Wednesday, February 10, 2016

Who Calls the Shots in Silicon Valley?

Of all the board members of the top 150 Silicon Valley public companies, 87% are male.
Silicon Valley, some will argue, has grabbed the heart of American commerce.  It's the unabashed global seat of technical innovation and creativity. Other regions in the country and around the world wish they could replicate at least a small portion of its entrepreneurial successes and its contributions to value in global markets and consumer satisfaction.

It's the home base of companies like Facebook, Apple, HP, Oracle, Alphabet/Google, Intel, Dropbox, Salesforce and eBay.  It's where the next new things are dreamed, groomed and designed.

But the Valley has fallen flat on its face when it comes to diversity.  And to its credit, it knows it.

The statistics tell the story, and so do casual glimpses of its board rooms, its venture financiers, and its popular tech-crunch conferences, where technology good-'ol-boys hang out, trade industry stories, and promote glistening new products.

Lonergan Partners, an executive-search and talent firm based in the Bay Area, recently presented its findings from a research project to determine who's who in Silicon Valley and who runs all the shows that make Silicon Valley soar. It focused on board membership at major Silicon Valley companies, what it calls the "Silicon Valley 150." With help from nearby Stanford Business School, it compiled statistics, summarized its findings, and made careful attempts to draw conclusions.

Its findings reaffirmed what most already suspected, what most had already observed.

The SV150, a moniker to rival the S&P 500 or Fortune 500, includes the top 150 publicly traded companies headquartered in Silicon Valley. It includes many companies with familiar names that went public within the past decade (Facebook, Twitter, LinkedIn, e.g.). It includes, also, companies that helped give birth to the region as a technology center of the universe (HP, e.g.).

It includes companies in assorted industries: IT, Internet, semiconductor, biotechnology, clean technology and consumer products.

It doesn't include recent start-ups and the dozens of companies classified as "unicorns," private companies that have been valued at $1 billion or more, but haven't yet decided to leap across the private-public divide into IPO land.

Apparently it would have included the best-known unicorns (Uber and AirBnB come to mind), if it could.  But for survey and research purposes, Lonergan wanted reliable, updated data, information that can more easily be obtained from public companies or at least from their annual reports and public filings (information public companies can't hide or camouflage).

It also doesn't include much of the finance sector, the venture capitalists who surround the industry prominently with promises of rounds of funding and who set the agenda for which companies will have the best chances to thrust themselves toward billion-dollar market valuations.

Nonetheless, the reliable results from a data pool of 150 public companies are informative and meaningful.  By examining the make-up and membership of the boards of directors of these companies, it could determine, based on data and not hearsay or hunches,

a) Who are the people who run the big Silicon Valley companies?

b) Who are the people who have influence at many companies in an industry?

c) What are the backgrounds, experiences and education of people who run these companies?

d) Are women represented in board rooms and in senior-management positions in meaningful numbers?

e) Are there board members in significant numbers from under-represented minority groups?

What did it find? And did it recommend solutions and next steps for an industry that sells products and services to the masses around the globes, but for which its core of leaders tend to be a cozy neighborhood of well-connected men?

Men run the show, for certain--as founders, as visionaries who get their projects funded, as private investors, as senior engineers and designers, as founder-CEO's, and as board members.

The SV150 tally shows an astounding number of male board members.  That's not shocking; the numbers reinforce what we already knew.

Of the 1,156 board members of the top 150 companies, 87% (as of August, 2015) are male, who at an average age of 59 are not as young as fables suggest and who tend to have had established business and board experience (about 7 years of board involvement). Board chairs are 97% male.

Not surprisingly, board memberships are interlocking, where members are typically selected from those already established within the network.  About 20% of the board members serve on other SV150 boards.

Over a quarter of the boards (42 or 28%) have no women.  How much does Silicon Valley trail all other top global companies? The Valley's 13% women board composition lags the S&P 500 (19%).

Well, what about new, young companies, more recently founded and perhaps more likely to be conscientious and progressive about board representation.  Lonergan research shows for companies that have gone public within the past five years, only 12% of board composition are women. Hardly any different from older, established companies.

The results aren't too sour. Some companies deserve applause.  Google, Symantec, Netflix and Cisco are among the nine companies with at least three women board members. The number of women CEO's is now up to eight.

Researchers tried to compile trends and numbers for minorities. They acknowledged challenges because they couldn't determine with certainty who fell into which groups, because they were not relying on (and likely couldn't rely) on companies self-reporting information by race and ethnicity.

As best as possible, they were able to conclude that among total employees, minorities (blacks, Latinos, and Asians) account for about 35% of the total.  Among board members, minorities comprised only 5%, most of whom were Asians (South and Pacific Asians).

The lists of reasons why the numbers are abysmal in 2016 are long and have been analyzed relentlessly. Solutions aren't always implemented well or aren't prioritized. Technology companies, especially those struggling to remain solvent or respond to pressing demands from venture investors, dance around or neglect the topic. Often they just aren't motivated to ensure leadership is as diverse as the users of their products.

The usual "excuses" include a scarcity of women and minorities in the "pipeline" for leadership roles and the low numbers of women and non-Asian minorities interested in or pursuing engineering. The real reasons are often tied to a lack of urgency or emphasis on the issues and tied to the tendency for busy people to appoint whom they know or hang around with or hire those with degrees or experiences they share.

Hewlitt-Packard is one company deserving a pat on the back, even if financial analysts have criticized the company's financial performance almost non-stop the past decade. In the midst of making a strategic decision to split up a company whose founders are often called pioneers of the Valley, HP announced the two new companies would have a set number of women and minority directors.  And it came through.

That it already had a woman CEO (Meg Whitman) might have been why it took bold, immediate steps.  The company now exists as two independent public companies (HP and HPE), but their boards now include at least three African-American women:  Pam Carter, a former Cummins executive, Stacey Mobley of DuPont, and Stacy Brown-Philpot, the COO of TaskRabbit.

In a club whose members can likely be counted on one hand (and maybe half of another), black board members among the 150 include James Bell at Apple and Robin Washington and Colin Powell at Salesforce.  Hector Garcia-Molina at Oracle is the only confirmed Mexican-born board member in a state where Latinos are at least 38% of the population (20% of the Bay Area).

Take a look at Facebook, whose hundreds of millions of daily users include huge numbers of women, blacks, Latinos and Asians.  Its board is small (only eight members).  Its membership includes, besides CEO Mark Zuckerman and COO Sheryl Sandberg, a predictable small club of Silicon Valley legends, (Marc Andreesen, Reed Hastings, and Peter Thiel).

If one reason for the lack of women and under-represented minorities in senior roles or positions in Silicon Valley is the tendency to appoint those who share the same degrees and schools, statistics prove it.  Over 20% of SV150 board members have a degree of some kind from Stanford.

There is indeed a core of favorite schools from which companies hire to populate the pipelines that eventually lead to appointments as senior managers and board members.  The Lonergan research showed that most board members and company senior managers (CEO's, CFO's, COO's) were graduates of just a handful of top schools:  Stanford, Harvard, Princeton, Berkeley, Yale and Michigan (undergraduate) and Stanford, Harvard, Berkeley, Penn, UCLA, Carnegie Mellon, and Cornell (graduate, including MBA's and including degrees from Consortium schools).

(Consortium business schools in California include USC-Marshall, UC-Berkeley-Haas, and UCLA-Anderson.)

Over 50% of the 150 women board members have an MBA, most from the list of top, favored schools.

The Valley has a long way to go. A long, long way.

Statistical research helps because it shows trends (and progress, where it might exist) and confirms notions we already have had.

However laudable such findings and research may be, they don't offer solutions or a game plan that would force board leaders and senior managers (including the clubs of founders, visionaries, and highly networked, well-contacted people that decide what's next in the Valley) to act now instead of "when the time is right."

Tracy Williams

See also:

CFN:  Venture Capital and the Pao Lawsuit, 2015
CFN:  Harvard Business School and Gender Diversity, 2013
CFN:  Horowitz and His Latest Venture, 2014
CFN:  Venture Capital Diversity Update, 2011
CFN:  Sally Krawchek's Pivot Move, 2014
CFN:  Muriel Siebert, Wall Street Pioneer, 2013
CFN:  Knocking Down Doors in Venture Capital, 2012

Monday, February 1, 2016

Collapsing Oil Prices: Painful for Banks?

Will the steep drop in oil prices haunt banks and their loan portfolios?
Last August, we endured the pain of wild swings in equity markets.  At that time, we blamed it on China, its boiled-over economy and its government's desperation to find quick solutions via currency manipulation and temporary shut-downs in the market.

In early 2016, we are enduring pain again, but from a different source:  the continuing collapse of oil prices.  How can this be?

Economists in years past have tried to show that slight, steady declines in oil prices can prompt slight, steady boosts in GNP.  A decline in the price of oil barrels is supposed to be kind-hearted to consumers, airlines, manufacturers, and auto-makers. A decline in the price of fuel and energy should bring joy to consumers and manufacturers, helping to boost confidence in capital markets and encourage consumers to get out and about and companies to invest and grow.

This time, however, markets are in disarray. The decline in prices is producing a far different effect, an impact that has sent shudders among stock investors before the new year can even get off its feet.  The woes of depressed oil prices have caused problems (and declining revenues and losses to be reported in the periods to come) for countless participants in the energy sector--from exploration companies and drillers to oil traders and powerful, big-name companies. (We'll see for sure in the weeks to come as big oil companies, announcing 2015 earnings, report substantial earnings declines.)

How steeply have prices declined?

Just two years ago, oil prices hovered about $100/barrel. This month, they slipped below $27/barrel. And yet world supply continues to increase in ways that puzzle many market watchers, which suggests the likelihood that prices will continue to fall.

Market analysts are examining the phenomenon in countless ways--global and regional supply, global and regional demand, U.S. energy policy and strategy, the impact of natural gas, the impact of fracking,  Middle Eastern politics and geographic tension, OPEC's intentions, OPEC's bluffs, and now Iran gaining the privilege of entering the world market.

In finance, what impact will depressed prices have on financial institutions--the banks that provide funding for exploration and drilling, the hedge funds that trade energy stocks and derivatives, the dealers that trade the bonds of energy companies, and the fund companies that bundle energy stocks into ETF's?

Inevitably it won't necessarily be positive. Negative impact at financial institutions implies loan losses, trading losses, and balance sheets bulging with concentrated, unhedged risks.

Banks do significant business with companies in this industry sector. They lend money, arrange financing, syndicate loans, provide advice and underwrite stocks and bonds for big oil companies like Exxon and Chevron and for companies involved in exploration, drilling, refining, and distribution. They also make markets in bonds, securities, and commercial paper issued by companies in the sector.

Until Dodd-Frank came along and until Volcker Rules became a reality, some banks dared to leap into the industry to become not arrangers or financiers, but "players," institutions that made markets in commodities like oil (and other energy components) and traded for their own accounts, speculating like hedge funds and buying and owning refineries.

New regulation has either prohibited banks from continuing down these paths or discouraged them by imposing onerous capital requirements.

Banks and other financial institutions continue to do significant business with the sector.  Take JPMorgan Chase, for example. In a corporate loan portfolio that totaled about $204 billion in Dec., 2014, about 9% is extended to oil and gas companies, companies now confronting a market where the price of one of the primary products they sell has declined 75% over the past 18 months, contributing to devastating impact on revenues and earnings.

At the end of 2014, JPMorgan's total credit exposure to the industry was reported at $19.2 billion, a total that includes loans outstanding, loan commitments, letters of credit, and derivatives activity. No doubt risk managers at the bank, along with the regulators camped within, have huddled to devise a risk strategy to address the risk of losses from doing business with this sector.  That likely means having to decide the right amount in loan reductions, loan sales, hedges, and loan-loss provisions in earnings. And it will possibly mean prohibiting overall loan growth for now.

In fact, when the bank announced its record-breaking 2015 earnings (over $24 billion), it cautioned investors that it had already begun to account for loan losses to energy companies. (It increased loan-loss provisions to its oil-and-gas sector in the fourth quarter.) And perhaps more will come.

Overall, the unfavorable aspects of depressed oil prices on banks can fall in the following categories:

1.  Loan portfolios

Banks with significant concentration of loan and credit risks to the sector are likely addressing concentration risks right now and getting set to identify non-performing loans and reserves for potential losses and allocate more capital for unexpected losses.  Bankers are also deciding how best to hedge (which credit-default swaps to purchase) and are sitting through many "portfolio reviews" to determine where else they might be most vulnerable.

Regulators, this time around, are hovering in the background to ensure banks are calculating expected and unexpected losses and allocating more capital for sector risks.

2.  Client relationships

Banks have significant client relationships with big energy companies.  Many relationships date back decades (even during the times of other energy-industry crises).  Some banks have files and cases of lessons learned that go back to industry troubles in the early 1970's and the early 1980's.  Bad loans during those periods led to the outright demise of big-name banks (Remember Continental Illinois?).

Long-term relationships must be managed tenderly, carefully. Client CFO's and senior managers, for some reason, tend not to forget how their banks treated them when they endured difficult periods. The same client for which the bank knocked down lobby doors to win a lead-underwriting role may now be one for which the bank must decide whether to reduce loan outstandings or demand more collateral and to postpone a debt offering.

3.  Corporate-bond yields

Banks and funds make markets and trade in corporate bonds, including those issued by energy companies.  All of a sudden, because risks loom indefinitely, bond yields are rising to account for the increased possibility of default by oil and gas companies.  A bond trading in the 90's and rated single-A by a major rating agency could suddenly trade in the 80's after a ratings downgrade to BB-.

If the bonds are already in a trading portfolio, higher yields imply bond-trading losses, unless the banks have hedged against these potential losses already.

4.  Energy-related derivatives, credit-default swaps

This includes many kinds of financial instruments:  oil futures, oil forwards, other energy-related futures and forwards, related derivatives traded and settled on exchanges and markets around the globe, often on behalf of energy-related companies or other speculators and hedgers.

This might include, too, credit-default-swap contracts and indices related to participants in the industry, for which hedgers and speculators may want to protect themselves against the possibility of a default by a company (or companies) in the sector or want to speculate that a company is about go beyond a cliff's edge.

Banks have limited roles in dealing and trading nowadays, but they are still smack in the middle of activity, standing in between trades, arranging each side, making markets for client-investors, clearing trades, and more. In these times, they'll want to ensure they are not handling trades for counter-parties that are over-exposed to the industry or simply don't know what they are doing in this sector.

5.  Commodity prices

There are oil prices and related volatility. There are also prices for other energy products that might have some correlation with or that might be influenced by oil-price fluctuation:  natural gas, ethanol, coal, and electricity, e.g.

Banks, traders and hedge funds are likely examining the impact of oil-price declines on these and other commodities, too, as they examine their trading portfolios, as well as the clients and counter-parties that have significant exposure to the other commodities.


6.  Clients that do business with energy companies

One sector overlooked in examining current risks is that which includes the companies that may not be energy-related, except they sell products (tools, real estate, drilling equipment, raw materials, etc.) to oil and gas companies.  These companies could be vulnerable, too.  And banks and financial institutions that do business with them will incur more risk, as well, if oil-related companies can't buy supplies in similar numbers from them anymore.

Hence, as they conduct their reviews of risks and vulnerability, banks will try to identify borrowers that fall in this group.

As we go through this unique, different type of "crisis" (a mini-crisis, we hope), hedge funds, because they aren't regulated, will take their lumps (as they have been doing so the past year or two). Equity investors in the sector will have a rocky road for a while.

As for banks?  Regulators, meanwhile, will intrude and are hopeful the strenuous capital requirements and risk-management rules they've imposed since the days Lehman collapsed will protect banks if large numbers of energy-related borrowers default, disappear, or collapse.

The new year is not yet 60 days old, but already financial institutions have a big risk item to manage in ways regulators hope they will do so with prudence, without much ado, and with no risk of banks failing.

Tracy Williams

Friday, January 15, 2016

The Fin-Tech Revolution

New fin-tech companies have sprouted by the hundreds and promote speed, cost efficiency, and information flow in financial services.

Financial technology is a bona fide industry sector in finance. Most people involved in banking and financial services refer to the sector as "fin-tech." (Some say, "FinTech.")

Fin-tech, however, encompasses much. It depends on who's describing the industry, talking about it or making observations.

We first heard widespread use of the term in the late 1990's, early 2000's, when securities and trading transactions drifted online, during an awakening when institutions realized that paper and telephone trading of securities or transferring of funds could be accomplished quite efficiently with computers communicating with each other.

Even back then, Bloomberg terminals were planted on most trading desks, and funds could be transferred electronically around the globe. But the industry was not yet sure how the Internet and other forms of technology could drastically improve the delivery of financial services.

Today, there is no boundary for what fin-tech refers to. In general, fin-tech describes a reorientation or new delivery of financial services, taking full advantage of technology and Internet connections. That can apply to any aspect of finance--from retail payments to the settlement of securities, from lending platforms to stock-trading matching engines, from corporate-finance modeling to corporate-finance advice, from wealth management to information gathering in capital markets.

That means just about anything beyond the conventional way of performing transactions and delivering services, as long as the new technology offers blinding speed, cost efficiency, and the neat assemblage of massive amounts of data.

A few years go, mention " fin-tech," and industry observers would think institutions trading securities online and institutions exploiting computer power to engage in algorithmic, high-frequency trading or organizations creating electronic markets to match buyers and sellers of securities, currencies, derivatives and commodities.

Today, fin-tech now means, also, payments, brokerage, and asset management for institutions and individuals.

The fin-tech phenomenon has resulted in the sprouting of hundreds of new companies, recent start-ups and young firms hustling to fill gaps in finance, occasionally threatening the domain of big banks.  They include companies with colorful names like PayPal, Square, Stripe, Wealthfront, Betterment, SoFi, CommonBond, ThinkNum, DataFox, and Axial.

(They include companies organized by Consortium alumni, like MyFinancialAnswers, founded by Virginia-Darden graduate Ben Pitts. There is even an boutique investment bank, FT Partners (as in "Financial Technology Partners"), based in San Francisco, solely focused on fin-tech deals.)

Many big banks, like JPMorgan Chase, Goldman Sachs and Citi, are aware they no longer compete just with each other and assorted funds, but also compete with well-funded enterprises with the best ideas about how to lend money, trade and settle securities, facilitate payments, and analyze markets--swiftly and cheaply and often without substantial capital deployment.

Over a decade and a half ago, JPMorgan established "LabMorgan" as an incubator for new ideas in fin-tech and helped birth new companies that went on to become leaders in selling services to quantify market and credit risks, trade credit derivatives and corporate bonds, and settle foreign currencies.

In the past year, JPMorgan's CEO Jamie Dimon mentioned in financial reports that his bank must now confront the competition of fin-tech start-ups that threaten to swipe swaths of market share in consumer banking, securities services or corporate finance.  In recent months, the bank established a working partnership with one outfit to facilitate to small business loans.

Fin-tech companies can be subdivided into the following categories:

Payments
Investments
Financing
Advisory
Processing and information 
Infrastructure

Robo-investing is now a popular sub-sector of fin-tech under the investments category. Bands of financial entrepreneurs have determined there are cheaper and scientific ways to help people invest, manage assets over a long term. They devised unbiased formulas to help investors to allocate funds among stocks, bonds and mutual funds. They argue that young investors will not pay exorbitant fees to financial advisers at large, reputable firms, when they can use surveys and algorithms to make the same selections at minimal costs (or at no cost, in some cases).

Examples of fin-tech firms include the following firms. Often, their employee rolls include computer specialists, data scientists, quantitative finance graduates, and finance portfolio theorists.

In robo-investing, ETF's tend to be the favorite investment, the better to minimize costs in all possible ways.  Investors sleep at night, aware that computer models update market statistics and assess performance and risk. They feed algorithms that redistribute funds among the classes of assets that include stocks, bonds, mutual funds, cash, commodities, and currencies. They allocate to minimize tax obligations, country risks or industry risks.

Wealthfront, a favorite among Silicon Valley professionals, claims to use behavior finance, machine learning and data science to strike the right allocation balance for investors.  It helps to have Burton Malkiel and Charles Ellis, legendary names in portfolio finance and investment banking, as advisers to give the firm credibility and to complement the core of Stanford MBA's on staff.  It helps, too, to have some of Silicon Valley's best known venture capitalists as backers.

The firm is now four years old and has amassed $2 billion in assets. Portfolios less than $10,000 pay no fees, an attractive lure for twenty-somethings, who are accustomed to DIY methodology and interfaces with computer screens.  The average client portfolio totals about $91,000.

On the East Coast, a competing firm is Betterment, based in Manhattan, a year older than Wealthfront and flocked with Columbia MBA's.  It, too, claims to offer algorithms that rebalance portfolios continually into about 12 asset classes (most of them ETF's), favoring "modern portfolio theory" (or more specifically a "Black-Litterman model," an updated version of finance that manages investment risks with a steady plan to diversify and rebalance).  It has accumulated $2.5 billion in assets.

The above firms, as investment-adviser companies, are not broker/dealers or stock-picking or stock-transacting firms.  Robinhood, a New York firm, falls in that category. It was founded by Stanford graduates who migrated to New York to work at big banks, but were outraged by high commissions on stock trades.  They devised a broker/dealer business model to use technology to reduce costs to virtually nothing and facilitate free trades. (Revenues will come from free use of customer balances and margin lending.)

They hope to upend the world of retail brokerage in the way the discount brokers (e.g., Charles Schwab) did a generation ago.  Operating in the fin-tech sector, the firm sells single stocks without hiring a house full of human brokers and consultants.  Andressen Horowitz, the venture capitalists, believes in the model enough to have invested with the firm.

At another end of the fin-tech spectrum exists Digital Asset Holdings (or "DA"), now run by former JPMorgan Chase executive Blythe Masters, best known for contributing to a core group there that created the credit-derivatives market.

While observing the explosion in popularity in the Bitcoin currency market the past two years, DA reasoned the technology and transaction logic behind Bitcoins could be useful in other markets.  DA's founders and computer programmers, with Masters now aboard , are researching ways to restructure the nuts, bolts, pipes and plumbing of traditional trading and settling of securities, currencies and derivatives by replicating the best of what happens in the Bitcoin marketplace.

DA claims when one bank agrees to sell a large corporate loan to another bank, it shouldn't take hours 2-3 weeks of negotiating documents and finalizing trade terms before the trade is settled. Technology should reduce such a trade to an immediate settlement after two parties consummate a transaction.

The Bitcoin market is decentralized, uses "distributed ledger technology," is an open data base, and boasts about being transparent, open-sourced, and, in some ways, democratic.  That market is not policed by government regulators, which presents issues for countless observers and potential participants. That market is also often volatile and unpredictable, although not necessarily because of its structure. (See CFN-Bitcoins.)

DA argues that, notwithstanding the volatility of the value of the Bitcoin market, the efficiencies of Bitcoin settlement can be transported into the trading, settling and risk management of corporate loans, foreign currencies, U.S. government repos, and derivatives.  While they present their case to institutions, they are in a fund-raising phase ($35-40 million), hoping to get investor and institutional support for a model that could diminish the roles of major organizations already involved in trading and securities clearance.

How about a fin-tech firm that takes advantage of social media?  Dataminr, a start-up formed by Yale graduates, does just that.  Aware that hedge funds, banks and traders are constantly hunting down information, news and data that will have impact on their portfolios or trading strategies, they determined it would be invaluable if all the updatesthat emanate from Twitter could be organized into "actionable signals."

Instead of traders sifting through mountains of Twitter feeds, Dataminr (for a fee) organizes Twitter feeds into useful streams related to mergers, acquisitions, energy, and specific companies.

If, therefore, bankers and traders have all this useful, organized information, expedited by Dataminr, what trading strategies should they adopt to take advantage of it?  Along comes another fin-tech outfit, SumZero, which was formed as an "investment community" of hedge-fund traders, asset managers, and private-equity investors to share ideas, research, concepts and thoughts about trading opportunities (for a fee, of course, and at different access levels).

It's ingrained in traders not to share investment strategies or trading positions they contemplate, but the site is popular and has attracted thousands of members, partly under the principle of reciprocity--that to find new strategies, you have to share your own.  A recent trading strategy on the site explained how traders can put on a Yahoo position (longs and shorts), tied to the likelihood the company will be split, the likelihood that it will have substantial tax liabilities related to its Alibaba investments, and the likelihood that it could be acquired.

The above companies are just a handful in scattered world of fin-tech, which now has tentacles in every sub-sector, every financial market.  The sample above hardly touched the bulge in fin-tech efforts in retail payments (mobile payments, online payments, etc.), consumer lending or small-business finance.

This snippet proves, nonetheless, how small technology-oriented enterprises are quietly and busily overhauling the industry in the way AirBnB and Uber are transplanting the travel and transportation industries.  Not only are these new companies changing the industry, mostly for the better, some are luring away the talent that otherwise might have opted for multi-decade careers at established firms.

And the big-name institutions know it.

Tracy Williams

See also:

CFN:  Bitcoins:  Embrace or Beware? 2014
CFN:  Financial Technology:  New Opportunities, 2014
CFN:  High-Frequency Trading:  What's Next?  2012
CFN:  Opportunities and Outlook, 2016

Monday, December 28, 2015

Opportunities and Outlook, 2016

Where are the best opportunities in finance for MBA graduates in 2016 and beyond?
Opportunities in finance ebb and flow, surge and subside, as most MBA graduates (and older, experienced alumni!) in finance know well.

Capital markets, economic trends, regulatory whims and winds, and the make-up of financial institutions will dictate how many and who will get hired from business-school campuses each year and how many and who will be able to transition from one sector in the industry to another, when they wish to do so. 

The year 2015 wasn't a disaster by anybody's measurement, although there were periods of head-turning turbulence (at least in August and at least in equity markets). Market watchers obsessed over China's economy, China's currency, and energy prices for most of the year. Optimists were happy investment portfolios didn't collapse. Pessimists were bothered that we didn't experience the upswings we observed in the year or two before. 

The economy improved by inches, and markets and finance managers waited the whole year for interest rates to make a microscopic upward budge, thanks to the Federal Reserve daring to make its first move. 

In corporate finance, deals proliferated, and, depending on the measuring stick, the year reached unprecedented levels in mergers, acquisitions, and restructurings.  The favorite deal du jour was the spin-off, the split-up, as company after company explored whether shareholders (HP, Yahoo, e.g.) were better off with simpler organization structures and less-diverse revenue streams.  (Pfizer announced its merger with Allergan and then announced that the two, when combined, will spin-off certain units. Hence, a merger begets a spin-off.)

Markets, transactions, politics, and corporate strategies down the road set the stage for whether opportunities exist for MBA graduates in the short term.  Let's explore by sector.

Let's also apply an informed, unscientific rating on the general outlook in each for opportunities to establish a thriving career:

What are the chances that a solid MBA finance graduate from a top (including Consortium) business school will encounter favorable opportunities in a particular sector in 2016-17?

Corporate treasury:  STABLE/POSITIVE

Opportunities in financial management, corporate treasury, and corporate finance depend on the corporate industry. In the current economy, where we are now long beyond the early stages of recovery, companies continue to grow, expand, and invest, sometimes not at the urgency that economists covet.  But these are not recessionary days. As long as companies grow and invest, they must finance activity, manage capital structures, issue debt and/or equity, and manage business investments and flows of funds. 

That ensures opportunities in financial management, financial analysis, and corporate treasury. It also means companies can develop future CFO's across all business lines. 

Investment banking: STABLE

The year 2015 was a blazing year in global mergers and acquisitions, while the year might have been lukewarm in other investment-banking-related activities (debt issuance, equity offerings, etc.).  

Investment-banking opportunities always present themselves in a whimsy--soaring one year; negative, cold and repulsive in another.  Activity by industry group will vary, as well.  When technology groups might be bustling, more staid groups like industrials, manufacturing and automotive might lag. Other groups like healthcare, financial institutions, or diversified will have deal flow and activity (as they did in 2015), mostly because those industries are restructuring or in immediate need of equity capital. 

In 2015, energy groups might be at a standstill or in "work-out" mode, as banks determine whether energy-related companies can manage through debt obligations in the current low-price environment. 

Market-timing and interest rates are also important factors that influence whether banks will hire more analysts and associates. 

Debt financing of all kinds (loans, bonds, notes, and private placements) flourished in years of low interests. Companies took advantage record low rates to refinance old, high-rate debt or invest in new projects with low cost of capital.  When interest rates rise, debt financing might pause or stay flat. 

The big names in banking tweak their hiring numbers from season to season, if not from year to year. Meanwhile, boutique firms (Moelis, Greenhill, Evercore, e.g.) continue to sprout. They start up, win headlines by slipping in the back door to advise on gigantic transactions, and don't go away. Some have been successful enough to increase their banker rolls steadily and expand into other cities, as they prepare for their own public offerings.  

As long as top bankers at "bulge bracket" banks (Goldman Sachs, Morgan Stanley, e.g.) feel the need to escape the bureaucracy, politics and regulatory burden at large institutions or decide they will enjoy the craft without being tethered to a large organization, boutique firms will appear, and some will survive and do fine.  

Private banking and private wealth management:  POSITIVE

Banks' best response to increased capital requirements (and to lesser returns on equity (ROE) is to expand in businesses that don't require enormous balance-sheet usage.  Private banking and wealth management are favorite go-to strategies. 

Banks don't deploy too much of their own balance sheets when they chase after clients to park their wealth in private-banking units.  The challenge, of course, is to keep others' assets under management (AUM) growing. 

In the last decade or so, banks (and financial-management start-ups that claim they can do better than banks) have hired aggressively in private wealth management.  New professionals, nonetheless, are usually required to hit the pavement promptly to help build assets.  

Corporate banking:  STABLE

In the 1990's and early 2000's, thanks to the generous regulation of the time, large banks rushed to reinvent themselves as investment banks. Many (JPMorgan Chase, Citi, e.g.) completed the transformation, but shifted some corporate-banking basics (corporate lending, cash-management services, payments, custody services, etc.) to the sidelines.  

After the financial crisis, large banks re-emphasized corporate banking, even if these activities pile up assets (loans) on the balance sheet.  They have renewed appreciation of the benefits of relationship banking, low-risk lending, and non-lending services, especially for mid-sized companies that can grow into prosperous global companies.

Opportunities exist in these areas, often for those with experience in specific bank functions (lending, cash management, securities processing, e.g.) and for those with both experience and deep corporate relationships. 

Sales and trading:  NEGATIVE

These are times when banks' large, football-field-size trading rooms are just as likely to be vacant or half-empty, as they are to be jammed with boisterous traders and blinking monitors. 

Regulation has pummeled this sector, and most banks except for a few (like JPMorgan and Goldman Sachs) have reduced emphasis substantially.  The new Volcker Rules (which prohibit proprietary trading), new limits on bank leverage, and increased capital requirements have made it near impossible for banks to rationalize large trading desks (in equities, fixed-income, and derivatives).  A few will forge ahead and make an effort.  Many others won't bother. 

Banks are permitted to facilitate "flow" or "customer-related" trading, but unless they are blessed with continually high volume, they have determined, too, it's not worth the pain to sift through trading to decide what's permissible (customer-related) and what's not (proprietary). 

Trading and capital-markets desks still exist at all banks (for foreign currencies, funds movement, repo markets and government securities and for some derivatives activity (interest-rate swaps, credit-default swaps, e.g.)). But the numbers are down, and the prospects for growth almost non-existent. 

Risk management:  POSITIVE

Risk management in financial institutions beefed up substantially after the crisis.  The function is well-integrated in bank organizations. Prudent risk management up and down the organization chart and in all business lines was a lesson well learned after the crisis. Moreover, bank regulation now requires banks to have an enhanced risk-management culture and rigorous risk-management discipline.  

Risk management nowadays encompasses several forms of risk:  credit risk, market risk, operations risk, legal and documentation risk, and even reputation and headline risks.  Financial institutions seek expertise, experience and talent in all these areas. They seek, too, expertise in managing all forms at once ("enterprise risk").  

Banks typically look for experienced people and have done poorly in explaining and promoting these roles when they recruit on campus.  Yet the needs exist, and opportunities abound. 

Asset management:  POSITIVE

Just like private banking and private wealth management, financial institutions continue to emphasize this segment.  (Asset management sometimes includes private banking and private wealth management and usually includes corporate and institutional clients and mutual-funds activities.)  

The impact of regulation hasn't been too harsh, and banks can still earn high returns.  Banks continue to push to accumulate and grow assets under management--fee-based businesses that don't require much balance-sheet usage. 

Competition is fierce among financial institutions.  But that hasn't dampened the aggressive efforts of most of them to compete for assets, charge reasonably for fees and generate satisfactory returns for shareholders.

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.  

The sector on the "sell side" underwent a massive overhaul in the early 2000's to eradicate conflicts of interest and too-cozy relationships with investment bankers (after related scandals of the era). Compensation models and incentives for analysts have changed, too. 

Research has now grown more comfortably into its new, mandated role. Analysts seem to understand clearly what they can and can't do, whom they should and shouldn't speak to. Opportunities exist based on corporate industries, asset classes, and institutions' willingness to promote the value of research.  

Research (on both sides: "sell" and "buy") performs an invaluable service.  Analysts not only attempt to determine proper values of stocks and bonds, but they digest, interpret and explain the vast amounts of information that influence the performance of companies in an industry.  

Venture capital:  POSITIVE

Venture capital is trendy in this era, especially the funds and firms that hover about Silicon Valley, all searching to invest in the next new thing.  

Opportunities would appear to be positive in selected segments and regions. The environment is optimistic, no matter the scuttlebutt about a "technology bubble" or over-valued "unicorns." Investors are eager to find and finance new business ideas and new companies in new industries.

But opportunities are fleeting. They exist, but are hard to find, difficult to ferret. There are few recruiting schedules or broadly announced openings. Connections, special industry expertise, and years of experience open doors to the elite VC firms (Kleiner Perkins, General Catalyst, Sequoia, et. al.).   

Opportunities, however, might exist at non-traditional venture-funding organizations, those that finance or "incubate" businesses with small scope and rely on various crowd-oriented financing. 

Private equity:  STABLE

The industry is dotted across the country (and globe). There are big, known firms like KKR, Blackstone, and Silverlake.  There are industry-niche firms like Vista.  

Macroeconomics, investor appetite, and general business conditions often influence opportunities and the decisions firms make to close down old funds and start new funds. PE firms prefer stable, businesses with proven management. 

Firms may specialize in a certain industry or, like a Blackstone, will traverse the landscape to find any stable business with predictable results (fast-foods, railroads, real estate, merchandising, e.g.).   When the economy blooms, PE firms invest, grow, and watch for easy-to-project returns on capital. When the economy sours, they sweat and tend to the large debt loads they mounted to gain control of the companies they acquire.

The brand-name firms (like Carlyle or Blackstone) have begun to seek analytical help by approaching campuses and establishing relationships at favorite schools.

Smaller PE firms will avoid campus recruiting and traditionally pick the pockets of big banks in numbers larger than banks and head-hunters care to admit. (One of the biggest headaches of investment banks is responding to the onslaught of PE firms making offers to young bankers who've gained just enough experience to be invaluable to outsiders.)

Hedge funds: NEGATIVE

The past two years have been a nightmare for most hedge funds.  Performance has lagged most equity benchmarks.  Hedge funds compete among themselves, but also compete with the proliferation of ETF's and other investment vehicles. "Crowds" of trading funds chase a handful of trading strategies, no matter how complex they are. Often the results are paltry or undistinguished when compared to what investors might reap from channeling funds into a low-cost, simple S&P index. 

Fund managers have had to redeem cash to investors, in 2015 upset with losses or embarrassing returns. Others have shut down funds or implemented new trading strategies.  

Opportunities may exist in pockets at a few established funds (Citadel?), but the industry is focused on bouncing back and convincing armies of investors that it still makes sense to pay high fees for specialized, professional management. 

Compliance and regulation:  POSITIVE

Knock on the door of just about any regulated financial institutions (banks, broker/dealers, insurance companies, and fund companies), and watch them roll out lists of jobs they need to fill in regulatory compliance.

Regulatory reform resulted in thousands of pages of new regulation.  Banks need people to interpret rules, accumulate related data, and ensure compliance. They need people to price assets, perform calculations, and preside over stress tests.  They need people who understand new rules for leverage, liquidity, capital, systemic risk, and money-laundering.  And they want people who will be attentive to the regulatory agenda, not prone to distractions, and who will want to stick around. 

Despite such needs, financial institutions haven't done well to explain these roles to candidates or promote them as desirable careers.  Often they prefer those who have some legal or compliance experience or who are comfortable being off the front-lines, away from doing deals and mingling with clients. 

Raise your hand, express interest and commitment, show that you can learn a lot about a dozen or so banking functions quickly, and the institutions will swoon.

Community banking:  STABLE

Regional banks, those that survived, have recovered after the mortgage woes of the crisis. They rebounded and restructured. Many have recommitted to community banking via on-line transactions and branch relationships.  

They, too, encounter strenuous capital requirements, but are figuring out a way to reap sufficient returns from plain-vanilla banking:  deposit-taking, consumer and small-business loans, mortgages, and perhaps credit cards.  

Business is still fiercely competitive, especially as new non-bank, financial-technology firms have discovered ways to attract customers with low fees and Internet connections. Banks, however, are not in a holding pattern as they fight off the competition. 

Community development:  STABLE

Banks are subject to regulation to support communities and are audited for compliance.  Most try to engage in their respective communities meaningfully. 

Financial technology:  POSITIVE

Financial technology (or "fin-tech") has grown significantly over the past 15 years and expanded into broad areas of finance. 

Think Internet, and think of various ways to exploit technology for the benefit of investors, retail customers, or corporate clients.  Think of various ways for investors to find opportunities via an Internet community, retail customers to do transactions (payments, loans, etc.) cheaply via a mobile device, or corporate clients to discover potential merger partners from an algorithmic match-making process.  

Fin-tech now encompasses all facets of finance. The number of companies that have organized, formed, and sold their services to a global market has exploded. Some (like PayPay, e.g.) will become household names. Others will disappear.  Shake-out is inevitable. 

Opportunities will exist in the years to come, but in unconventional ways.  Many will prefer to recruit as if they are the start-ups they indeed are.  Many will prefer those experienced in finance, financial transactions, and capital markets.  

Electronic markets:  STABLE

This includes electronic exchanges; trade-matching engines; markets in equities, fixed-income, derivatives, municipals, and currencies, and the controversial sub-sector of high-frequency traders. 

Since the late 1990's, the presence of electronic markets has increased steadily, although growth might have plateaued. (There are now nearly a dozen electronic stock exchanges under the auspices of the SEC.) 

Electronic markets evolve, too, under the wary eyes of regulators and other industry participants. Some electronic markets are match-makers or pure brokers. Some see themselves as "liquidity providers" or "liquidity-takers."  Others are involved in trade-processing, trade-settlement or trade-netting.  Others are involved in pricing and quoting services.  

Almost all try to persuade markets (and their investors) they perform services to improve liquidity, efficiency and fairness in markets. Some critics say high-frequency traders inhibit market efficiency and fairness.  

Opportunities will exist, but may not be easy to find.  They may exist best for those with technology skills and an uncanny understanding of how markets work and function.  

Tracy Williams

See also:


Friday, December 18, 2015

Pharmaceutical Flurry

What should pharmaceuticals do to satisfy investors:  acquire, merge, raise prices, or conduct painstaking research, as they used to do?
The pharmaceutical industry always seems to be in a state of flux. A flurry, more or less. Or a state of tumult.  Observe the headlines and investor discussions this past year.

It's an industry that seems to want to remodel and reinvent itself and that confronts a phalanx of issues related to economics, profit margins, board rooms, taxes, tax domiciles and shareholder value. Occasionally opportunities tied to potential miracle drugs and old-fashioned research and development forge to the top.

Observe the torrent of activity in the stocks of many pharmaceutical names this year (Bristol-Meyers, Pfizer, Merck, Lilly, Amgen, etc.). What captures the headlines and incites debate among industry leaders, analysts, and observers (including consumers)?

a) Big mergers 

b) Big companies acquiring small, unknown companies to achieve growth

c) Companies or hedge funds unrelated to the industry acquiring small drug companies

d) Companies setting or raising prices carelessly and without compassion for consumers

e) Companies engaged in mergers to avoid U.S. tax obligations

f) Companies accused of presenting misleading financial information.

Observe this fall's headlines of one company (Valeant) accused of presenting inaccurate financial information and maintaining shady ties with its distribution channels.  Notice this month's headline of securities fraud and accusations of investment trickery and price-gouging committed by hedge-fund types (Martin Shkreli, now labeled an industry scoundrel, and cohorts) who seem to have no ethical commitment to providing medical benefits to a broad public.

In some ways, it's ugly, it's messy and it's evolving, as pharmaceutical board rooms (and shareholder activists who roam around them pushing for results) rap their heads to figure out the best and fairest business model to achieve the highest returns on equity. 

The older, familiar business model involves a lengthy timeline.  Drug companies spend billions on research making a bet that a drug that will take most of a decade develop will be safe, will be approved by government regulators, and will be accepted by and helpful to a mass market. The model permits them to reap rewards by setting prices as high as much as the market can bear. In due course, they lose exclusivity in pricing the drug, at which time it becomes a "generic," attracts competition, and results in low profit margins.

At that point, they must repeat the cycle:  Engage in more research (continue to spend in R&D) to find the next new miracle.

Because the timeline is lengthy and long-term research has uncertain outcomes, pharmaceutical companies must look also to other strategies to appease investors. They pose the question: How do you achieve revenue growth and maximize ROE while still supporting the traditional model?

In the past year, the industry and its big names have focused on three strategy strands. Some companies resort to all three:

a) Acquire smaller companies--which requires financing and often regulatory approval, but shortens the timeline to discover and market new drugs. Revenues grow as soon as the acquisition is consummated.

b) Tweak pricing of existing drugs--which doesn't require financing or regulatory approval and can be done whether drugs are exclusive (protected by patents) or non-exclusive (especially if there are few competitors or pipelines to the marketplace). "Tweaking" prices is a euphemism for having the ability (and some say the economic power or right) to set the highest price possible for drugs to a public desperate for the drugs' life-saving capacities. 

c) Conduct old-fashioned research and development--which requires budgeted spending, market patience, long-term financing, meticulous testing, and regulatory approval, all of which is subject to a long, uncertain timetable. 

Because strategy (c) poses long-term risks, has uncertainty hurdles, and involves a painstaking regulatory process (not to mention an expensive marketing campaign), no wonder industry leaders look to achieve higher revenues and ROE's (and higher stock prices) by resorting to (a) and (b).

No matter the business model, the industry encounters other ongoing factors:  Who will pay for the drugs that are developed and marketed, and through what channels will they get to the consumer?Healthcare policy and the roles of insurance companies influence any business model the drug companies adopt. 

Take a peek at Merck. The global pharmaceutical firm remains profitable, despite recurrent restructurings and desperate efforts to find new drugs to offset older ones no longer with patent protection. After paring down, selling off business parts and acquiring small units, revenue growth is stagnant.  In recent years, revenues have slipped a bit.

Merck is a $42 billion-revenue company that still finds ways to squeeze out sufficient profits to pay dividends, manage a modest debt load, and generate lukewarm returns to shareholders. (ROE's are satisfactory (8-11%), not too low to incite shareholder activists, but not high enough to result in ovations from investors.)

It's a company knocking its head to find ways to get to the $50 billion-revenue mark, a threshold shareholders want to see soon enough, a level it can reach only if it pinpoints and adopts the right strategy to get there. (CEO Kenneth Frazier leads the charge.)

Which business model or corporate strategy should it settle on? Should it (a) acquire many smaller drug companies, as others have done, (b) double down on research and development expenses (and related investments), (c) diversify, expand into or invest in complementary, non-pharmaceutical ventures, or (d) merge with another big-pharmaceutical powerhouse?

If Pfizer hadn't adopted strategy (d) already via its recent blockbuster announcement to merge with Allergan, a combined Merck-Pfizer would have resulted in a $90 billion company (revenues). Yet the combination might have made little bottom-line sense and could have taken months to get regulatory approval and years to consolidate in the trenches.  (Pfizer is already enduring a publicity blow, as public officials argue Pfizer rationalizes the merger by boosting cash flow by avoiding U.S. taxes.)

While Pfizer went on a merger prowl, Merck, meanwhile, searches for growth with small add-on acquisitions and by retreating to the laboratory, promising that R&D won't fall annually below $7 billion and betting the old way that miracles will result from years of research toil.

Merck investors and credit ratings agencies haven't been too unhappy.  The stock has fluctuated significantly since market turbulence in August. Investors were pleased with corporate restructuring, but market values are down slightly in 2015.

Like all pharmaceuticals, investors get frustrated when they want growth, but don't see much evidence of it. Ratings agencies are kinder, since the company still generates cash flow (about $8-10 billion a year) to handle over $18 billion in debt.

For any company, R&D spending always has uncertain results. Certainty in this industry is that drug companies can't and don't stand still.  The flurry and the reshaping of business models will continue.

Tracy Williams

See also:

CFN:  What Does the Market See in Amazon? 2013
CFN:  Pepsico's CEO: Always on the Hot Seat, 2015
CFN:  Shake Shack's IPO, 2015
CFN:  Verizon Rescues AOL, 2015
CFN:  Tools for Financial Models, 2014
CFN:  Updating Financial Models, 2015


Tuesday, November 10, 2015

MBA Recruiting, 2015-16: Ready, Set, Go

It's that time of the year at top business schools.  Recruiting season is about to be launched in full swing.

First- and second-year finance students must implement strategies they've devised to find the right job in the right sector at the right company. MBA graduates everywhere remember how recruiting is a full-time effort, a sixth course, an effort that requires massive amounts of time and worry.

The Consortium Finance Network, as part of its mission, hosted its fourth annual recruiting and interviewing webinar Nov. 5 for first-year Consortium students in finance.  Students from all 18 Consortium schools were invited to dial in to get advice from a panel of Consortium alumni in finance.

During the one-hour session, CFN hosts and panelists reviewed opportunities in several finance sectors (from investment banking to private equity) and provided step-by-step guidance on how students can sell themselves and convince prospective employees to extend an offer--for the summer or for full-time employment.

This year, in the webinar's second half-hour, CFN decided to focus on venture capital, private equity and financial entrepreneurship, partly because these sectors do not recruit formally on campus and because these sectors have abundant hurdles when MBA graduates try to get through the front doors.

CFN steering-committee members D-Lori Newsome-Pitts, Camilo Sandoval, and Tracy Williams organized and hosted the webinar.

Panelists included Consortium alumni Ed Torres of Lilly Ventures (Michigan MBA), Ben Pitts of MyFinancialAnswers (Virginia MBA), Eddie Galvan of Nomura (USC MBA), Mark Linao of Technicolor Ventures (Michigan MBA), Sinclair Ridley-Thomas of JMP Securities (USC MBA), and Enoch Karuiki of HIG (Dartmouth MBA).  (Karuiki and Galvan had participated in a previous CFN recruiting webinar and returned to volunteer their advice and experiences this year.) All panelists had thoughtful guidance and offered lessons learned from their own days in business school. They added special tips and encouragement, based too on their own few years inside the front doors and on the front lines.

Outlook, 2016

Webinar participants evaluated financial sectors and offered a rating outlook for employment in 2016 for interns and for long-term careers.  Opportunities are a function of many factors, including economic trends and cycles, companies' relationships with specific schools, companies' past success in hiring MBA graduates, and financial regulation.

Banks and other financial institutions' business opportunities are somewhat constrained or influenced by new regulation.  Limitations on balance sheet and leverage and new rules, for example, discourage banks from hiring in large numbers in sales and trading.

A "Positive" rating suggests major institutions in the sector project revenue growth and business opportunities that will likely require hiring ample numbers of MBA finance graduates to come on board in the next few years.

The following sectors were assigned "Positive" outlook ratings:

Financial technology (payments, processing, clearing, advisory)
Compliance and regulation
Risk management (credit, market and operations risks)
Asset management (all asset classes)
Private wealth management
Venture capital

Webinar hosts and panelists awarded a rating outlook of "Stable" for the following sectors:

Corporate treasury (financial management, non-financial institutions)
Investment banking (bulge-brackets and boutiques)
Corporate banking
Investment research (equity and credit)
Private equity
Community banking
Community development
Electronic markets (exchanges, market-makers)

Sectors receiving a "Negative" rating, based on constraints banks are experiencing and general performance over the past few years, include the following:

Hedge funds 
Sales and trading (at regulated institutions)

Galvan, an investment banker in the financial-sponsors group at Nomura, reminded students that within investment banking, certain industry groups are "hot."  There could be glowing opportunities in technology, health-care, energy and real-estate groups.

Torres of Lilly Ventures agreed that while the outlook in venture capital is as favorable as ever, the route to employment continues to be hard, unpredictable.  "Very few folks get hired by a VC firm right out of school," he said. The best way to land a good offer from a prestigious firm (like Kleiner Perkins or Sequoia), he suggested, is to have already racked up many years as a successful entrepreneur. "Been-there-done-that experience is what is attractive to VC firms."

Torres added, in venture capital, "It's not a recruiting process. It's a dating process."

Summer Goals

When an MBA student in finance wins an offer, another phase of hard work is about to begin. Student interns have less than 10 weeks to prove they can do the work, make contributions, and fit in. CFN panelists summarized the primary goals in an internship, which fall in many broad categories:

Networking
Technical skills
Industry knowledge
Work ethics
Firm culture
Clients
Diversity

MBA interns and graduates on a new job should show they have expert technical skills and industry knowledge and demonstrate it everyday.  If they haven't mastered the skills, they should prove they can learn quickly.

The summer is also a chance for them to observe the culture around them and decide whether the company, the company's diversity commitment and the industry are right for them.  Work ethics count for much, too, and MBA students will need to show they will work hard, produce, show up, be eager, and contribute.

As they become more closely linked to the outcome of deals or transactions, MBA associates will want to show their comfort and rapport with clients.

Of course, the ultimate goal is to win a full-time offer, even if the intern has decided the fit at the company is not favorable or the culture is not ideal. It's ideal to at least have the offer in the pocket when the first days of second year arrive.

Interview Road Map

CFN co-founder Sandoval reviewed CFN's road map to interviewing successfully.  He reminded students they should have a strategy set for the season and asked, "What is your story?" New recruits should know their story, know what they want, and polish the story. "Think about why you want to work (at a financial institution)," he said. " Don't miss any opportunity to discuss who you are."

CFN's road map is based on the MBA interviewee being able to express clearly (a) background, (b) interest, (c) drive, (d) capability, and (e) insight.

Galvan from Nomura said, "There are two different routes to investment banking.  The non-core school route and the core-school route."  Galvan had gone to a non-core school (USC-Marshall), a school not necessarily on the primary recruiting lists at top investment banks when he pursued and eventually earned a job offer at JPMorgan.

"Show active interest and the 'want-to-be-there'," he added.  Coming from a non-core school, "I became the guy from USC that everybody liked.  I don't get the technical interview if I don't show interest."

Karuiki from the venture-capital firm HIG said that the interview process is sometimes summarized by the recruit answering a series of why's:  Why do you want to be a banker? Why do you prefer and enjoy finance? While he was at Dartmouth-Tuck, his strategy was to combine his science background with his interests in finance. (He worked at UBS before eventually joining HIG.)

Ridley-Thomas, a recent USC-Marshall graduate, was able to secure an internship after his first year with the private-equity firm Oaktree Capital.  He said he connected with the right people before the interview process started and he "benefited from referrals," getting to know people who could recommend other people.

Linao, who worked at Amazon during his MBA summer, explained how he pursued working for a start-up when he began to look for full-time opportunities, but ended up in venture capital in the process.

Pitts, while at Virginia-Darden, was able to gain offers from firms like Lehman Brothers (before its demise) and Goldman Sachs, where he worked after graduation before founding his own private-wealth firm. "Do what is genuine to you," he advised MBA students.  "Don't get easily distracted from your own goals. Be true to yourself."

Mentors matter a lot, panelists said.  "Seek out the most senior people you can," Pitts added. In school, "you have to be at all the corporate social events."

Torres advised students, "During the interview process, focus not just on the 'what,' but also on the 'how,' too."  Interviewers, he said, will want to know whether MBA graduates know how markets, finance, products and companies work or how to get a job or task done.

Galvan said, "The (recruiting) process starts really early, so be prepared."

Linao, an associate in venture capital, said, "A lot of it (the process, getting an offer) is being lucky. You'll want to force serendipity."

Pitts, the entrepreneur, encouraged graduates to consider the daring route he took after a few years at Goldman.  He started his own firm that offers wealth-management solutions.  "People think being an entrepreneur is this mystical thing," he said. "I think it's about just doing it. Motivation, relationships, and just do do it. The actual risk is less than the perceived risk."

Ridley-Thomas said, "Get focused as quickly as possible. Be relentless."

Focus on Venture Capital

Sandoval led a special discussion on venture capital, explaining major principles of how a VC firm is organized, how it raises funds, how it invests in companies, and what goals it has in the short- and long-term.

For the benefit of MBA finance students, Karuiki explained the primary difference between venture capital and investment banking.  Investment bankers have a transactional approach. Bankers work from deal to deal and seek to close them as quickly as possible. Venture capitalists, he demonstrated, have a long-term approach with clients (4-5 years typically).  They have a sustained, high level of involvement and get involved closely with people issues and senior-management hiring.

Torres, who has spent over two decades years leading Eli Lilly's venture-capital unit, said venture capitalists spend enormous amounts of time immersed in the operations of the companies they invest in.  There is a different pace and timeline when considering a deal, investing in a deal and monitoring it.  Unlike investment banking, where deals are birthed and consummated in short order, in venture capital, Torres said, "It may take three months just to decide whether to work on a deal and six months to complete a deal.  It may take four, five, six years before we exit."

In venture capital, there are winners and loses, home runs and duds, whopping gains and occasionally embarrassing losses.  "You've got to have perspective," Torres said. Venture-capital firms look at countless possible investment opportunities before they invest. "You're looking for reasons to say no. We look at 100, 150 deals for every one we do."

He summed up, "In venture capital, we're looking for the jockey, the horse, and a large unmet need." Strong management, efficient operations, and an interesting, novel product.

Tracy Williams

See also:

CFN:  Recruiting Webinar, 2013
CFN:  Recruiting Webinar, 2012
CFN:  Recruiting Webinar, 2011
CFN:  MBA Job-Hunting:  No Need to Panic Yet, 2012
CFN:  MBAs:  Second-Year Dilemma, 2010
CFN:  Opportunities, 2015
CFN:  The Finance Resume' and Recruiters, 2014
CFN:  Summertime, Summer Internships, 2010

Wednesday, October 21, 2015

Corporate Debt: Elephant in the Room

How much is too much debt?  In its announced acquisition of EMC, Dell will borrow over $40 billion to complete the deal

Financial analysts, including equity-research analysts, asset managers, and investment bankers, spend gobs of time assessing the equity of a company.  They value the stock, they assess market and book values, and they project performance and tie that to the company's overall value.  

MBA students in finance take courses in analyzing stock values of companies. They learn theories of valuation, portfolio analysis, and the factors that influence market values.  In business school, however, they seldom immerse themselves in subject matter that addresses the intricacies and complexities of companies taking on debt. 

Unless they are credit analysts and risk managers at banks, even experienced analysts sometimes overlook the burden of debt. Or they don't address it properly. Or they take it for granted (take for granted that companies can borrow when they need financing to support growth and take for granted that companies can make payments in timely fashion).  Some analysts prefer companies avoid debt altogether or dismiss how debt can be a vehicle that leads to higher returns on equity.

(Corporate debt includes an array of funding sources:  bank loans, corporate bonds, private-placement notes, structured notes, subordinated debt, convertible debt, etc.)

Debt:  A Burden or a Spark?

Debt can be a burden; it be can be hurdle, a conundrum, or the elephant in the room. This month, Dell announced it will acquire EMC, the cloud-computing and data-storage company, in a major deal that will acquire that it assume over $40 billion in new debt to consummate it.  Will that debt load eventually haunt the combined companies? Or will it be the spark to promote revenue growth and surging earnings?

If shrewdly deployed, debt can lead to higher stock prices or company valuations.  Some companies could be better off if they borrowed more.  Other companies have no more room to borrow another dime.  

It's up to financial analysts (including bankers, fixed-income researchers, and arguably equity analysts) to determine what's the right amount--what's too much and what might be too little. How is the analyst assured that the company under review can generate cash flow to meet all debt requirements due in the next quarter?

Apple avoided debt by all means during the Steve Jobs era, but now embraces it (if only to pay dividends, buy back stock, and get accustomed to the discipline required to run a company with higher leverage).  Other companies (Dell and Verizon, e.g.) resort to debt to finance large acquisitions.

Others use a combination of new debt and new equity to spearhead growth and expansion.  Financial institutions, with blessing from regulators, pile on long-term debt to avert the possibility of an occasional "run on the bank." 

All companies (and the analysts who follow them), nonetheless, wrestle with the right amount.  When does debt become too much of a burden?  When do once-manageable debt loads evolve into a mad scramble by companies to find cash in its operations to make interest and principal payments?

Financial analysts have tools, models, and ratios--even for debt--to help them draw conclusions.  Yet analysts also use intuition and experience to determine how much is too much.

Debt-to-equity ratios are often analyzed. Cash-flow coverage models are deployed.  Analysts sample many capital structures to determine the right debt load.  Past experience and history (previous defaults, bankruptcies, and companies that deteriorated in the past, e.g.) and current statistics (probabilities of defaults, e.g.) are useful, as well.

Grappling with "Ebitda"

To determine what might be too much of a burden, a favorite, traditional ratio for analysts is a Debt-to-Ebitda (“E-bit-dah”). Earnings, of course, are an obvious source to manage the burden and pay down debt when it's due. Debt/Ebitda is a useful tool to measure what's too much, but the ratio alone is a flawed approach.

First things first. Let’s agree on what “Ebitda” is, why it is a popular reference to a company’s performance, and why it might lead to a flawed approach.

Credit and equity analysts like to use this common pre-tax earnings line item as a proxy for operating cash flow, a “back-of-the-napkin” estimate of actual cash generated from operations before they derive it more precisely.

Picture two bankers in a discussion of a client’s performance. They want to size up operating cash flow without the benefit of spreadsheets, calculators or detailed financial information. Ebitda is a start.

Ebitda is the first glance at whether operating cash flow is positive, negative or trending one way or the other. It is what it can be—a cash-flow proxy. Analysts, nonetheless, must be mindful it disregards working-capital adjustments, capital expenditures, and a list of other required pay-outs (e.g., lease and tax payments).

Sometimes Ebitda is a fairly close approximation to actual derivations; often, it over-states actual cash flow or disregards how a company may generate cash from non-operating activities (e.g., the sale of an investment or manufacturing facility). (Last year, Pepsico reported Ebitda of about $14 billion. An analyst might compute gross operating cash flow at about $12 billion.)

But all analysis must start from somewhere.

Debt-to-Ebitda as a Debt-Burden Tool

Now Debt-to-Ebitda. This ratio is used frequently to measure debt burden. To assess whether debt is too high or has become a financial challenge, analysts look at an array of debt ratios (Debt/Equity, Debt/Tangible Equity, LT Debt/Equity, Cash/ST Debt, e.g.).

Or they examine Debt/Ebitda. 

The ratio is popular among bankers, credit analysts, and deal-doers. It is widely used in loan agreements as a financial covenant (borrower requirement) or in comparing debt levels for peer companies in an industry. Ebitda is much easier to confirm than actual cash flow, which may require bankers from different institutions to agree on the derivation.

Analysts interpret the ratio in many ways. For example, it can be an approximation for how long (in years) it might take for a company’s business operations to pay down a set level of debt. 

For any analysis to be complete, analysts will still eventually go through the painstaking exercise to compute and project actual cash flows, but Debt/Ebitda gets the analysis off the starting blocks. 

Debt/Ebitda < 3, for example, as a financing benchmark, implies debt on the current balance sheet will likely take about three years to amortize, three years to expunge if the company opted to do so.

Indeed many strong companies with stable, predictable cash flows will exhibit Debt/Ebitda < 3. However, in the realm of “leveraged finance” (financing structures for less creditworthy, but established borrowers), those negotiating big debt deals will argue analysts should find a way to get comfortable with Debt/Ebitda > 5, based on an argument Ebitda (or actual cash flows) for the borrower is stable, sustainable, and predictable. 

Some analysts use the ratio as another way to put leverage in perspective. A borrower might have a high Debt/Equity ratio (> 3?), but with relatively strong earnings, could have a low Debt/Ebitda ratio (< 2?). Debt, therefore, may appear high on the balance sheet, but earnings are strong enough to amortize it quickly. 

Take a look at recent calculations of the ratio: Microsoft 1.6, Yahoo 5.5, Pepsico 1.6, Goodyear 8.8, and Merck 1.0. 

The ratios imply Microsoft, Pepsico and Merck have earnings that result in healthy cash flows that can amortize debt in less than 2-3 years. They suggest that Goodyear and Yahoo might have earnings and cash-flow woes, where debt will take years to amortize and could be a burden, especially if earnings prove to be volatile in the future.

In leveraged-finance transactions, analysts determine the maximum amount of debt that creditors will tolerate for an earnings stream (maximum Debt/Ebitda). The more confident they are that the borrower can achieve a stream of earnings, the more comfortable they are with debt, which will be amortized by the same, predictable flow of earnings. That explains the possibility of getting a debt deal done at Debt/Ebitda ratios < 5. 

When Verizon acquired all of Verizon Wireless from Vodafone in 2013 and took on $49 billion in new debt to do so, Debt/Ebitda calculations pushed toward eye-popping 9.0--very little room for error in operating performance to pay this all down.)

No matter how much the ratio is discussed or used, analysts should recognize its flaws, because 
  1. Ebitda, as mentioned, is still an approximation of cash flows,
  2. The ratio assumes cash from operations is available only for debt-related payments,
  3. The ratio disregards interest rates and related fluctuations,
  4. The ratio neglects that tax obligations are real, required, and must be tended to, and
  5. The ratio presumes earnings are not necessarily available for dividends, new investments and capital expenditures—an unrealistic scenario for many companies.
A thorough analysis, of course, requires the analyst to use Ebitda to derive actual cash flow from operations and to consider a variety of factors, including investment requirements, working-capital requirements and adjustments, and perhaps other cash sources. 

But all deals, discussions of new financings and negotiations must have a starting point, and why not Debt/Ebitda?

Debt Capacity: 
What's the Most a Company Can Tolerate?

For any company under review by an analyst, what about the approach of computing the maximum amount of debt the company's operating cash flows can handle?

When they project operating cash flows in the periods to come, whether 5- or 7-years out, analysts measure whether a company can pay down existing debt and interest expense and any new debt that’s necessary to generate those projected cash flows. 

Analysts, too, if they wish, can compute an imprecise, but useful number: a maximum “debt capacity,” the highest amount of debt the operations can tolerate over a certain time frame. (Five-year debt capacity would be the sum of discounted projected cash flows over five years, discounted at the interest cost of debt and assuming all cash flow is used for debt-service only.)

“Debt capacity” can be a marketing tool for bankers in discussions with clients who contemplate new debt to finance growth, new investments or planned expansion. Knowing what might be maximum debt capacity, bankers can respond immediately to a client to confirm whether new debt is worth considering. 

Pepsico, for example, has about $23 billion in debt. A rough debt-capacity exercise might show its extremely reliable cash flows will tolerate as much as $20 billion more in debt (or $45 billion in total capacity). It won’t need this much in new debt, but it proves what its operating cash flows can handle despite debt-equity ratios that continue to rise.

Debt-capacity calculations come with red flags. Does the calculation reflect all the capital expenditures necessary to keep the company growing? Does it allow for cash to be set aside for unplanned or emergency purposes? 

Does it permit companies to pay dividends to shareholders who expect predictable quarterly payouts (as a company like Pepsico would surely want to do)? Does it capture no-growth and worst-case scenarios? 

Just like the Debt/Ebitda, “debt capacity” is merely one tool among many. Analysts must probe and still take steps beyond. 

At least companies (and the analysts who assess them) have ways to get more comfortable with that elephant in the room, tame it and use it to gain advantages to shareholders. 

Tracy Williams