

Hedge funds and their industry are hurting. Funds big and fall have disappointed investors; funds here and abroad have shut down in stunning numbers. 

Let's give an example. The S&P equity index, through October, was up 11% in 2014. The HFRI index, an example of hedge-fund performance among multiple strategies, is up only 2%. Investors must wonder why they would share significant profits with hedge-fund managers who have under-performed a basic market (minimal-cost) index. 

Hedge-fund managers argue they offer less volatility on returns (and many statistics prove that), but the argument hasn't been persuasive enough to keep some funds from closing or some of their investors from demanding redemption. 

The better known funds with decades of a track record or those that have (share we dare say) diversified into many opportunities and operations will survive. Citadel, the fund and the firm, and Bridgewater, the fabled fund in Connecticut, come to mind. 


FINANCIAL REGULATION: More and More

Banks have become stifled by financial regulation, often frustrated, sometimes claiming that regulatory compliance distracts them from trying to find ways to achieve reasonable profits and returns with fewer business lines and surging capital requirements. JPMorgan, for example, announced during the year the thousands it has hired in regulatory compliance and billions it has invested in compliance technology. 

For banks, it was the year to respond to "MRA's," or "Matters requiring attention" from regulators. Stroll the corridors of bank headquarters and listen to executives discussing liquidity ratios and liquidity requirements, stress tests, leverage requirements, and definitions and requirements of "SIFI's," strategically important financial institutions now saddled with even more strenuous regulations. For big banks (Citi, JPMorgan, Goldman Sachs, Wells Fargo, et. al.), it's the new normal. 

Now more than ever, a big bank's board is faced with a nearly impossible challenge: How does the bank achieve returns on capital of 10-12% with reduced leverage, reduced risks, and increased capital requirements and much of that capital invested in compliance activity? Stay tuned. 

BITCOINS: What happened? 

A year ago, a fuss, a fury and an infatuation with Bitcoins swamped business headlines. Some said it would be the investment opportunity of the decade; others swore that Bitcoins, its payments system, and its increasing values would supplant foreign-currency activity or perhaps credit-card payments and some factions of the banking payments system. Proponents argued that investors, traders, large corporations and even consumers would be foolish to ignore the trend. 

Much of the glow of Bitcoins has dimmed, especially after a few Bitcoin-related companies imploded and became mired in legal turmoil. The volatility of the value of Bitcoin, at unacceptable levels, also proved too much for many investors or payments-users. Many were discouraged by the secrecy that surrounds the system and by the complexity in explaining how value and Bitcoins are derived or created. What was valued at over $1,000 a year ago has now dwindled to just over $300. 

Bitcoins haven't disappeared. The desperate urge to get into this profit-surging game before it's too late seems to have dwindled. Meanwhile, the puncturing of an apparent fad gives regulators a chance to catch up, understand the system and consider how to regulate it appropriately--an advantage regulators didn't have when other complex financial instruments were bombarding the markets in the 1990's and 2000's. We assume, of course, regulators haven't shelved the phenomenon for the time being, too. 

ALIBABA: Touchdown on U.S. Soil 

Who knew much about Alibaba before the company decided to plant itself (at least in the way of doing an IPO) on American soil? The company's IPO at the New York Stock Exchange, one of the biggest ever and involving a roomful of stalwart underwriters, might be called the industry's deal of the year. 

The company propelled itself onto U.S. capital-markets terrain with its $25 billion offering and a market valuation around and about $200 billion, threatening to go head-to-head with Amazon, eBay, Google and any digital enterprise on these shores. By becoming a household name in homes from Nevada to New Hampshire, it achieved its biggest milestones (becoming known and talked about). In the board rooms and senior suites at Amazon and Google, they now much take a peek at what's hovering over their shoulders from China. 

BUSINESS SCHOOLS: Always Evolving

Business schools are like the marathon runner who doesn't give up. They adjust and push ahead and change gears. They continue to try to stay relevant. MBA curricula everywhere are tweaked and massaged. Occasionally at some schools, the course outline is overhauled and many have instituted online courses to supplement the case approach, lectures, group work and problem sets. 

Business schools, even the best ones, tag along following trends in business and capital markets, riding the coattails of free enterprise's every move. They are more willing to scrap what doesn't work more than, say, their counterparts in law or medicine schools. And they embrace new topics that hardly existed as a discipline just a few years ago. 

Business schools now sponsor courses in digital advertising, data analytics, venture financing, financial regulation and electronic trading. Just about every year, they redesign core courses, subtracting something, adding a few, rethinking what the consummate MBA graduate should master before landing on the doorsteps of Morgan Stanley, Microsoft, McKinsey or Pepsico. Many top schools require MBA candidates to spend time overseas in projects, internships and courses of study. 

Yet they never feel they've caught up. They worry, too, that tuition costs will deter top students. So they spend perhaps too much in resources to accommodate students with state-of-the-art facilities (to help students justify tuition payments and opportunity costs in not working). In some places, those facilities architectural gems. Schools such as Yale, Wharton, Michigan and Stanford (some of them Consortium schools) have built sparkling campuses to attract students and faculty. Those that haven't (Columbia, e.g.) are hustling to do so. 

The year expires with markets trying to interpret the impact of the late-2014 plunge in oil prices. Markets gyrate now and then, even in December, trying to evaluate whether such a decline prices is good for consumers and companies or bad for large energy companies and whether what's bad for energy companies has greater impact than what's good in other sectors.

Some will say, let the markets gyrate a little, when we never expected fuel prices to have dwindled so low. Not a bad thing. 

And not so bad a year. 

Tracy Williams

See also:

Friday, December 5, 2014

Preparing for a Diverse Work World

Phil Miller, Consortium board member,
Assistant Dean, Univ. Wisconsin
Phil Miller is assistant dean for research programs at the Wisconsin School of Business, a Consortium school. He is also a 15-year board member of the Consortium and has been one of its most ardent, consistent supporters. Few have pushed harder for diversity initiatives at Wisconsin and for increasing the awareness of the business school than Miller. Wisconsin is like many large, well-known business schools.  The efforts to promote and maintain diversity among students and faculty are ongoing. They don't stop. Arguably, few have thought longer and deeper than Miller about how to improve diversity at schools like Wisconsin. 

Miller shared perspectives in a Nov. 14 edition of the Capital Times, the news journal based in Wisconsin.  He explained yet another reason why business schools must take a greater, more emphatic and visible lead in diversity: If business schools are not diverse, more than ever before, large, reputable companies will be reluctant to recruit there.   

The article mentions cases where companies like Procter & Gamble, General Motors and Alcoa halted their recruiting programs because the student population at schools like Wisconsin wasn't as diverse as it could be.  The companies stopped not only because schools didn't have meaningful diversity in its ranks (among students and faculty at undergraduate and graduate levels), but because they felt the students there would not be sufficiently prepared for a diverse workplace (or, just as much, a diverse customer base).

Think about it.  Companies, especially large, global institutions with international markets and customers, want evidence, too, that students are prepared to work for, work with or lead others that have different backgrounds and perhaps different perspectives and points of view.  

As companies expand, it's not just about America. ("This is not America's century," Consortium CEO Peter Aranda states in the same article. "U.S. companies used to be able to go someone, plant the flag and be better then everyone else. That is no longer reality.) It's about international talent, multiple markets and unique cultures. It's about an expansive, broad customer base that may be as unfamiliar to Madison, Wisconsin, as Wisconsin may be to them. Business schools, Miller says, must prepare students to do business anywhere and with colleagues and clients from around the world. 

Hence, when they roam non-diverse campuses, attend their corporate receptions and give presentations to students, companies have become concerned the students aren't ready for or accustomed to diversity.  

Wisconsin felt the pressure, needed to do something about it, and Miller has taken a lead there for many years. "Diverse perspectives enrich the education of majority students," he told the Capital Times.  

"Businesses drove us to change, not just to provide a diverse pool for their hiring needs, but also because so many majority students were not prepared to face a diverse work world," Miller said.  He has had many administrative positions at the business school the past 15 years. 

There has been noticeable progress at Wisconsin. In the undergraduate business school, the percentage of blacks, Latinos, Native Americans and Asians has risen from 2.7% to 7.3% in the last seven years, according to the article. 

The statistics are better at its full-time MBA program.  Its affiliation with the Consortium is a factor in better numbers, because the Consortium helps ensure a steady pipeline. In the current second-year class, 14% of the class is classified as minority; 14%, international.  In the current first-year class, the numbers are even better:  17% minority and 25% international. 

The school is also unique in offering special concentrations in such fields as risk managment, insurance, arts administration, investment analysis, and supply-chain management.  

The school, like others around the country, was swift-kicked to improve diversity on campus. But it quickly understood the premise.  Recruiters weren't going to show up on campus, and students who attended the school would be disadvantaged.  

And recruiters these days (at least those from global companies with global markets) want to be assured business-school graduates will thrive in a business environment with other professionals who were born elsewhere, who had starkly different upbringings, who were nurtured in different cultures, who likely speak different languages, and all of whom have invaluable perspectives and points of view.

Tracy Williams

See also:


Sunday, November 16, 2014

This Fall's Big-Bank Thorn: FX

Banks must now settle FX-market-related charges
Senior management at big, global banks these days operates as if they are shell-shocked.   Or operates as if another debilitating dooms day is on the horizon. Every page they turn and everywhere they look, an apparent crisis looms. Or the apparent crisis becomes the real ordeal, particularly one where the end result is a billion-dollar hit to earnings because of reserves they must take for previous transgressions, legal settlements or massive reorganization.

On top of crisis management, senior bankers must manage (what they perceive) overwhelming regulatory requirements and other priorities of the moment.  Bankers in this decade spend much of their time responding to the lingo of the moment:  "MRA's" or "matters requiring action" (jargon used by regulators to help banks prioritize what they need to do to get on the regulators' good side).

Think about the long list of issues banks must address--minute by minute, everyday, all the time: mortgage-related settlements, derivatives-trading processes, increasing capital requirements, stress tests, equity trading and "dark pools," threats from shadow-banking segments, compensation restrictions, and a Libor scandal (and the related settlements).

In the current year, the challenges continue to mount: cybersecurity, balance-sheet leverage restrictions, and contemplation of what a "SIFI" (systemically important financial institutions) designation implies.

Now comes another crushing headache:  Allegations of cheating, collusion and misrepresentation in one of the biggest markets big banks have controlled over the past four decades--the trillion-dollar market for foreign-exchange sales and trading.

FX sales and trading have been a stable, profitable machine for large global banks for decades. They have controlled markets, trading, processing and clearing, products, and pricing. They are the dealers in the middle of the fray around which all other players, participants and users must operate. Hedge funds, speculators, small dealers, and the treasury teams at major corporations that use FX for hedging and payments purposes must--for the most part--go through the circle of big banks.

Banks control access to and insight regarding FX markets, partly because they have history and experience in FX and partly because they control the deposit accounts and funds-transfer systems that allow the market to operate.

They make markets in currencies of all kinds, estasblish prices and facilitate actual settlement (receipt and delivery of currency into bank accounts).  Banks also have expertise in specialty products: FX options, long-dated FX trading (trading for settlements at dates in the future), and currency swaps. FX market participants who need, use or even want to speculate in currencies can't avoid banks, unless they choose to do this entirely in futures markets, and even then, they will likely use banks for clearance, brokerage and settlement.

Think of the FX market as a commodity market with foreign currencies traded as if they were products, subject to supply and demand and influenced by the machinations of interest rates and macro-economic factors. Companies that do business internationally (exports and imports, e.g.) will require currencies for payments or receive currencies in sales. They may also engage in FX transactions to hedge balance sheets and earnings statements from the impact of FX volatility.

Because prices fluctuate in predictable and unpredictable ways, speculators are attracted to the market. Price movement will imply opportunities to profit from the increase or the decline in the values of currencies.

Think of banks as operating a the top echelon of this vast market, one that features a shelf of sometimes oddly behaving and sometimes predictably reacting commodities (Euro, sterling pound, Japanese yen, etc.).

Now banks are in trouble in this marketplace in the way they were in the fixed-income arena in the Libor and mortgage-related scandals the past decade.  A bevy of regulators in the U.S. and in Europe has investigated and begun to levy billions in fines and penalties or arrange for legal settlements (over $4 billion in total so far, and over $300 million at many banks).

This fall has become another migraine for big banks (including HSBC, Barclays, JPMorgan, RBS, Citi and UBS). Another quarter with a special loss provision to account for the transgressions regulators claimed banks committed. (Front-running trading--in front of their own clients for their own accounts--is one allegation. Price collusion in setting daily prices is another.)

With banks forced to clean up strings of lingering issues, is this one reason why we haven't seen new products, banking innovation, and new financing ideas in the way we saw financing creativity in the 1990's through mid-2000's?  Has financing creativity been discouraged, because it has been linked often to the financial failures of the crisis?

Or have banks resigned themselves to the notion that innovation and efforts at fancy transactions and novel banking products will eventually lead to market implosion, reputation risks and billion-dollar legal settlements a decade later? Or just as important, will the process of introducing a new product or a new financing method take much longer, as banks decide whether the financial and reputation risks are worth it? Are the risks now perceived to be too overwhelming for the short-term rewards?

A decade or so ago, who would ever have thought that plain-vanila FX sales and trading (not to mention, pegging Libor interest rates) would result in alleged scandal and billion-dollar blows to earnings?

Tracy Williams

See also:
CFN:  Libor in Crisis, 2012
CFN:  Making Sense of Derivatives, 2013
CFN:  High-frequency Trading, 2012
CFN:  Can You Stand Market Volatility, 2011
CFN:  JPMorgan's Regulatory Strategy, 2014
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Friday, October 31, 2014

Market Volatility: Delivering the Message

The participants, players and pros in finance (the traders, bankers, analysts, and deal-makers) love euphemisms.  They play with words and phrases to get deals done, raise capital, make investments, advise companies, and keep investors comfortable. Sometimes they are guilty of rolling out old products with brand-new, updated nomenclature.

Remember "junk bonds."  When the industry introduced them as an important, popular financing channel for young companies in the 1980's--thanks mostly to the trading prowess of then-powerhouse bank Drexel Burnham, nobody minded calling them "junk." When the junk market imploded for a period in the late 1980's-early 1990's and after Drexel was railroaded into non-existence partly because of fraud, market-makers and bankers avoided the term.

When the market revived and such bonds found a permanent place on the fixed-income shelf, the industry preferred to call them "high-yield" instruments.  They are still referred to as high-yield bonds. "Junk bonds," the term, receded into finance history.

Finance historians will likely be able to identify other times when the industry recycled instruments and financial strategies, but unveiled them later under the banner of new terms, new phrasing.  A play on words.

This fall, financial markets have rocked and rolled like a roller-coaster with plunges that remind us of episodes during the financial crisis.  But investment analysts, the media, financial consultants and bankers have been careful in their choice of words, if only to keep investors comfortable and calm, if only to avert the possibility of panic and rampant selling. Markets have fallen steeply some days; other days they have crept upward. 

But industry participants prefer not to convey to investors (clients, shareholders, et. al.) that markets are in trouble.  They prefer more palatable terms.  You hear often these days that markets are going through a "correction"--which implies that the surges in the past year overstepped their targets and are settling back to where they should be.  You hear markets are "recalibrating," suggesting that equity-market values are settling into their proper valuations.

You also hear such terms as "volatility" and "divergence."

Are advisers, bankers, and the media being deceitful? Or are they doing their part to discourage investors and traders from irrational, panic-stricken behavior? Are the terms a fair interpretation of what is actually going on?  If headlines hint at "market recalibration" instead of exclaiming "market plunge," will that keep traders and investors focused on fundamentals and long-term strategies and trends?

It's likely a little of both.  A little bit of deceit, and a lot of encouraging investors and market-players to act rationally.  And it's also a little bit of acknowledging how equity markets have moved in the past.  If traders and investment managers say the market is "recalibrating" while the Dow is falling by hundreds of points, they suggest, too, that (a) markets might have over-shot their true values in the past year and (b) decades of technical analysis suggest equity markets (at least those in the U.S.) do tend to bounce back. To ensure investors and traders (from the Baby Boomers with nest eggs to the black boxes in the back rooms of hedge funds) use common sense and not stir trouble, they avoid declaring markets are in a free for all.

The industry works that way.  Use terminology that won't unsettle stomachs.  Bankers won't necessarily say a company lacks cash, but will suggest it is "illiquid."  A company with exorbitant amounts of debt, struggling to find ways to meet interest and principal payments, is not necessarily over-burdened with too many loans, but is "highly leveraged." The company with dwindling net worth is "under-capitalized."

Creative terminology is not new in finance.  There is, nonetheless, the ongoing tendency to come up with even more clever terms to describe market activity.  When stock markets crashed in 1929, few headlines denoted a "market correction."  When they crashed in 1989, we didn't hear much about "market recalibrations." Each market event spawns more terms to attempt to describe what's going on...

...and to keep investors sane and in the game.

Tracy Williams

See also:
CFN:  Market Volatility:  Can You Stand It? 2011
CFN: Dark Days at Knight Capital, 2012
CFN:  Alibaba's IPO, 2014
CFN:  High Frequency Trading:  What's Next? 2012
CFN:  No Time for Doldrums, 2013

Sunday, October 19, 2014

Will HP's Split-up Help Stock Values?

Does separating the company into two equal parts create more value than a consolidated whole?
As the third quarter, 2014, ended and before companies had a chance to announce earnings, HP slipped through to report it plans to split the company --literally (based on revenues) into two equal parts:  One half, to be called HP Enterprise, will focus on a corporate client base (cloud computing, business software, business services and data storage).  The other will focus on consumers who purchase personal computers and printers.  Right down the middle.

HP is a $100 billion-dollar company, enormous by most measures. The split-up (accomplished by spinning off the personal-computer business to current shareholders) will result in two $50 billion businesses, each still large enough to appear on Fortune 500-type lists. (HP will present a stock -like dividend to shareholders and allow the market to re-value what remains. They, along with their expensive banking advisers, hope the sum of the parts will be greater than the historical whole.)

Does the split (or spin-off) make sense? Was this a surprise?  Was this a maneuver it pondered for years, but CEO Meg Whitman now dares to do it?  Or did shareholder activists push for a financial-engineering move to help boost stock values? Corporate-finance experts:  What achieves maximum shareholder value--spinning off the perceived valuable parts of a global giant or accumulating diverse, well-run businesses to achieve the advantages of diversity?

The 1960's marked a finance period when investment gurus claimed equity values surge by building conglomerates (via mergers and acquisitions). (Think ITT, as the business-school's classic example.)

In current times, investing activists argue equity values rise because of focused management: Companies, they reason, increase equity values (and boost stock prices) by getting leaner, more nimble, and more targeted toward few product lines.  Company management is less distracted, corporate strategy is simple, costs are better controlled, and resources (human and funding) are less constrained.

If it isn't a subject already, HP's mishaps in management strategy and management misdirection and its misguided efforts to go head-to-head with any formidable competitor could be seminal business-school cases in corporate strategy. Whitman, after her renowned tenure at eBay and foiled attempts in politics, swooped in to try to salvage the company or at least restore some of its prominence.

With competition getting more fierce and with a fickle customer base always drifting to the latest new thing, Whitman may have been boxed into making this latest move.

In the eyes of equity investors, HP has slipped, recovered, stumbled, and been revived intermittently for years, but question marks still shroud its long-term outlook.

Its financial performance, nonetheless, has been laudable and overlooked by the fuss over strategy and competition.  Yes, total revenues have reached a plateau (with occasional slippage), and it absorbed giant losses as it restructured itself in the last few years.  As big as it is and as much as some project that competition and technology evolution will puncture it into non-existence, its track record for generating sound returns on equity and managing costs consistently is satisfactory.  (ROE in 2013 = 19%, and the company is on pace to generate  ROE = 16% in 2014.). The company didn't have to break up to return to profitability, because earnings exist and cost margins have been stable.

Its balance sheet is fragile, because about a third of it (over $50 billion) includes intangibles and it needs the debt that's piled on. (That intangible overload, which includes "goodwill" arising from a chain of flimsy acquisitions, leads to reported negative tangible equity; hence, liabilities exceed assets that can be touched, felt and presumably sold. Debt burden, which might be normal, in most financial situations is exacerbated with the existence of such negative tangible equity.)

Fortunately debt doesn't swallow the balance sheet too much, and stable (if not growing) cash flow from business activity keep debt investors comfortable.  (Ratings agencies haven't been harsh--BBB+/A---although they too have criticized management strategy in years past.)

But equity investors want the promise of growth.  They want to see sales increasing in leaps and bounds for indefinite periods. And they want to see returns on equity creeping toward 20%. The combination of impressive, boundless growth in sales, earnings, and ROE leads to big gains in stock price.

The split-up, they argue, is the best way to reach those big gains. Conglomerates contend big combinations of business result in cost synergies and economies of scale.  HP advisers and its board will try to show that dividing the company into two parts will give the company a chance to rationalize and reduce costs and clarify strategy.  The market, they claim, will know what HP Enterprise wants to be and do. The market will understand, they hope, that HP (the consumer side) will need to (and will successfully) figure out what it wants to be.

Another view? Institutional investors and activists prefer investments in two companies--one with stagnating prospects and one with growth possibilities--than an investment in one company with an uncertain, unstable outlook or the possibility of arm dragging down the other.

What poses a challenge in achieving those gains after the division?

1.  As the two entities polish their strategies and introduce products and services that can compete capably, how will costs be divided? Will they be divided fairly or divided in a way to give one a value boost more quickly than the other?

2.  CEO Whitman will have senior presiding roles in both entities.  Will management attention be even more stretched and pulled apart than it is already?

3.  That fragile, awkward balance sheet:  Which entity will accept the burden? Will deal-structurers decide to present HP, the consumer side, the gift of a sturdy, sound balance sheet with positive tangible capital and manageable debt burden?  Will HP Enterprise bear the burden of a capital structure with far more debt than its sister (or cousin?) company?

Dividing the company into two fairly equal parts sounds straightforward. But creating sturdy balance sheets for both and manageable cost structures (as one is extracted from the other) will be formidable tasks--enough to possibly postpone the scheduled late 2015 spin-off.

And enough to give investing activists enough time to develop or discover the next value-creating equity trend.

Tracy Williams

See also:

CFN:  Merger Mania, Boom Times Ahead?  2013
CFN:  What Will 2014 Bring?  
CFN:  Why is Dell Going Private?  2013

Monday, October 13, 2014

The Finance Resume' and Recruiters


A bank Vice President is tapped to be involved in recruiting new bankers for the upcoming year. The group plans to expand its business with new deal flow, new clients, new accounts, and perhaps a new office presence in London or Tokyo. The group must, therefore, expand the number of associates who analyze and rationalize deals, prepare presentations to clients, research markets and market trends, and explain the pros and cons of financial instruments.

She and others on her recruiting team are asked to review a handful of resumes' to determine who should be offered chances to interview in first rounds or who should be rewarded with "call backs" for further rounds.

For each resume', the team reviews, sizes up, summarizes and concludes in just a few minutes. What did they notice? What stood out? How can they decide who's worthy of more attention (and eventually an offer) from mere glimpses of resume' material that candidates took years to accumulate? What do they see? What do they look for? And what do they target on a page filled with words, recruiting jargon, and an array of experiences?

Or how does the candidate in finance (before the interview, before the laborious second and third rounds) make a resume' impression in just a few minutes?

Career advisers and MBA counselors like to refer to the "elevator speech,"  the 30 seconds a candidate might sell himself when he encounters a senior department head at a reception, after a meeting or, in fact, in the elevator.  On a resume', the candidate must sell himself to the recruiting team in a frightening flash.

If the role is in finance (corporate finance, banking, trading, investing, asset management, equity research, corporate banking, e.g.), in the midst of a list of highlights of candidates who, say, captained their debate teams, recruiting teams look quickly for clues that the candidate can do the work. First things first, does the candidate have first-rate technical skills? Can the candidate excel in the day-to-day requirements of the job of a job in finance?

In finance, for MBA's, that often means proving competence in accounting, corporate finance, financial analysis, and capital markets.  At some firms, it will mean proving competence in much more:  financial modeling, corporate firm valuation, and financial products.

Recruiting teams can't give a test to ascertain competence. (That can wait for second-round interviews.)  But they can look for familiar clues.  An MBA in finance, a CFA certification (even Level I passing), a CPA certification, and experience in banking and finance will be superb clues that the candidate can thrive in a world of numbers, spreadsheets, projections, forecasts, ratios, sensitivity analyses, and financial theory.

Sometimes listing specific courses (in an MBA course) will help, too.  Courses in intermediate corporate finance, intermediate accounting, options theory, mergers & acquisitions, derivatives markets and equity valuation will confirm competence.  If an MBA candidate has thrived in a course expounding on Black Scholes options theory or if the candidate has studied how FX currency markets are tied to interest-rate expectations, then recruiting teams will check with a plus.

There is no one way to promote technical skills and competence on a resume'.  They should be highlighted clearly and, if possible, headlined (not buried).  Recruiting teams must get over this hurdle before they begin to look for other qualities. The MBA student or graduate from Dartmouth-Tuck with a specialty in corporate finance, who studied corporate valuation, who worked previously at Lazard Freres, who has an engineering undergraduate degree, and who won prizes for stock-market valuation, will vault to the front lines in the eyes of prospective employers.

Unfortunately large numbers of candidates will meet these initial tests.  So finance professionals looking to hire will look for other qualities.  They then cast their eyes on clues that demonstrate productivity, professionalism, engagement, impact, creativity, and teamwork.  They ask:  What is there on the resume' that will show us that the candidate will get work done, can produce an enormous amount within tight deadlines, will show special insight and make useful recommendations, and represent the company in a professional way.

This exercise is more difficult for recruiting teams. Sometimes it requires a dissection of intangibles and qualities. If the candidate uses numbers to show priority or impact, employers must understand the context.  Still, on the resume', the candidate must maximize impression with specific experiences, good examples, and clarity.

Yes, clarity counts for much in reading resumes'.  Some of the best candidates hurt themselves because when they describe experiences, they retreat to fancy jargon or awkward (or erroneous) terminology.

Even the most qualified technical MBA's should showcase intangibles and special qualities on the resume'.  There is no formula, but they can ask themselves what examples and experiences will show impact, creativity, and productivity.

What hurts on the resume'?  Remember, the recruiting team is dissecting a lifetime of activities in a few minutes.  Tedium, detail, and illogical presentation of material slow down the reader.  Or they  distract the reader.  Unexplained, confusing descriptions of past experiences hamper the reader, too.  In an effort to upgrade experiences or embellish them, sometimes candidates end up describing gobbledygook. Simplicity and clarity work best.  If busy finance professionals can understand the experience immediately, there is another check plus.

Hyperbole hurts, too. Too often candidates slip and exaggerate past achievement, not realizing how the description sounds.  If the MBA student says he started a $100 million hedge fund at age 21, a fund that exceeded all benchmarks during years when many funds stumbled and closed, is that believable? Will recruiting teams apply a question mark, instead a check plus?

Recruiting professionals and career counselors will say resume' preparation also involves promoting a brand, becoming marketable, and showing ambition.  But first things first, the experienced recruiting teams at big banks and notable firms take a first-things-first approach:  Prove technical competence (from classes, courses, and previous work).  Prove impact, productivity, creativity and professionalism with crisp, simple descriptions of past experiences and past accomplishments. And then survive the second and third rounds.

Tracy Williams

See also:

CFN: MBA's Eye the Summer, 2014

CFN:  MBA Recruiting:  Working the Game Plan, 2013
CFN:  MBA Job Hunting:  No Need to Panic Yet, 2012
CFN:  First-year MBA's:  Internships and Recruiting, 2011