Friday, November 18, 2016

That Coveted Goldman Partnership

Goldman recently announced its 2016 class of "partners." Is the title still one of the most coveted goals on Wall Street?
Every other year in even years, mid-autumn becomes hush-hush time around the corridors at Goldman Sachs.  That's when the big bank announces its new slate of partners.

A partnership at Goldman has long been a treasured milestone, the culm
ination of a decade or two of hard work and internal accomplishments--at hours of commitment that most workers can't fathom.

Is it still coveted reward? Do prestige, power, and mounds of wealth accompany the promotion in the way it often did through much of the firm's history?

The New York Times reported the recent announcement and elected to focus on the percentage of women in this year's class and assess in any trends.  Of the 84 named, 19 (or 23 percent) were women. Trends show improvement in the numbers, although the increases trickle upward; they don't surge upward. No information was disclosed about under-represented minorities.

Like most banks (commercial, corporate and investment banks), senior bankers are granted the title managing director. At Goldman, a subset of managing directors have partnership privileges.  They are not partners in the company, because Goldman is not a partnership (although it was decades ago).  Managing director-partner is a privileged title.  Those who hold the title are granted, however, a large percentage of shares.

For this new partnership roster, is Goldman the same firm as it was when partners numbered less than a couple of hundred (not the 500-plus today) and when it focused much of its activity on mergers, acquisitions, underwriting and a modest amount of trading?  Is a partnership there still a stepping stone toward the top of Goldman's hierarchy or (as has been in the past) a pathway to a senior, powerful government post?

What is the true Goldman today?

It's now formally classified as a bank holding company, subject to the same supervision and oversight that its new group of peers (like JPMorgan Chase and Citi) must adapt to everyday. It still maintains predictable leads in the league tables that investment bankers care much about (mergers, acquisitions, IPO's, bond underwriting, etc.). And it appears to have a side-table seat and the ears of board members involved in the merger transactions that keep getting bigger and bigger as years go by.

Yet because it's a big bank (a "systemically important" one, in fact) and because it chooses to remain aggressively at the frontlines of sales and trading, it has to confront issues and challenges that JPMorgan and Citi do, issues and challenges its IB boutique peers (Evercore, Moellis, Greenhill, Lazard, e.g.) aren't bothered with.

Addressing many of those issues and challenges often means boosting capital, reducing leverage, stockpiling liquidity, and worrying excessively about stable funding--all while sending its armies of M&A and advisory bankers around the world to advise on the biggest companies on what they should do and how they should finance what they should do.

Peek at recent numbers.

Investment banking is for which Goldman is best known--the merger deal valued in the tens of billions, the advice its teams present to CEO's and board members to buy out another company or defend itself from unwanted suitor, the financing packages they assemble to permit Company A to acquire Company B with debt levels that might cause the unacquainted to faint, and the timetables they lay out to shepherd a Silicon Valley unicorn through its IPO.

The numbers, however, show Goldman--despite restraints from regulators--is still a trading powerhouse.  Trading has been slowed down, even hand-cuffed. Yet Goldman continues to push in that direction, seizing roles and market share where other banks have stepped back. Trading activity (from trading and commissions revenues) contributes about half of all net revenues at the bank. Investment-banking fees, by comparison, comprise less than a quarter.

Still, some would argue the IB tail wags the trading dog. IB polishes the Goldman name and brand.

Critics have lately cited the bank's lagging returns on equity, especially compared to some of its peers. Check the best measurement of ongoing performance:  returns on (book) equity (ROE), the returns the bank generates on behalf of its owners, including the hundreds of partners who run the firm.  ROE for the past two years hovers about 7-8% (including 2016 results)--returns that lag some banks (JPMorgan Chase and Wells Fargo, e.g.) and returns that shove it into a pack of mediocrity.
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All big banks struggle to generate decent returns nowadays. Regulators insist on greater and greater levels of capital and also limit leverage and the size of balance sheets.  Furthermore, the Volcker Rule (which prohibits proprietary trading) puts constraints on what Goldman can do well: trade all classes of securities, derivatives and options in most venues and in many countries and manage related risks.

In 2016, the bank is on a pace to generate about $13 billion in trading revenues.  Imagine how much more it could generate if it weren't hampered by the Volcker Rule or didn't have to adhere too closely to capital requirements and leverage limits.

Critics would argue, of course, that restrictions keep Goldman from taking on extraordinary risks that lead to billions in losses. By comparison, Goldman takes on about the same level of trading and derivatives risks (measured by the common market-risk metric "value at risk") as JPMorgan Chase and Citi, but has about a third the amount of capital.  (Goldman could rebut and show it doesn't have the same level of loan and credit risks as JPMorgan and Citi.)

Investment-banking fees (the fees it generates from the Wall Street Journal headline-splashing deals) comprises only 21% of 2016 net revenues for the firm. For decades, the firm has been an elite institution in corporate finance and advisory, and it will continue to attract the talent (and pay the talent) to ensure that it will also be. The brand alone will help keep Goldman in the top 5 in most league tables (barring any embarrassing scandal). But IB fees fluctuate. They rise, fall, come and go, based in part on corporate balance sheets, company shareholders' desperation to grow, and confidence in the economy.

Since the crisis, Goldman is supervised by the Federal Reserve. It is no longer a pure investment bank and broker/dealer. The bank holding company presides over bank, broker/dealer, and asset-management operations.  It can choose to take deposits and make corporate and consumer loans in the way Wells Fargo does.  But it hardly emphasizes loan-making. The loan books of Bank of America, Citi, and JPMorgan Chase are about 20-times greater. (The lending it does is focused almost entirely on corporates, real estate and wealthy individuals and is likely done to accommodate treasured clients on a special-needs basis.)

No need to be sympathetic toward the firm.  Despite less-than-stellar results (or results that might pale in comparison to some of the glory days before the Federal Reserve imposed the new set of rules), the firm will still press on. 

ROE's will touch and occasionally exceed 10%. Risks will be measured and managed.  It will get the first call from corporate clients when they set out to do the biggest deals. It will attract its share of the best talent from top business schools.  Partners will be selected and be compensated at jaw-dropping levels. 

Let's make sure it doesn't forget to include a fair number of women and under-represented minorities at that table.

Tracy Williams

See also:

CFN: How Does Goldman Do It? 2010
CFN: Did Goldman Overpay for its Facebook Stake? 2011
CFN:  Volckerized, 2010
CFN:  Goldman and Work-Life Balance, 2013
CFN:  Goldman and the Greg Smith Letter, 2012

Friday, October 7, 2016

Deutsche: Why the Turmoil and Concern?

Is Deutsche Bank the next Lehman? Shouldn't new rules avert the next Lehman-like crisis?
For a moment or so, some wondered whether we were headed down another 2008-like path, as if investors, traders, and lenders in capital markets are resigned to a recurrence of the financial crisis. This time, it's not Lehman, Bear Stearns, Washington Mutual or Countrywide.

Deutsche Bank is the target this month, the subject of widespread concern about which large financial institution could be the next to fail--even after politicians and regulators had imposed new rules, stress tests and capital requirements to minimize another Lehman-like implosion.

What explains this concern?

Much of it followed the U.S. Government's announcement that it intends to fine the bank $14 billion for mortgage-crisis improprieties.  Can a bank with equity capital of about $70 billion absorb such a substantial payout? Does it have enough leverage to negotiate a much-lower settlement? These are similar to the big penalty payments other big banks have paid in the wake of the problems mortgage securities contributed to the mid-2000's crisis.

Now there is anxiety about the bank's health. Some gauge it might not be able to manage fine payouts or at least convince the Government to reduce the penalty and settle for something less.

In the world of financial institutions, concern about the solvency of an important player, counterparty or market participant often leads to anxiety and often unsubstantiated rumors that could be true or may not be.  For the institutions that trade with it, lend it money, deposit funds  or clear and process its securities, they prefer not to be caught off guard.  They flee.  And when they flee en masse, the institution singled out struggles to survive.  When the run is on, days of survival can be counted. They end up getting acquired or winding down.

But Deutsche Bank, a Germany-based powerhouse tightly interwoven into the global financial system and in such size that the numbers are unthinkably large?

In the years since the crisis, legislators and regulators implemented layers of rules to eliminate the occurrence of another Lehman, to reduce the likelihood of runs on banks, and minimize the impact of unexpected market and credit losses. As if the current rules aren't enough, more rules are in draft and will come later.  Think capital requirements, liquidity rules, stable-funding requirements, long-term-funding requirements, stress tests and orderly-wind-down scenario runs--all to ensure big institutions like, yes, Deutsche will survive every conceivable banking scenario.

So why are respectable hedge funds and other large institutions running scared, pulling funds out, canceling securities-trading arrangements, and withdrawing? Why is its stock price plummeting?

Wouldn't the capital and leverage ratios have hinted at certain risks? Wasn't the bank (or at least its U.S. operations) required to pass tests related to market, liquidity and credit risks and smooth liquidations?

And wouldn't regulators, who normally park themselves on floors of big banks for extended periods, not be aware of specific risks that could jeopardize the bank's existence?

What do the numbers suggest?

They tell part of the story. The bank meets most the standard regulatory requirements, but in some instances, barely.

In 2016, the bank is not losing money. But with returns on equity (ROE) less than 2% this year, it's not making enough money to justify the enormous risks the bank takes and the leverage it uses to support risk-taking activity. Some shareholders are justified in dumping shares (on that basis).

The bank conducts an array of activities with a $2 trillion of assets on the balance sheet (and similar amounts off balance sheet). Yet it does so with about a third of the amount equity capital as some of its U.S. peers (JPMorgan Chase, Citi, Bank of America, e.g.), which have similar-size balance sheets with different risk content. 

A glance at the details of the balance sheets shows a bank less involved in deposit-taking and loan-making and more involved operating a large derivatives-market-making machine.  Its loan book is almost half the size of peers (including Chase, Citi and also-under-watch Wells Fargo).  Its derivatives activities, at least what appears on the balance sheet, exceeds some peers by almost 10 times. 

In essence, annual reports and public statements may tell the story of one kind of bank. The financials suggest a bank with an ironclad strategy to generate profits and returns from seizing the role of market-making in derivatives (swaps of all kinds, currencies, options, forwards, futures, etc.). While capital has dipped in recent periods (partly because of losses last year), derivatives activity explains as much as a third of its balance sheet.  Earnings from the same haven't contributed in the same proportions, as bank profits still rely on net-interest from lending and other areas to overcome mediocre results on the trading side.

So wouldn't a bank with such leverage, with significant trading risks, and flat levels of capital have trouble meeting regulators' strenuous requirements for minimum capital and maximum leverage?

It should, but it doesn't.  The bank follows the rules and benefits from some of the relief the rules permit (hedging, collateral, netting agreements with counterparties, e.g.), which soften some of the blow of hefty balance-sheet leverage.  It appears to have taken baby steps to increase long-term stable funding (steady increases in long-term debt to offset reliance on short-term, fickle funding), something regulators are encouraging.

The irony is the bank could arrange to pay out $14 billion and still be just above minimum capital requirements and meet most regulatory tests (likely coming in right on the button for leverage tests). (Some equity analysts argue the maximum it can pay out without threat to solvency is about $4 billion.

The reality, nonetheless, is that it would thereafter have no more room for error--no room for further losses, no room to increase the balance sheet or risk levels. It would be a bank that survives, complies with rules, but forced to wrestle with whether or not its role as a global bank with a too-big-to-fail trading role is the right strategy for the years ahead.

The solution?  Big boosts in capital (and all the funding sources that get counted as "bank capital").

Tracy Williams

See also:

CFN:  MF Global:  Too Small to Save, 2011
CFN:  Dark Days at Knight Capital, 2012
CFN:  Basel III Becoming Real, 2013
CFN:  Jefferies: Comfortable in its Niche, 2012

Monday, September 12, 2016

Checking In: Opportunity Outlook, 2016

For new MBA students, time to review where opportunities are prominent in financial services.
This is the season when Consortium MBA students in finance, old and new, return to campus.

Some, the first-years, are gleeful, excited and anxious about the new days ahead, new courses, new contacts, and new relationships with professors, deans and career advisers.  Some, second-years, are still hopeful that summer internships, including the celebrated networking receptions and occasional work on deals, will turn into offers any day now.

Both groups, whether they head back to campus at Darden, Tuck, Ross, Marshall or Haas, know they need to allot the right amounts of time to make career and employment decisions.  Corporate-finance case work is important, and so are finance-club duties and public-policy presentations. But trying to decide where to go by next summer is crucial, too.

As we head toward the latter days of 2016, let's update where the state of opportunities among sectors of finance.  Let's peek and highlight where banks, funds and financial institutions have elected to expand (or not), grow (or not) or support (or not). 

Opportunities, in general, seem bright, if only because capital markets, while occasionally volatile and uncertain, are stable these days, notwithstanding ongoing uncertainty about where interest rates are headed.  Market experts know well that with a finger snap, markets can misbehave, volatility can surge and financial institutions will retreat and tighten up as quickly as winter will inevitably approach.

This follows reviews and assessments from late, 2015, and early, 2016.

Corporate treasury:  STABLE/POSITIVE

If companies are growing, expanding and investing in new businesses, then such growth or new assets must be funded. New cash generated from growing business operations must be managed or reinvested.  Hence, corporate-treasury and finance functions (at non-financial institutions) are active, tapping into resourceful ways to finance the business and reduce financing costs or assisting senior managers in deciding how best to deploy cash on hand.
 
Many big companies (the familiar Fortune 500 names, for example) continue to try eke out higher returns and bolster stock prices by taking advantage of cheap debt and continuing to repurchase stock.  That keeps corporate-finance types busy, too. 

Many other big companies choose to hoard millions/billions in cash, taking precious time to decide the right investment opportunity (if they choose not to buy back stock to boost market values).  That keeps them busy, too. Other finance managers are actively involved in hedging balance sheets and earnings against interest-rate spikes or unforeseen currency movement (similar to "Brexit" fluctuations, e.g.).

Investment banking: STABLE

Investment bankers are in satisfactory moods these days.  Deals are in the pipeline, mergers and acquisitions continue to bloom, and these might be good times to spark up the IPO engine.  Big companies continue to issue cheap debt and buy back stock--under the guidance of bankers.  Other companies are always on the prowl for the next right acquisition--also guided by bankers.  A technology bubble burst was projected by naysayers earlier this year, but it hasn't happened yet. Technology bankers, however, haven't been successful in convincing many familiar "unicorns" (Uber, AirBnB, e.g.) to go public.

With banking, a lot depends on the sector:  healthcare, consumer goods, real estate, energy, financial institutions, diversified, industrials, technology, media, pharmaceuticals, etc. For much of 2016, energy has been the untouchable (oil and gas exploration, most notably), but activity in many ways is still brisk in pharmaceuticals and some technology segments. 

Boutique firms continue to form, sprout, spread and make an impact. And companies, large and small, won't hesitate to be advised by small outfits still unpacking boxes in a new Park Avenue office.  

The big I-banking names, however, continue to push hard in banking, because investment-banking fees are more valuable than ever--fees from advising, underwriting, committing, processing, managing, arranging, and syndicating.  The big names (including Goldman, Morgan Stanley, Citi, Bank of America, and JPMorgan) haven't curtailed their investment-banking strategies.

Some foreign banks (Deutsche Bank, Credit Suisse, e.g.) are having second thoughts, as they seem to do every other year.  Other names (like Wells Fargo and other foreign-based banks) start, stop and resume in the sector, but still command respect in certain niches. Barclays this year, with many prominent hires in the senior ranks, appears to be regrouping to prepare to compete fiercely with the big names.
  
Private banking and private wealth management:  POSITIVE

For more than a decade, financial institutions have adored wealth management as a business line, partly because of the stable, predictable fee-income streams and partly because the related activities come with manageable risks and manageable balance-sheet requirements. This, along with other asset-management businesses, has been a targeted growth area.

Results have been satisfactory at most banks, and growth might not have soared as they had hoped. But it's still a preferred area, as banks prefer to grow in sectors where capital requirements aren't onerous and where balance-sheet impact is tolerable. 

Competition, however, is fierce--and not necessarily from other large institutions. Robo-advisers have surfaced and claim to provide the same banking, wealth management and asset management services for much lower costs. Financial institutions now fend them off or try to convince clients they aren't better off retreating toward algorithmic-driven online advisers. The robo-segment will likely seize younger clients and those just starting to build wealth. Banks must decide a strategy of how to react: Compete or form partnerships. 

Corporate banking:  STABLE/POSITIVE

Regulators like it when banks go back to basics--deposit-taking and loan-making. With more and more restrictions and with banks' hands tied in knots, corporate banking appears more attractive than banks' pre-crisis efforts to engage in the exotic in those go-go years.  Banks appreciate the corporate relationships and more stable net-interest-earned revenues that come with corporate banking.

Boosting this business helps boost revenues and potential transactions in investment banking. The two go hand in hand now.  In fact, many big banks combine the sectors. It's more common to see the sectors named "Corporate and Investment Banking."  The banking group that can issue the bonds on behalf of a big company will likely be the same group that can arrange a billion-dollar syndicated loan.

Corporate banking, nonetheless, comes with big risks.  Some of the biggest losses banks have absorbed over many decades have resulted from bad risk management or aggressive corporate lending in certain industries. 

Thus, while they beef  up corporate-banking units, they must concomitantly beef up risk management and suffer the headaches (and capital requirements) that come with big loans to big companies.

Sales and trading:  NEGATIVE

The outlook for those interested in working on trading desks is negative, but that doesn't imply there aren't opportunities to sell and trade securities, derivatives and currencies profitably. As long as there are thriving capital markets, there are opportunities to trade for gains.

But financial institutions continue to review and rationalize sales-and-trading businesses. Senior managers are still determining what their roles should be and what the right business model will be. Some institutions are deciding whether computers and machines can substitute for the roles of humans on trading desks consummating large equity or bond sales/trades with other institutions.

Regulation has restricted what they can do or how they can do it. Profit opportunities are fewer.  Dodd-Frank's Volcker Rule (which prohibits proprietary trading at banks) is in place. Some banks have scaled back; other big banks continue to hold big positions (to facilitate customer flow), while they struggle to ensure compliance with new rules.  Some determined banks have found ways to be profitable, but most banks aren't seeking to expand these areas aggressively. Hiring occurs, but not in the way it did before 2008.

Risk management:  POSITIVE

Risk management opportunities continue to grow, even if banks have not figured out the best ways to recruit talented MBA's in finance into these areas.  For the most part, risk management has become a complex responsibility. At major financial institutions, it is now sub-divided into several areas:  market risk, liquidity risk, credit risk, operations risk and now even such areas as reputation risk and enterprise risk.

Many financial institutions seek what they need in mid-level and senior roles by convincing bankers and traders to assume risk positions. Some banks have tried hiring junior risk managers and developing them through the years, as they take on more responsibility. 

Risk management, like it or now, now encompasses regulatory compliance. The new rules have become voluminous, arcane and difficult and are often tied to how a financial institution quantifies and manages risks.  The best risk managers are now expected to understand new regulation, as well as understand clients, borrowers, counterparties, markets, financial modeling and analysis, and (more and more) advanced levels of statistics.

Banks have always encountered the fact that few colleges and business schools offer courses in financial risk management, if only to give students an idea of what risk management is all about. So when they recruit, they must convince prospects of the importance of such roles (and of course pay them as if they would pay bankers and traders).

Yet year after year, most institutions are desperate to find the right people to fill critical roles.

Asset management:  POSITIVE

Like private wealth management, asset management is a targeted growth area. Financial institutions (including banks and some insurance companies) scramble to accumulate investors' assets (ranging from individuals to institutions and mutual funds) and charge fees for holding and investing them, based on criteria.

The arena is crowded and now includes the aforementioned robo-advisers.  Because it's crowded, institutions must offer competitive pricing or offer a bundle of services under a price sheet. Robo-advisers claim they can provide much of the service bundle at much lower cost.

Like private wealth management, banks are attracted to asset management's minimal regulation:  Not much capital is required to appease the Federal Reserve when managing a billion dollars. The fees and a tolerable amount of regulation keep some banks pushing harder to expand and grow, although performance has reached a plateau in recent years.

Investment research:  STABLE

Research applies to institutional equities and fixed-income ("sell side") for broker/dealers and may apply to the same ("buy side") for asset managers.  

After years of trying to fix the business model of equity and bond research (after scandals during the dot-com-bubble era), the industry seems to have settled into something that works for many institutions.  Debt investors still examine credit ratings from ratings agencies. Equity investors and traders still seek guidance on company stocks and embrace the research and valuations researchers offer. Those researchers are still paid from the commissions their firms generate from equity-trading activity. And many investment managers will still do some credit and equity research themselves.

While an MBA in finance is an advantage, many institutions like what the CFA adds.

Venture capital:  POSITIVE

At the start of 2016, many suspected we might be on the brink of a technology bubble, a bubble that could burst the apparently inflated stock values of new companies and burst the enthusiasm of venture-capital companies supporting any start-up that has a heart beat.

But the bubble hasn't burst yet. The industry proceeds, however, with both caution and optimism. 

For opportunities for MBA's, the challenge is always the same even when the going is good:  Finding a way to get through the front doors of a closed-off, clubby world.

Private equity:  STABLE/POSITIVE

Private equity differs from venture capital in one important way. Both industry segments invest in and manage operations in private companies. Venture-capital firms focus on the unknown--new company, new managers, a vision, new products or services, almost no track record.  Private-equity firms focus on the known--often old companies, experienced managers, old products and services, a withering brand, long track records, and often a worn-out vision. 

Venture-capital firms determine a business model and find new ways to generate revenues and cash flow.  Private-equity firms often invest in companies with sound revenue streams, but focus on streamlining operations, reducing costs efficiently, and exploring new markets or channels.  At some point, when timing is right and after companies are spruced up, they consider selling those old companies back into the public markets.

There is an argument that private-equity firms thrive when equity markets are down, the better for them to discover and buy under-valued companies. There is another argument that private-equity firms thrive when equity markets soar, the better for them to consider selling refurbished companies back to the public market.

When business is brisk and opportunities exist, private-equity firms are always stalking banks and business schools to find the hordes who will do the complex finance models to determine when to buy and when to sell.

Hedge funds: NEGATIVE

Might these be the worst of times for hedge funds?

Hedge funds have experienced horrible returns and times the past two years. Many have shut down, closed shop, and returned money to disappointed investors. Some updated statistics show as much as 15-20% in redemptions, partly reflecting dismal performance when other market indicators are doing well, partly reflecting frustrations at investors paying fund managers the proverbial 2-and-20 fees (2% asset fees and 20% of fund profits) for almost embarrassing outcomes.

These would also include activist-shareholder funds, funds that do less frequent trading and are more involved in building equity stakes in notable companies to drive a new financial strategy (merge, acquire, expand, change business model, pay more in dividends, reward shareholders better, reconstruct board membership, conduct stock buy-back campaigns, etc.).  Some have had satisfactory results; some, too, have had weak returns. Others have just merely withdrawn their relentless efforts to force the new strategy.

Many hedge funds, therefore, aren't opening their doors widely to new candidates fresh from business school.

Compliance and regulation:  POSITIVE

Dodd-Frank has been in force for more than a half-decade. Financial institutions continue to do all they can to understand, interpret, analyze and comply with the thousands of pages (yes, thousands) of new rules.  Many rules under Dodd-Frank and Basel III are still in formation, still in draft form.  So banks must be ready to comply with regulation that has still not been written in entirety.  Or they must work harder to improve the metrics that show they have excess levels of whatever is required--capital, liquidity, stable funding, cash reserves, etc.  They must survive complex annual stress tests and prove their demise (even if it won't happen soon) won't damage the financial system.

Compliance and regulation are now beastly tasks that require attention, investments (for systems), and expertise (in the rules, in statistical analysis, or in organization structures).  And they must be explained to bankers and traders in a way to help them understand the impact on their businesses and their dwindling returns on capital.

They must prove (based on new quantitative tests of their roles in the financial system) they aren't "too big to fail" or suffer the onerous regulatory requirements that come with being global, colossal institutions.

Many large institutions will admit they don't have sufficient enough people who willingly and eagerly want to be involved in ongoing compliance. Those doors are as wide open as any door in a bank is these days.

Financial technology:  POSITIVE

If there's a hot sector for the times, it's financial technology--or fin-tech. The time is ripe where the worlds of technology, new ventures, and financial services are locking hands to create something new, or at least "disrupt" the traditional ways of providing financial services, advice and funding. 

Fin-tech presents innumerable opportunities. While the trends are upward and show promise, the sector is too broad and too unpredictable to pinpoint how young professionals can best take advantage of opportunities.  Fin-tech includes electronic payments, small-business lending and robo-advising in wealth management, but it may also include mergers and acquisition, investment research, and financial reporting.

Companies have formed everywhere, not just in Silicon Valley or on Wall Street.  Companies have been started by computer experts and former bankers and traders.

A few themes are emerging:  Big institutions have taken notice and are responding with their own strategies (and investments or partnerships). As with most new ventures, not all fin-tech businesses and models will survive.  Many won't be able to expand in scale.  Others will make mistakes not in technology, but market strategy or risk management.  Most will require time to perfect a business model (how to provide financial services, funding, or advice profitably).

But all that won't diminish opportunity in the early days of what might be called a financial revolution of sorts.

Tracy Williams

See also:


Tuesday, August 2, 2016

Yahoo Tosses in the Towel

It's been about two years since Yahoo board members and CEO Marissa Mayer huddled among themselves time and again to decide what to do with the company. Few companies, including many of its competitors all along the Silicon Valley corridor, have endured as many volatile ups and downs in its two-decade history. Yahoo's earnings, revenues and its strategic direction have bounced around like balls in an aimless path.

Mayer was hired from Google to become the CEO who would devise the strategic, pick the people, make the acquisitions, and develop the products that would thrust the company into the elites among technology companies that depend on digital advertising.  Mayer was supposed to push Yahoo to seize once again its top perch among Internet "portal" companies.
Somewhere along the way, Yahoo stepped into a blockbuster of good fortune from having invested in Alibaba, the big Chinese company that combines the best of PayPal, eBay and Amazon and issued its equity over here.  Yet Yahoo stumbled a few times. It picked itself up, stumbled again, and reached a point of not being sure what that best next step should be--except to separate the company into its Alibaba parts and its website parts and let another big company, with resources enough to take risks with it, decide what that next strategy should be.

Verizon has decided to purchase the non-Alibaba parts of Yahoo for a mere $4.8 billion. (Yahoo could have sold itself to Microsoft years ago for nearly 10-times that amount.) Verizon decided to find a partner for AOL, which Verizon acquired within the past year.  Put AOL and Yahoo together, take advantage of their millions of subscribers and tens of millions of clicks, coordinate the content they both pour through websites, reduce duplicate expenses, and make gobs of money from digital advertising.

Yahoo was not on the verge of bankruptcy or insolvency. Revenues have been flat, and earnings exist, although losses are occasional.  Mayer staged many acquisitions (Tumblr, for example), but none could help boost revenues much beyond $4 billion/year. Alibaba brought a fortune--tens of billions in unusual earnings and needed cash reserves.  It also brought bothersome levels of tax headaches.  Yahoo had modest levels of debt (to help its acquisition binge and to develop content), but dwindling cash flow meant it had little room to borrow more.

Markets, disappointed and signaling frustration in slipping stock prices, pushed Meyer and the Yahoo board toward a final move. The market, in fact, had valued Yahoo, minus its Alibaba asset, at negative values.

Mayer's rise to a top post Silicon Valley was meteoric, rapid, and not unexpected (from those who had knew her work at Google).  As a woman CEO not yet 45, she was watched, observed, and perhaps over-analyzed. Every quarterly earnings announcement (or quarterly misstep) and every large-scale, over-priced acquisition were headlined, heralded, or overly analyzed. When the desired revenue growth never appeared, her strategies were second-guessed. It's unfortunate the Verizon acquisition reduces women CEO's in Silicon Valley by one--a worrisome number in a corporate sector where women CEO's can tallied by less than two hands.

No matter what Mayer attempted, the company couldn't rocket itself to where it wanted to be, even if it head years of a head start before the Googles and Facebooks were household names.  Sales were stagnant at below $5 billion. No matter what it acquired, developed, and created, operating revenues (excluding anything related to Alibaba) never topped that $5 billion lid. Earnings and cash flow were erratic (They were losses and deficits last year).  The company spent and spent (development, administrative, and traffic-acquisition expenses), but revenue growth didn't accompany the spending sprees. Debt levels were moderate (less than $2 billion), but would have become a difficult burden if losses continued.

In the eyes of a potential acquirer, Yahoo offered some form of equity value, measured not by growing flows of operating cash, but from the metrics that technology companies with digital-advertising business crave:  subscribers, views, and clicks from a predictable core.

Just as it reasoned with AOL, Verizon likely rationalized that $4 billion and change is not an outrageous price to pay for a company that attracts enough eyeballs daily to generate a base level of $4 billion in revenues. It also likely concluded it could erase much of the billions in Yahoo expenses within a year and eliminate its debt without a flinch. Verizon may quickly turn something that is lackluster breakeven operation into something cash-flow positive. 

The challenges, however, will be (a) how to increase revenues to justify the acquisition, (b) how to mesh Yahoo's operation with that of AOL, which had its own set of financial woes, and (c) how to respond to regulators who might all of a sudden express concern about Verizon amassing enormous amounts of customer information from its combined Verizon-AOL-Yahoo data bases in its efforts to sell the most-targeted form of digital ads.

Tracy Williams

See also: 

CFN:  Verion Acquires Vodafone, 2013
CFN: Why is Dell Going Private? 2013
CFN:  Verizon Rescues AOL, 2015
CFN:  Will Yahoo Ever Rebound? 2015
CFN:  Who Calls the Shots in Silicon Valley? 2016

Friday, July 15, 2016

Who Attracts the Best Talent?

Financial institutions are scarce on LinkedIn's new talent-attraction list, but Goldman Sachs slips in at no. 27 on its U.S. list
Which companies around the globe attract the best and the brightest?  Where do the most talented want to work?  What are the coveted places for those who are select their employers, before employers select them?

LinkedIn used its stockpile of data from over 400 million users and took a stab at creating a list. It used data analytics and data science. It tapped intuition and made assumptions (many of them). Here's one:  Companies that attract the best talent are companies that get the most job requests in LinkedIn or garner the most attention in LinkedIn updates or communications. 

In early July, it presented the results of the project, its first such effort. Its data and models produced a ranking of top companies or financial institutions it contends are successful in attracting the best talent. Some of the familiar names (Apple, Google, Amazon, Facebook, e.g.) led the top of the list.  Financial institutions were few in number, and there might be reasons.

Be mindful that a broad survey or analysis of the kind LinkedIn led could lead to possible false impressions or misrepresentations. (What is the real definition of "talent"? Aren't many talented people recruited without their making inquiries in LinkedIn?)

Yet the final list included names we would expect in 2016, names of companies that pay well, that have ambitious plans to grow and make a societal difference, that offer pleasing perks, and that present interesting problems for smart people to find solutions in their first few days on the new job.

Up front, LinkedIn needed to define top talent and best talent.  It then assembled a set of assumptions to define what it means to attract talent.   Are the companies at the top of its list attracting employees who sported the highest GPA's, who performed beyond expectations during internships, who have in-depth levels of skills in technical areas, and who have demonstrated qualitative skills (drive, energy, work ethic, leadership, etc.) in previous work assignments? Are they MBA's from top business schools, those who lead class discussions in investment analysis or chair the finance club?  Are they mostly computer science whizzes from elite engineering schools?

There's a global list and a U.S. list. Apple, Salesforce, Facebook, Google, Amazon, Microsoft, Uber, Unilever, and Coca-Cola and Oracle appear on both lists.  In the U.S. compilation, you see Uber, Stryker, Netflix, Under Armour and Tesla. Are we not surprised? Don't talented people want to work at companies making a mark or sitting on the cusp of extraordinary growth? (Many of the companies on the global list are Consortium sponsors.)  Few financial institutions appear on the list, and we might be able to rationalize why.

LinkedIn explains the criteria clearly, even if many will argue about the flaws (as there are in just about all lists published and promoted widely).  LinkedIn has access to voluminous data--from companies, recruiters, employees, industry leaders, potential hires, students, etc.  It culled the data, deciphered trends, clicks and activity from its users, put together a set of rules and used results to present a list.

Its premise for talent-attraction is based on (a) reach and clicks (how well known the company and its brand are) (b) engagement and interaction (how often LinkedIn users connect with the company in some form), (c) job interest (how often LinkedIn users explore or seek employment at the company), and (d) staying power (how long do employees remain at the company).

Some filtering of data must have been necessary, because those who lack required skills or talent are also clicking and exploring and pursuing job opportunities at many of the same companies.  And often the best are discovered and tapped in other ways or through other channels.  They need not spend much time completing job applications discovered from an exploratory moment in LinkedIn. But LinkedIn asserts, if thousands are exploring employment opportunities at Google, then Google's chances of hiring the best increase.

Now what about financial institutions?  Why don't they crowd or dominate the list in the way they might have in the 1990's or mid-2000's, when art-history and music majors expressed interest in gaining a spot in an investment-banking class at, say, Credit Suisse or Lehman Brothers?

Why are Goldman Sachs (no. 27 on the U.S. list ) and Morgan Stanley (no. 40 on the U.S. list ) the only two large financial institutions on the list?  Do financial-service companies (banks, funds, institutions, insurance companies, and asset managers) not attract top talent annually from undergraduate and business schools or from other industries?  Are this generation's brightest choosing careers mostly in technology, new ventures or less-bureaucratic and less-hierarchal organizations?  And are work-life-balance issues factors?

What implications can we make from LinkedIn's efforts to highlight the paths that talented people take in pursuing opportunities or employment?

1) Investment banking might still be a lure.

Goldman and Morgan appear on the list, partly because of the continuing attraction of investment banking.  They are no longer "pure investment banks." (They are officially bank holding companies.) But in some circles, they are considered major investment banks before they are labeled commercial banks.

Wells Fargo, Citi, or JPMorgan Chase with similar brands and, in some cases, strong financial results might easily have supplanted Goldman and Morgan.  With Goldman and Morgan Stanley, there is the apparent direct tie (and heritage) to investment banking, where compensation packages are still lucrative and deals, transactions and trading still cause surges of adrenaline.

2)  The steady transformation of financial services (including the impact of regulation) can be daunting.

With new regulation keeping banks strapped in many ways, talented people might be restricted from being creative, expanding on bold ideas, and coming up with new products.  Regulated financial institutions have restrained balance sheets and thousands of pages of new rules to adhere to. 

3)  The survey, with some flaws, could still have omitted some institutions or miscalculated "talent attraction."

Let's consider that banks such as Wells Fargo, hedge funds such as Bridgewater and Citadel and private equity firms such as KKR, Carlyle and Blackstone indeed attract the financially talented.  How do they not appear on the lists? In some cases, they aren't household brands (one of the criteria). In other ways, they identify talent in stealth ways and hire in limited numbers.  And they may have a limited presence in LinkedIn.

4) The fintech revolution might, in fact, even its early unproven stages, be enticing talent that might otherwise have gone to work at Charles Schwab or Bank of America.

New companies that fit the mold of "fintech" didn't ease onto the lists. A few notable ones (Square) did. Others might show up on lists in the years to come. SoFi is a prominent example. But the wave has come and is far from peaking. They have affected talent retention at banks, which are suffering anxiety trying to determine a counter-strategy:  Beat them or join them or invest in them?

An MBA graduate (of a Consortium school?) with a concentration in finance and an extensive background in computer science is just as likely to want to explore working for a transformative, business-model-breaking fintech company as she would want to start out as an associate in project finance at Deustche Bank.

So the list is out, slowly slipping onto the digital screens of young professionals (and those more experienced).  It will likely be an annual LinkedIn roll-out, and no doubt it'll polish and update the criteria next year.

One special note:  Microsoft, which just announced its planned acquisition of LinkedIn, appears on the list.  LinkedIn list organizers unabashedly said they will keep the new parent on the list this year. For now, at least.

Tracy Williams

CFN:  The Fintech Revolution, 2016
CFN:  Financial Technology and Opportunities, 2014
CFN:  Bitcoins:  Embrace or Beware, 2014
CFN:  High-Frequency Trading:  What's Next? 2014
CFN:  Fortune's Best Places to Work, 2016


Sunday, July 3, 2016

Another Round of Stress Tests

Global banking these days is so much about building capital bases and passing complicated stress tests.
First there was "Brexit," the U.K.'s referendum leading to a surprising, planned departure from the European Union. Then came the big banks' stress tests, graded by Federal regulators.  In the days after Brexit, there couldn't have been a better time to announce the 2016 results of the annual bank-holding-company stress exams. 

Banks have mountains of new regulation for which they must adhere to between now and 2019. Along the way, they must pass yearly stress tests administered by the Federal Reserve Bank and falling under the more expansive title, "Comprehensive Capital Analysis and Review," referred to more often as "C-CAR."

In the wake of Dodd-Frank legislation, regulators want banks to have sufficient amounts of capital to withstand shocks, losses and surprises during the ordinary course of business and to endure the worst possible scenarios, those that lead to unexpected losses.  The capital guidelines are detailed and complex. The formulas used to calculate precisely the amounts of capital to act as worst-case cushions are as complicated as a graduate-school statistics course. They aim to compute expected and unexpected losses.  They consider such factors and variables as 99-percent confidence levels (for worst-case scenarios), correlation, loan default probabilities, concentration, market volatility, market sensitivity and market shortfalls. 

But even after data accumulation and calculations and after banks report they have far more than the minimum amounts, U.S. regulators require the stress tests. They want to cover all bases. They want to make sure they haven't overlooked other negative influences--like a Brexit-type event, oil prices deep-diving toward $20/barrel, or a global recession appearing from nowhere.

So the exercise is this: 

Banks first address Basel III requirements.  They routinely tally up all their risks (credit, market, operational, contingent, and off-balance-sheet), perform the calculations to assure regulators they have enough capital (the sum of equity and some forms of long-term debt) and assert their capital totals will tolerate massive losses, including that arise about once a century (like those from the period of 2008-09). 

The risk tally sums up to a total of risk-weighted assets (RWA). A bank's loan to, say, investment-grade companies like Home Depot or John Deere is "risk-weighted" downward, compared to the bank's loan to a struggling, non-investment-grade borrower like, say, Sears, Valeant, or now-bankrupt Sun Edison. The minimum capital requirements (Common Equity, Tier 1, Tier 2, Total Capital), tied to RWA, are stipulated by Basel III rules. 

And then, oh, by the way, after all those calculations, come the stress tests.  Regulators require yet another vigorous shake-up to balance sheets, bank operations and the financial system to see if banks can still survive with ample amounts of capital.

Hence, the latest stress tests.

Every U.S. bank passed this time, although one bank (Morgan Stanley) was put on what might be called regulatory probation, a conditional watch list. (Two subsidiaries of foreign banks ran into trouble:  Deutsche Bank and Santander.)  Citi, which fumbled the test the last time, was determined to be a leader of the pack this time.  Its stress test showed how the worst of all worst-case scenarios could lead to the bank suffering over $34 billion in losses over an 18-24-month period. Yet it proved (and regulators agreed) it would still have ample capital resources to remain sound and viable--not just barely solvent. Its equity "cushion" would still exceed $150 billion. (Most of those losses would come from loan losses on its consumer and corporate-lending portfolio.)

In the latest test, regulators presented the following scenario:

1) U.S. unemployment rates would rise above 10%. That would have impact on consumer loan and residential-mortgage portfolios and would have eventual impact on corporate borrowers that depend on thriving retail markets.

2) The U.S. dollar appreciates substantially. That would have impact on global corporate loans and U.S. borrowers with substantial exports. It would affect U.S. banks with big balance sheets abroad. (Some would argue that banks' currency-trading units, which thrive on volatility, might have income upswings to offset other losses.)

3)  U.S. Treasury securities will trade with negative yields (as many Euro-issues have done in the past year). That would have a detrimental impact on bank earnings (net-interest margins) and might encourage banks to take out-size risks to recoup negative earnings on Treasuries they may have held for liquidity purposes.

4) "Flight-to-safety" capital flows would occur and would like result in rocky, strangely behaving markets.  That would result in financial institutions dumping riskier assets for safe-haven instruments (sovereign debt, high-rated bonds, or even U.S. Treasuries with negative yields), likely causing a collapse in a range of assets (equities, commodities, lower-rated corporate bonds, mortgages, etc.). This would replicate 1998's Asian and Russian crisis, when flights to safety led to a sudden widening of bond spreads, as investors dumped mortgage bonds and any asset that smelled risk for U.S. Treasuries.

Regulators this time hadn't really identified a Brexit, didn't predict it, or at least didn't specify such a case in the detail they described for scenario possibilities. But stress tests are supposed to capture the risks of Brexit-like occurrences. 

The tests aren't conducted as easily as they appear.  While it is straightforward to describe a stress scenario, all bank activities, assets, loans, trading positions, liabilities, and legal entities are subject to these downside cases. All results must be quantified with reasonable precision.

Out spills a grand total of possible losses over a defined time horizon. The losses are subtracted from current capital totals. Regulators then access whether the bank, after all, still has sufficient loss-absorbing capital to meet Basel III requirements.

Banks that pass can exhale. The exercises, however, don't go onto a shelf or get buried in electronic files in a compliance department.  Banks gear up and prepare for the next test or take measures to ensure on an ongoing basis they can pass the test any time its administered with a different, but similarly outrageous, but realistic list of extreme market characteristics.

Some big banks this year proved to have so much ample capital they proved to the Federal Reserve they could pay higher dividends and resume stock-repurchase programs. They proceed with such shareholder rewards, confident they will continue to generate earnings quarter after quarter.

Ever since Dodd-Frank and Basel II and III rolled onto the financial scene, banks know well they must continue to keep those capital bases swelling and growing. And they want to the headlines that come with having fallen short of expected capital requirements or having failed a stress test.

Tracy Williams

See also:

CFN:  Basel III Becoming Real, 2013
CFN:  JPMorgan's Refined Regulatory Strategy, 2014
CFN:  Big Banks:  The Dreadful Downgrades, 2012
CFN:  Bank ROE's: Stuck at 10%, 2015
CFN:  Banks and Living , 2016
CFN:  Banks and Their Energy Loans, 2016
CFN: When Does a Bank Have Enough Capital? 2015



Monday, June 20, 2016

Was LinkedIn for Sale All Along?

Out of the blue, LinkedIn made itself available for sale.  Microsoft reached out.
Did anybody see it coming?

Did anybody know Microsoft had its eyes set on acquiring LinkedIn? Yes, this is the LinkedIn almost all professionals are familiar with, the website that presides over business networking, permits its hundreds of millions of users to post their resumes' online, and is a gateway for corporate recruiters to sift through data on those who work in the most junior positions to those who have roles on a floor C-Suite.

There hadn't been rumors floating around about LinkedIn searching for a suitor or buyer. Not much whispering about its board members adopting a strategy to convince shareholders the company would benefit from a merger. The merger announcement, on a late-spring Monday morning, emerged from around the bend.

Microsoft has announced it plans to acquire LinkedIn for $26 billion.  The acquired company, after another year of losses when it had actually turned the corner toward profitability two years ago, had decided that its best bet was a merger. 

Too much risk and uncertainty loomed if it opted to push ahead, find clever ways to boost sales, and figure out a way to generate predictable streams of income (which it hasn't yet done). Too much uncertainty loomed if it thought its current business model, strategy and financial results could thrust the company to valuation levels (above $100 billion) that could reach the class of Facebooks or Googles.

Might there have been clues the past few months that LinkedIn had put itself up for sale?

A few clues.  Last year's performance. This year's first-quarter outlook and performance.  And the implosion in its stock price in February when an unfavorable outlook presented by the company led to a decline by almost 50%.

Had the board decided that the company's valuation, as an independent company, right now was as high as it could possibly get?

Unlike some ventures in Silicon Valley that were launched in the late 1990's and early 2000's and that eventually went public, LinkedIn had begun to eke out small profits or at least get near break-even. But the company last year sagged and reported losses. 

Revenues were growing at rates Silicon Valley followers covet. The company now boasts of sales of almost $3 billion, about three times revenues from three years ago.  New users, new services, and more interesting and useful items that cascade through its version of a newsfeed helped to generate more fees and advertising revenue. 

But expenses across the board surged. The more it has grown, the more it has spent to spur growth or find ways to make LinkedIn special in complex sphere of social and business networks.  Revenues show signs of flattening out, and the company was on a pace to lose about $250-300 million this year.

The balance sheet has a modest amount of debt (about $1 billion), and the operations actually squeeze out some cash flow, despite recent losses. Much of that cash flow has been siphoned toward new investments and capital expenditures. 

In other words, as a relative new company in a technology arena, the company was doing what it thought it's supposed to do to grow and remain relevant, interesting, and hip. Like many new Bay Area companies, it hasn't even thought of paying dividends yet.

With revenues apparently topping out, with it perhaps having run out of ideas for how to push usage on the site and with stock values gyrating in sometimes unexplained ways, LinkedIn figured its best bet was a sale.

So now the ball is in Microsoft's court. How does LinkedIn fit in? What will it do to or for the company? How realistic are the reported synergies between Microsoft's strengths and LinkedIn's purpose?

Despite some equity analysts and market watchers squirming after the announcement, Microsoft has the heft and might to do the merger.  Its market value exceeds LinkedIn's by 10-times. LinkedIn's sales will contribute, at least for now, less than 3 percent of the combined company. Despite some who lament Microsoft being an old-school, behind-the-times technology company, it still can still be counted on to generate over $10 billion in profits (and over $20 billion in operating cash flow). Like Apple, it has over $50 billion of cash sitting on the balance sheet waiting to prey on a new investment opportunity. (It's those kinds of cash-flow numbers that permit credit-rating agencies to rate it AAA.)

LinkedIn, therefore, would only cause a slight scratch in Microsoft's numbers, if the merger fails.  Somehow, however, critics and pundits might be right in wondering how the two fit together. Will professionals using Excel spreadsheets really seek advice or input from their connections in LinkedIn?

Tracy Williams

See also:

CFN:  Who Calls the Shots in Silicon Valley? 2016
CFN: Twitter's Turn for an IPO, 2013
CFN: Why Did Dell Opt to Go Private? 2013
CFN:  Google Reorganizes as Alphabet, 2015


Monday, May 23, 2016

Taking a Bite Out of Apple

Warren Buffett likely gave a nod of approval before Berkshire decided to invest $1 billion in Apple

To the surprise of many who figured Buffett and his Berkshire Hathaway investment company always steer far from investments that sound and smell “technology,” the group announced in May it would invest $1 billion in Apple stock. 

In the days before the announcement, Apple’s stock had tumbled a bit following what it deemed a lackluster first-quarter performance (a slight decline in revenues for a company that had hardly experienced bad-news earnings the past decade). In the moments after the announcement, its stock price bounced upward. A Buffett stock-purchase gesture will do that for you. 

Some analysts responded in the media this signaled a step toward retirement for Buffett, now 85--a hint that he is allowing others to lead the company’s investment decisions and that might have spurred the decision behind the Apple stake.

On the other hand, no matter how many detect Buffett is permitting others to make investment decisions, a billion-dollar investment in Apple or Coca Cola or any major company likely required Buffett’s nod of approval. The next generation of decision-makers at Berkshire will likely have sought Buffett’s input and sign-off. He might have not have come up with the idea or might not have immersed himself in the research that usually accompanies a Berkshire stake. Others performed the analysis and industry research and presented a legitimate case to invest; Buffett, no doubt, okayed it.

What did they see, as they researched and reached a decision that must have conformed to the company’s decades-long investment principles? The  principles form the backbone of investments in companies that will show consistent, stable and sustainable performance for a long time. 

Buffett and his Omaha crew for ages have preached investments in

(a) businesses they know and understand and businesses with readily understood operating models,

(b) industries that will be important for a long time to a large buying market, 

(c) companies that have groomed leaders to be astute, shrewd business managers, 

(d) companies that hit certain measurable objectives: good, stable returns on equity (book value), most notably, 

(e) companies that have “intrinsic” values that far exceed the values calculated by emotion-swamped and flighty short-term shareholders, 

(f) companies that have cost control and exhibit some signs of growth (after a modest amount of tweaking by the same experienced management team), 

(g) companies that may occasionally experience downturns or slumps, but will be granted time to recover and even soar.

And yes, companies that pay steady dividends from predictable streams of cash flow, aren’t burdened with too much debt and aren’t daring to venture into non-core, exotic activities or activities that appear to be CEO “hobbies.” 

Does Apple qualify? What could have swayed them, beyond Apple’s decades-long performance of stunning levels of operating cash flow? 

Take a peek. 

a) Market values that fall shy over “intrinsic” values, even if Apple hasn’t yet unveiled the next gadget of the decade.

Apple now has a market value that now exceeds $510 billion, even after the stock price cascaded downward from above $130/share to the mid-90’s today. Berkshire analysts may have concluded after a slight downturn in earnings (“down” to $10 billion in the first quarter), equity markets might have over-reacted. Has the market been too concerned about Apple's product line, uncertainties about an Apple watch product and slippage in revenues warrant declining values? 

A recent P-E ratio computed to 10, for a company operating in a still-growing industry where normal P-E’s range above 15. A P-E ratio hovering about 10 suggests markets aren’t willing to give value to uncertain levels of growth. 

The Omaha team may have concluded the market is under-estimating future growth. They are confident Apple management (under Tim Cook, as CEO) can still crank out operating cash flows continually in a $10-15 billion range each quarter. 

b) Cash reserves, which rest visibly on its balance sheet. 

Apple still sits on billions in cash, even if in recent years, the company has elected to reward shareholders with dividends and not hoard it all. Beyond dividend pay-outs and stock repurchases, it still has about $40 billion to “play with”—for new investments, new projects, an occasional acquisition. (Another $30-40 billion resides in operating units overseas and unconsolidated subsidiaries, targets for many who claim the company keeps that cash there to avoid tax obligations.)

A few years ago, shareholder activists protested that some of the cash reserves should be siphoned off to equity-holders in the form of dividends, if only to boost an already astounding ROE’s (returns on equity). 

Apple complied, started paying dividends for the first time and instituted a stock-buy program. It replenished much of the stockpile from new cash from operations and from proceeds of new debt. (Apple continues to pay out about 15% of operating cash flow in dividends.) 

Activists pushed for stock buy-backs, too, and begged for a capital structure that welcomed cheap debt, less equity. A little financial engineering, so to speak. Apple has obliged and has conducted occasional stock repurchases the past three years or so. 

c) Operating cash flow 

Even if it claims it experienced a “bad” first quarter (unsuitable for its standards), the company is still generating sustainable (predictable) cash flow (after capital expenditures) from operations of about $15 billion a quarter, over $60 billion a year, reliable streams that get Berkshire analysts excited.

Berkshire analysts could have concluded that operating cash flow won’t surge to $80 billion a year soon, but the market may be under-valuing a company that will likely continue to generate at least $40-50 billion cash from profits, even in the toughest years. 

d) Book-value returns. 

Buffett has often said they assess performance based on a company’s ability to generate earnings on book value. Apple produced an ROE of 44% last year (31% last quarter). Getting comfortable with low-cost debt (as it has done the past few years) has enhanced returns. High profit margins (22% ROS) on products peddled to consumer public has helped. (Remember, iPhones have $500-plus price tags affixed to them.)

Buffet is attached to companies with operations that result in returns (ROE) that exceed expectations and cost-of-capital requirements. 

In the end, the team of analysts concluded sustainable cash flows and sound returns on capital offset the label of Apple being a “technology” company. They crunched the numbers and felt comfortable the right management is in place for a long time. And Cook and his corps of product creators will develop new products that will keep piles of cash flooding its doorsteps. 

Buffett and team are less worried about whether Apple’s watch didn’t usurp the iPhone in popularity, not too concerned because one or two quarters fell short of fabulous earnings in previous years. They may have beamed they could swoon in and grab a piece of a $500 billion company they think—with cash flows and predictable streams and a business culture that finds a way of producing the next new thing—is really worth $600-700 billion. 

Tracy Williams

See also:


Thursday, April 21, 2016

What's This About "Living Wills"?

Bank regulators, including the FDIC, gave failing grades to some well-known banks in the recent "living wills" test

U.S. financial regulators delivered another blow toward big banks in mid-April, 2016. Some analysts and equity markets considered it a benign one because bank stock prices hardly budged.  It provided easy fodder, however, for the bands of critics (including a presidential candidate or two) who wage arguments that big banks must be broken up.

This time the FDIC and Federal Reserve announced its list of banks that didn't pass its latest test to assure the public that tax-payer funds won't bail out the next Lehman or Bear Stearns. A slate of banks (including JPMorgan Chase, Bank of America, Wells Fargo, and State Street) failed the "Living Wills" test.

This requirement is not arbitrary or recent. Dodd-Frank, the U.S. legislation that spells out much of bank regulation after 2010, permits regulators to establish rules that require big banks (especially the ones deemed "too big too fail") to show how they will wind down their vast operations in the event of extreme distress (at or near bankruptcy) without putting us through what the globe endured in 2008.

In other words, if a bank like JPMorgan or Wells Fargo in control of over $2 trillion in assets in all parts of the globe is in jeopardy of going out of business (perhaps because of mounting loan losses, extraordinary asset concentration, gigantic trading losses, insufficient capital, or fraud), can it manage an orderly liquidation of the business? Can it do it without hurting depositors and causing wreckage in capital markets?

And can it do so without the U.S. Government having to intervene? Can it do it without the Government feeling obliged to inject new capital to keep markets at peace and avoid jeopardizing the existence of the financial system? Can that orderly process occur with only shareholders (and maybe subordinated debt-holders) bearing the inevitable billions in losses?

In 2015, regulators requested banks to complete this  exercise.  After assessing the "living wills," they would decide which banks passed or failed--regardless of how well those banks are performing today or how well the banks meet current regulatory requirements for capital, leverage and liquidity.

The banks got their report cards recently, and they accepted their wrist slaps in stride, suffered a little embarrassment and promised to redesign their respective liquidation plans.  They must present improved presentations of  "living wills," and they are taking this seriously.

Why did JPMorgan, a bank cushioned with over $200 billion in book capital, fail this test?

How could the big behemoth, with $20 billion-plus annual profits and with its hands entangled in about every form of financial transaction that exists, have not passed?  JPMorgan management is blaming technicalities.  And it might have a case (although that won't convince regulators to change their grade).

Regulators examined a hypothetical scenario where the bank's credit ratings have been downgraded to near-default status (or the ratings have been withdrawn) and where the bank's parent company is in or on the verge of bankruptcy. They argued a JPMorgan liquidation process, as catastrophic as that seems, has short falls that require immediate attention. The bank has the rest of this year to redo the will. A catastrophic-sounding wind down, regulators insist, must have minimal impact on the rest of the financial system.

In reality, if JPMorgan is about to implode and if rumors of bankruptcy abound and even if its problems and woes are isolated, it's likely other big institutions will be fumbling (or failing) because of similar issues.  Big banks have similar businesses,  strategies, balance-sheet content, and ways of managing risks. They often interface, compete, or aggressively manage markets in similar ways. Paraphrased, they often copy each other, if only to compete and grow. If JPMorgan is going down, then it's likely Goldman Sachs and Citi are suffering similar financial anxiety.

The goal of a "living will" is to ensure an orderly, safe liquidation that follows a regulatory-approved "playbook."  The implied goal is to assure all of us the financial system won't suffer a repeat of 2008.

Explaining in clear communication, regulators directed JPMorgan to clean up lingering issues with liquidity management, complex legal structures, and derivatives exposures.  To their credit, they outlined the problems in layman's detail.

Bank overseers say the bank's liquidity plan has weaknesses.  The bank has vast amounts of cash reserves (to meet short-term obligations), but the bank is over confident its ability to summon up cash that might be trapped in subsidiaries, particularly regulated entities.  Regulators want the bank to assume that parent cash deposited at a major subsidiary might become "ring-fenced," trapped overseas, blocked by other rule-makers or encumbered by third parties, unable to be funneled back to the parent.

They also remark the bank's parent entity presides over a sometimes inexplicably complex legal structure, one that would with certainly impede an orderly liquidation. They recommend the bank consider aligning legal entities with business activities.  No doubt regulators are aware big financial institutions create hundreds of legal entities, often to separate regulated activity from non-regulated activity, sometimes to extract exotic, difficult-to-value assets from trading units that seek a high-grade credit rating.

Regulators also want to see a better plan for recapitalizing some of those entities, if and when necessary. And they are pushing for a stronger outline for how it would wind down billions in derivatives exposures.

The strikes above result partly from the bank's size (cash reserves residing on balance sheets around the world, vast numbers of unexplained legal entities, and exposures in nearly every kind of derivative that is traded).  That explains why it can be harder for JPMorgan to pass a "living will" test than it would be for a   domestic, medium-size bank, even one that isn't growing or is barely profitable.

However, it's a strike, and it's a new era. The bank's legal staff, compliance officers and financial managers will hastily respond and resubmit a stronger liquidation plan, even if the probability of a such a bankruptcy is low and unimaginable.

Tracy Williams

See also:

CFN:  Banks and their Energy Loans and Losses, 2013
CFN:  JPMorgan's Regulatory Rant, 2012
CFN: Credit Suisse Makes a Big Move, 2015

Monday, March 28, 2016

Best Work Places: Financial Institutions?

Why aren't financial institutions on this list in greater numbers?
Fortune magazine just published another list.  Lists sell print copies.  They attract views and readers online.  Starting with the Fortune 500, Fortune's lists--from top global companies to its power and diversity lists--get the attention its editors crave.  Lists spur dialogue and discussion. They at least encourage the larger population to talk about the subject, even if many disagree lists are subjective.

Lists can be disconcerting and controversial, especially the criteria on which most lists are made.  Criteria are often too subjective and permit list-makers to exploit statistics, data, numbers and surveys in the way they might want lists to appear.  Fortune's 500 list, it happens, might be one of the least-subjective lists around.  They are based on public company's disclosed, audited sales totals.

(BusinessWeek's and USNews' lists of top business schools are subjective and can change significantly by tweaking one variable among many in a list of criteria. Such lists can be helpful, but should viewed with caution. Should business-publication editors get to decide what business school is "better" than another one?)

Fortune's latest list is its list for the best companies to work for.  Remember, this is not a "500" list. Companies appear based on a set of subjective criteria, surveys, interviews, and evidence of perks, special benefits, and hear-say.

The net worth, market values or profitability of companies is not a primary factor, although some of the "best companies" on this list attract top talent because they have proven results and strong financial performance.  Vice versa, strong companies are able to invest in perks and benefits to attract top talent and keep the talent for years because of such benefits.

The usual names appear at the top of this year's list:  Google/Alphabet, Salesforce, KPMG, EY, Pricewaterhouse, IKEA, Whole Foods, and Deloitte. Even GoDaddy, Mars (Candy), and the Cheesecake Factory made the list. (Many, in fact, are Consortium sponsors.)

But what about financial institutions:  banks, broker/dealers, asset managers, insurance companies, hedge funds, mutual-funds companies, securities exchanges, etc.?  Do they appear on the list? If not, why? And how has this trend changed in recent years?

First, let's check Fortune's criteria, at least the way the publication organized and presented the criteria in 2016. Remember, this isn't a list that measures size, bottom-line metrics or a company's ability to generate tens of billions in sales, although many on the list are big and generate returns that keep investors smug and satisfied.

Happy, talented employees contribute to strong performance, no doubt. And employees are generally happy when companies eagerly provide perks, nurture sane work environments, and maintain common sense about employees' own lifestyles and family constraints. Fortune's criteria revolve around just that:  benefits, rewards, and attractions that help retain employees for the long term.  They include childcare, sabbatical privileges, flexible workdays, healthcare, and exercise gyms.

What financial institutions appeared on the list?  Some names are familiar. American Express, for example, no matter recent performance issues it has had to deal with, is still a favorite place for employees--thanks, still, to the leadership of its CEO Kenneth Chenault.

A few are scattered on the list--some insurance companies (Nationwide, e.g.) and a handful of banks and regional broker/dealers (CapitalOne, Edward Jones, American Express, Robert Baird, e.g.). Goldman Sachs doesn't  make the top 50.  Major banks or institutions such as Citi, Blackstone, JPMorgan Chase, and Morgan Stanley aren't listed at all.

Why don't financial institutions appear on these lists in large numbers?

There might be some an assortment of reasons.  Large size and unwieldy organization structures might be factors.  The volatile, unpredictable nature of financial markets could be a contributing factor, too.  That many financial institutions are the results of a series of clunky mergers shouldn't be minimized.  But let's try to tackle a few common reasons:

1)  Regulatory requirements and related priorities. 

Financial institutions are deeply immersed in a complex web of financial regulation.  Compliance is difficult, laborious, expensive, and critical.  As much as they are attentive to financial performance (shareholder returns, revenue growth and cost-cutting), they are wading through thousands of pages of new regulation and playing catch-up even when they catch up.  (Bank regulation continues to evolve and expand each year since the crisis.)

Meeting capital, shedding trading desks, reducing leverage, and passing stress tests with top grades become priorities. Gifting employees with free perks and caring about work-life balance issues get thrust into the back seat.

2)  Still haunted by the financial crisis.

The financial crisis has receded into financial history, but financial institutions today take business steps and adopt strategy with one foot pointed ahead and the other anchored down by debilitating risks that caused a near collapse in the financial system.

Banks, hedge funds and broker/dealers are not necessarily risk-adverse at all hours of the clock. But they operate in anxiety, pushing buttons to ensure they don't slip back into a setting where all markets are slamming their balance sheets, capital bases and earnings reports. Nor do they want to make an errant, rash decision that might result in hundreds of millions in litigation years from now.

3)  Less able to attract the best talent.

In recent years with a surge in interest in technology, entrepreneurship, and new business models, financial institutions may no longer be the most desirable destination for undergraduates and for those with professional degrees (JD, MBA, e.g.).

Banks know that and have worked hard to redefine the experiences and growth paths in their institutions. Some are "creating" interesting roles to attract not only those who adore capital markets and investment management, but those interested in computer science, engineering, and international relations.

It's a tough sell. Some interested in financial services may turn first to opportunities in "fin-tech," or financial-technology start-ups and related new ventures.

4)  Fewer benefits, perks and special attractions.

Financial institutions are bogged down with capital requirements that increase every year (as rules are amended to ensure they can stand down the next crisis).  They are steadfastly focused on containing or cutting costs to reach profitability objectives.  The best way to achieve an ROE that pleases shareholders, when revenue growth is limited, is to wage aggressive cost-cutting campaigns, the kinds of campaigns that cut into the core of a business operation. If abolishing tuition reimbursements for employees helps cut costs, then so it goes.

Large banks have cut their costs or managed them well in recent years.  The expense numbers prove it, and the profit margins in recent years show it. (Just this month, Credit Suisse announced bold efforts to cut cuts even more.)  But what gives and what goes away?  Employee benefits, employee perks, long-term or contractual compensation, and many of the factors that might help put banks on best-work-place lists.

5)  An industry still in flux.

The industry of financial services is evolving quickly.  Regulators are concerned about institutions being "too big to fail" and have imposed restrictions on activities like proprietary trading and on balance-sheet leverage.  Smaller start-up companies, not yet constrained by regulation, have begun to tread on bank territory to provide payments and lending services. Securities exchanges have sprouted all over the place electronically.

What financial institutions from banks and broker/dealers to exchanges and futures dealers could do years ago might be prohibited or limited today.  What they could do years ago might make little economic sense today. How they do things (processing securities and making payments, e.g.) is changing rapidly.

Uncertainty in some industries can present opportunities.  Uncertainty in financial services presents opportunities, as well, but can also discourage talent, if the talent is unsure what the role of large financial institutions in 10 years will be.

6)  Fluctuating, unpredictable patterns in compensation.

Compared to many industries, financial services continues to pay well, especially in areas like investment banking, investment management, research, private equity, and hedge funds (when they are doing well).  The old guard might complain that the era of star bankers and stratospheric, guaranteed compensation is over, but head-shaking compensation packages still exist.

Sometimes, however, compensation--no matter how lucrative--varies significantly from year to year and is too often be based on subjective criteria. The best employee is not always assured of being paid fairly or commensurately.

7)  Working under a constant threat of lay-offs, reductions, and firings.

Within the industry, there have been precedent and patterns since the financial crisis.  Financial professionals no longer join the industry confident they can spend 20 years or more doing well on the job and be handsomely rewarded and aptly promoted. The days of such comfort are gone.

Companies, banks and firms in financial services nowadays make critical decisions on businesses, geographies, products, balance sheets, and profitability. Unfortunately people are affected. That has led to a work environment, unlike decades before, where employees say they work under a cloud that "this day could be the last."

Staff reductions and dismissals exist in all industries.  Yet the aura of "the last day" and ongoing efforts by employees to look for omens (little signs that lay-off-related announcements are looming) persist often in financial services, because of what has occurred regularly in the past decade.

8)  Lack of attention to professional and management development.

The industry does an outstanding job in providing experience and expertise to junior staff about products, markets, clients, services, and systems.

The industry focuses first on "closing the deal," "booking the best trade" or "providing the most lucrative advice" and ensuring that everybody involved is equipped with market information, data, or financial models.

The industry, however, falls short in helping develop new professionals to become shrewd, compassionate managers of businesses, sectors, and people. And much of that is due to fierce, ironclad attention toward the market place and to regulatory compliance, while professional development is overlooked as a priority.

9) The hours.

Stories about "the hours" working in a financial institution are legendary:  the so-called 100-hour work weeks, the sudden demands from higher ups to cancel weekend plans, the Sunday-afternoon conference calls, beach vacations spent in front of a laptop, etc.

Long hours exist in other industries, too. Management consultants, computer programmers, and entrepreneurs work similar hours and have the same level of demands. Those who work for banks, hedge funds, and private-equity boutiques don't complain as much about the long hours as much as they screech about the lack of control over the hours they work.  Few who choose the industry mind the deals, transactions, trading, and research they do.  Many enjoy the thrill of the deal, trade, client closing or investment find. Yet many will say the uncertainties and sometimes the whims of supervisors or clients are too hard to tolerate.

Let's not lampoon the industry without highlighting its attractions and explaining why, despite all, thousands of graduates swarm toward Wall Street or its regional equivalents every year.

Why would or should a financial institution appear on the list?

1) Technical innovation and changes in the industry.

For good or bad and despite demands and clamors from regulatory authorities, the industry is in the midst of constant change.  Technology helps drive that. Entrepreneurs and a new-venture spirit contribute.  The impact of technology over the past 15 years has been extraordinary. The way securities are traded and cleared is swift, efficient and less cumbersome (although some say more improvements are necessary).  They way payments (institutional and retail) are made are similarly swift and smooth. Loans (including small-business and student-related credit) have hopped this electronic, swift-approval bandwagon.

Such constant innovation, much of which has helped to spur growth and cost-efficiencies and much of which has sparked the formation of new companies or partnerships with big institutions, can attract talent into the industry.  The computer expert who might have fled to Silicon Valley to join an interesting new venture might choose to accept Goldman Sachs' offer to build a trading model that might reduce the market risks of billions of dollars of derivatives.

2)  Capital resources: breadth and size

Critics from all over argue loudly financial institutions (banks and insurance companies) should not get too big. With their lists of who's too big and who's not, regulators worry, as well. Substantial size leads to significant systemic risks and "contagion" within the system. We've heard these argument lines regularly since the crisis, and many offer valid points, while regulators obsess in what else they can do.

Capital resources and size, however, typically mean big institutions can take on big, bold projects and make big investments that can have important impact.  Big institutions can also preside over big transactions and deals (loans, underwritings, trades, etc.) or operate across the globe if they choose to do so.

The ability to capitalize on size, scale and resources can be attractions to those who like to work on headline transactions, big deals, or financings that have widespread impact.  Size and resources in the industry make it easier to get things done in capital markets or with clients with operations around the world. The MBA finance graduate, newly arrived from Dartmouth-Tuck, can work on a $5 billion equity offering on the first day on the job or help arrange the merger of two large pharmaceutical companies the next week.

3)  International presence.

Large financial institutions have a global footprint. They operate just about in every major locale, where there exist vibrant capital markets or bustling business activity, where there exists a groomed financial system.  This often means banks, insurance companies, and asset managers will station themselves in New York, Chicago, San Francisco, London, Paris, Brazil, Tokyo, and Singapore at the blink of an eye.

Opportunities to work around the world amidst different culture and environments or having an impact on emerging markets are attractions to talented, diverse employees.

4)  Compensation benchmarks

Even if it is volatile and unpredictable and even if it comes with fewer other perks and special privileges, compensation within the industry is still more than satisfactory. In certain institutions or financial-sector niches, opportunities to increase rewards (via stock and incentive plans or investments) continue to be favorable industry attributes.

5)  And, yes, the thrill of financial and capital markets

In the end, the industry will always be attractive to those who understand the significant, varied contributions of financial companies (as traders, as intermediaries, as market-makers, as advisers, as researchers, as asset managers, and as innovators of new financial instruments).

Financial markets can be a thrill to follow, to dissect, to analyze and explain. Financial instruments offer vast amounts of funds sources that spur investments in new products, industries and regions.

And those who are enamored will be willing to step in to do the analysis, do the trade, do the investment, do the research, nurture the client, help the customer, and close the transaction.

Tracy Williams

See also:
CFN:  Summertime, Summer Internships, 2010
CFN:  Work-life Balance:  The Discussions Continue, 2014
CFN:  Delicate Balance:  Long Hours and Personal Lives, 2010
CFN:  Finance:  Still a Popular Destination? 2014
CFN:  Is I-Banking Still Hot? 2011CFN:  Diversity:  Black Enterprise's Top 40, 2009
CFN:  Diversity Top 50, 2012
CFN:  Fortune's Best Places, 2013
CFN:  Affinity Groups in the Work Place, 2011