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Fatally Flawed Bonds
Fatally Flawed Bonds
by Kit R. Roane
Sep 23 2008
Western markets aren't the only ones shaken by change. A popular instrument in the red-hot Islamic finance sector has been declared in conflict with the Koran.
Investors in Western securities have been given plenty to fret about recently as markets have seized up, money flows have frozen, and confidence has evaporated. But at least they haven't had to tangle with God as well.
Not so in the land of Islam, where the world's fastest-growing debt market has hit the skids in part because leading Islamic scholars began to question whether some popular Islamic bonds, or sukuks, followed religious law.
The fact that such questions exist point to a peculiar risk in Islamic markets that—because leverage is generally eschewed and securities are closely tied to assets—have been viewed as more resilient than their Western counterparts.
The questions also come at a time when that resilience is showing its limits; the Middle East is now grappling with the contagious global credit crunch and worries over its own overheated asset market. And the debate among Islamic scholars is sure to complicate those woes.
"The irony is that current market conditions are the result of deficiencies with [the] backbone of the conventional finance industry," says Rahail Ali, head of Islamic Finance at the Dubai office of Lovells, an English law firm.
Ali added that the debate among Shariah scholars has gained prominence because the sukuk market is now "open to a much wider investor base, some of which isn't familiar with the fact that differences of opinion among the Shariah scholars are very much to be expected."
Those investors got their first taste of "religious interpretation risk" last November when Sheik Muhammad Taqi Usmani said he believed that as much as 85 percent of Islamic bonds already in the market had a critical religious flaw baked into them: They guaranteed a buyer that principal would be paid back, even in the case of default.
Conventional bonds routinely carry such provisions but they are problematic for Muslims who are, among other things, barred from accepting interest, or engaging in any business where profit and risk are not equally shared.
To work around some of the simplest issues, Islamic bonds are supposed to derive their payment stream from the revenue thrown off by a real asset or some similar structure, while any repurchase is seen as just a return on a lease, and should be done at market rates.
But in an attempt to securitize a wider array of assets, or to make more appealing structures, many Islamic bonds have veered too close to a Western interpretation of what a bond should be. Or, as Usmani wrote, Islamic financial institutions, in an attempt to compete in "the conventional, interest-based marketplace," have churned out products that give lip-service to Islam while using "ploys that sound minds reject and bring laughter to enemies."
Such statements by Usmani, who is the powerful chairman of the board of Islamic scholars at the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions, sent a chill through the sukuk market.
A clarification in February by the entire A.A.O.I.F.I. board outlining more clearly how sukuks could stay in compliance didn't provide much reassurance.
The effect on financing has been measurable. So far this year, only about $14 billion in Islamic bonds have been issued, compared with around $23 billion during the same time frame last year, according to Standard & Poor's. That is a decline of almost 40 percent.
Noting the "confusion" over what scholars will deem to be acceptable Islamic debt structures, Jaime Sanz of Fitch's emerging markets structured-finance team wrote in a recent research note that "a liquid, transparent, and efficient" Islamic debt market "is of paramount importance" as countries including Saudi Arabia and the United Arab Emirates face the need for "substantial" infrastructure investments.
While much of the Middle East's development still relies on conventional finance, the $70 billion Islamic bond market has grown rapidly thanks to the huge influx of petrodollars and the greater interest in Shariah-compliant investing among Muslims.
"Just as there are more women wearing veils, there are more people interested in Islamic products," says Professor Ibrahim Warde, of the Fletcher School of Law and Diplomacy at Tufts University. The sukuk market, he adds, is just part of a $900 billion Islamic financial sector that grew about 37 percent in 2007.
Those assets have attracted Western bankers looking for a foothold in the Middle East, and Western institutions looking for diversification with attractive yields. Just "10 or 15 years ago, many Western institutions would not have been interested in Islamic finance because it looked too complicated," Warde says. But now, Western banks like J.P. Morgan, Citigroup, and Morgan Stanley are among the leading underwriters in the Islamic bond market.
That market has become the spine of the Islamic insurance industry, a catalyst for the development of the region's capital markets, and has funded the development of everything from Bahrain's financial center and Dubai's Palm development to Emirates Airlines' expansion and a Kuwaiti-led consortium's leveraged buyout of British sports-car maker Aston Martin.
Sukuks have also begun to be floated in Western markets and are backing Western assets. The German state of Saxony-Anhalt and the World Bank have both issued sukuks, while a small Texas oil and gas exploration firm called East Cameron Partners issued an Islamic bond backed by some of its offshore Louisiana gas reserves.
Standard & Poor's estimates that the sukuk market will exceed $100 billion by 2009, even with the latest hiccup. But the Islamic bonds that will be floated are unlikely to push the envelope in the ways others did before, and the innovation that helped sukuks gain acceptance in an ever-growing universe of deals could slow.
Dr. Mohamed Damak, a ratings specialist at Standard & Poor's, notes that he has "clearly noticed a shift in the structures of sukuks issued in 2008 toward Ijara (where financing is accomplished through a form of sale-lease back of real assets) away from Musharakah (a more controversial form of profit-sharing questioned by Islamic scholars).
Even without the religious controversy, questions remain as to whether sukuks might ever grow beyond being a niche product, since Islamic law prohibits them from being tranched (sliced up into different yields) or effectively hedged.
Professor Samuel Hayes of Harvard Business School notes that the prohibition on hedging means that any financial arrangement that could be affected by changes in exchange rates or in the rate of inflation leaves the investor "vulnerable to a very substantial risk."
They also have yet to be tested in a default. Warde says this is among the chief concerns for the market going forward. Although sukuk issuers have tried to devise asset liquidation mechanisms that dovetail with those found in conventional bonds, none of these have been tested in court.
"The main fear that investors have is what will happen in practice if some sukuk goes bad," he says. While most Islamic contracts now prescribe English law to be governing, Warde says that "in the case of failure of sukuk, the process of adjudication will be a complex and long-drawn affair, whereby judges will want to know what sukuk really are, and as part of that process, Shariah scholars will no doubt have some input."
With easy credit and oil powering the Gulf real estate markets to dizzying heights, such defaults might come sooner than anyone thinks, making the Shariah scholars among the hottest commodities around.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
(continued)
by Kit R. Roane
Sep 23 2008
Western markets aren't the only ones shaken by change. A popular instrument in the red-hot Islamic finance sector has been declared in conflict with the Koran.
Investors in Western securities have been given plenty to fret about recently as markets have seized up, money flows have frozen, and confidence has evaporated. But at least they haven't had to tangle with God as well.
Not so in the land of Islam, where the world's fastest-growing debt market has hit the skids in part because leading Islamic scholars began to question whether some popular Islamic bonds, or sukuks, followed religious law.
The fact that such questions exist point to a peculiar risk in Islamic markets that—because leverage is generally eschewed and securities are closely tied to assets—have been viewed as more resilient than their Western counterparts.
The questions also come at a time when that resilience is showing its limits; the Middle East is now grappling with the contagious global credit crunch and worries over its own overheated asset market. And the debate among Islamic scholars is sure to complicate those woes.
"The irony is that current market conditions are the result of deficiencies with [the] backbone of the conventional finance industry," says Rahail Ali, head of Islamic Finance at the Dubai office of Lovells, an English law firm.
Ali added that the debate among Shariah scholars has gained prominence because the sukuk market is now "open to a much wider investor base, some of which isn't familiar with the fact that differences of opinion among the Shariah scholars are very much to be expected."
Those investors got their first taste of "religious interpretation risk" last November when Sheik Muhammad Taqi Usmani said he believed that as much as 85 percent of Islamic bonds already in the market had a critical religious flaw baked into them: They guaranteed a buyer that principal would be paid back, even in the case of default.
Conventional bonds routinely carry such provisions but they are problematic for Muslims who are, among other things, barred from accepting interest, or engaging in any business where profit and risk are not equally shared.
To work around some of the simplest issues, Islamic bonds are supposed to derive their payment stream from the revenue thrown off by a real asset or some similar structure, while any repurchase is seen as just a return on a lease, and should be done at market rates.
But in an attempt to securitize a wider array of assets, or to make more appealing structures, many Islamic bonds have veered too close to a Western interpretation of what a bond should be. Or, as Usmani wrote, Islamic financial institutions, in an attempt to compete in "the conventional, interest-based marketplace," have churned out products that give lip-service to Islam while using "ploys that sound minds reject and bring laughter to enemies."
Such statements by Usmani, who is the powerful chairman of the board of Islamic scholars at the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions, sent a chill through the sukuk market.
A clarification in February by the entire A.A.O.I.F.I. board outlining more clearly how sukuks could stay in compliance didn't provide much reassurance.
The effect on financing has been measurable. So far this year, only about $14 billion in Islamic bonds have been issued, compared with around $23 billion during the same time frame last year, according to Standard & Poor's. That is a decline of almost 40 percent.
Noting the "confusion" over what scholars will deem to be acceptable Islamic debt structures, Jaime Sanz of Fitch's emerging markets structured-finance team wrote in a recent research note that "a liquid, transparent, and efficient" Islamic debt market "is of paramount importance" as countries including Saudi Arabia and the United Arab Emirates face the need for "substantial" infrastructure investments.
While much of the Middle East's development still relies on conventional finance, the $70 billion Islamic bond market has grown rapidly thanks to the huge influx of petrodollars and the greater interest in Shariah-compliant investing among Muslims.
"Just as there are more women wearing veils, there are more people interested in Islamic products," says Professor Ibrahim Warde, of the Fletcher School of Law and Diplomacy at Tufts University. The sukuk market, he adds, is just part of a $900 billion Islamic financial sector that grew about 37 percent in 2007.
Those assets have attracted Western bankers looking for a foothold in the Middle East, and Western institutions looking for diversification with attractive yields. Just "10 or 15 years ago, many Western institutions would not have been interested in Islamic finance because it looked too complicated," Warde says. But now, Western banks like J.P. Morgan, Citigroup, and Morgan Stanley are among the leading underwriters in the Islamic bond market.
That market has become the spine of the Islamic insurance industry, a catalyst for the development of the region's capital markets, and has funded the development of everything from Bahrain's financial center and Dubai's Palm development to Emirates Airlines' expansion and a Kuwaiti-led consortium's leveraged buyout of British sports-car maker Aston Martin.
Sukuks have also begun to be floated in Western markets and are backing Western assets. The German state of Saxony-Anhalt and the World Bank have both issued sukuks, while a small Texas oil and gas exploration firm called East Cameron Partners issued an Islamic bond backed by some of its offshore Louisiana gas reserves.
Standard & Poor's estimates that the sukuk market will exceed $100 billion by 2009, even with the latest hiccup. But the Islamic bonds that will be floated are unlikely to push the envelope in the ways others did before, and the innovation that helped sukuks gain acceptance in an ever-growing universe of deals could slow.
Dr. Mohamed Damak, a ratings specialist at Standard & Poor's, notes that he has "clearly noticed a shift in the structures of sukuks issued in 2008 toward Ijara (where financing is accomplished through a form of sale-lease back of real assets) away from Musharakah (a more controversial form of profit-sharing questioned by Islamic scholars).
Even without the religious controversy, questions remain as to whether sukuks might ever grow beyond being a niche product, since Islamic law prohibits them from being tranched (sliced up into different yields) or effectively hedged.
Professor Samuel Hayes of Harvard Business School notes that the prohibition on hedging means that any financial arrangement that could be affected by changes in exchange rates or in the rate of inflation leaves the investor "vulnerable to a very substantial risk."
They also have yet to be tested in a default. Warde says this is among the chief concerns for the market going forward. Although sukuk issuers have tried to devise asset liquidation mechanisms that dovetail with those found in conventional bonds, none of these have been tested in court.
"The main fear that investors have is what will happen in practice if some sukuk goes bad," he says. While most Islamic contracts now prescribe English law to be governing, Warde says that "in the case of failure of sukuk, the process of adjudication will be a complex and long-drawn affair, whereby judges will want to know what sukuk really are, and as part of that process, Shariah scholars will no doubt have some input."
With easy credit and oil powering the Gulf real estate markets to dizzying heights, such defaults might come sooner than anyone thinks, making the Shariah scholars among the hottest commodities around.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
(continued)
Time's Running Out on the Billable Hour
Time's Running Out on the Billable
Hour
by Kit R. Roane
July 13 2008
"The billable hour stinks" as a way to buy legal services, one lawyer says. Finally, there is some movement toward alternatives.
William Nelson Cromwell famously earned a million dollars for his work in selling the Panama Canal a century ago. His fee, the New York Times noted in 1908, was "the like of which can hardly be paralleled in the history of the legal profession."
News of some recent paydays probably would have Cromwell, whose legacy lives on in the top-tier Wall Street firm Sullivan & Cromwell, wishing he could get back to work.
Delphi, an auto parts maker, racked up nearly $100 million in legal, accounting, and consulting fees in the first eight months of its bankruptcy proceeding in 2006. Lawyers who succeeded in an Iowa antitrust case against Microsoft were awarded $75 million in fees and costs last August. And this March, the law firm representing one segment of investors suing financial institutions tied to the Enron bankruptcy requested a whopping $688 million in fees.
With some lawyers now charging upwards of $1,000 an hour, and phalanxes of partners and associates being marshaled to fight increasingly complex and time-consuming (read: billable-hour-generating) battles, one can rightly wonder whether the first billion-dollar legal bill could be far behind.
The fear of just such a billing Armageddon has caused some of the nation's largest corporations to push back. Some are instituting a moratorium on fee hikes, others are insisting that fees actually be slashed, and many are installing new billing software to track and cap expenses. A few are even prodding law firms to come up with wholly new compensation arrangements that better align their interests with those of their corporate clients.
Last November, the news that some new law firm associates were being paid $160,000 a year spurred Wal-Mart to action. The company responded with a "moratorium on across-the-board rate increases" for all of its outside firms and demanded that they provide the hourly rates charged for every associate working on a Wal-Mart account going back to "the class of 2004."
That same year, Tyco International named a single firm, Eversheds, as its preferred outside counsel in Europe, the Middle East, and Africa, pulling about $20 million in legal work from more than 200 other firms. Eversheds got the work by discounting fees and agreeing to let Tyco have final approval over cost estimates.
Companies like Pfizer are making strides in reducing legal costs by making law firms compete head to head for business, with cost as a major factor. Others, including AOL, Barclays, and General Motors, have embraced electronic billing systems that flag legal expenses over set amounts.
These firms "can't enter a cost that doesn't fit in the box you create," says Susan Hackett, senior vice president and general counsel of the Association of Corporate Counsel, whose 24,000 members are among the major employers of outside law firms.
"It can be something as simple as saying no plane travel in excess of $500," Hackett adds. "If the lawyer tries to enter a ticket for $650, it will bounce, and the onus is then on the firm to say why the expense was necessary."
This September, Hackett's association plans to begin a more organized assault on high legal fees. The multiyear effort will result in a set of tools that can help even small corporations get a handle on legal costs.
These include best-practice guidelines to help model and price specific legal services such as certain stages of litigation, and an online network where corporate counsels and law firms from across the country can easily obtain references and compare fee information in specific geographic areas.
"The billable hour stinks, but it is the symptom of the underlying problem," Hackett says, noting that most corporate law departments are too small to easily monitor what their outside counsel is doing.
Combined with that reality, "law firms are not run on the concept of how quickly and efficiently they can do work for their client," Hackett adds. "They are run on how much they can charge their client before they are fired. It's the throw-up point."
Getting a handle on outside legal costs certainly makes sense for corporations. It can be a boon to the bottom line. Dupont, for instance, pioneered a program to partner with its law firms in the 1990s after mass tort litigation left it swimming in outside legal fees.
"We had a docket in excess of 4,000 cases and we were spending $140 million a year in 1994 dollars," notes Thomas Sager, Dupont's general counsel and senior vice president of litigation.
The company has since whittled down the number of law firms it uses to 43 from 350, has traded a promise of long-term relationships for a willingness by the firms to offer alternative fees and discounted rates, and has produced a host of systems to better track and monitor the legal work that results.
Sager said Dupont's cost savings is between $15 million and $20 million a year, or about 18 percent of the company's total expenditures on outside counsel.
Felice Wagner, who heads Sugarcrest Development Group, a law firm consultancy, notes that other companies have had similar success. It's no coincidence, she adds, that the industry spending the least on counsel is the group that most aggressively tracks its outside firms. The insurance industry pays, on average, just $294,098 per lawyer per year. “They have been very successful at putting the screws into their law firms,” says Wagner.
Whether or not these corporations will soon force white-shoe law firms into a new way of thinking is another story. "The Sullivan & Cromwells of the world like the status quo and don't see the need to move toward alternative fees," Sager says.
It's easy to see why. The 2007 Law Firm Economics Survey from Lexis Nexis found that the operating profit margins at top firms climbed to 41 percent in 2007 from 35 percent a year earlier, while a separate recent survey by the National Law Journal found billing rates locked in a long-term climb, gaining an average of 7.7 percent in 2007.
The bill to clients is considerable. The median amount that large corporations pay annually for each outside lawyer working for them was $616,519 in 2007, according to the 2007 Altman Weil Law Department Metrics Benchmarking Survey. Chemicals manufacturers topped the list, reporting that average outside legal expenses reached more than $1.1 million per lawyer. That is music to the ears of law firms on the receiving end.
Still, some firms see the growing discontent as an opening to take a new tack. Jay Shepherd, who runs the employment-litigation firm Shepherd Law Group in Boston, jettisoned the billable hour system in favor of flat rates for all client matters at his firm.
Other firms have taken similarly drastic steps, though the number can be counted on two hands—among them, Bartlit Beck Herman Palenchar & Scott and the Valorem Law Group, both in Chicago, Exemplar Law Group, in Boston, Summit Law Group, in Seattle, and Leader & Berkon, in New York.
However, Shepherd's success in gaining business is noteworthy. His firm's year-over-year revenue more than doubled in 2007, after increasing 5 to 10 percent per year between 2004 and 2006. Among his new clients is Adobe Systems.
Although the vast majority of the software company's outside legal work is still done on the billable-hour system, Ronald Friedman, associate general counsel and head of litigation at Adobe, says he's been pleased by Shepherd's flat-fee arrangement, noting that it "allows you to know up front what your costs are going to be."
He hints that, unless billing rates begin to fall, more such deals could be in the offing.
"I am always interested in exploring alternative billing arrangements," he says. But "the more the hourly rates continue to increase to the point of being difficult to justify, the more I am going to be interested in exploring other alternatives where the interests of the client and the lawyer are better aligned."
If enough companies like Adobe make that call, the Sullivan & Cromwells of the world may have to begin listening.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
by Kit R. Roane
July 13 2008
"The billable hour stinks" as a way to buy legal services, one lawyer says. Finally, there is some movement toward alternatives.
William Nelson Cromwell famously earned a million dollars for his work in selling the Panama Canal a century ago. His fee, the New York Times noted in 1908, was "the like of which can hardly be paralleled in the history of the legal profession."
News of some recent paydays probably would have Cromwell, whose legacy lives on in the top-tier Wall Street firm Sullivan & Cromwell, wishing he could get back to work.
Delphi, an auto parts maker, racked up nearly $100 million in legal, accounting, and consulting fees in the first eight months of its bankruptcy proceeding in 2006. Lawyers who succeeded in an Iowa antitrust case against Microsoft were awarded $75 million in fees and costs last August. And this March, the law firm representing one segment of investors suing financial institutions tied to the Enron bankruptcy requested a whopping $688 million in fees.
With some lawyers now charging upwards of $1,000 an hour, and phalanxes of partners and associates being marshaled to fight increasingly complex and time-consuming (read: billable-hour-generating) battles, one can rightly wonder whether the first billion-dollar legal bill could be far behind.
The fear of just such a billing Armageddon has caused some of the nation's largest corporations to push back. Some are instituting a moratorium on fee hikes, others are insisting that fees actually be slashed, and many are installing new billing software to track and cap expenses. A few are even prodding law firms to come up with wholly new compensation arrangements that better align their interests with those of their corporate clients.
Last November, the news that some new law firm associates were being paid $160,000 a year spurred Wal-Mart to action. The company responded with a "moratorium on across-the-board rate increases" for all of its outside firms and demanded that they provide the hourly rates charged for every associate working on a Wal-Mart account going back to "the class of 2004."
That same year, Tyco International named a single firm, Eversheds, as its preferred outside counsel in Europe, the Middle East, and Africa, pulling about $20 million in legal work from more than 200 other firms. Eversheds got the work by discounting fees and agreeing to let Tyco have final approval over cost estimates.
Companies like Pfizer are making strides in reducing legal costs by making law firms compete head to head for business, with cost as a major factor. Others, including AOL, Barclays, and General Motors, have embraced electronic billing systems that flag legal expenses over set amounts.
These firms "can't enter a cost that doesn't fit in the box you create," says Susan Hackett, senior vice president and general counsel of the Association of Corporate Counsel, whose 24,000 members are among the major employers of outside law firms.
"It can be something as simple as saying no plane travel in excess of $500," Hackett adds. "If the lawyer tries to enter a ticket for $650, it will bounce, and the onus is then on the firm to say why the expense was necessary."
This September, Hackett's association plans to begin a more organized assault on high legal fees. The multiyear effort will result in a set of tools that can help even small corporations get a handle on legal costs.
These include best-practice guidelines to help model and price specific legal services such as certain stages of litigation, and an online network where corporate counsels and law firms from across the country can easily obtain references and compare fee information in specific geographic areas.
"The billable hour stinks, but it is the symptom of the underlying problem," Hackett says, noting that most corporate law departments are too small to easily monitor what their outside counsel is doing.
Combined with that reality, "law firms are not run on the concept of how quickly and efficiently they can do work for their client," Hackett adds. "They are run on how much they can charge their client before they are fired. It's the throw-up point."
Getting a handle on outside legal costs certainly makes sense for corporations. It can be a boon to the bottom line. Dupont, for instance, pioneered a program to partner with its law firms in the 1990s after mass tort litigation left it swimming in outside legal fees.
"We had a docket in excess of 4,000 cases and we were spending $140 million a year in 1994 dollars," notes Thomas Sager, Dupont's general counsel and senior vice president of litigation.
The company has since whittled down the number of law firms it uses to 43 from 350, has traded a promise of long-term relationships for a willingness by the firms to offer alternative fees and discounted rates, and has produced a host of systems to better track and monitor the legal work that results.
Sager said Dupont's cost savings is between $15 million and $20 million a year, or about 18 percent of the company's total expenditures on outside counsel.
Felice Wagner, who heads Sugarcrest Development Group, a law firm consultancy, notes that other companies have had similar success. It's no coincidence, she adds, that the industry spending the least on counsel is the group that most aggressively tracks its outside firms. The insurance industry pays, on average, just $294,098 per lawyer per year. “They have been very successful at putting the screws into their law firms,” says Wagner.
Whether or not these corporations will soon force white-shoe law firms into a new way of thinking is another story. "The Sullivan & Cromwells of the world like the status quo and don't see the need to move toward alternative fees," Sager says.
It's easy to see why. The 2007 Law Firm Economics Survey from Lexis Nexis found that the operating profit margins at top firms climbed to 41 percent in 2007 from 35 percent a year earlier, while a separate recent survey by the National Law Journal found billing rates locked in a long-term climb, gaining an average of 7.7 percent in 2007.
The bill to clients is considerable. The median amount that large corporations pay annually for each outside lawyer working for them was $616,519 in 2007, according to the 2007 Altman Weil Law Department Metrics Benchmarking Survey. Chemicals manufacturers topped the list, reporting that average outside legal expenses reached more than $1.1 million per lawyer. That is music to the ears of law firms on the receiving end.
Still, some firms see the growing discontent as an opening to take a new tack. Jay Shepherd, who runs the employment-litigation firm Shepherd Law Group in Boston, jettisoned the billable hour system in favor of flat rates for all client matters at his firm.
Other firms have taken similarly drastic steps, though the number can be counted on two hands—among them, Bartlit Beck Herman Palenchar & Scott and the Valorem Law Group, both in Chicago, Exemplar Law Group, in Boston, Summit Law Group, in Seattle, and Leader & Berkon, in New York.
However, Shepherd's success in gaining business is noteworthy. His firm's year-over-year revenue more than doubled in 2007, after increasing 5 to 10 percent per year between 2004 and 2006. Among his new clients is Adobe Systems.
Although the vast majority of the software company's outside legal work is still done on the billable-hour system, Ronald Friedman, associate general counsel and head of litigation at Adobe, says he's been pleased by Shepherd's flat-fee arrangement, noting that it "allows you to know up front what your costs are going to be."
He hints that, unless billing rates begin to fall, more such deals could be in the offing.
"I am always interested in exploring alternative billing arrangements," he says. But "the more the hourly rates continue to increase to the point of being difficult to justify, the more I am going to be interested in exploring other alternatives where the interests of the client and the lawyer are better aligned."
If enough companies like Adobe make that call, the Sullivan & Cromwells of the world may have to begin listening.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
SPAC Attacks
SPAC Attacks
by Kit R. Roane Mar 3 2008
The financial world's biggest names want loot for their buyout funds—but they may be tossing away some investors' rights.
Can buyout-king Ronald Perelman be trusted with a blank check?
Investors have long craved the chance to follow big-name moneymen like Perelman into deals. But plowing cash into the billionaire's MAFS Acquisition Corp.—one of a spate of so-called Special Purpose Acquisition Companies, or SPACs, about to hit the market—carries a host of financial risks, none of which have to do with his ex-wife Ellen Barkin.
Perelman is among a slew of financial titans and luminaries now looking to score with a SPAC, with everyone from Apple co-founder Steve Wozniak and Triarc C.E.O. Nelson Peltz to the retired C.I.A. director George Tenet and former Vice President Dan Quayle seeing opportunity to mint new riches.
The problem is that such gains may not trickle down to the hoi polloi. The market for SPACs, which are publicly traded corporate shell companies that hunt for merger opportunities, is getting crowded. Sponsors have been quietly watering down essential investor protections. And public investors in many SPACs have already seen dismal returns.
In fact, this strange corner of the market holds the increasing potential to leave SPAC shareholders with crumbs while their big name sponsors makes a mint on the I.P.O.
Such worries haven't slowed down the SPAC underwriting train. More than $12 billion in SPACs went to market last year, accounting for about one-quarter of all initial public offerings. Nearly $3 billion in SPACs went public over the first 45 days of 2008. This is close to the total $3.3 billion in SPACs that were priced in all of 2006, according to Dealogic.
The numbers continue to grow even as longtime SPAC underwriters worry that recent mega-SPACs have already sucked away the liquidity necessary to support them. Thirty-four SPACs, with an estimated combined value of about $7.9 billion, are in the pipeline.
And as the market has zoomed ahead recently, a curious thing has happened to some of the basic investor protections that were once standard fare in a SPACs prospectus. With a cut here and a rewording there, they've been reduced.
"They don't call these things blank-check companies anymore, but that is effectively what they are," says Dirk Jenter, professor of finance at Stanford University, adding that the first blank check companies floated in the 1980s worked wonderfully, as have many of the early SPACs.
But "the pattern you see in financial innovations always seems to run the same way. I'm worried that we might be right around the cusp where people made good money, but now the less sophisticated are getting involved and being offered worse deals and worse protections."
With the moribund I.P.O. market, it's easy to see why underwriters like SPACs—they generate hefty fees. Perelman's MAFS, for instance, expects to pay its underwriter, Citigroup Global Markets Inc., nearly $40 million in fees. That sort of money has attracted other bulge-bracket banks like UBS, Lazard, Bank of America, and Deutsche Bank to this former backwater.
The founders of SPACs like the deals because, in a time of tight credit, they are able to take large and controlling positions in a cash-rich acquisition vehicle for a few cents on the dollar.
This has obvious allure to Perelman who used a supermarket chain to gobble up a cosmetics giant, bought out a comic book empire using the remnants of a video-rental company, and turned a maker of licorice extract into a collection of businesses encompassing check printing, test scanning, and data management.
If MAFS successfully completes an acquisition, its sponsor and management team—essentially Perelman and his closely held company MacAndrews & Forbes Holdings Inc.—will control 20 percent of the shares.
Still, just because such investing whales do well for themselves, does not mean that those who follow will reap the same rewards—just ask those who've stuck with Perelman-controlled Revlon, which has gone from an iconic American brand to a financial life support, struggling under its own debt and a stock price that can barely lift its head above one dollar.
SPACs also have a spotty history. In the 1980s, scam artists running blind pools, a SPAC forerunner, fleeced many investors. When SPACs started percolating in 2005, attorneys general in several states protested the American Stock Exchange's willingness to list them.
Backers countered that SPACs had been reformed. Most SPACs, for instance, held at least 80 percent of the proceeds from an offering in trust until an acquisition was made. The companies acquired generally had to have a market value of at least 80 percent of the SPACs assets, and most SPACs required 80 percent of shareholders to approve an acquisition for it to go through. If no acquisition target was found within a set period, typically two years, then investors were supposed to get their money back with interest, minus expenses.
John Nester, a spokesman for the Securities and Exchange Commission, says the S.E.C. currently has no concerns about the structure of SPACs, adding that most of them do "seek shareholder approval and offer shareholders the opportunity to get their money back instead of holding an interest in the combined entity."
But not all SPACs are created equal. The Financial Industry Regulatory Authority says it has open investigations in the area and that it is looking at how SPACs are both marketed and sold. State regulators have voiced concerns about price manipulation.
Meanwhile, several recent entrants have quietly chiseled away what were once standard protections outlined in their S.E.C. filings, protections at the very heart of SPACs current popularity boom.
Perelman-controlled MAFS has continued to reduce the level of shareholder voting rights with every subsequent filing of its proposed $500 million I.P.O. As of Feb. 12, the registration statement notes that an acquisition will go through if as few as 60 percent of MAFS stockholders agree.
To make sure MAFS shareholders don't work together to stop an acquisition, any single stockholder, or stockholders acting as a "group," who controls more than 10 percent of the shares and votes against an acquisition, will be prohibited from converting more than 10 percent of their shares into cash.
The filing notes that the changes will make it easier for MAFS to finalize an acquisition, explaining that "we believe we have limited the ability of a small group of stockholders to unreasonably attempt to block a transaction which is favored by our other public stockholders."
A spokeswoman for Perelman declined to comment for this story, noting that MAFS is in its quiet period.
Confronted with the fact that SPAC investors have balked at several proposed mergers, sponsors see such loosening of restrictions as necessary to keep their SPAC from being greenmailed by hedge funds or other investors.
But Stanford's Jenter doesn't buy that argument. If a SPAC's investment team finds a good acquisition, he asks, "why wouldn't investors vote yes?" And even if there was a problem convincing some stockholders of the deal's merits, other investors would certainly see their folly and buy up shares in the open market.
Such restrictions on investor rights can raise serious questions about the sponsor's intentions, adds Donghang Zhang, an assistant professor of finance at the University of South Carolina who studies SPAC listings.
"It may not be the case that they used a technical loophole to avoid the regulations," he says. "But these deviations nevertheless are alarming in that the sponsors may find they can sell the deals without offering the protections."
The investor protections outlined in SPACs are of particular importance because sponsors face a host of potential conflicts. They are given wide latitude in choosing a deal, are sometimes allowed to buy companies in which they or their officers have an interest, and, perhaps most crucially, they can receive a big payoff whenever a deal is sealed, even if the company being bought is a bad fit, or was purchased at an inflated price.
An unhappy SPAC investor's main recourse in such cases is his ability to vote against a merger, or cash out his investment and walk away.
Service Acquisition Corp. International started life as a $7 stock. When it announced plans to purchase Jamba Juice, several institutions also ponied up $7.50 a share in a $200 million private placement to help cover what the SPACs original investors couldn't. Now Jamba Juice is barely holding at $2.75.
According to SPAC Analytics, a research firm, the annualized return for all SPACs that have completed an acquisition target since 2003 is a negative 1.4 percent, while those that end up being liquidated return a negative 2.3 percent. In an example of the premium paid for hope, SPACs that have yet to find a target have an annualized return of 1.7 percent.
A recent study by Vijay Jog and Chengye Sun, doctoral students at Ottawa-based Carleton University, put the chasm between management and investor in the SPAC universe in even greater relief.
Shareholders in the 62 blank-check I.P.O.'s they studied earned negative 3 percent annual returns, while management took home a whopping 1,900 percent annualized return.
The most recent MAFS filing makes clear the reason for such stark figures.
"Upon consummation of our offering, our sponsor will continue to exercise significant influence over us," it says, "and its interests in our business may be different than yours."
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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by Kit R. Roane Mar 3 2008
The financial world's biggest names want loot for their buyout funds—but they may be tossing away some investors' rights.
Can buyout-king Ronald Perelman be trusted with a blank check?
Investors have long craved the chance to follow big-name moneymen like Perelman into deals. But plowing cash into the billionaire's MAFS Acquisition Corp.—one of a spate of so-called Special Purpose Acquisition Companies, or SPACs, about to hit the market—carries a host of financial risks, none of which have to do with his ex-wife Ellen Barkin.
Perelman is among a slew of financial titans and luminaries now looking to score with a SPAC, with everyone from Apple co-founder Steve Wozniak and Triarc C.E.O. Nelson Peltz to the retired C.I.A. director George Tenet and former Vice President Dan Quayle seeing opportunity to mint new riches.
The problem is that such gains may not trickle down to the hoi polloi. The market for SPACs, which are publicly traded corporate shell companies that hunt for merger opportunities, is getting crowded. Sponsors have been quietly watering down essential investor protections. And public investors in many SPACs have already seen dismal returns.
In fact, this strange corner of the market holds the increasing potential to leave SPAC shareholders with crumbs while their big name sponsors makes a mint on the I.P.O.
Such worries haven't slowed down the SPAC underwriting train. More than $12 billion in SPACs went to market last year, accounting for about one-quarter of all initial public offerings. Nearly $3 billion in SPACs went public over the first 45 days of 2008. This is close to the total $3.3 billion in SPACs that were priced in all of 2006, according to Dealogic.
The numbers continue to grow even as longtime SPAC underwriters worry that recent mega-SPACs have already sucked away the liquidity necessary to support them. Thirty-four SPACs, with an estimated combined value of about $7.9 billion, are in the pipeline.
And as the market has zoomed ahead recently, a curious thing has happened to some of the basic investor protections that were once standard fare in a SPACs prospectus. With a cut here and a rewording there, they've been reduced.
"They don't call these things blank-check companies anymore, but that is effectively what they are," says Dirk Jenter, professor of finance at Stanford University, adding that the first blank check companies floated in the 1980s worked wonderfully, as have many of the early SPACs.
But "the pattern you see in financial innovations always seems to run the same way. I'm worried that we might be right around the cusp where people made good money, but now the less sophisticated are getting involved and being offered worse deals and worse protections."
With the moribund I.P.O. market, it's easy to see why underwriters like SPACs—they generate hefty fees. Perelman's MAFS, for instance, expects to pay its underwriter, Citigroup Global Markets Inc., nearly $40 million in fees. That sort of money has attracted other bulge-bracket banks like UBS, Lazard, Bank of America, and Deutsche Bank to this former backwater.
The founders of SPACs like the deals because, in a time of tight credit, they are able to take large and controlling positions in a cash-rich acquisition vehicle for a few cents on the dollar.
This has obvious allure to Perelman who used a supermarket chain to gobble up a cosmetics giant, bought out a comic book empire using the remnants of a video-rental company, and turned a maker of licorice extract into a collection of businesses encompassing check printing, test scanning, and data management.
If MAFS successfully completes an acquisition, its sponsor and management team—essentially Perelman and his closely held company MacAndrews & Forbes Holdings Inc.—will control 20 percent of the shares.
Still, just because such investing whales do well for themselves, does not mean that those who follow will reap the same rewards—just ask those who've stuck with Perelman-controlled Revlon, which has gone from an iconic American brand to a financial life support, struggling under its own debt and a stock price that can barely lift its head above one dollar.
SPACs also have a spotty history. In the 1980s, scam artists running blind pools, a SPAC forerunner, fleeced many investors. When SPACs started percolating in 2005, attorneys general in several states protested the American Stock Exchange's willingness to list them.
Backers countered that SPACs had been reformed. Most SPACs, for instance, held at least 80 percent of the proceeds from an offering in trust until an acquisition was made. The companies acquired generally had to have a market value of at least 80 percent of the SPACs assets, and most SPACs required 80 percent of shareholders to approve an acquisition for it to go through. If no acquisition target was found within a set period, typically two years, then investors were supposed to get their money back with interest, minus expenses.
John Nester, a spokesman for the Securities and Exchange Commission, says the S.E.C. currently has no concerns about the structure of SPACs, adding that most of them do "seek shareholder approval and offer shareholders the opportunity to get their money back instead of holding an interest in the combined entity."
But not all SPACs are created equal. The Financial Industry Regulatory Authority says it has open investigations in the area and that it is looking at how SPACs are both marketed and sold. State regulators have voiced concerns about price manipulation.
Meanwhile, several recent entrants have quietly chiseled away what were once standard protections outlined in their S.E.C. filings, protections at the very heart of SPACs current popularity boom.
Perelman-controlled MAFS has continued to reduce the level of shareholder voting rights with every subsequent filing of its proposed $500 million I.P.O. As of Feb. 12, the registration statement notes that an acquisition will go through if as few as 60 percent of MAFS stockholders agree.
To make sure MAFS shareholders don't work together to stop an acquisition, any single stockholder, or stockholders acting as a "group," who controls more than 10 percent of the shares and votes against an acquisition, will be prohibited from converting more than 10 percent of their shares into cash.
The filing notes that the changes will make it easier for MAFS to finalize an acquisition, explaining that "we believe we have limited the ability of a small group of stockholders to unreasonably attempt to block a transaction which is favored by our other public stockholders."
A spokeswoman for Perelman declined to comment for this story, noting that MAFS is in its quiet period.
Confronted with the fact that SPAC investors have balked at several proposed mergers, sponsors see such loosening of restrictions as necessary to keep their SPAC from being greenmailed by hedge funds or other investors.
But Stanford's Jenter doesn't buy that argument. If a SPAC's investment team finds a good acquisition, he asks, "why wouldn't investors vote yes?" And even if there was a problem convincing some stockholders of the deal's merits, other investors would certainly see their folly and buy up shares in the open market.
Such restrictions on investor rights can raise serious questions about the sponsor's intentions, adds Donghang Zhang, an assistant professor of finance at the University of South Carolina who studies SPAC listings.
"It may not be the case that they used a technical loophole to avoid the regulations," he says. "But these deviations nevertheless are alarming in that the sponsors may find they can sell the deals without offering the protections."
The investor protections outlined in SPACs are of particular importance because sponsors face a host of potential conflicts. They are given wide latitude in choosing a deal, are sometimes allowed to buy companies in which they or their officers have an interest, and, perhaps most crucially, they can receive a big payoff whenever a deal is sealed, even if the company being bought is a bad fit, or was purchased at an inflated price.
An unhappy SPAC investor's main recourse in such cases is his ability to vote against a merger, or cash out his investment and walk away.
Service Acquisition Corp. International started life as a $7 stock. When it announced plans to purchase Jamba Juice, several institutions also ponied up $7.50 a share in a $200 million private placement to help cover what the SPACs original investors couldn't. Now Jamba Juice is barely holding at $2.75.
According to SPAC Analytics, a research firm, the annualized return for all SPACs that have completed an acquisition target since 2003 is a negative 1.4 percent, while those that end up being liquidated return a negative 2.3 percent. In an example of the premium paid for hope, SPACs that have yet to find a target have an annualized return of 1.7 percent.
A recent study by Vijay Jog and Chengye Sun, doctoral students at Ottawa-based Carleton University, put the chasm between management and investor in the SPAC universe in even greater relief.
Shareholders in the 62 blank-check I.P.O.'s they studied earned negative 3 percent annual returns, while management took home a whopping 1,900 percent annualized return.
The most recent MAFS filing makes clear the reason for such stark figures.
"Upon consummation of our offering, our sponsor will continue to exercise significant influence over us," it says, "and its interests in our business may be different than yours."
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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Smacked Down
Smacked Down
by Kit R. Roane Feb 18 2008
In the brawl for the hearts and wallets of young male fans, ultimate fighting has boxing and wrestling on the ropes.
Sometimes success hinges on the little things. Outlawing the eye-gouge, for instance, or banning the crotch kick.
Such rule changes have helped to turn mixed martial arts from a virtual outlaw operation into one of the fastest growing sports in the country, muting critics, enticing advertisers, and taking on its rivals—boxing and professional wrestling—for both fans and market share.
The sport Senator John McCain once famously branded as “human cockfighting” rakes in more than $200 million in pay-per-view loot, has broadcast deals with Spike TV, Fox Sports Net and MyNetwork, and has spawned a reality series, The Ultimate Fighter, which along with the fights grabbed more 18- to 34-year-old male eyeballs than either Nascar or the N.B.A. playoff games.
Robert Jacobson, president and C.E.O. of In Demand Networks, which provides about 90 percent of the cable industry’s pay-per-view content, notes that mixed martial arts accounted for virtually no revenue on his network in 2004. “Now it’s neck and neck with boxing, and is a little ahead of wrestling,” he says.
The current leader in the M.M.A. business, Ultimate Fighting Championship, went from $45 million in pay-per-view revenues in 2005 to $222 million in 2006 and appears to have held that number for 2007, according to Deana Myers, a senior analyst at SNL Kagan. U.F.C.’s revenue numbers are close to, and at points have exceeded, those reported by HBO, the main boxing pay-per-view provider, and those of World Wrestling Entertainment, the dominant force in professional wrestling.
Mixed martial arts (M.M.A.) has grown in popularity despite having had less financial backing and nowhere near the distribution network of boxing or wrestling to publicize its matches. Newspapers ignore M.M.A. events M.M.A. and the major networks eschew them. Both New York And Massachusetts, two of the most important states from a marketing and distribution standpoint, ban the matches altogether.
Marc Ratner, the Ultimate Fighting Championship vice president of government and regulatory affairs, says the problem is the long shadow cast by the bad-old days of the sport—“when it was advertised as no-holds barred,” and often left a pool of blood on the mat to prove it.
But momentum is building in M.M.A.’s favor. Thirty-two states have sanctioned the sport, with 10 of them coming on board over the last 14 months alone.
Ratner’s own conversion is telling. Back in 1995, he called the sport “barbaric,” and, as the respected head of the Nevada State Athletic Commission, he helped Senator McCain lead a largely successful charge to outlaw ultimate fighting across the country.
Then, in 2000, members of the sport and the athletic commissions in Nevada and New Jersey hammered out medical and judging standards, weight limits, and restrictions on fighting techniques for M.M.A. Nevada hosted its first M.M.A. fight the next year. “It became something you could regulate,” says Ratner, who joined U.F.C. in 2007.
In contrast to those still troubled by the free-form combat (which often takes place in a cage), Ratner now sees restraint and tactical skill. In M.M.A., he notes that an opponent can win through a variety of different pins and holds, while, in boxing, the objective “is strictly trying to knock that ugly guy unconscious.”
Whether brand-name advertisers will see the nuance is another question. Both boxing and professional wrestling have harnessed wide distribution networks and attracted a bountiful stream of well-known sponsors, such Procter & Gamble. But it’s been a harder road for M.M.A., despite having an audience that skews toward the young male, a demographic presumed to be both free-spending and susceptible to advertisers’ wiles.
“They all love the demographic,” says Jay Larkin, head of the International Fight League, a pink-sheets-traded M.M.A. company now jockeying with the U.F.C. and several other recent entrants for distribution and advertising dollars. But “no sponsor in his right mind is going to want to see blood smeared over their logo,” something Larkin says remains a distinct possibility in many M.M.A. events.
In order to avoid this potential messiness, his league has gone even further to placate the sensibilities of potential advertisers. Certain hits, like the elbow strike, are not permitted in I.F.L. bouts, and the league doesn’t put its contestants in a pen. “We don’t have the negative association of putting men in cages and having them fight,” says Larkin, the former head of boxing events for Showtime.
I.F.L. has inked deals with Fox Sports Net and MyNetwork to broadcast fight,s and the World Combat League, a new entrant backed by martial-arts master Chuck Norris, is following similarly restrictive rules.
Such precautions could turn off some hardcore fans. They may also prove unnecessary, as M.M.A. grows in popularity. The U.F.C. recently signed on Harley Davidson, and is hinting that an even more recognizable brand will come on board, possibly as early as next month.
Meanwhile, Spike TV has drawn advertisers like Burger King and DirectTV to its U.F.C.-based shows. These include matches and a popular reality series, The Ultimate Fighter, which tracks the rise and fall of hopeful combatants. Last year, both the fights and the reality show brought in more viewers from the 18- to 34-year-old male demographic than either Nascar or the N.B.A. playoff games shown on ESPN and TNT.
The show has also made one fighter, Chuck Liddell, into a minor celebrity, catapulting him into guest spots on HBO’s hip series Entourage and propelling his new book, Iceman: My Fighting Life, into a bestselling memoir, according to Amazon’s sales rankings.
“Our 18 to 34 numbers are great, rates are consistently up, and we’ve also drawn marquee advertisers,” says Brian Diamond, the senior vice president of sports and specials for Spike TV. “I’m 49 and I grew up with boxing—and I love it. But most of the younger guys are part of the MTV generation. They want things quick. They don’t want to watch something go for 12 rounds.”
Still, it’s unclear if M.M.A. has either of its rivals in a guillotine choke. After a difficult 2006, boxing had one of its best years ever in 2007, propelled by a few lucrative fan-pleasing matches like the May middleweight title fight between Oscar De La Hoya and Floyd Mayweather.
Meanwhile, publicly-traded World Wrestling Entertainment, continues to be a massive brand and licensing franchise, with a strong Web presence. Last week [February 14] W.W.E. reported $485 million in revenues for 2007, a record by the company despite grappling with the murder-suicide committed by one of its stars, Chris Benoit, and an expensive federal steroids investigation that ultimately led to the suspension of several wrestlers.
But there are signs of trouble. Except for top-tier fights such as the De La Hoya-Mayweather bout, few boxing matches ever sell out— that’s in marked contrast to recent M.M.A. events. And while M.M.A. has been zooming ahead in the important pay-per-view battle, professional wrestling has been losing ground. This month, its free distribution also took a hit, with the CW network choosing not to renew W.W.E.’s long-running Friday-night SmackDown. W.W.E. did not return requests for comment.
Desertions to the mixed martial arts ring by well-known practitioners of boxing and professional wrestling may be the most worrisome sign.
Known to professional wrestling fans as “The Next Big Thing,” Brock Lesnar made his U.F.C. debut earlier this month. As other pro wrestlers like “Stone Cold” Steve Austin and the Undertaker looked on from the sidelines, Lesnar was taken down one minute and 30 seconds into the first round, but he has vowed to fight in the cage again another day.
A more explosive move may be in the offing. Mayweather, whose 2007 pay-per-view brawl with De la Hoya brought in $134 million, has gone from talking trash about the sport—calling it “nothing but a fad” and comparing it to “a street fight”—to recently discussing entering the M.M.A. ring with Mark Cuban’s HDNet.
Royce Feour, who spent 37 years writing about boxing for the Las Vegas Review-Journal, doubts Mayweather would ever leave his very successful and lucrative boxing career to take a chance in mixed martial arts, although a well-funded promotional bout wouldn’t be beyond the realm of reason.
That would further cement M.M.A.’s place in the world of combat sports. But even if it doesn’t happen, Feour says fans of all stripes should probably be thankful M.M.A. has lit a fire under promoters and made them pay closer attention to their audiences.
“It has been a good year for boxing because they are letting their best fighters fight each other,” says Feour. That wasn’t happening before M.M.A. burst onto the scene, “so it is definitely having a beneficial effect, whether or not anyone wants to admit it.”
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
by Kit R. Roane Feb 18 2008
In the brawl for the hearts and wallets of young male fans, ultimate fighting has boxing and wrestling on the ropes.
Sometimes success hinges on the little things. Outlawing the eye-gouge, for instance, or banning the crotch kick.
Such rule changes have helped to turn mixed martial arts from a virtual outlaw operation into one of the fastest growing sports in the country, muting critics, enticing advertisers, and taking on its rivals—boxing and professional wrestling—for both fans and market share.
The sport Senator John McCain once famously branded as “human cockfighting” rakes in more than $200 million in pay-per-view loot, has broadcast deals with Spike TV, Fox Sports Net and MyNetwork, and has spawned a reality series, The Ultimate Fighter, which along with the fights grabbed more 18- to 34-year-old male eyeballs than either Nascar or the N.B.A. playoff games.
Robert Jacobson, president and C.E.O. of In Demand Networks, which provides about 90 percent of the cable industry’s pay-per-view content, notes that mixed martial arts accounted for virtually no revenue on his network in 2004. “Now it’s neck and neck with boxing, and is a little ahead of wrestling,” he says.
The current leader in the M.M.A. business, Ultimate Fighting Championship, went from $45 million in pay-per-view revenues in 2005 to $222 million in 2006 and appears to have held that number for 2007, according to Deana Myers, a senior analyst at SNL Kagan. U.F.C.’s revenue numbers are close to, and at points have exceeded, those reported by HBO, the main boxing pay-per-view provider, and those of World Wrestling Entertainment, the dominant force in professional wrestling.
Mixed martial arts (M.M.A.) has grown in popularity despite having had less financial backing and nowhere near the distribution network of boxing or wrestling to publicize its matches. Newspapers ignore M.M.A. events M.M.A. and the major networks eschew them. Both New York And Massachusetts, two of the most important states from a marketing and distribution standpoint, ban the matches altogether.
Marc Ratner, the Ultimate Fighting Championship vice president of government and regulatory affairs, says the problem is the long shadow cast by the bad-old days of the sport—“when it was advertised as no-holds barred,” and often left a pool of blood on the mat to prove it.
But momentum is building in M.M.A.’s favor. Thirty-two states have sanctioned the sport, with 10 of them coming on board over the last 14 months alone.
Ratner’s own conversion is telling. Back in 1995, he called the sport “barbaric,” and, as the respected head of the Nevada State Athletic Commission, he helped Senator McCain lead a largely successful charge to outlaw ultimate fighting across the country.
Then, in 2000, members of the sport and the athletic commissions in Nevada and New Jersey hammered out medical and judging standards, weight limits, and restrictions on fighting techniques for M.M.A. Nevada hosted its first M.M.A. fight the next year. “It became something you could regulate,” says Ratner, who joined U.F.C. in 2007.
In contrast to those still troubled by the free-form combat (which often takes place in a cage), Ratner now sees restraint and tactical skill. In M.M.A., he notes that an opponent can win through a variety of different pins and holds, while, in boxing, the objective “is strictly trying to knock that ugly guy unconscious.”
Whether brand-name advertisers will see the nuance is another question. Both boxing and professional wrestling have harnessed wide distribution networks and attracted a bountiful stream of well-known sponsors, such Procter & Gamble. But it’s been a harder road for M.M.A., despite having an audience that skews toward the young male, a demographic presumed to be both free-spending and susceptible to advertisers’ wiles.
“They all love the demographic,” says Jay Larkin, head of the International Fight League, a pink-sheets-traded M.M.A. company now jockeying with the U.F.C. and several other recent entrants for distribution and advertising dollars. But “no sponsor in his right mind is going to want to see blood smeared over their logo,” something Larkin says remains a distinct possibility in many M.M.A. events.
In order to avoid this potential messiness, his league has gone even further to placate the sensibilities of potential advertisers. Certain hits, like the elbow strike, are not permitted in I.F.L. bouts, and the league doesn’t put its contestants in a pen. “We don’t have the negative association of putting men in cages and having them fight,” says Larkin, the former head of boxing events for Showtime.
I.F.L. has inked deals with Fox Sports Net and MyNetwork to broadcast fight,s and the World Combat League, a new entrant backed by martial-arts master Chuck Norris, is following similarly restrictive rules.
Such precautions could turn off some hardcore fans. They may also prove unnecessary, as M.M.A. grows in popularity. The U.F.C. recently signed on Harley Davidson, and is hinting that an even more recognizable brand will come on board, possibly as early as next month.
Meanwhile, Spike TV has drawn advertisers like Burger King and DirectTV to its U.F.C.-based shows. These include matches and a popular reality series, The Ultimate Fighter, which tracks the rise and fall of hopeful combatants. Last year, both the fights and the reality show brought in more viewers from the 18- to 34-year-old male demographic than either Nascar or the N.B.A. playoff games shown on ESPN and TNT.
The show has also made one fighter, Chuck Liddell, into a minor celebrity, catapulting him into guest spots on HBO’s hip series Entourage and propelling his new book, Iceman: My Fighting Life, into a bestselling memoir, according to Amazon’s sales rankings.
“Our 18 to 34 numbers are great, rates are consistently up, and we’ve also drawn marquee advertisers,” says Brian Diamond, the senior vice president of sports and specials for Spike TV. “I’m 49 and I grew up with boxing—and I love it. But most of the younger guys are part of the MTV generation. They want things quick. They don’t want to watch something go for 12 rounds.”
Still, it’s unclear if M.M.A. has either of its rivals in a guillotine choke. After a difficult 2006, boxing had one of its best years ever in 2007, propelled by a few lucrative fan-pleasing matches like the May middleweight title fight between Oscar De La Hoya and Floyd Mayweather.
Meanwhile, publicly-traded World Wrestling Entertainment, continues to be a massive brand and licensing franchise, with a strong Web presence. Last week [February 14] W.W.E. reported $485 million in revenues for 2007, a record by the company despite grappling with the murder-suicide committed by one of its stars, Chris Benoit, and an expensive federal steroids investigation that ultimately led to the suspension of several wrestlers.
But there are signs of trouble. Except for top-tier fights such as the De La Hoya-Mayweather bout, few boxing matches ever sell out— that’s in marked contrast to recent M.M.A. events. And while M.M.A. has been zooming ahead in the important pay-per-view battle, professional wrestling has been losing ground. This month, its free distribution also took a hit, with the CW network choosing not to renew W.W.E.’s long-running Friday-night SmackDown. W.W.E. did not return requests for comment.
Desertions to the mixed martial arts ring by well-known practitioners of boxing and professional wrestling may be the most worrisome sign.
Known to professional wrestling fans as “The Next Big Thing,” Brock Lesnar made his U.F.C. debut earlier this month. As other pro wrestlers like “Stone Cold” Steve Austin and the Undertaker looked on from the sidelines, Lesnar was taken down one minute and 30 seconds into the first round, but he has vowed to fight in the cage again another day.
A more explosive move may be in the offing. Mayweather, whose 2007 pay-per-view brawl with De la Hoya brought in $134 million, has gone from talking trash about the sport—calling it “nothing but a fad” and comparing it to “a street fight”—to recently discussing entering the M.M.A. ring with Mark Cuban’s HDNet.
Royce Feour, who spent 37 years writing about boxing for the Las Vegas Review-Journal, doubts Mayweather would ever leave his very successful and lucrative boxing career to take a chance in mixed martial arts, although a well-funded promotional bout wouldn’t be beyond the realm of reason.
That would further cement M.M.A.’s place in the world of combat sports. But even if it doesn’t happen, Feour says fans of all stripes should probably be thankful M.M.A. has lit a fire under promoters and made them pay closer attention to their audiences.
“It has been a good year for boxing because they are letting their best fighters fight each other,” says Feour. That wasn’t happening before M.M.A. burst onto the scene, “so it is definitely having a beneficial effect, whether or not anyone wants to admit it.”
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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The Next Asset Bubble
The Next Asset Bubble
by Kit R. Roane Feb 4 2008
Infrastructure investing is growing in popularity as stocks and real estate tumble. But too much money is once again threatening to chase too few opportunities.
Gaze out your window at the cars going by. Now pretend you will be paid a quarter every time one passes.
These days, the world's largest investors are making similar calculations, and they like what they see. Stable cash flow is something to cherish, with volatility whipsawing stocks and the debt market nursing the sting of billions in collateralized debt obligations gone awry. So the once-sleepy backwater of infrastructure investment—the buying up of public roadways, utilities, airports, hospitals, and even prisons—has become fertile ground for Wall Street titans.
The problem is that the chief benefit of the investment—a safe long-term inflation-adjusted return—becomes harder to reach as more investors pile into the market seeking it.
Experts worry that prices have already been driven too high for many of the best assets. As evidence, they note that more deals are being loaded up leveraged-buyout levels of debt. At the same time, yield-hungry investors are increasingly willing to build or buy infrastructure in riskier corners of the world.
Is infrastructure fated to become the next asset bubble? Ryan J. Orr, executive director of Stanford's Collaboratory for Research on Global Projects, says: "We're already there."
Such concerns aren't stopping the party. Financial-services companies continue to flood the market with new infrastructure funds and new ideas about putting these funds to work. Some of those new ideas involve less-traditional assets like lotteries, gas stations, and old folks homes.
Stanford's Collaboratory estimates that more than 72 new infrastructure funds have been introduced since the beginning of 2006 and that more than $160 billion has been raised during that period for infrastructure investment.
Robert Dove, co-manager of Carlyle Infrastructure Partners, said new funds are cropping up because "there is certainly an appetite in the investment community for more stable, predictable investments." He adds that Carlyle, which closed its first infrastructure fund in November after raising almost $1.2 billion in about 18 months, sees "great opportunities" in the sector.
It's an opportunity based on hard times, as governments around the world will have difficulty paying for what is estimated to be $53 trillion in needed infrastructure investment over the next 25 years. This leaves the door open for private investors to offer a helping hand—for a price.
At the same time, some of private equity's biggest clients, pension funds and other institutional investors, are looking at the possibility that one day they might not meet growing needs going forward. Underfunded pension plans in the United States currently have liabilities of more that $1.2 trillion but assets of only $875 billion. Infrastructure investment is seen as playing an integral role in helping to close this gap.
"Our bottom line always has been and will be to maximize investment returns and thereby minimize contributions needed to fund our retirement benefits for 1.5 million members," says Clark McKinley, a spokesman for the California Public Employees' Retirement System, which earmarked $2.5 billion for infrastructure investment last month.
He adds that the people served by his fund, which is known as Calpers, depend on investment returns for 75 cents of every dollar they receive. "Prudent, smart infrastructure investments may help us sustain those kind of returns for the benefit of our people and other Californians," he explains.
But the easy money may have already been made by old hands like Macquarie Bank, the Australian company that pioneered the idea of the infrastructure fund in the early 1990s. It now controls billions of dollars worth of airports, toll roads, ports, and utilities.
When Macquarie got into the field, financial sponsors, like pension funds and private equity groups, accounted for only about 6 percent of infrastructure purchases. Now they measure closer to 20 percent. And, instead of partnering up, they're often competing madly against each other.
Calpers, for instance, says it is considering making direct investments in infrastructure assets, instead of buying through another sponsor like a private equity fund. Other pension funds have already entered the fray, competing directly with sovereign wealth funds, endowments, and their former advisers in the private equity and investment-banking world.
"We made a decision around 2002 to focus on direct investment," says Stephen Dowd, Ontario Teachers' Pension Plan's vice president for infrastructure investments, adding that many other pension funds have also benefited from the approach. "They all have strong teams, are able to compete, and are in fact ahead of the game when compared with a lot of the third party funds."
Unfortunately, all this competition is diluting returns from infrastructure investments for everyone involved, contributing to an increase in both the multiples being paid for assets and the aggressive financial leverage being used to fund them.
Standard & Poor's notes that while the number of global infrastructure deals increased 24 percent between 2005 and 2007, the value placed on those deals increased by 90 percent as investors offered more and more for less and less.
To take one example, regulated water companies in Britain fetch well over a 25 percent premium to their asset value.
"Some of these multiples are scary," says Orr, noting that funds "promising high double-digit returns on brownfield buy-outs—where they buy assets, lever them up with debt, do some fancy financial engineering and packaging—are never going to be able to achieve those aggressive performance targets."
Bidding wars have raised the level of risk to a point where investors like Stephen Dowd have become more cautious, forcing him to sometimes walk away from a deal.
"It's more of a challenge now and you have to be disciplined about the pricing of risk," Dowd says. "If you lose to someone who prices it differently, you have to just go on to the next one." The Ontario Teachers' Pension Plan currently has about 7 percent of its $103.6 billion in net asset in infrastructure investments.
Not everybody is dialing back the danger. There is too much new money sloshing around in the sector, much of it destined for marquee purchases and all of it needing to be put to work.
Some investors, hoping to avoid inflated prices in Europe and in the United States, are now looking to emerging markets, where infrastructure investment has been rising at a fast clip. More than $56 billion was spent on Russian infrastructure in 2007, compared with only $3.9 billion the year before, for example.
Other investors are taking what could be an even bigger gamble, partnering with construction companies to build the infrastructure of the future—known as greenfield developments—instead of bidding on what already exists.
All of these investors can draw comfort from reams of data projecting the risks and the rewards inherent in their decisions. But the world can change quickly and forecasting gets a lot harder the further out you go.
Just ask the investors who were forced to renegotiate Latin American infrastructure investments in the 1990s; those caught short when the Eurotunnel linking England and France defaulted on its debt; or anyone hit by boycotts of their sparkling new toll roads.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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by Kit R. Roane Feb 4 2008
Infrastructure investing is growing in popularity as stocks and real estate tumble. But too much money is once again threatening to chase too few opportunities.
Gaze out your window at the cars going by. Now pretend you will be paid a quarter every time one passes.
These days, the world's largest investors are making similar calculations, and they like what they see. Stable cash flow is something to cherish, with volatility whipsawing stocks and the debt market nursing the sting of billions in collateralized debt obligations gone awry. So the once-sleepy backwater of infrastructure investment—the buying up of public roadways, utilities, airports, hospitals, and even prisons—has become fertile ground for Wall Street titans.
The problem is that the chief benefit of the investment—a safe long-term inflation-adjusted return—becomes harder to reach as more investors pile into the market seeking it.
Experts worry that prices have already been driven too high for many of the best assets. As evidence, they note that more deals are being loaded up leveraged-buyout levels of debt. At the same time, yield-hungry investors are increasingly willing to build or buy infrastructure in riskier corners of the world.
Is infrastructure fated to become the next asset bubble? Ryan J. Orr, executive director of Stanford's Collaboratory for Research on Global Projects, says: "We're already there."
Such concerns aren't stopping the party. Financial-services companies continue to flood the market with new infrastructure funds and new ideas about putting these funds to work. Some of those new ideas involve less-traditional assets like lotteries, gas stations, and old folks homes.
Stanford's Collaboratory estimates that more than 72 new infrastructure funds have been introduced since the beginning of 2006 and that more than $160 billion has been raised during that period for infrastructure investment.
Robert Dove, co-manager of Carlyle Infrastructure Partners, said new funds are cropping up because "there is certainly an appetite in the investment community for more stable, predictable investments." He adds that Carlyle, which closed its first infrastructure fund in November after raising almost $1.2 billion in about 18 months, sees "great opportunities" in the sector.
It's an opportunity based on hard times, as governments around the world will have difficulty paying for what is estimated to be $53 trillion in needed infrastructure investment over the next 25 years. This leaves the door open for private investors to offer a helping hand—for a price.
At the same time, some of private equity's biggest clients, pension funds and other institutional investors, are looking at the possibility that one day they might not meet growing needs going forward. Underfunded pension plans in the United States currently have liabilities of more that $1.2 trillion but assets of only $875 billion. Infrastructure investment is seen as playing an integral role in helping to close this gap.
"Our bottom line always has been and will be to maximize investment returns and thereby minimize contributions needed to fund our retirement benefits for 1.5 million members," says Clark McKinley, a spokesman for the California Public Employees' Retirement System, which earmarked $2.5 billion for infrastructure investment last month.
He adds that the people served by his fund, which is known as Calpers, depend on investment returns for 75 cents of every dollar they receive. "Prudent, smart infrastructure investments may help us sustain those kind of returns for the benefit of our people and other Californians," he explains.
But the easy money may have already been made by old hands like Macquarie Bank, the Australian company that pioneered the idea of the infrastructure fund in the early 1990s. It now controls billions of dollars worth of airports, toll roads, ports, and utilities.
When Macquarie got into the field, financial sponsors, like pension funds and private equity groups, accounted for only about 6 percent of infrastructure purchases. Now they measure closer to 20 percent. And, instead of partnering up, they're often competing madly against each other.
Calpers, for instance, says it is considering making direct investments in infrastructure assets, instead of buying through another sponsor like a private equity fund. Other pension funds have already entered the fray, competing directly with sovereign wealth funds, endowments, and their former advisers in the private equity and investment-banking world.
"We made a decision around 2002 to focus on direct investment," says Stephen Dowd, Ontario Teachers' Pension Plan's vice president for infrastructure investments, adding that many other pension funds have also benefited from the approach. "They all have strong teams, are able to compete, and are in fact ahead of the game when compared with a lot of the third party funds."
Unfortunately, all this competition is diluting returns from infrastructure investments for everyone involved, contributing to an increase in both the multiples being paid for assets and the aggressive financial leverage being used to fund them.
Standard & Poor's notes that while the number of global infrastructure deals increased 24 percent between 2005 and 2007, the value placed on those deals increased by 90 percent as investors offered more and more for less and less.
To take one example, regulated water companies in Britain fetch well over a 25 percent premium to their asset value.
"Some of these multiples are scary," says Orr, noting that funds "promising high double-digit returns on brownfield buy-outs—where they buy assets, lever them up with debt, do some fancy financial engineering and packaging—are never going to be able to achieve those aggressive performance targets."
Bidding wars have raised the level of risk to a point where investors like Stephen Dowd have become more cautious, forcing him to sometimes walk away from a deal.
"It's more of a challenge now and you have to be disciplined about the pricing of risk," Dowd says. "If you lose to someone who prices it differently, you have to just go on to the next one." The Ontario Teachers' Pension Plan currently has about 7 percent of its $103.6 billion in net asset in infrastructure investments.
Not everybody is dialing back the danger. There is too much new money sloshing around in the sector, much of it destined for marquee purchases and all of it needing to be put to work.
Some investors, hoping to avoid inflated prices in Europe and in the United States, are now looking to emerging markets, where infrastructure investment has been rising at a fast clip. More than $56 billion was spent on Russian infrastructure in 2007, compared with only $3.9 billion the year before, for example.
Other investors are taking what could be an even bigger gamble, partnering with construction companies to build the infrastructure of the future—known as greenfield developments—instead of bidding on what already exists.
All of these investors can draw comfort from reams of data projecting the risks and the rewards inherent in their decisions. But the world can change quickly and forecasting gets a lot harder the further out you go.
Just ask the investors who were forced to renegotiate Latin American infrastructure investments in the 1990s; those caught short when the Eurotunnel linking England and France defaulted on its debt; or anyone hit by boycotts of their sparkling new toll roads.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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Can This Deal Be Saved?
Can This Deal Be Saved?
by Kit R. Roane Aug 17 2007
Handicapping deals endangered by the credit market meltdown and volatility in stocks.
Sure, Sallie Mae looked good back in April. But that was before the debt keg got tapped out and Sallie's suitors sobered up.
Now the $25.3 billion deal to take over Sallie Mae, the country's largest student loan provider, seems in jeopardy. Part of the reason is that the proposed federal cut in education loans would make Sallie Mae less attractive. But the overarching concern, experts say, is that the debt needed by the J.C. Flowers-led consortium to finance the highly leveraged deal just became much more expensive.
Sallie Mae is far from the only belle to find her fortunes suddenly dim with the recent upheaval in the credit markets, which has choked off what was once cheap and plentiful debt, and spread pain across large swaths of the buyout landscape.
"Some of the helium is out of the balloon," says Colin Blaydon, director of Dartmouth's Center for Private Equity and Entrepreneurship. He adds that private equity buyers are "expressing a bit of remorse and looking to get out" of deals.
Although no one knows how many buyouts will actually fall apart, the trouble on the horizon is noteworthy. On Wednesday, for example, the homebuilder Levitt found its acquirer, BFC Financial, backing out.
Home Depot, after disclosing that its profit fell 14.8 percent in the second quarter, said that the sale of its HD Supply unit to another consortium was under threat. If the sale doesn't go through, Home Depot said its $22.5 billion stock repurchase plan would be sliced nearly in half.
The stocks of other companies in the middle of buyouts, such as Tribune Co., Hilton Hotels, and First Data Corporation are all trading at discounts to their buyout prices, signaling these deals could be in trouble as well.
Meanwhile, the mountains of debt created by what research firm Dealogic estimates was about $713 billion in global leveraged buyout volume this year, continues to hang over the market like overripe fruit.
Robert Polenberg, director of S&P Leveraged Commentary & Data, says the banks that underwrote the deals are still on the hook for $234 billion in loans. Since the banks either have to sell that debt at a deep discount or keep it-and its risks-on their books, this is holding up completed deals and backing up others about to be signed.
The deal flow isn't just slow, it's essentially stopped. Polenberg said there were only two deals in the first half of August.
Tishman Speyer Properties and Lehman Brothers Holdings delayed their $15.2 billion acquisition of Archstone-Smith Trust, saying that debt market conditions had made it too difficult to sell the $17 billion in debt needed to complete the deal.
Cerberus Capital ran into the same problem. To finalize its takeover of Chrysler, Cerberus and the seller, Daimler, had to shoulder $2 billion of the $12 billion loan that was slated to be sold to others. Again the reason was "highly volatile U.S. loan markets," according to DaimlerChrysler.
Of course there is a silver lining for some players. Many hedge funds and private equity firms are now trolling the credit markets, picking up debt on the cheap.
And in a perverse turn of events, the crisis has given some companies a new handle on their foes. TXU, a Texas utility, has been using the debt crisis to rally support for its private equity suitors, telling recalcitrant shareholders that bids are unlikely to get better given current market conditions.
Others have been given breathing room to accept offers when activist shareholders themselves switched course and decided to support the company's plans.
On Tuesday, Pershing Square Capital Management finally gave its blessing to a buyout of Ceridian, which processes payrolls, after fighting tooth and nail against it. Pershing grew concerned that deteriorating credit markets would make any higher offer unlikely and would jeopardize the offer on the table.
But for many companies, the deteriorating credit conditions have closed the window on their ability to entertain any takeover at all. British software maker Civica, British cable operator Virgin Media, and Texas-based Nexstar Broadcasting Group, among others, have halted takeover talks or pulled themselves from the market.
At the same time, the credit crunch could doom some older targets now being digested by private equity firms, targets that may have stiff loan covenants or heavy variable-rate debt burdens.
"Probably not too many of these deals are going to implode in the next six to 12 months, but I think it is inevitable that some of them will have problems," says Edward Altman, director of the credit and debit markets research program at New York University's Stern School of Business. "In terms of those deals that are interest-rate sensitive or refinance sensitive, I think it will be sooner, rather than later."
It remains unclear whether the current crisis signals an end to the buyout boom, or whether even the shock of a highly-leveraged buyout defaulting could end the party.
"So far, that shoe has not dropped," Blaydon notes. Both the Federal Reserve and the world's other central bankers have been increasing the money supply to keep it from doing so.
What is certain is that deals completed in the future will be different from some of the highly leveraged and pricey pursuits that led 2007. Buyers now will have to put more equity into deals or obtain lower purchase prices to get them done.
That means private equity groups will be pickier in choosing acquisitions, and, despite the recent swoon in the equity markets, stock prices may have to come down even further to garner much interest.
As George Roberts, the founder of Kohlberg Kravis Roberts & Co., told analysts on Wednesday, "Stock markets haven't fully reflected what's taken place in the credit markets."
None of this is inherently bad, says Jeanne Montague of Montague Partners, a San Francisco investment bank. It is likely to damp down the overheated prices being paid for some companies, she said.
Large corporate L.B.O.'s in the second quarter of 2007 had an average price of 10.6 times earnings before interest, taxes, depreciation, and amortization. Last year, the average was 8.5 times Ebitda.
"This is almost a 25 percent increase in the purchase price multiple, which is a dramatic change," she says. "I do not see any underlying factors in the health of either the U.S. or the global economy which can support those types of multiple increases in such a short period of time."
In the end, the credit lockup and the stock market swoon may be just what the doctor ordered to keep the L.B.O. deal alive for another day.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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by Kit R. Roane Aug 17 2007
Handicapping deals endangered by the credit market meltdown and volatility in stocks.
Sure, Sallie Mae looked good back in April. But that was before the debt keg got tapped out and Sallie's suitors sobered up.
Now the $25.3 billion deal to take over Sallie Mae, the country's largest student loan provider, seems in jeopardy. Part of the reason is that the proposed federal cut in education loans would make Sallie Mae less attractive. But the overarching concern, experts say, is that the debt needed by the J.C. Flowers-led consortium to finance the highly leveraged deal just became much more expensive.
Sallie Mae is far from the only belle to find her fortunes suddenly dim with the recent upheaval in the credit markets, which has choked off what was once cheap and plentiful debt, and spread pain across large swaths of the buyout landscape.
"Some of the helium is out of the balloon," says Colin Blaydon, director of Dartmouth's Center for Private Equity and Entrepreneurship. He adds that private equity buyers are "expressing a bit of remorse and looking to get out" of deals.
Although no one knows how many buyouts will actually fall apart, the trouble on the horizon is noteworthy. On Wednesday, for example, the homebuilder Levitt found its acquirer, BFC Financial, backing out.
Home Depot, after disclosing that its profit fell 14.8 percent in the second quarter, said that the sale of its HD Supply unit to another consortium was under threat. If the sale doesn't go through, Home Depot said its $22.5 billion stock repurchase plan would be sliced nearly in half.
The stocks of other companies in the middle of buyouts, such as Tribune Co., Hilton Hotels, and First Data Corporation are all trading at discounts to their buyout prices, signaling these deals could be in trouble as well.
Meanwhile, the mountains of debt created by what research firm Dealogic estimates was about $713 billion in global leveraged buyout volume this year, continues to hang over the market like overripe fruit.
Robert Polenberg, director of S&P Leveraged Commentary & Data, says the banks that underwrote the deals are still on the hook for $234 billion in loans. Since the banks either have to sell that debt at a deep discount or keep it-and its risks-on their books, this is holding up completed deals and backing up others about to be signed.
The deal flow isn't just slow, it's essentially stopped. Polenberg said there were only two deals in the first half of August.
Tishman Speyer Properties and Lehman Brothers Holdings delayed their $15.2 billion acquisition of Archstone-Smith Trust, saying that debt market conditions had made it too difficult to sell the $17 billion in debt needed to complete the deal.
Cerberus Capital ran into the same problem. To finalize its takeover of Chrysler, Cerberus and the seller, Daimler, had to shoulder $2 billion of the $12 billion loan that was slated to be sold to others. Again the reason was "highly volatile U.S. loan markets," according to DaimlerChrysler.
Of course there is a silver lining for some players. Many hedge funds and private equity firms are now trolling the credit markets, picking up debt on the cheap.
And in a perverse turn of events, the crisis has given some companies a new handle on their foes. TXU, a Texas utility, has been using the debt crisis to rally support for its private equity suitors, telling recalcitrant shareholders that bids are unlikely to get better given current market conditions.
Others have been given breathing room to accept offers when activist shareholders themselves switched course and decided to support the company's plans.
On Tuesday, Pershing Square Capital Management finally gave its blessing to a buyout of Ceridian, which processes payrolls, after fighting tooth and nail against it. Pershing grew concerned that deteriorating credit markets would make any higher offer unlikely and would jeopardize the offer on the table.
But for many companies, the deteriorating credit conditions have closed the window on their ability to entertain any takeover at all. British software maker Civica, British cable operator Virgin Media, and Texas-based Nexstar Broadcasting Group, among others, have halted takeover talks or pulled themselves from the market.
At the same time, the credit crunch could doom some older targets now being digested by private equity firms, targets that may have stiff loan covenants or heavy variable-rate debt burdens.
"Probably not too many of these deals are going to implode in the next six to 12 months, but I think it is inevitable that some of them will have problems," says Edward Altman, director of the credit and debit markets research program at New York University's Stern School of Business. "In terms of those deals that are interest-rate sensitive or refinance sensitive, I think it will be sooner, rather than later."
It remains unclear whether the current crisis signals an end to the buyout boom, or whether even the shock of a highly-leveraged buyout defaulting could end the party.
"So far, that shoe has not dropped," Blaydon notes. Both the Federal Reserve and the world's other central bankers have been increasing the money supply to keep it from doing so.
What is certain is that deals completed in the future will be different from some of the highly leveraged and pricey pursuits that led 2007. Buyers now will have to put more equity into deals or obtain lower purchase prices to get them done.
That means private equity groups will be pickier in choosing acquisitions, and, despite the recent swoon in the equity markets, stock prices may have to come down even further to garner much interest.
As George Roberts, the founder of Kohlberg Kravis Roberts & Co., told analysts on Wednesday, "Stock markets haven't fully reflected what's taken place in the credit markets."
None of this is inherently bad, says Jeanne Montague of Montague Partners, a San Francisco investment bank. It is likely to damp down the overheated prices being paid for some companies, she said.
Large corporate L.B.O.'s in the second quarter of 2007 had an average price of 10.6 times earnings before interest, taxes, depreciation, and amortization. Last year, the average was 8.5 times Ebitda.
"This is almost a 25 percent increase in the purchase price multiple, which is a dramatic change," she says. "I do not see any underlying factors in the health of either the U.S. or the global economy which can support those types of multiple increases in such a short period of time."
In the end, the credit lockup and the stock market swoon may be just what the doctor ordered to keep the L.B.O. deal alive for another day.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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The Art of Investing in Art
The Art of Investing in Art
by Kit R. Roane Jun 27 2007
Hedge funds turn to art as another asset to be arbitraged and flipped. Promises of significant profit potential are offset by some sobering precautions.
Wealthy investors looking for a reprieve from recent volatility in stocks and bonds will soon have a sophisticated way to play the art market, even if they can't tell a Rubens from a sandwich.
All they need is money to burn—about $200,000 minimum—and a taste for new risk.
With cold calculation, Artistic Investment Advisers, a British money-management firm, has set a July 1 launch for what is being billed as the first hedge fund to trade art like a commodity and to offer a hedge if the market goes south.
The Art Trading Fund, which says it has attracted about $40 million from investors, is among a growing number of new investment vehicles trying to harness investor interest in assets not subject to the vagaries of the stock or bond markets. It is also a testament to the financial world's ability to commoditize, securitize, and trade just about anything.
In addition to those focusing on art, hedge funds tracking the market for vintage wine and rare violins have cropped up recently, while Wall Street traders have been making sport of arbitrage on everything from fine watches to duck decoys.
"The people of Wall Street are setting a new trend," says Denis Gardarin, director of the Sean Kelly Gallery, which represents contemporary artists, in New York City. He adds that the rise in some auction prices has been propelled by a new focus on investment returns and the desire among some investors to show off both their money and their power.
"There is this exhibitionist sort of behavior now," he says. "How you are supposed to collect and what you collect is being shaken by this."
Driven by the same global liquidity that has fueled a buyout boom, prices for many contemporary artworks have skyrocketed in recent years.
This May, for instance, Sotheby's auctioned off Mark Rothko's White Center (Yellow, Pink and Lavender on Rose) for $72.8 million. (The seller, David Rockefeller, bought the painting for $10,000 in 1960.)
The sale price was about $30 million more than was expected and the highest price ever paid at auction for a contemporary work. By comparison, Rothko's Homage to Matisse fetched only $22.41 million two years ago.
The Mei Moses Fine Art Index, which tracks global art auction sales, showed returns of more than 18 percent last year, beating out the S&P 500 Index by more than 2 percentage points. According to Beautiful Asset Advisors, which produces the fine art index, annual returns on art auction sales have also bested stocks over the past five- and 10-year periods.
That has caused a lot of people to divorce art from meaning, says Mitchell Moss, director of the Taub Urban Research Center at New York University. "The art of collecting has turned into the science of investing," he says. "Art has now gone from being something you hang on the wall, that you collect, to being an annuity."
Artistic Investment Advisers is firmly in the annuity camp. In fact, its backers couldn't care less if art forced people, as Jackson Pollock put it, to come "face to face" with themselves, unless that reflection revealed some riches too.
"I am not really interested in art," says Justin Williams, an art collector and a director of Artistic Investment Advisers. "It is simply a commodity, which, when plugged into our business model, produces substantial returns for investors."
One of his partners, Chris Carlson, adds that he has no idea what makes good art. "I am not an art critic," he says.
What Williams and Carlson, a former trader at Deutsche Bank and UBS, say they do know—and know well—is how to profit from an inefficient market, even when it is not rising. They say they intend to do this by exploiting the geographical arbitrage that exists between what buyers and sellers in different cities and countries are willing to pay, by picking up pieces during distress sales, and by buying directly from a select group of artists.
Williams says the fund will focus on Impressionist, Post-Impressionist, Modern, and contemporary art and that it will deal only with artists who have substantive and verifiable track records. He adds that the fund has little interest in "finding the next ‘great' artist" and that the fund will rapidly trade the art it buys through prearranged exit strategies, often selling pieces within a few months of a purchase.
"All our trades have at least three exit opportunities attached," says Williams. "We go for the exit with the quickest and best margin of return."
Based on audited performance of the art trading done by the company privately over the last three years, Williams says the fund should make 30 percent net returns annually. Its hedge, he adds, is basically a bet against 10 to 15 securities tied to the art market that should protect investors from any catastrophic drop.
Both the quick trading and the fund's hedging may come in handy. Although art has been a good investment over certain discrete periods, Merrill Lynch research indicates that it is one of the few assets where the probability of losing money remains high even for long-term investors, while also noting that art provides "inferior returns while generating substantially more risk."
The risks to the art market seem to grow more ominous every day if the past is any judge. The art market appreciated in the mid-1980s, with Impressionists and old masters (including Peter Paul Rubens) ringing up record sales to real-estate-rich Japanese investors.
The top of that market can be timed to the 1990 sale of Vincent van Gogh's Portrait of Dr. Gachet to Japanese industrialist Ryoei Saito. The chairman of Daishowa Paper Manufacturing, Saito paid $82.5 million for the painting, then was ensnared in a bribery scandal, went broke, and died. The painting, incidentally, never resurfaced.
It could be that the portrait's current owners are still waiting to get their money out of it, as art prices followed Saito's fortunes, tumbling 36 percent in 1991 and entering a near decade-long bear market. Many of the old masters and Impressionist works that led the market failed to recover.
That said, the Art Trading Fund might not be the best vehicle to profit from a rising market either. The fund will carry hefty fees—a 2 percent annual management fee and a 20 percent charge on investment performance—and rapidly buying and selling the art will drive up transaction costs, especially since auction houses and dealers already lard the process with fees of their own.
Nor will such a fund be an easy sell in alternative investment circles. Institutional investors, for example, would probably have trouble slipping this type of fund through their investment committees.
In addition, many investment advisers would worry about putting clients' money in something they themselves have a hard time understanding.
"This certainly qualifies as an alternative investment," says Joseph Aaron, of Wood, Hat & Silver LLC, a San Francisco firm that invests in hedge funds for individuals and institutions. "But I suspect it is a tad too alternative for traditional portfolios."
Even art market players with experience in more traditional art investment funds are skeptical. William Pearlstein, a well-known art investor and art market lawyer with New York-based Golenbock Eiseman Assor Bell & Peskoe is among those who believe investors can still obtain top pieces of art that "will garner the esteem and praise of peers," while not breaking the bank.
Pearlstein is also an experienced hand at art investment funds, having been an investor in one that imploded last year. The fund, Fernwood Art Investments, was launched in 2005 with great fanfare. It was shuttered more quietly in 2006 amid charges of mismanagement, and it is now the subject of several investor lawsuits, including one joined by Pearlstein.
Although Pearlstein still believes in the concept of art investment funds, calling Fernwood "a good idea" that succumbed to "flawed execution and garden-variety human frailty," he is circumspect about the quick-trading and commoditization of art embraced by the Art Trading Fund.
"The art market isn't a stock market," he says. "People who buy art are generally collectors or connoisseurs of a particular kind and there aren't millions of them with a taste for a particular artist, so I'm not sure about this idea of slipping in and out of pieces. There is not a lot of liquidity short-term."
Of course, the Art Trading Fund could still become a roaring success for its principals if a few well-heeled investors buy into the idea. With so much money chasing returns, all it takes is "a narrow inch of the world to get comfortable with it," says Pearlstein, then it's off to the races.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
by Kit R. Roane Jun 27 2007
Hedge funds turn to art as another asset to be arbitraged and flipped. Promises of significant profit potential are offset by some sobering precautions.
Wealthy investors looking for a reprieve from recent volatility in stocks and bonds will soon have a sophisticated way to play the art market, even if they can't tell a Rubens from a sandwich.
All they need is money to burn—about $200,000 minimum—and a taste for new risk.
With cold calculation, Artistic Investment Advisers, a British money-management firm, has set a July 1 launch for what is being billed as the first hedge fund to trade art like a commodity and to offer a hedge if the market goes south.
The Art Trading Fund, which says it has attracted about $40 million from investors, is among a growing number of new investment vehicles trying to harness investor interest in assets not subject to the vagaries of the stock or bond markets. It is also a testament to the financial world's ability to commoditize, securitize, and trade just about anything.
In addition to those focusing on art, hedge funds tracking the market for vintage wine and rare violins have cropped up recently, while Wall Street traders have been making sport of arbitrage on everything from fine watches to duck decoys.
"The people of Wall Street are setting a new trend," says Denis Gardarin, director of the Sean Kelly Gallery, which represents contemporary artists, in New York City. He adds that the rise in some auction prices has been propelled by a new focus on investment returns and the desire among some investors to show off both their money and their power.
"There is this exhibitionist sort of behavior now," he says. "How you are supposed to collect and what you collect is being shaken by this."
Driven by the same global liquidity that has fueled a buyout boom, prices for many contemporary artworks have skyrocketed in recent years.
This May, for instance, Sotheby's auctioned off Mark Rothko's White Center (Yellow, Pink and Lavender on Rose) for $72.8 million. (The seller, David Rockefeller, bought the painting for $10,000 in 1960.)
The sale price was about $30 million more than was expected and the highest price ever paid at auction for a contemporary work. By comparison, Rothko's Homage to Matisse fetched only $22.41 million two years ago.
The Mei Moses Fine Art Index, which tracks global art auction sales, showed returns of more than 18 percent last year, beating out the S&P 500 Index by more than 2 percentage points. According to Beautiful Asset Advisors, which produces the fine art index, annual returns on art auction sales have also bested stocks over the past five- and 10-year periods.
That has caused a lot of people to divorce art from meaning, says Mitchell Moss, director of the Taub Urban Research Center at New York University. "The art of collecting has turned into the science of investing," he says. "Art has now gone from being something you hang on the wall, that you collect, to being an annuity."
Artistic Investment Advisers is firmly in the annuity camp. In fact, its backers couldn't care less if art forced people, as Jackson Pollock put it, to come "face to face" with themselves, unless that reflection revealed some riches too.
"I am not really interested in art," says Justin Williams, an art collector and a director of Artistic Investment Advisers. "It is simply a commodity, which, when plugged into our business model, produces substantial returns for investors."
One of his partners, Chris Carlson, adds that he has no idea what makes good art. "I am not an art critic," he says.
What Williams and Carlson, a former trader at Deutsche Bank and UBS, say they do know—and know well—is how to profit from an inefficient market, even when it is not rising. They say they intend to do this by exploiting the geographical arbitrage that exists between what buyers and sellers in different cities and countries are willing to pay, by picking up pieces during distress sales, and by buying directly from a select group of artists.
Williams says the fund will focus on Impressionist, Post-Impressionist, Modern, and contemporary art and that it will deal only with artists who have substantive and verifiable track records. He adds that the fund has little interest in "finding the next ‘great' artist" and that the fund will rapidly trade the art it buys through prearranged exit strategies, often selling pieces within a few months of a purchase.
"All our trades have at least three exit opportunities attached," says Williams. "We go for the exit with the quickest and best margin of return."
Based on audited performance of the art trading done by the company privately over the last three years, Williams says the fund should make 30 percent net returns annually. Its hedge, he adds, is basically a bet against 10 to 15 securities tied to the art market that should protect investors from any catastrophic drop.
Both the quick trading and the fund's hedging may come in handy. Although art has been a good investment over certain discrete periods, Merrill Lynch research indicates that it is one of the few assets where the probability of losing money remains high even for long-term investors, while also noting that art provides "inferior returns while generating substantially more risk."
The risks to the art market seem to grow more ominous every day if the past is any judge. The art market appreciated in the mid-1980s, with Impressionists and old masters (including Peter Paul Rubens) ringing up record sales to real-estate-rich Japanese investors.
The top of that market can be timed to the 1990 sale of Vincent van Gogh's Portrait of Dr. Gachet to Japanese industrialist Ryoei Saito. The chairman of Daishowa Paper Manufacturing, Saito paid $82.5 million for the painting, then was ensnared in a bribery scandal, went broke, and died. The painting, incidentally, never resurfaced.
It could be that the portrait's current owners are still waiting to get their money out of it, as art prices followed Saito's fortunes, tumbling 36 percent in 1991 and entering a near decade-long bear market. Many of the old masters and Impressionist works that led the market failed to recover.
That said, the Art Trading Fund might not be the best vehicle to profit from a rising market either. The fund will carry hefty fees—a 2 percent annual management fee and a 20 percent charge on investment performance—and rapidly buying and selling the art will drive up transaction costs, especially since auction houses and dealers already lard the process with fees of their own.
Nor will such a fund be an easy sell in alternative investment circles. Institutional investors, for example, would probably have trouble slipping this type of fund through their investment committees.
In addition, many investment advisers would worry about putting clients' money in something they themselves have a hard time understanding.
"This certainly qualifies as an alternative investment," says Joseph Aaron, of Wood, Hat & Silver LLC, a San Francisco firm that invests in hedge funds for individuals and institutions. "But I suspect it is a tad too alternative for traditional portfolios."
Even art market players with experience in more traditional art investment funds are skeptical. William Pearlstein, a well-known art investor and art market lawyer with New York-based Golenbock Eiseman Assor Bell & Peskoe is among those who believe investors can still obtain top pieces of art that "will garner the esteem and praise of peers," while not breaking the bank.
Pearlstein is also an experienced hand at art investment funds, having been an investor in one that imploded last year. The fund, Fernwood Art Investments, was launched in 2005 with great fanfare. It was shuttered more quietly in 2006 amid charges of mismanagement, and it is now the subject of several investor lawsuits, including one joined by Pearlstein.
Although Pearlstein still believes in the concept of art investment funds, calling Fernwood "a good idea" that succumbed to "flawed execution and garden-variety human frailty," he is circumspect about the quick-trading and commoditization of art embraced by the Art Trading Fund.
"The art market isn't a stock market," he says. "People who buy art are generally collectors or connoisseurs of a particular kind and there aren't millions of them with a taste for a particular artist, so I'm not sure about this idea of slipping in and out of pieces. There is not a lot of liquidity short-term."
Of course, the Art Trading Fund could still become a roaring success for its principals if a few well-heeled investors buy into the idea. With so much money chasing returns, all it takes is "a narrow inch of the world to get comfortable with it," says Pearlstein, then it's off to the races.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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Will Dark Pools Swallow Wall Street?
Will Dark Pools Swallow Wall
Street?
by Kit R. Roane Jul 9 2007
In search of lower prices, less scrutiny, and fewer rules, some of the biggest securities traders are turning to private exchanges called dark pools to make their biggest deals.
Dark liquidity pools may sound like something out of science fiction, but they're real. And they're already spreading throughout Wall Street.
These pools are basically internal systems for trading stocks privately, off of public exchanges and out of the public eye. They are growing rapidly, both in number and in volume of trades.
Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.
An activist hedge fund, for instance, may not want to reveal that it is buying up large blocks of stock in a company it is about to attack, or a mutual fund might want to sell a large amount of stock without causing a downdraft that would hurt any shares it still holds.
But these alternative trading systems have also raised concerns as they have multiplied over the last two years. Poking fun at some of the hand-wringing over these secretive pools, the Securities and Exchange Commission's libertarian-leaning commissioner, Paul Atkins, joked recently that someone should make a horror movie about them, perhaps called The Dark Pool That Swallowed Manhattan!.
Jokes aside, major stock exchanges have some reasons to be nervous about the dark pools' proliferation. The mainstream exchanges see the pools as yet another group attempting to steal revenue-producing trades and liquidity from their markets. That's in addition to a welter of new electronic-trading platforms that offer faster execution and lower transaction costs. These platforms alone have triggered a wave of consolidation among traditional exchanges.
Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.
Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.
The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.
The idea behind dark pools isn't exactly new. Brokerages have long tried to cross (or satisfy) trades internally, by matching one customer's sale with another customer's purchase. The first true dark pool is believed to be Investment Technology Group's two-decade-old Portfolio System for Institutional Trading, or Posit.
But now new technologies have combined with market changes to make these alternative, private exchanges a hotter place to invest.
The consolidation of public stock exchanges, the rise of slice-and-dice algorithmic trading, and new regulations—including order-handling rules—have had the effect of reducing liquidity, or ease of trading, in the public markets.
They have also led to a shrinkage of order size, so it has become increasingly difficult to buy or sell a large block of stock without being noticed—and thereby, often, moving the price of the underlying security.
Meanwhile, sophisticated electronic-trading systems have made buying and selling away from public markets both easier and more efficient. There are even new systems aimed at providing access to large numbers of dark pools.
For hedge funds, pension funds, and other big traders, the beauty of the system is that it can often allow these institutional investors to use the public markets to set stock prices while they buy and sell stock discreetly and at set terms in a private market.
"The public exchange is mandated to be equal and fair and open," says Jeromee Johnson, a senior analyst at Tabb Group, a firm that conducts research into and provides advice about financial markets. "The dark pools don't have to provide equal and fair access or, necessarily, a level playing field."
"And for institutions," he adds, "it can mean a better execution because they are able to protect the information about the size and type of their order and negotiate with the other counterparties."
It can also be cheaper than having a broker-dealer route the order onto the public market.
As an example, Johnson uses a simple scenario in which a relatively illiquid—that is, infrequently traded—stock has a three-cent spread between the bid and the ask price. An institution wanting to buy or sell a quarter-million shares would save several thousand dollars (the difference between the public bid and ask prices) by making the trade in a dark pool.
Of even greater importance would be the additional value of eliminating the spike in supply or demand caused by its big order, which would lead to a swing in the stock's price. "The potential value of savings on the transaction could be in the 80 or 90 percent range," Johnson says. "These are significant savings."
The hunger for anonymous block trading has caused the field to explode. There are about 40 active pools, double the number just last year. New pools and services to aggregate them are announced almost every month.
The pools control about 512 million shares per day in trades, or about 10 percent of all equity shares traded in the United States, according to data compiled by the Tabb Group.
Nearly every major Wall Street institution seems to have a system in place, from Goldman Sachs' Sigma X and Merrill Lynch's Block Alert to the consortium-owned BIDS network, whose principals include Bank of America, Bear Stearns, and Deutsche Bank.
Each system has its own character, with some allowing negotiated prices and others setting prices based on the quotes in the public markets. Some systems only allow large orders, while others will mix small orders in the trades. A few—worried about manipulation—won't let hedge funds in the door. But others welcome them because they bring liquidity.
Hedge funds were early adopters of the computer algorithms used to find and exploit price discrepancies in dark pools. These algorithms are now so important to the business that Citigroup recently developed a new one, called I.S. Shadow, just to assuage the concerns of two funds that weren't able to complete enough of the profitable trades they had found.
Backers of the pools are attracted to the game because it is lucrative. By satisfying orders internally, they not only avoid stock exchange trading fees but also get paid to make the trades.
Liquidnet, for instance, reported an average daily volume of nearly 57 million shares in the U.S. during the first quarter of 2007, a 28 percent increase from the same quarter in 2006. This seven-year-old company has become the ninth-largest broker on the New York Stock Exchange and is estimated to be worth more than $2 billion.
The Tabb Group predicts that these internal crossing networks and internal markets will continue to eat into the market share of the public exchanges, trading nearly 1.5 billion shares per day by 2010, an annual growth rate of more than 40 percent. That would equal about 15 percent of all equity shares traded in the United States.
By comparison, the N.Y.S.E.'s market share is expected to fall to 32 percent in 2010, from about 40 percent this year, while the Nasdaq is expected to lose just over six percentage points of its current market share over that period, falling to 34 percent.
Public exchanges have been fighting back with plans for their own anonymous-trading systems.
At the same time, Catherine Kinney, the N.Y.S.E.'s president, has attempted to rally opposition to dark pools. She has argued in conferences that private exchanges are already hurting investors by reducing the information that public markets use to set stock prices.
Adding insult to injury, dark pools often use retail investors' money to increase their liquidity. Charles Schwab, for instance, sends some retail-order flow into a dark pool owned by UBS.
The Tabb Group's Johnson explains: "So the institutions are able to take a large order and park it in the pool, then let the non-educated retail flow pass through," nibbling away at it but without being able to see the large block aching to be filled or being able to affect the price being paid for the shares.
These are just niggling concerns compared with the problems such pools might bring if they continue to scarf up market share at their current rapid pace. Something ugly could be around the bend.
"As these dark pools grow, then the public—you and I—will get less liquidity in the sense of price," says Boston University Law professor Tamar Frankel, a securities and regulation expert.
"There will come a point," she adds, "where the price on the open exchanges will not be sufficiently informative, and that will hurt everybody, even the parties that trade on these dark exchanges, because the price may no longer be representative of the true value of the shares."
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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by Kit R. Roane Jul 9 2007
In search of lower prices, less scrutiny, and fewer rules, some of the biggest securities traders are turning to private exchanges called dark pools to make their biggest deals.
Dark liquidity pools may sound like something out of science fiction, but they're real. And they're already spreading throughout Wall Street.
These pools are basically internal systems for trading stocks privately, off of public exchanges and out of the public eye. They are growing rapidly, both in number and in volume of trades.
Behind the boom in dark pools are large hedge funds and institutional clients that want to build and liquidate large stock positions at lower costs, while also being shielded from those who might profit by knowing their intentions.
An activist hedge fund, for instance, may not want to reveal that it is buying up large blocks of stock in a company it is about to attack, or a mutual fund might want to sell a large amount of stock without causing a downdraft that would hurt any shares it still holds.
But these alternative trading systems have also raised concerns as they have multiplied over the last two years. Poking fun at some of the hand-wringing over these secretive pools, the Securities and Exchange Commission's libertarian-leaning commissioner, Paul Atkins, joked recently that someone should make a horror movie about them, perhaps called The Dark Pool That Swallowed Manhattan!.
Jokes aside, major stock exchanges have some reasons to be nervous about the dark pools' proliferation. The mainstream exchanges see the pools as yet another group attempting to steal revenue-producing trades and liquidity from their markets. That's in addition to a welter of new electronic-trading platforms that offer faster execution and lower transaction costs. These platforms alone have triggered a wave of consolidation among traditional exchanges.
Exchanges are at a disadvantage as they try to compete with dark pools. The S.E.C. regulates traditional exchanges, and new rules being phased in over the next few months will require them to share information fairly and mandate that trades be routed to whichever exchange gives the best and fastest price.
Dark pools, by contrast, can largely avoid regulation if they keep their trading volumes under a set threshold. This makes them attractive to big institutional traders seeking to avoid being so transparent about their trading patterns that competitors can anticipate their actions or otherwise gain an edge.
The S.E.C., meanwhile, is worried that the fundamental lack of transparency in these pools might lead to price manipulation or other abuses.
The idea behind dark pools isn't exactly new. Brokerages have long tried to cross (or satisfy) trades internally, by matching one customer's sale with another customer's purchase. The first true dark pool is believed to be Investment Technology Group's two-decade-old Portfolio System for Institutional Trading, or Posit.
But now new technologies have combined with market changes to make these alternative, private exchanges a hotter place to invest.
The consolidation of public stock exchanges, the rise of slice-and-dice algorithmic trading, and new regulations—including order-handling rules—have had the effect of reducing liquidity, or ease of trading, in the public markets.
They have also led to a shrinkage of order size, so it has become increasingly difficult to buy or sell a large block of stock without being noticed—and thereby, often, moving the price of the underlying security.
Meanwhile, sophisticated electronic-trading systems have made buying and selling away from public markets both easier and more efficient. There are even new systems aimed at providing access to large numbers of dark pools.
For hedge funds, pension funds, and other big traders, the beauty of the system is that it can often allow these institutional investors to use the public markets to set stock prices while they buy and sell stock discreetly and at set terms in a private market.
"The public exchange is mandated to be equal and fair and open," says Jeromee Johnson, a senior analyst at Tabb Group, a firm that conducts research into and provides advice about financial markets. "The dark pools don't have to provide equal and fair access or, necessarily, a level playing field."
"And for institutions," he adds, "it can mean a better execution because they are able to protect the information about the size and type of their order and negotiate with the other counterparties."
It can also be cheaper than having a broker-dealer route the order onto the public market.
As an example, Johnson uses a simple scenario in which a relatively illiquid—that is, infrequently traded—stock has a three-cent spread between the bid and the ask price. An institution wanting to buy or sell a quarter-million shares would save several thousand dollars (the difference between the public bid and ask prices) by making the trade in a dark pool.
Of even greater importance would be the additional value of eliminating the spike in supply or demand caused by its big order, which would lead to a swing in the stock's price. "The potential value of savings on the transaction could be in the 80 or 90 percent range," Johnson says. "These are significant savings."
The hunger for anonymous block trading has caused the field to explode. There are about 40 active pools, double the number just last year. New pools and services to aggregate them are announced almost every month.
The pools control about 512 million shares per day in trades, or about 10 percent of all equity shares traded in the United States, according to data compiled by the Tabb Group.
Nearly every major Wall Street institution seems to have a system in place, from Goldman Sachs' Sigma X and Merrill Lynch's Block Alert to the consortium-owned BIDS network, whose principals include Bank of America, Bear Stearns, and Deutsche Bank.
Each system has its own character, with some allowing negotiated prices and others setting prices based on the quotes in the public markets. Some systems only allow large orders, while others will mix small orders in the trades. A few—worried about manipulation—won't let hedge funds in the door. But others welcome them because they bring liquidity.
Hedge funds were early adopters of the computer algorithms used to find and exploit price discrepancies in dark pools. These algorithms are now so important to the business that Citigroup recently developed a new one, called I.S. Shadow, just to assuage the concerns of two funds that weren't able to complete enough of the profitable trades they had found.
Backers of the pools are attracted to the game because it is lucrative. By satisfying orders internally, they not only avoid stock exchange trading fees but also get paid to make the trades.
Liquidnet, for instance, reported an average daily volume of nearly 57 million shares in the U.S. during the first quarter of 2007, a 28 percent increase from the same quarter in 2006. This seven-year-old company has become the ninth-largest broker on the New York Stock Exchange and is estimated to be worth more than $2 billion.
The Tabb Group predicts that these internal crossing networks and internal markets will continue to eat into the market share of the public exchanges, trading nearly 1.5 billion shares per day by 2010, an annual growth rate of more than 40 percent. That would equal about 15 percent of all equity shares traded in the United States.
By comparison, the N.Y.S.E.'s market share is expected to fall to 32 percent in 2010, from about 40 percent this year, while the Nasdaq is expected to lose just over six percentage points of its current market share over that period, falling to 34 percent.
Public exchanges have been fighting back with plans for their own anonymous-trading systems.
At the same time, Catherine Kinney, the N.Y.S.E.'s president, has attempted to rally opposition to dark pools. She has argued in conferences that private exchanges are already hurting investors by reducing the information that public markets use to set stock prices.
Adding insult to injury, dark pools often use retail investors' money to increase their liquidity. Charles Schwab, for instance, sends some retail-order flow into a dark pool owned by UBS.
The Tabb Group's Johnson explains: "So the institutions are able to take a large order and park it in the pool, then let the non-educated retail flow pass through," nibbling away at it but without being able to see the large block aching to be filled or being able to affect the price being paid for the shares.
These are just niggling concerns compared with the problems such pools might bring if they continue to scarf up market share at their current rapid pace. Something ugly could be around the bend.
"As these dark pools grow, then the public—you and I—will get less liquidity in the sense of price," says Boston University Law professor Tamar Frankel, a securities and regulation expert.
"There will come a point," she adds, "where the price on the open exchanges will not be sufficiently informative, and that will hurt everybody, even the parties that trade on these dark exchanges, because the price may no longer be representative of the true value of the shares."
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
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Own a Chip of Blackstone ... If You Dare
Own a Chip of Blackstone ... If You
Dare
by Kit R. Roane Jun 13 2007
Buying into Blackstone Group's I.P.O. is tempting, considering the firm's impressive track record. But is this offer the wrong approach at the wrong time?
Groucho Marx once claimed he'd never join a club that would have him as a member. Retail investors lining up to get a piece of the Blackstone Group's much-touted initial public offering might do well to follow Groucho's lead.
It's not that there's anything wrong with the Blackstone Group. As private investment firms go, it's one of the most recognized brands in the world, a behemoth with $88.4 billion in funding and a lengthy track record of handily beating others in its field as well as the stock market in general. How does a 23 percent annual return grab you, for instance? And that's going back to 1987.
But there are many reasons to be cautious about the deal that Blackstone C.E.O. Stephen Schwarzman is pitching to investors -- a deal that is now expected to come to market in two weeks. And nearly all of those reasons come back to the same question: What would Schwarzman do?
It's easy to see what he thinks is the smart side of the trade. Schwarzman's business savvy has earned him a place among the richest men in the world; his net worth is around $3.5 billion. Now he sees nothing to lose in offering retail investors a piece of the company he built with his own blood and sweat, and possibly others' tears. He's selling. And that should make investors wary.
For Blackstone, the deal is a no-brainer. It stands to gain about $4.75 billion in new and permanent funding from people who are willing to pay a high price for access to the firm's wizardry-investors who won't have much right to squawk later on if they discover that they overpaid or dislike the direction Blackstone takes.
Meanwhile, the $2.3 billion in compensation that Schwarzman and Peter Peterson, a co-founder of the firm, are receiving will probably leave Blackstone in the red "for a number of years," according to company filings released Monday.
Retail investors, on the other hand, are buying into a game that's already long in the tooth. On a macro level, private equity's "alpha," or its rate of return over that of the broader market, has been driven by access to cheap debt and by the fact that many public companies have traded at a discount compared with what they would fetch if they were private.
It has been the best of times, as Schwarzman noted in his January keynote address at the Wharton Private Equity and Venture Capital Conference. But, he added, nothing lasts forever.
"Nobody knows when or why it"—the end of easy and cheap credit—"will happen," he said. "But it's hard to imagine it can get better than it is. We're at maximum advantage, in all probability, right now."
However, these driving forces are already showing signs of fatigue. Competition from other private equity firms and hedge funds is increasingly pushing up the cost of acquisitions. (While Schwarzman may not have really wanted to pay $39 billion to beat out rivals for Equity Office Properties Trust, as he told the Wall Street Journal, "I always think about what will kill off the other bidder.")
The stock market is giving a better valuation to many possible targets, in part because of takeover fever. Long-term-bond yields have risen, which has in turn increased the cost of borrowing. And some lenders are tightening their purse strings, or at least thinking about it.
Blackstone has confined its comments to filings with the Securities and Exchange Commission, citing rules forbidding securities issuers from speaking publicly immediately before an I.P.O. "We are gagged and bound by the S.E.C. at the moment unfortunately," Blackstone spokesman John Ford said.
In those filings, Blackstone states that it believes "the long-term growth trends in our businesses are favorable" but adds that there "may be significant fluctuations in our financial results from quarter to quarter" and that investors should expect to "remain unit-holders for a number of years."
The filings notes several risks, including possible jeopardy to the tax treatment underpinning the endeavor. "Current law may change" and "the value of our common units would be adversely affected," one filing says.
Many investors will shrug all of this off. After all, Blackstone may be deft enough to continue minting money from its acquisitions. And thoughts of becoming a limited partner in the firm-owning a little piece of the same sunshine enjoyed by the wealthiest 1 percent of the world, including the Greenwich elite, Arab sheiks, and European playboys-may be too much to pass up.
Such speculators are not likely to be concerned about the fact that, with Blackstone-style leverage, they could earn similar returns by sticking with the S&P 500-or that Blackstone hasn't transmuted every deal into gold. Freescale Semiconductor, for example, has continued to struggle, even after a Blackstone-led group beat out rival firms in a $17.6 billion deal to take the manufacturer private last year.
But Blackstone unit-holders won't actually be getting the same sort of access as other groups who have bought into the firm's various funds. Instead, I.P.O. investors are buying a piece of the management fees and "carry interest," or performance fees, taken in by the firm. Nor will they be getting the transparency they might find in other I.P.O.'s
"What is it that the investors are really investing in? To a certain extent, I don't think even Blackstone knows," says Steve Howard, a lawyer with Thacher Proffitt & Wood who has worked on similar offerings. "It is a bit of a moving target."
Not that investors would have much choice if they didn't like the assets Blackstone buys or didn't approve of the managers' job performance. That's because such investors won't be shareholders; they will be unit-holders in a partnership, with the right to little more than a percentage of the take.
Furthermore, that income stream is already under threat. The Blackstone I.P.O. benefits from an unusual tax break that depends on the I.R.S.'s believing that the majority of income generated comes from passive investments. If this requirement is met, the I.R.S. considers the enterprise a partnership, thereby qualifying it to be taxed at less than half the corporate rate. But some in Congress worry that the tax dodge isn't kosher.
If Congress amends the rules, says University of Colorado law professor Victor Fleischer, an expert in such tax issues, the investors will be the ones who bear the brunt.
Kit R. Roane has written for U.S. News & World Report and the New York Times, among other publications.
Portfolio.com © 2008 Condé Nast Inc. All rights reserved. Use of this site constitutes acceptance of our User Agreement and Privacy Policy.
Advertisement
by Kit R. Roane Jun 13 2007
Buying into Blackstone Group's I.P.O. is tempting, considering the firm's impressive track record. But is this offer the wrong approach at the wrong time?
Groucho Marx once claimed he'd never join a club that would have him as a member. Retail investors lining up to get a piece of the Blackstone Group's much-touted initial public offering might do well to follow Groucho's lead.
It's not that there's anything wrong with the Blackstone Group. As private investment firms go, it's one of the most recognized brands in the world, a behemoth with $88.4 billion in funding and a lengthy track record of handily beating others in its field as well as the stock market in general. How does a 23 percent annual return grab you, for instance? And that's going back to 1987.
But there are many reasons to be cautious about the deal that Blackstone C.E.O. Stephen Schwarzman is pitching to investors -- a deal that is now expected to come to market in two weeks. And nearly all of those reasons come back to the same question: What would Schwarzman do?
It's easy to see what he thinks is the smart side of the trade. Schwarzman's business savvy has earned him a place among the richest men in the world; his net worth is around $3.5 billion. Now he sees nothing to lose in offering retail investors a piece of the company he built with his own blood and sweat, and possibly others' tears. He's selling. And that should make investors wary.
For Blackstone, the deal is a no-brainer. It stands to gain about $4.75 billion in new and permanent funding from people who are willing to pay a high price for access to the firm's wizardry-investors who won't have much right to squawk later on if they discover that they overpaid or dislike the direction Blackstone takes.
Meanwhile, the $2.3 billion in compensation that Schwarzman and Peter Peterson, a co-founder of the firm, are receiving will probably leave Blackstone in the red "for a number of years," according to company filings released Monday.
Retail investors, on the other hand, are buying into a game that's already long in the tooth. On a macro level, private equity's "alpha," or its rate of return over that of the broader market, has been driven by access to cheap debt and by the fact that many public companies have traded at a discount compared with what they would fetch if they were private.
It has been the best of times, as Schwarzman noted in his January keynote address at the Wharton Private Equity and Venture Capital Conference. But, he added, nothing lasts forever.
"Nobody knows when or why it"—the end of easy and cheap credit—"will happen," he said. "But it's hard to imagine it can get better than it is. We're at maximum advantage, in all probability, right now."
However, these driving forces are already showing signs of fatigue. Competition from other private equity firms and hedge funds is increasingly pushing up the cost of acquisitions. (While Schwarzman may not have really wanted to pay $39 billion to beat out rivals for Equity Office Properties Trust, as he told the Wall Street Journal, "I always think about what will kill off the other bidder.")
The stock market is giving a better valuation to many possible targets, in part because of takeover fever. Long-term-bond yields have risen, which has in turn increased the cost of borrowing. And some lenders are tightening their purse strings, or at least thinking about it.
Blackstone has confined its comments to filings with the Securities and Exchange Commission, citing rules forbidding securities issuers from speaking publicly immediately before an I.P.O. "We are gagged and bound by the S.E.C. at the moment unfortunately," Blackstone spokesman John Ford said.
In those filings, Blackstone states that it believes "the long-term growth trends in our businesses are favorable" but adds that there "may be significant fluctuations in our financial results from quarter to quarter" and that investors should expect to "remain unit-holders for a number of years."
The filings notes several risks, including possible jeopardy to the tax treatment underpinning the endeavor. "Current law may change" and "the value of our common units would be adversely affected," one filing says.
Many investors will shrug all of this off. After all, Blackstone may be deft enough to continue minting money from its acquisitions. And thoughts of becoming a limited partner in the firm-owning a little piece of the same sunshine enjoyed by the wealthiest 1 percent of the world, including the Greenwich elite, Arab sheiks, and European playboys-may be too much to pass up.
Such speculators are not likely to be concerned about the fact that, with Blackstone-style leverage, they could earn similar returns by sticking with the S&P 500-or that Blackstone hasn't transmuted every deal into gold. Freescale Semiconductor, for example, has continued to struggle, even after a Blackstone-led group beat out rival firms in a $17.6 billion deal to take the manufacturer private last year.
But Blackstone unit-holders won't actually be getting the same sort of access as other groups who have bought into the firm's various funds. Instead, I.P.O. investors are buying a piece of the management fees and "carry interest," or performance fees, taken in by the firm. Nor will they be getting the transparency they might find in other I.P.O.'s
"What is it that the investors are really investing in? To a certain extent, I don't think even Blackstone knows," says Steve Howard, a lawyer with Thacher Proffitt & Wood who has worked on similar offerings. "It is a bit of a moving target."
Not that investors would have much choice if they didn't like the assets Blackstone buys or didn't approve of the managers' job performance. That's because such investors won't be shareholders; they will be unit-holders in a partnership, with the right to little more than a percentage of the take.
Furthermore, that income stream is already under threat. The Blackstone I.P.O. benefits from an unusual tax break that depends on the I.R.S.'s believing that the majority of income generated comes from passive investments. If this requirement is met, the I.R.S. considers the enterprise a partnership, thereby qualifying it to be taxed at less than half the corporate rate. But some in Congress worry that the tax dodge isn't kosher.
If Congress amends the rules, says University of Colorado law professor Victor Fleischer, an expert in such tax issues, the investors will be the ones who bear the brunt.
Kit R. Roane has written for U.S. News & World Report and the New York Times, among other publications.
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Confounding His Critics
Confounding His Critics
GOP stalwart Cox sidesteps partisan labels as he settles in as the country's chief financial watchdog
By Kit R. Roane
Posted 4/15/07
As the nation's top financial regulator, Christopher Cox frequently describes a framed check for $3.36 that he keeps in his office. The check is made out to his grandfather and represents the tiny recovery the elderly man received from Insull Utility Investments Inc. after it went belly up during the Great Depression. In speeches, Cox has called Samuel Insull "the Ken Lay of his day," adding that the check serves to remind him that, as head of the Securities and Exchange Commission, he is "standing up for the little guy."
Christopher Cox (right) and Fed Chairman Ben Bernanke testify on Capitol Hill.
ALEX WONG-GETTY IMAGES
But the Insull case is not the only one that has shaped his view of shareholder rights. As an Orange County, Calif., congressman, Cox was once-and he would say unfairly-the subject of a shareholder class-action lawsuit. He went on to push for laws limiting the ability of shareholders to sue, calling the status quo "a legal torture chamber." And Cox says that his views on the subject have not changed one iota since becoming chairman of the SEC.
"The problem of litigation taking too long and costing too much is with us today, even more than it afflicted Dickens's time," he complains, adding that the lawsuit at the heart of Charles Dickens's Bleak House "wended on for generations."
To his critics, such statements are proof that Cox is the proverbial fox in the henhouse, a pro-business lackey intent on dismantling shareholder protections at every turn. But nearly two years after leaving Congress to take the helm of the SEC, Cox has deftly defied attempts to paint him into this corner.
Cox, 52, is steeped in Republican politics, having worked for the Reagan White House before California voters elected him to Congress in 1988 on a free-enterprise platform. Looking back, he expresses no regrets about his votes: "I still strongly believe in economic growth through lower taxes and a whole lot of things I don't have anything to do with as commissioner."
However, while a strong believer in the Republican agenda, he has publicly kept his distance from Bush administration complaints that American markets are suffering from burdensome overregulation. Cox has allowed senior SEC officials to publicly disagree with these claims and has done so himself. America is not overregulated, he says; it merely needs to "keep pace with change."
Cox's diplomatic approach since becoming the SEC chairman is in marked contrast to the reign of his predecessor, William Donaldson, who fought with the commission's two Republican members. Cox has instead sought common ground. "The temptation in Washington is to put politics first," he says. "But ... [when we are] in charge of protecting American investors, we have a responsibility to keep partisanship out."
Some critics give the SEC chairman high marks. Barney Frank, the Democratic head of the House Financial Services Committee who has tangled with Cox, says, "I'd like things to go further, but Cox has generally been helpful in his decisions. He has shown that he understands the difference between being a legislative adviser and a law enforcement officer."
Watchdog. At a time when some business interests have drastically increased the pressure to roll back regulation, Cox has pushed for new ones or tried to strengthen existing regulations. He says he is proud that he was able to force greater disclosure of executive pay. Also, in the face of intense lobbying, Cox instituted a rule requiring brokers to fill orders based on the fastest trade at the best price regardless of which exchange offers it. And Cox has continued to seek a Donaldson-era proposal that would require the chairman and the majority of the board of directors at mutual funds to be independent. "My job is to keep us focused on the facts and our legal authority," says Cox.
Robert Glauber, the former chief of the NASD, a private-sector securities regulator, says Cox's political acumen has served him well, both in wrangling consensus among the other SEC commissioners and in selling his policies to the public. "I think he's shown himself to be more balanced than people on either extreme expected," says Glauber. "I think he has been very effective so far."
Cox has had a more difficult time recently. Last spring, the chairman was battered by questions about the SEC's willingness to go after all corporate wrongdoers. And the SEC's handling of a probe into trading by the hedge fund Pequot Capital raised questions of whether political considerations were affecting investigations. The investigator in charge of the probe was fired after he insisted on interviewing Morgan Stanley CEO John Mack, an important Bush fundraiser. Republican Sen. Chuck Grassley, who conducted hearings into the matter, says that the case shows "there's good reason to question whether the SEC enforcement division treats all investors equally."
Last month, the SEC's chief accountant, Conrad Hewitt, urged the capping of legal damage awards against accounting firms that fail to uncover fraud in corporate audits. Cox has distanced himself from Hewitt's remarks. But he has defended the SEC's calls for courts to use a stricter standard in deciding whether shareholders can sue companies for fraud, saying it protects shareholders from "unscrupulous lawyers" bringing frivolous cases.
His stridency on this issue has raised new questions about his agenda. "If I remember my history correctly, the SEC was not established for the purpose" of limiting shareholder litigation, says Boston University law Prof. Tamar Frankel, an expert on financial regulation.
Reforms. One reason shareholder lawsuits skyrocketed early in the decade, of course, was the avalanche of fraud that occurred in cases such as Enron, Tyco, WorldCom, and Adelphia Communications. Prosecution of these cases brought about the sweeping antifraud provisions known as the Sarbanes-Oxley Act of 2002, a law now under broad attack.
Such litigation has decreased substantially, says Columbia Law School Prof. Harvey Goldschmid, who was an SEC commissioner from 2002 to 2005: "There are a lot more important things to do" than offering new protections to accounting firms or "setting up high hurdles in plaintiffs' lawsuits, in a world where there are already high hurdles."
The SEC chairman's involvement in the litigation issue raises hackles because of his personal history. In 1995, Cox was named in shareholder lawsuits against First Pension Corp. He had worked as a lawyer for the company as it sought to securitize mortgages for sale to investors. In one letter to the California Department of Corporations, the state's top regulator, Cox noted that the trust deeds were "relatively low risk" and "not only fair but advantageous to purchasers." The company later went bankrupt, and its founder, William E. Cooper, was convicted of defrauding investors of $130 million. Cox says he had no inkling of Cooper's criminal dealings.
Cox's concerns about America's litigious tendencies are probably about to take a back seat. Bigger worries are on the front burner. Overseas markets have grown rapidly over the past few decades, increasing Americans' appetite to invest in them. At the same time, the markets are consolidating, including the New York Stock Exchange's merger with Euronext. Foreign brokerages may start pitching directly to American investors.
All of this means Americans may soon have much greater opportunities to invest, and to invest more cheaply, but possibly at the cost of U.S. regulatory protections. Just how the SEC deals with this internationalization of markets will be the greatest test of Cox's approach to regulation. These are relatively uncharted waters, says Frankel, noting that the SEC must "establish when it can trust the market to self-regulate and where it should intervene to maintain market integrity and efficiency." She adds that "the line is never clear, especially when there are so many market changes."
Cox knows this is true. "There is no question where the market is headed. But securities regulations in the 21st century have to be sturdy enough to protect American investors and our markets, in the midst of truly international forces," he says. "Maintaining America's high standards in this era of global securities markets is one of our greatest challenges."
Born: Oct. 16, 1952
Family: Married, with three children
Education: B.A., University of Southern California; M.B.A. and J.D., Harvard
Public Service: Senior associate White House counsel, 1986-88; Republican congressman, 1988-2005; SEC chairman, 2005-present
This story appears in the April 23, 2007 print edition of U.S. News & World Report.
GOP stalwart Cox sidesteps partisan labels as he settles in as the country's chief financial watchdog
By Kit R. Roane
Posted 4/15/07
As the nation's top financial regulator, Christopher Cox frequently describes a framed check for $3.36 that he keeps in his office. The check is made out to his grandfather and represents the tiny recovery the elderly man received from Insull Utility Investments Inc. after it went belly up during the Great Depression. In speeches, Cox has called Samuel Insull "the Ken Lay of his day," adding that the check serves to remind him that, as head of the Securities and Exchange Commission, he is "standing up for the little guy."
Christopher Cox (right) and Fed Chairman Ben Bernanke testify on Capitol Hill.
ALEX WONG-GETTY IMAGES
But the Insull case is not the only one that has shaped his view of shareholder rights. As an Orange County, Calif., congressman, Cox was once-and he would say unfairly-the subject of a shareholder class-action lawsuit. He went on to push for laws limiting the ability of shareholders to sue, calling the status quo "a legal torture chamber." And Cox says that his views on the subject have not changed one iota since becoming chairman of the SEC.
"The problem of litigation taking too long and costing too much is with us today, even more than it afflicted Dickens's time," he complains, adding that the lawsuit at the heart of Charles Dickens's Bleak House "wended on for generations."
To his critics, such statements are proof that Cox is the proverbial fox in the henhouse, a pro-business lackey intent on dismantling shareholder protections at every turn. But nearly two years after leaving Congress to take the helm of the SEC, Cox has deftly defied attempts to paint him into this corner.
Cox, 52, is steeped in Republican politics, having worked for the Reagan White House before California voters elected him to Congress in 1988 on a free-enterprise platform. Looking back, he expresses no regrets about his votes: "I still strongly believe in economic growth through lower taxes and a whole lot of things I don't have anything to do with as commissioner."
However, while a strong believer in the Republican agenda, he has publicly kept his distance from Bush administration complaints that American markets are suffering from burdensome overregulation. Cox has allowed senior SEC officials to publicly disagree with these claims and has done so himself. America is not overregulated, he says; it merely needs to "keep pace with change."
Cox's diplomatic approach since becoming the SEC chairman is in marked contrast to the reign of his predecessor, William Donaldson, who fought with the commission's two Republican members. Cox has instead sought common ground. "The temptation in Washington is to put politics first," he says. "But ... [when we are] in charge of protecting American investors, we have a responsibility to keep partisanship out."
Some critics give the SEC chairman high marks. Barney Frank, the Democratic head of the House Financial Services Committee who has tangled with Cox, says, "I'd like things to go further, but Cox has generally been helpful in his decisions. He has shown that he understands the difference between being a legislative adviser and a law enforcement officer."
Watchdog. At a time when some business interests have drastically increased the pressure to roll back regulation, Cox has pushed for new ones or tried to strengthen existing regulations. He says he is proud that he was able to force greater disclosure of executive pay. Also, in the face of intense lobbying, Cox instituted a rule requiring brokers to fill orders based on the fastest trade at the best price regardless of which exchange offers it. And Cox has continued to seek a Donaldson-era proposal that would require the chairman and the majority of the board of directors at mutual funds to be independent. "My job is to keep us focused on the facts and our legal authority," says Cox.
Robert Glauber, the former chief of the NASD, a private-sector securities regulator, says Cox's political acumen has served him well, both in wrangling consensus among the other SEC commissioners and in selling his policies to the public. "I think he's shown himself to be more balanced than people on either extreme expected," says Glauber. "I think he has been very effective so far."
Cox has had a more difficult time recently. Last spring, the chairman was battered by questions about the SEC's willingness to go after all corporate wrongdoers. And the SEC's handling of a probe into trading by the hedge fund Pequot Capital raised questions of whether political considerations were affecting investigations. The investigator in charge of the probe was fired after he insisted on interviewing Morgan Stanley CEO John Mack, an important Bush fundraiser. Republican Sen. Chuck Grassley, who conducted hearings into the matter, says that the case shows "there's good reason to question whether the SEC enforcement division treats all investors equally."
Last month, the SEC's chief accountant, Conrad Hewitt, urged the capping of legal damage awards against accounting firms that fail to uncover fraud in corporate audits. Cox has distanced himself from Hewitt's remarks. But he has defended the SEC's calls for courts to use a stricter standard in deciding whether shareholders can sue companies for fraud, saying it protects shareholders from "unscrupulous lawyers" bringing frivolous cases.
His stridency on this issue has raised new questions about his agenda. "If I remember my history correctly, the SEC was not established for the purpose" of limiting shareholder litigation, says Boston University law Prof. Tamar Frankel, an expert on financial regulation.
Reforms. One reason shareholder lawsuits skyrocketed early in the decade, of course, was the avalanche of fraud that occurred in cases such as Enron, Tyco, WorldCom, and Adelphia Communications. Prosecution of these cases brought about the sweeping antifraud provisions known as the Sarbanes-Oxley Act of 2002, a law now under broad attack.
Such litigation has decreased substantially, says Columbia Law School Prof. Harvey Goldschmid, who was an SEC commissioner from 2002 to 2005: "There are a lot more important things to do" than offering new protections to accounting firms or "setting up high hurdles in plaintiffs' lawsuits, in a world where there are already high hurdles."
The SEC chairman's involvement in the litigation issue raises hackles because of his personal history. In 1995, Cox was named in shareholder lawsuits against First Pension Corp. He had worked as a lawyer for the company as it sought to securitize mortgages for sale to investors. In one letter to the California Department of Corporations, the state's top regulator, Cox noted that the trust deeds were "relatively low risk" and "not only fair but advantageous to purchasers." The company later went bankrupt, and its founder, William E. Cooper, was convicted of defrauding investors of $130 million. Cox says he had no inkling of Cooper's criminal dealings.
Cox's concerns about America's litigious tendencies are probably about to take a back seat. Bigger worries are on the front burner. Overseas markets have grown rapidly over the past few decades, increasing Americans' appetite to invest in them. At the same time, the markets are consolidating, including the New York Stock Exchange's merger with Euronext. Foreign brokerages may start pitching directly to American investors.
All of this means Americans may soon have much greater opportunities to invest, and to invest more cheaply, but possibly at the cost of U.S. regulatory protections. Just how the SEC deals with this internationalization of markets will be the greatest test of Cox's approach to regulation. These are relatively uncharted waters, says Frankel, noting that the SEC must "establish when it can trust the market to self-regulate and where it should intervene to maintain market integrity and efficiency." She adds that "the line is never clear, especially when there are so many market changes."
Cox knows this is true. "There is no question where the market is headed. But securities regulations in the 21st century have to be sturdy enough to protect American investors and our markets, in the midst of truly international forces," he says. "Maintaining America's high standards in this era of global securities markets is one of our greatest challenges."
Born: Oct. 16, 1952
Family: Married, with three children
Education: B.A., University of Southern California; M.B.A. and J.D., Harvard
Public Service: Senior associate White House counsel, 1986-88; Republican congressman, 1988-2005; SEC chairman, 2005-present
This story appears in the April 23, 2007 print edition of U.S. News & World Report.
The New Face of Capitalism
The New Face of Capitalism
Private buyers are gobbling up some of the premier names in corporate America
By Kit R. Roane
Posted 11/26/06
Time was, America's largest corporations would fight tooth and nail (and with poison pills) to remain public companies. No longer. Now many of the world's biggest and best-known brands clamor to be taken private by investors they once shunned. A parade of marquee names have sold out-Clear Channel Communications, Cablevision, Reader's Digest, Dunkin' Donuts, SunGard Data Systems, Freescale Semiconductor, Toys "R" Us, Neiman Marcus, Metro-Goldwyn-Mayer, and hospital giant HCA, to note just a few. And the deal making shows no sign of abating anytime soon, as the private Blackstone Group announced plans last week to buy Equity Office Properties Trust, the nation's largest owner of office buildings, in a record-breaking deal.
It is a significant turn not just in corporate thinking but in the way the private-equity buyers are viewed. They have never been so loved. What a difference a couple of decades can make. Nearly 20 years after Kohlberg Kravis Roberts's $30.6 billion hostile takeover of RJR Nabisco left private-equity firms tagged as the "barbarians at the gate" and their partners vilified by Hollywood's Gordon "Greed is good" Gekko, these firms have mainly shed the perception they are corporate raiders pillaging for profit. These days, private-equity firms like KKR and the Blackstone and Carlyle groups aren't feared so much as revered-as deep-pocketed saviors willing to pay a premium to take over companies feeling neglected and misunderstood by Wall Street or overburdened by securities regulations.
Gone are the days when other publicly traded companies, known as strategic buyers, were the usual buyout suitors. Private-equity firms now surface as the chief bidders in most deals, say investment bankers and others involved in the buyout business. And new funds pop up every week focused on industry niches such as aftermarket auto parts or specializing in geographic areas like Idaho or Montana.
This year, there have been more than 2,282 private-equity buyouts worldwide with a combined value of $601.3 billion, up from only 885 deals valued at $71.4 billion in 2001, according to researchers at Dealogic.
Dark side. But as the number and size of the private-equity deals have soared, uncomfortable questions have again been raised about whether the hot leveraged-buyout market they are fueling may end up leaving some companies and shareholders burned. Federal prosecutors are probing charges of collusion among various private groups. The Securities and Exchange Commission is looking into allegations of insider trading and multimillion-dollar fraud.
Shareholders have filed lawsuits to stop some deals, such as the recently successful buyout of hospital chain HCA, complaining they are being shortchanged. Stunningly large dividend payouts to private-equity buyers from companies such as Hertz have sometimes made the firms seem greedy. And overseas, where many of the best deals are to be had, private-equity partners have been called "locusts" and threatened with arrest.
For much of their history, private-equity firms existed in a quiet corner of the financial world, content with buying, building, and operating promising companies. Many still do just that. But what made them household names in the 1980s was the increased use of leveraged buyouts, where the groups added huge borrowings to their own cash, mainly because of debt-friendly laws that shield profits from the tax man.
The earlier buyout wave revealed the potential downside of piling debt on companies-the turning of beloved brands like Federated Department Stores into bankrupt shells that had to struggle mightily to come back, giving private-equity firms a black eye for the immense sums they took out of such deals.
These days, private-equity firms have largely changed their stripes, taking on less debt and often concentrating more on building up companies rather than cutting them to the bone. But problems do remain. And private-equity firms are painfully aware of the damage bad publicity can do to their positive new image. Fear of being lumped in with hedge funds-whose own practices have drawn sharp attention from regulators-is one reason that Carlyle, Blackstone, KKR, and Texas Pacific Group are moving to form the Private Equity Council, the industry's first concerted attempt to educate the public and lobby the government. Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business, says the firms are setting up the council "largely because of the potential backlash they could get around the world because of their expanded activities."
The private-equity buyouts are fueled by several factors. The shares of many public companies, after wringing out the excesses of the late 1990s, are now trading at cheap prices compared with their underlying assets and revenue streams. The Sarbanes-Oxley Act, passed in 2002 as the antidote to a wave of corporate accounting scandals, makes it more difficult and expensive for smaller firms to go public and for already public firms to stay listed. And private-equity firms have found plentiful and cheap debt to leverage their own considerable treasuries, money hoards that continue to attract almost unprecedented amounts of capital from pension funds, university endowments, and wealthy investors seeking greater returns than found in the global stock markets. "When you are looking for historically high rates of return, where else do you go?" asks Dennis Block, a partner with the law firm Cadwalader, Wickersham & Taft who helped shepherd KKR's bid for RJR Nabisco. In recent years, even union pension funds-whose members can be on the other end of the stick when private interests take over and downsize some of these companies-have invested.
Although returns vary greatly, the best and the brightest private-equity firms often provide returns to their investors of 25 percent a year, experts say. Data from Thomson Financial and the National Venture Capital Association, an industry group, show that U.S. leveraged-buyout funds have averaged at least 13 percent annual returns over the past 20 years, and the California Public Employees' Retirement System recently reported cumulative returns of up to 133 percent over the past six years from one of its private-equity-fund investments.
"There has been an explosion in not just the number of funds but also the dollar value of the capital that they are raising," says Jeanne Montague of Montague Partners, a small San Francisco-based investment bank. "I can remember when the first announcement of a $1 billion fund set the market stirring. Now Blackstone has raised $15 billion in one fund. The numbers are becoming almost difficult to comprehend."
Clubby. The funds are likely to keep getting bigger. In fact, Blackstone recently announced that it would bring its $15 billion fund up to $20 billion. Other large private-equity firms are building similar war chests. At the same time, they are often combining forces in "club deals." These accounted for $414 billion in buyouts over the past 12 months, according to Thomson Financial. This is roughly a 10-fold increase from the same period five years ago. Home-improvement behemoth Home Depot, whose shares are worth some $79 billion, and computer maker Dell, at around $56 billion, have both been bandied about as possible targets, if some of the biggest private-equity firms combined forces.
"If I represent a seller and I go to 40 buyers, half will be private-equity firms now," says Montague. "Ten years ago, there'd be maybe two."
But the amount of money chasing deals has bidden up prices and thereby crimped returns for some private-equity funds. There's an "illogical" element to parts of the market, complains Mark Jrolf of Heritage Partners, a Boston-based private-equity firm. He notes that some investor groups are paying well beyond what strategic, public-company buyers would in some takeovers, and "that doesn't make sense."
Attempting to avoid this competition, private-equity firms have increasingly looked both farther afield and farther up the food chain for their next deal. But in doing so, their activities have drawn the scrutiny of shareholders and regulators, and not just in the United States.
The Bank of England signaled its concern recently by calling the voracious appetite for leveraged takeovers one of the six greatest threats to the financial system, while the country's Financial Services Authority, Britain's version of the SEC, said this month that it is monitoring private-equity firms for insider trading and conflicts of interest. The FSA warned that the collapse of a large private-equity firm was likely, given the number of deals such firms were making and their high levels of debt.
Politicians have also weighed in. In Germany, a prominent lawmaker recently compared private-equity firms snapping up companies there to "locusts." And in South Korea, where the buyout firms are called the moktui, or "eat and run," trouble abounds. One lawmaker there has said that private-equity firms' interest in "short-term profits could lead to the drain of national wealth."
Private-equity players aren't always helping defuse the situation. The subject of the lawmaker's ire, Dallas-based Lone Star Funds, recently admitted that it broke South Korean tax laws when the firm's former head in the country embezzled $12 million. Now prosecutors are delving through Lone Star's Korea Exchange Bank deal looking for, among other things, evidence that the private-equity firm might have intentionally driven down the bank's share prices in 2003 before making its bid. Prosecutors are seeking the arrest and extradition of several members of the firm, including Lone Star Funds cofounder Ellis Short.
In the United States, the Justice Department's antitrust division sent out letters last month to several of the largest buyout firms requesting information on all their deals in the past five years. "There is no smoking gun that one can point to here," cautions Andrew Metrick, a finance professor at the University of Pennsylvania's Wharton School. "The values being paid are higher than that offered by the public market, and the directors don't have to sell."
More bad publicity for private-equity firms could come courtesy of the SEC,which has begun looking into whether people associated with or informed about some buyouts may have profited from trading on insider information before the deals were announced. SEC Chairman Christopher Cox said last month that his investigators were examining a host of suspicious trades.
A partner at one large firm has already fallen. Justin Huscher, a cofounder of Chicago-based Madison Dearborn, paid more than $116,000 in SEC fines this year to settle charges that he illegally profited by buying stock in Unisource Energy Corp. after learning that a private-equity club deal for the corporation was about to be announced.
There is also growing worry about fraud. The SEC recently charged Chicago-based AA Capital Partners with misappropriating more than $10.7 million in client funds. The firm, spun off from the Dutch financial powerhouse ABN Amro NV in 2001, was headed by John Orecchio, who had once helped run a $5 billion private-equity fund for Bank of America. Investigators allege some investor funds were used to spruce up Orecchio's horse farm, while others were funneled into a strip club.
Richer bids. Shareholders are also squawking about the prices offered in several deals, complaining that they have been shortchanged by an unholy alliance between management and the private-equity firms being favored. In several recent cases, shareholders have found that company management, smitten with deals that would leave them in charge, disregarded higher bids or took measures to dissuade them. Shareholders of the Tennessee-based regional retailer Goody's Family Clothing balked last year when management proposed a leveraged buyout. A later lawsuit revealed that the private-equity firm chosen was not the highest bidder. When the process was finally opened up, a three-way bidding war added 20 percent to the $327 million price tag.
Arthur Abbey, whose law firm, Abbey Spanier Rodd Abrams & Paradis, represented several of the shareholders, says that the higher bid proved that "both the price and the process was unfair." Saying management-led buyouts are "replete with conflicts," Abbey adds: "My view is that the only independent review these deals ever get is in a lawsuit by shareholders themselves."
Private-equity partners argue that they can't be accused of taking advantage of shareholders when they generally pay a high premium over a company's market value. And many of these lawsuits are being filed not by the individual investor but by hedge funds and other market sophisticates, they add. "These stocks are not being held by orphans and widows anymore," says one private-equity partner, who asked to remain anonymous. "These are the same type of 'deal people' looking out the windows in that skyscraper across from me."
Sometimes price shouldn't be the key factor for a company in choosing a suitor, say leveraged-buyout experts, adding that different buyout groups have expertise in certain areas and some will be more willing to take a long-term approach in turning companies around. Stewart Kohl, the co-CEO of the Riverside Co., says his firm tends to take relatively small companies, reinvest in them, and build them over the course of many years, often by combining them with other complementary acquisitions.
In 2000, Riverside took control of a small manufacturer of trailer jack stands and couplers named HammerBlow. The company was a leader in its field, but the owner had died, and his estate wanted to sell. Kohl liked the company's management and inexpensive manufacturing process. While working to expand the company's operation and reduce its costs, he bought other companies in the towing and trailer-hitch market and combined them under the HammerBlow brand. In about two years, he had tripled the company's revenues to $108 million. In 2003, he sold the company for $143 million to a competitor, TriMas, also owned by private-equity interests.
"This isn't drive-by investing or financial engineering," says Kohl. "This is value created through a lot of heavy lifting. We don't just get our hands dirty-we get our whole bodies filthy working to build the companies."
A recent study by economists Jerry Cao of Boston College and Josh Lerner of Harvard Business School counters the perception that private-equity firms are flip artists. Their examination of 496 companies taken public by private-equity firms between 1980 and 2002 found that the share prices of these companies tended to outperform those of both other initial public offerings and the general market. Companies held privately for more than a year did best of all when released into the public markets again.
But the barbarians-at-the-gate perception is grounded in some fact. Standard & Poor's recently found that private-equity firms had loaded their acquisitions with more than $25 billion in debt over the past year just to fund dividends for themselves. Exceedingly rare at the beginning of the decade, these payouts have become commonplace. Sometimes the buyout firms (the general partners) take their profits even before their investors-pension funds, endowments, and other limited partners-have recouped their investment.
In the case of Hertz Global Holdings, a private-equity consortium led by the Carlyle Group paid itself a $1 billion dividend less than six months after putting up $2.3 billion to buy the company from Ford Motor Co. in 2005 for a total of $15 billion, including assumed debt. The firms took Hertz public again last week.
The deal has gained the attention of the Justice Department. But bond watchers are also worried. Citing this case, S&P argued that such equity extractions, known as dividend recapitalizations, greatly increase a company's chance of defaulting on its debt, while also leaving the private-equity partners less concerned about fixing underlying troubles.
This may be a worrisome trend because a sluggish IPO market has made it less likely that many of these deals can be spun out to investors as IPOs after a year or so. "It is not a wonderful time for private equity in some ways because their ultimate exit strategy is to go public, and you don't have a nicely behaved equity market right now," says Satya Pradhuman, Merrill Lynch's chief small-company strategist, who tracks leveraged buyouts.
Instead, some targets of leveraged buyouts find themselves sold repeatedly from one private-equity firm to another, with each deal often leading to a dividend recapitalization that yanks cash from the company's balance sheet. For some private-equity firms, the dividend recap has become the exit strategy.
Many investors did stay away from the Hertz IPO. The company went public November 16 at a lower price than was expected and then barely budged off its $15 offering price. But it was still a sweet deal for Carlyle and the other private-equity firms involved. They are expected to have doubled their money after having owned Hertz less than a year.
Party poopers. So, what will spoil the private-equity party? If returns begin to suffer because of competition, unhappy investors could slow their stampede into the funds. Hints of other frauds could have the same effect.
But the real bogey is the debt markets, because borrowing underpins private-equity firms' ability to make many deals. Any sudden upward move in interest rates could inflict serious pain in the buyout world. Right now, lenders, competing heavily to be part of deals, are giving easy payment and loan terms that could help forestall any default of a company owned by private equity if it got into financial distress. But these lenders are also allowing private-equity firms to take on buyout loans that represent ever-higher multiples of earnings.
Some buyouts are also adding newer and more risky types of debt to the mix, as they offer up more and more of a company's assets and earnings to secure it. Second-lien loans and "payment in kind" notes, which have yet to be tested in a severe economic downturn, have become popular. The notes pay extremely high rates but usually don't begin payments for several years and are likely to become worthless in any bankruptcy.
A few private-equity-owned companies have already had trouble, and some have filed for bankruptcy protection. Concern about the increased risks being taken in new deals is becoming increasingly palpable in bond and derivative markets. For instance, when Anheuser-Busch was rumored to be a private-equity target, the cost of buying credit protection on its bonds rose drastically.
A shakeout is coming, experts say. It is just a question of when. Many banks, law firms, hedge funds, and private-equity groups are already bolstering the ranks of their distressed-debt units and are gathering bankruptcy specialists for just such an occasion. Private-equity player Wilbur Ross, known for his astute nose in picking up distressed companies on the cheap, says it won't be long. Too much money is being paid to take on too much risk with too much debt, Ross warns, adding that bets by some highly leveraged buyout firms that they will be able to cheaply refinance their deals in a few years have "been building in a time bomb." In this scenario, higher default rates aren't just likely, he concludes; "they are quite inevitable."
If Ross is right, many private-equity firms and the companies they take over may find the 1980s have cast a longer shadow than any would have hoped.
This story appears in the December 4, 2006 print edition of U.S. News & World Report.
Private buyers are gobbling up some of the premier names in corporate America
By Kit R. Roane
Posted 11/26/06
Time was, America's largest corporations would fight tooth and nail (and with poison pills) to remain public companies. No longer. Now many of the world's biggest and best-known brands clamor to be taken private by investors they once shunned. A parade of marquee names have sold out-Clear Channel Communications, Cablevision, Reader's Digest, Dunkin' Donuts, SunGard Data Systems, Freescale Semiconductor, Toys "R" Us, Neiman Marcus, Metro-Goldwyn-Mayer, and hospital giant HCA, to note just a few. And the deal making shows no sign of abating anytime soon, as the private Blackstone Group announced plans last week to buy Equity Office Properties Trust, the nation's largest owner of office buildings, in a record-breaking deal.
It is a significant turn not just in corporate thinking but in the way the private-equity buyers are viewed. They have never been so loved. What a difference a couple of decades can make. Nearly 20 years after Kohlberg Kravis Roberts's $30.6 billion hostile takeover of RJR Nabisco left private-equity firms tagged as the "barbarians at the gate" and their partners vilified by Hollywood's Gordon "Greed is good" Gekko, these firms have mainly shed the perception they are corporate raiders pillaging for profit. These days, private-equity firms like KKR and the Blackstone and Carlyle groups aren't feared so much as revered-as deep-pocketed saviors willing to pay a premium to take over companies feeling neglected and misunderstood by Wall Street or overburdened by securities regulations.
Gone are the days when other publicly traded companies, known as strategic buyers, were the usual buyout suitors. Private-equity firms now surface as the chief bidders in most deals, say investment bankers and others involved in the buyout business. And new funds pop up every week focused on industry niches such as aftermarket auto parts or specializing in geographic areas like Idaho or Montana.
This year, there have been more than 2,282 private-equity buyouts worldwide with a combined value of $601.3 billion, up from only 885 deals valued at $71.4 billion in 2001, according to researchers at Dealogic.
Dark side. But as the number and size of the private-equity deals have soared, uncomfortable questions have again been raised about whether the hot leveraged-buyout market they are fueling may end up leaving some companies and shareholders burned. Federal prosecutors are probing charges of collusion among various private groups. The Securities and Exchange Commission is looking into allegations of insider trading and multimillion-dollar fraud.
Shareholders have filed lawsuits to stop some deals, such as the recently successful buyout of hospital chain HCA, complaining they are being shortchanged. Stunningly large dividend payouts to private-equity buyers from companies such as Hertz have sometimes made the firms seem greedy. And overseas, where many of the best deals are to be had, private-equity partners have been called "locusts" and threatened with arrest.
For much of their history, private-equity firms existed in a quiet corner of the financial world, content with buying, building, and operating promising companies. Many still do just that. But what made them household names in the 1980s was the increased use of leveraged buyouts, where the groups added huge borrowings to their own cash, mainly because of debt-friendly laws that shield profits from the tax man.
The earlier buyout wave revealed the potential downside of piling debt on companies-the turning of beloved brands like Federated Department Stores into bankrupt shells that had to struggle mightily to come back, giving private-equity firms a black eye for the immense sums they took out of such deals.
These days, private-equity firms have largely changed their stripes, taking on less debt and often concentrating more on building up companies rather than cutting them to the bone. But problems do remain. And private-equity firms are painfully aware of the damage bad publicity can do to their positive new image. Fear of being lumped in with hedge funds-whose own practices have drawn sharp attention from regulators-is one reason that Carlyle, Blackstone, KKR, and Texas Pacific Group are moving to form the Private Equity Council, the industry's first concerted attempt to educate the public and lobby the government. Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck School of Business, says the firms are setting up the council "largely because of the potential backlash they could get around the world because of their expanded activities."
The private-equity buyouts are fueled by several factors. The shares of many public companies, after wringing out the excesses of the late 1990s, are now trading at cheap prices compared with their underlying assets and revenue streams. The Sarbanes-Oxley Act, passed in 2002 as the antidote to a wave of corporate accounting scandals, makes it more difficult and expensive for smaller firms to go public and for already public firms to stay listed. And private-equity firms have found plentiful and cheap debt to leverage their own considerable treasuries, money hoards that continue to attract almost unprecedented amounts of capital from pension funds, university endowments, and wealthy investors seeking greater returns than found in the global stock markets. "When you are looking for historically high rates of return, where else do you go?" asks Dennis Block, a partner with the law firm Cadwalader, Wickersham & Taft who helped shepherd KKR's bid for RJR Nabisco. In recent years, even union pension funds-whose members can be on the other end of the stick when private interests take over and downsize some of these companies-have invested.
Although returns vary greatly, the best and the brightest private-equity firms often provide returns to their investors of 25 percent a year, experts say. Data from Thomson Financial and the National Venture Capital Association, an industry group, show that U.S. leveraged-buyout funds have averaged at least 13 percent annual returns over the past 20 years, and the California Public Employees' Retirement System recently reported cumulative returns of up to 133 percent over the past six years from one of its private-equity-fund investments.
"There has been an explosion in not just the number of funds but also the dollar value of the capital that they are raising," says Jeanne Montague of Montague Partners, a small San Francisco-based investment bank. "I can remember when the first announcement of a $1 billion fund set the market stirring. Now Blackstone has raised $15 billion in one fund. The numbers are becoming almost difficult to comprehend."
Clubby. The funds are likely to keep getting bigger. In fact, Blackstone recently announced that it would bring its $15 billion fund up to $20 billion. Other large private-equity firms are building similar war chests. At the same time, they are often combining forces in "club deals." These accounted for $414 billion in buyouts over the past 12 months, according to Thomson Financial. This is roughly a 10-fold increase from the same period five years ago. Home-improvement behemoth Home Depot, whose shares are worth some $79 billion, and computer maker Dell, at around $56 billion, have both been bandied about as possible targets, if some of the biggest private-equity firms combined forces.
"If I represent a seller and I go to 40 buyers, half will be private-equity firms now," says Montague. "Ten years ago, there'd be maybe two."
But the amount of money chasing deals has bidden up prices and thereby crimped returns for some private-equity funds. There's an "illogical" element to parts of the market, complains Mark Jrolf of Heritage Partners, a Boston-based private-equity firm. He notes that some investor groups are paying well beyond what strategic, public-company buyers would in some takeovers, and "that doesn't make sense."
Attempting to avoid this competition, private-equity firms have increasingly looked both farther afield and farther up the food chain for their next deal. But in doing so, their activities have drawn the scrutiny of shareholders and regulators, and not just in the United States.
The Bank of England signaled its concern recently by calling the voracious appetite for leveraged takeovers one of the six greatest threats to the financial system, while the country's Financial Services Authority, Britain's version of the SEC, said this month that it is monitoring private-equity firms for insider trading and conflicts of interest. The FSA warned that the collapse of a large private-equity firm was likely, given the number of deals such firms were making and their high levels of debt.
Politicians have also weighed in. In Germany, a prominent lawmaker recently compared private-equity firms snapping up companies there to "locusts." And in South Korea, where the buyout firms are called the moktui, or "eat and run," trouble abounds. One lawmaker there has said that private-equity firms' interest in "short-term profits could lead to the drain of national wealth."
Private-equity players aren't always helping defuse the situation. The subject of the lawmaker's ire, Dallas-based Lone Star Funds, recently admitted that it broke South Korean tax laws when the firm's former head in the country embezzled $12 million. Now prosecutors are delving through Lone Star's Korea Exchange Bank deal looking for, among other things, evidence that the private-equity firm might have intentionally driven down the bank's share prices in 2003 before making its bid. Prosecutors are seeking the arrest and extradition of several members of the firm, including Lone Star Funds cofounder Ellis Short.
In the United States, the Justice Department's antitrust division sent out letters last month to several of the largest buyout firms requesting information on all their deals in the past five years. "There is no smoking gun that one can point to here," cautions Andrew Metrick, a finance professor at the University of Pennsylvania's Wharton School. "The values being paid are higher than that offered by the public market, and the directors don't have to sell."
More bad publicity for private-equity firms could come courtesy of the SEC,which has begun looking into whether people associated with or informed about some buyouts may have profited from trading on insider information before the deals were announced. SEC Chairman Christopher Cox said last month that his investigators were examining a host of suspicious trades.
A partner at one large firm has already fallen. Justin Huscher, a cofounder of Chicago-based Madison Dearborn, paid more than $116,000 in SEC fines this year to settle charges that he illegally profited by buying stock in Unisource Energy Corp. after learning that a private-equity club deal for the corporation was about to be announced.
There is also growing worry about fraud. The SEC recently charged Chicago-based AA Capital Partners with misappropriating more than $10.7 million in client funds. The firm, spun off from the Dutch financial powerhouse ABN Amro NV in 2001, was headed by John Orecchio, who had once helped run a $5 billion private-equity fund for Bank of America. Investigators allege some investor funds were used to spruce up Orecchio's horse farm, while others were funneled into a strip club.
Richer bids. Shareholders are also squawking about the prices offered in several deals, complaining that they have been shortchanged by an unholy alliance between management and the private-equity firms being favored. In several recent cases, shareholders have found that company management, smitten with deals that would leave them in charge, disregarded higher bids or took measures to dissuade them. Shareholders of the Tennessee-based regional retailer Goody's Family Clothing balked last year when management proposed a leveraged buyout. A later lawsuit revealed that the private-equity firm chosen was not the highest bidder. When the process was finally opened up, a three-way bidding war added 20 percent to the $327 million price tag.
Arthur Abbey, whose law firm, Abbey Spanier Rodd Abrams & Paradis, represented several of the shareholders, says that the higher bid proved that "both the price and the process was unfair." Saying management-led buyouts are "replete with conflicts," Abbey adds: "My view is that the only independent review these deals ever get is in a lawsuit by shareholders themselves."
Private-equity partners argue that they can't be accused of taking advantage of shareholders when they generally pay a high premium over a company's market value. And many of these lawsuits are being filed not by the individual investor but by hedge funds and other market sophisticates, they add. "These stocks are not being held by orphans and widows anymore," says one private-equity partner, who asked to remain anonymous. "These are the same type of 'deal people' looking out the windows in that skyscraper across from me."
Sometimes price shouldn't be the key factor for a company in choosing a suitor, say leveraged-buyout experts, adding that different buyout groups have expertise in certain areas and some will be more willing to take a long-term approach in turning companies around. Stewart Kohl, the co-CEO of the Riverside Co., says his firm tends to take relatively small companies, reinvest in them, and build them over the course of many years, often by combining them with other complementary acquisitions.
In 2000, Riverside took control of a small manufacturer of trailer jack stands and couplers named HammerBlow. The company was a leader in its field, but the owner had died, and his estate wanted to sell. Kohl liked the company's management and inexpensive manufacturing process. While working to expand the company's operation and reduce its costs, he bought other companies in the towing and trailer-hitch market and combined them under the HammerBlow brand. In about two years, he had tripled the company's revenues to $108 million. In 2003, he sold the company for $143 million to a competitor, TriMas, also owned by private-equity interests.
"This isn't drive-by investing or financial engineering," says Kohl. "This is value created through a lot of heavy lifting. We don't just get our hands dirty-we get our whole bodies filthy working to build the companies."
A recent study by economists Jerry Cao of Boston College and Josh Lerner of Harvard Business School counters the perception that private-equity firms are flip artists. Their examination of 496 companies taken public by private-equity firms between 1980 and 2002 found that the share prices of these companies tended to outperform those of both other initial public offerings and the general market. Companies held privately for more than a year did best of all when released into the public markets again.
But the barbarians-at-the-gate perception is grounded in some fact. Standard & Poor's recently found that private-equity firms had loaded their acquisitions with more than $25 billion in debt over the past year just to fund dividends for themselves. Exceedingly rare at the beginning of the decade, these payouts have become commonplace. Sometimes the buyout firms (the general partners) take their profits even before their investors-pension funds, endowments, and other limited partners-have recouped their investment.
In the case of Hertz Global Holdings, a private-equity consortium led by the Carlyle Group paid itself a $1 billion dividend less than six months after putting up $2.3 billion to buy the company from Ford Motor Co. in 2005 for a total of $15 billion, including assumed debt. The firms took Hertz public again last week.
The deal has gained the attention of the Justice Department. But bond watchers are also worried. Citing this case, S&P argued that such equity extractions, known as dividend recapitalizations, greatly increase a company's chance of defaulting on its debt, while also leaving the private-equity partners less concerned about fixing underlying troubles.
This may be a worrisome trend because a sluggish IPO market has made it less likely that many of these deals can be spun out to investors as IPOs after a year or so. "It is not a wonderful time for private equity in some ways because their ultimate exit strategy is to go public, and you don't have a nicely behaved equity market right now," says Satya Pradhuman, Merrill Lynch's chief small-company strategist, who tracks leveraged buyouts.
Instead, some targets of leveraged buyouts find themselves sold repeatedly from one private-equity firm to another, with each deal often leading to a dividend recapitalization that yanks cash from the company's balance sheet. For some private-equity firms, the dividend recap has become the exit strategy.
Many investors did stay away from the Hertz IPO. The company went public November 16 at a lower price than was expected and then barely budged off its $15 offering price. But it was still a sweet deal for Carlyle and the other private-equity firms involved. They are expected to have doubled their money after having owned Hertz less than a year.
Party poopers. So, what will spoil the private-equity party? If returns begin to suffer because of competition, unhappy investors could slow their stampede into the funds. Hints of other frauds could have the same effect.
But the real bogey is the debt markets, because borrowing underpins private-equity firms' ability to make many deals. Any sudden upward move in interest rates could inflict serious pain in the buyout world. Right now, lenders, competing heavily to be part of deals, are giving easy payment and loan terms that could help forestall any default of a company owned by private equity if it got into financial distress. But these lenders are also allowing private-equity firms to take on buyout loans that represent ever-higher multiples of earnings.
Some buyouts are also adding newer and more risky types of debt to the mix, as they offer up more and more of a company's assets and earnings to secure it. Second-lien loans and "payment in kind" notes, which have yet to be tested in a severe economic downturn, have become popular. The notes pay extremely high rates but usually don't begin payments for several years and are likely to become worthless in any bankruptcy.
A few private-equity-owned companies have already had trouble, and some have filed for bankruptcy protection. Concern about the increased risks being taken in new deals is becoming increasingly palpable in bond and derivative markets. For instance, when Anheuser-Busch was rumored to be a private-equity target, the cost of buying credit protection on its bonds rose drastically.
A shakeout is coming, experts say. It is just a question of when. Many banks, law firms, hedge funds, and private-equity groups are already bolstering the ranks of their distressed-debt units and are gathering bankruptcy specialists for just such an occasion. Private-equity player Wilbur Ross, known for his astute nose in picking up distressed companies on the cheap, says it won't be long. Too much money is being paid to take on too much risk with too much debt, Ross warns, adding that bets by some highly leveraged buyout firms that they will be able to cheaply refinance their deals in a few years have "been building in a time bomb." In this scenario, higher default rates aren't just likely, he concludes; "they are quite inevitable."
If Ross is right, many private-equity firms and the companies they take over may find the 1980s have cast a longer shadow than any would have hoped.
This story appears in the December 4, 2006 print edition of U.S. News & World Report.
A Yen For Dollars Spurs This Trade
A Yen For Dollars Spurs This
Trade
Small investors dive into the risky currency market
By Kit R. Roane
Posted 4/23/06
The euro was dropping fast, the dollar rising. It would have been beautiful to have been on the right side of the trade. Instead, in about 10 minutes, the small investor had lost about $350. Thank goodness this was just a demo.
But at that very moment, tens of thousands of other small investors worldwide were playing the currency-trading game for real, leveraging the funds in their accounts to buy or sell tens of thousands of dollars, euros, or yen.
Day trading of stocks lost its luster after the stock market crash of 2000. But retail currency trading is alive and well. In fact, it's booming. Although the market's size is hard to gauge because many trading platforms treat their volumes as proprietary information, Greenwich Associates, a consulting and research firm, notes that its surveys put growth rates at 50 to 60 percent a year and that the true growth rate of retail currency trading is probably even higher.
"We are showing significant volume growth, not only in the United States but in Japan and somewhat in Europe," says Tim Sangston, a managing director with Greenwich. Some experts estimate that retail traders now account for one third of the total currency flow in Japan, Sangston adds.
The amateurs. Currency trading was once left up to professionals--the central banks, commercial banks, multinational corporations, and hedge funds that still make up most of the $1.9 trillion daily trade. But after being virtually absent from the market at the beginning of the decade, small investors are now believed to account for several billion dollars in currency trades every day.
That has been a boon for online currency trading companies such as FXCM Group. The firm says its number of accounts has tripled and the yearly volume on its systems has nearly quintupled since 2003, to more than 8.8 million trades.
Currency-trading seminars and conventions are drawing ever larger crowds. One convention, the Forex Trading Expo, didn't even exist until November. But organizers say its March show in Fort Lauderdale, Fla., attracted upwards of 1,500 retail currency traders. "There's not the same hysteria that was seen when we started [a general online trading expo] in 1999," says Tim Bourquin, cofounder of the expo. "People coming to the shows are not quitting their job to become traders, and barbers aren't giving hot currency tips yet. But it's really growing in terms of interest." That interest may well be boosted further as exchange-traded funds based on currency markets are launched. One, the Rydex Euro Currency ETF, began trading late last year; others are in the pipeline.
The currency-trading boom among small investors has also proved fertile ground for fraud. Daniel Roth, president of the National Futures Association, called foreign-exchange trading "the current scam of choice among fraudsters" in testimony to Congress. Since 2000, the Commodity Futures Trading Commission has brought 88 foreign-currency cases against firms charged with defrauding nearly 25,000 customers of over $385 million. Yet legal loopholes let many fraudulent currency brokers continue to ply their trade.
The currency markets exist to oil the gears of the global economy by making the trade of goods and services across borders fluid. A nation's central bank might wade into the market to buy or sell its own country's currency to check inflation or spur exports. Multinational companies might tap the currency market to repatriate profits made overseas or to pay for components made abroad.
Most American consumers rarely think about the foreign currency exchange markets (commonly referred to as the forex). But the market--and the values it places on currencies--affect everyone. "China is hypercompetitive now because of the value of the yuan--which is a lot lower than many U.S. policymakers want it to be," says Prof. Richard Lyons, an economist and currency expert at the University of California-Berkeley. "Consumers don't see that when they walk into Target. They just see a lot of things that are astoundingly reasonably priced."
Currency trading has always been a powerful draw for speculators. In 1992, George Soros famously became the man who "broke the Bank of England" when he earned over $1 billion trading against the British pound. The Bank of England was forced to devalue the currency.
But until very recently, small investors didn't have access to the currency market. "Ten years ago I wouldn't put in a call to Deutsche Bank and say, 'I want to trade. I have $150.' They would have hung up the phone," says Sangston. "Now you can go online and trade currencies for as little as a dollar."
To begin trading, a small investor just opens an account with a company like Gain Capital or FXCM, which are known as aggregators. They, in turn, are clients of major banks whose online currency systems connect to the larger interbank currency markets. The aggregators make money by increasing the spread between the buy and sell prices offered to their retail customers. The banks profit from the volume of currency flow going through their system. They also use retail currency flows as a tool for their own traders to gauge market direction.
Siren's song. Currencies can be volatile, can be traded 24 hours a day, and can be traded with much more leverage than stocks--all qualities that are enticing to small investors. For example, once an investor has set up an account with a trading house, one dollar can be leveraged to control 100 or 200 times the size of that position in the currency market. But the hook that attracts most investors is very likely the same one that leads them to risky stock investments, the dream of life-changing wealth. (Others might call it greed.) The Internet is awash in blogs, websites, and book promotions spurring investors on. "Find out how I make over $3.2 million a year currency trading," says one, while another claims that every day, trillions float "through the hands of people who aren't any smarter than you." Sangston says he knew retail currency trading was gaining momentum when he recently saw a late-night infomercial telling "Mom and Pop" how to do it. "When you reach the level of the Ginsu knife and nonstick cookware, you've really arrived," he jokes.
The problem is that the hedge funds, banks, and other sophisticated players in the market are likely to be more agile and better informed than small investors. "It is a very vicious market if you are not prepared, and you can lose everything very quickly," says Franco Marsico, president of Greenbriar Global Management Fund, a currency-trading hedge fund. Even traders who previously worked for currency-trading desks at large banks find trading currencies outside that system challenging. They are, Marsico says, "no longer perched high enough on the tree."
Most small investors are not even on a low branch. Yin-Wong Cheung, an economics professor at the University of California-Santa Cruz and a former bank currency trader, likens retail currency traders to boxers with "one hand tied behind their back"--sometimes two. "Most individual investors are not sophisticated enough to get a sense of what is going on, and that can put them in a very dangerous position," he says, adding that currency trading is a "zero-sum game": For every winner there is a loser.
This story appears in the May 1, 2006 print edition of U.S. News & World Report.
Small investors dive into the risky currency market
By Kit R. Roane
Posted 4/23/06
The euro was dropping fast, the dollar rising. It would have been beautiful to have been on the right side of the trade. Instead, in about 10 minutes, the small investor had lost about $350. Thank goodness this was just a demo.
But at that very moment, tens of thousands of other small investors worldwide were playing the currency-trading game for real, leveraging the funds in their accounts to buy or sell tens of thousands of dollars, euros, or yen.
Day trading of stocks lost its luster after the stock market crash of 2000. But retail currency trading is alive and well. In fact, it's booming. Although the market's size is hard to gauge because many trading platforms treat their volumes as proprietary information, Greenwich Associates, a consulting and research firm, notes that its surveys put growth rates at 50 to 60 percent a year and that the true growth rate of retail currency trading is probably even higher.
"We are showing significant volume growth, not only in the United States but in Japan and somewhat in Europe," says Tim Sangston, a managing director with Greenwich. Some experts estimate that retail traders now account for one third of the total currency flow in Japan, Sangston adds.
The amateurs. Currency trading was once left up to professionals--the central banks, commercial banks, multinational corporations, and hedge funds that still make up most of the $1.9 trillion daily trade. But after being virtually absent from the market at the beginning of the decade, small investors are now believed to account for several billion dollars in currency trades every day.
That has been a boon for online currency trading companies such as FXCM Group. The firm says its number of accounts has tripled and the yearly volume on its systems has nearly quintupled since 2003, to more than 8.8 million trades.
Currency-trading seminars and conventions are drawing ever larger crowds. One convention, the Forex Trading Expo, didn't even exist until November. But organizers say its March show in Fort Lauderdale, Fla., attracted upwards of 1,500 retail currency traders. "There's not the same hysteria that was seen when we started [a general online trading expo] in 1999," says Tim Bourquin, cofounder of the expo. "People coming to the shows are not quitting their job to become traders, and barbers aren't giving hot currency tips yet. But it's really growing in terms of interest." That interest may well be boosted further as exchange-traded funds based on currency markets are launched. One, the Rydex Euro Currency ETF, began trading late last year; others are in the pipeline.
The currency-trading boom among small investors has also proved fertile ground for fraud. Daniel Roth, president of the National Futures Association, called foreign-exchange trading "the current scam of choice among fraudsters" in testimony to Congress. Since 2000, the Commodity Futures Trading Commission has brought 88 foreign-currency cases against firms charged with defrauding nearly 25,000 customers of over $385 million. Yet legal loopholes let many fraudulent currency brokers continue to ply their trade.
The currency markets exist to oil the gears of the global economy by making the trade of goods and services across borders fluid. A nation's central bank might wade into the market to buy or sell its own country's currency to check inflation or spur exports. Multinational companies might tap the currency market to repatriate profits made overseas or to pay for components made abroad.
Most American consumers rarely think about the foreign currency exchange markets (commonly referred to as the forex). But the market--and the values it places on currencies--affect everyone. "China is hypercompetitive now because of the value of the yuan--which is a lot lower than many U.S. policymakers want it to be," says Prof. Richard Lyons, an economist and currency expert at the University of California-Berkeley. "Consumers don't see that when they walk into Target. They just see a lot of things that are astoundingly reasonably priced."
Currency trading has always been a powerful draw for speculators. In 1992, George Soros famously became the man who "broke the Bank of England" when he earned over $1 billion trading against the British pound. The Bank of England was forced to devalue the currency.
But until very recently, small investors didn't have access to the currency market. "Ten years ago I wouldn't put in a call to Deutsche Bank and say, 'I want to trade. I have $150.' They would have hung up the phone," says Sangston. "Now you can go online and trade currencies for as little as a dollar."
To begin trading, a small investor just opens an account with a company like Gain Capital or FXCM, which are known as aggregators. They, in turn, are clients of major banks whose online currency systems connect to the larger interbank currency markets. The aggregators make money by increasing the spread between the buy and sell prices offered to their retail customers. The banks profit from the volume of currency flow going through their system. They also use retail currency flows as a tool for their own traders to gauge market direction.
Siren's song. Currencies can be volatile, can be traded 24 hours a day, and can be traded with much more leverage than stocks--all qualities that are enticing to small investors. For example, once an investor has set up an account with a trading house, one dollar can be leveraged to control 100 or 200 times the size of that position in the currency market. But the hook that attracts most investors is very likely the same one that leads them to risky stock investments, the dream of life-changing wealth. (Others might call it greed.) The Internet is awash in blogs, websites, and book promotions spurring investors on. "Find out how I make over $3.2 million a year currency trading," says one, while another claims that every day, trillions float "through the hands of people who aren't any smarter than you." Sangston says he knew retail currency trading was gaining momentum when he recently saw a late-night infomercial telling "Mom and Pop" how to do it. "When you reach the level of the Ginsu knife and nonstick cookware, you've really arrived," he jokes.
The problem is that the hedge funds, banks, and other sophisticated players in the market are likely to be more agile and better informed than small investors. "It is a very vicious market if you are not prepared, and you can lose everything very quickly," says Franco Marsico, president of Greenbriar Global Management Fund, a currency-trading hedge fund. Even traders who previously worked for currency-trading desks at large banks find trading currencies outside that system challenging. They are, Marsico says, "no longer perched high enough on the tree."
Most small investors are not even on a low branch. Yin-Wong Cheung, an economics professor at the University of California-Santa Cruz and a former bank currency trader, likens retail currency traders to boxers with "one hand tied behind their back"--sometimes two. "Most individual investors are not sophisticated enough to get a sense of what is going on, and that can put them in a very dangerous position," he says, adding that currency trading is a "zero-sum game": For every winner there is a loser.
This story appears in the May 1, 2006 print edition of U.S. News & World Report.
Hedging Their Debts
Hedging Their Debts
Hedge funds find there's money to be made in lending to distressed firms and start-ups
By Kit R. Roane
Posted 4/2/06
San Francisco start-up Pay By Touch didn't take venture-capital money when it sought $130 million in new financing for its biometric fingerprint-reading system. The battered baker Krispy Kreme Doughnuts shunned banks when it wanted to refinance its debt. And the management buyout of British clothier Peacock Group didn't tap private equity shops to do the deal.
Instead, all three turned to another group of investors who were both flush with cash and quick on the draw: the nation's hedge funds and their more than $1 trillion in assets. Many of these 8,000 or so funds have been eating their way up the lending food chain and are becoming increasingly powerful forces in U.S. debt markets.
Hedge funds are providing loans for everything from small outfits, like payday lenders and start-up technology firms, to large automotive companies, airlines, and retailers. They are snapping up securitized loan bundles tailored to sate their appetite for risk, scooping up higher-risk loans on the open market, and swooping in to provide companies with bailout funds.
"These guys have a ton of cash on their hands, and they are trying desperately to put it to work," explains Rob Polenberg, an associate director with Standard & Poor's. He adds that hedge fund participation in the debt markets "has just become huge."
Corporate default rates are near historic lows, and that means "pretty slim pickings" in the debt areas traditionally traveled by hedge funds, says Prof. Edward Altman, a debt expert with New York University's Stern School of Business. But at the same time, many companies want to retire higher-yielding bonds, make acquisitions, or shore up operating funds without giving up more equity to do it. With banks shedding some of their corporate loans and becoming tighter in their lending, yield-hungry hedge funds have rushed in to exploit other areas of the debt market.
Big yields. Some hedge fund companies, like Ritchie Capital Management, have formed new divisions that focus only on direct lending. Bill DeMars, who heads the Ritchie Technology & Life Sciences Finance Division, says that hedge funds are attracted to such loans because they help diversify their investments, have had low default rates, and offer "double digit" yields. He says it's a good deal for the companies, too. Many of the firms don't generate a lot of cash flow, so traditional bankers "avoid getting involved."
Hedge funds are also continuing to take ground in the public debt markets. Standard & Poor's data show that hedge funds accounted for 12 percent of all loans allocated to institutional investors last year, compared with less than 1 percent in 2001. Some experts estimate that they now account for 70 to 80 percent of the entire volume in one popular product, a loan called the second lien, which is squeezed out of the equity left between first-lien creditors and bondholders.
The use of second-lien loans, which are seen as transitional loans and usually carry variable interest rates and shorter terms than bonds, has ballooned in recent years. They now account for $16 billion in trades, up from only $600 million in 2002. The size of individual loans has also risen dramatically. Among the beneficiaries: embattled Krispy Kreme, which took a $225 million loan backed by Credit Suisse First Boston and the hedge fund Silver Point Financial. The company said the cash would be used to pay down $90 million in other debt and provide a cash cushion.
Hedge funds have helped bring liquidity to these debt markets while driving down lending costs for some companies and giving others in a rough patch a chance to breathe. But it's not always clear that these companies should have been kept afloat, says David Feldman, a partner at the law firm Kramer Levin Naftalis & Frankel, which has many hedge funds as clients. While default rates have remained low, he says that easy access to debt, particularly second liens, "has really been a band-aid" for many companies, forestalling an eventual and inevitable fall into bankruptcy.
Even for those companies that stay afloat, owing money to a hedge fund can be trying. Salton Inc. is most famous for its George Foreman line of grills. But in the financial world, it is also famous for its contentious relationship with one of its debt holders, the hedge fund Third Point Management Co.
Traditional lenders usually don't write and then publish angry screeds about CEOs. But Daniel Loeb, Third Point's chief executive, did just that, repeatedly, when dealing with Salton's CEO, Leonhard Dreimann. In one, sent in April 2005 (and copied to the Securities and Exchange Commission, on whose website it is posted), Loeb wrote that while he was aware of Dreimann's "reputation for extravagance, poor judgment, and ... overall limitations as a manager ... it was only over time that we came to recognize the magnitude of your incompetence." Loeb then added that he looked forward to "personally dedicating my considerable energy to serving on the creditors' committee and seeking your ouster at that time."
Calpine's case. Dreimann is lucky compared with some; he's still at the helm. Executives at Calpine turned to hedge funds to prop the company up as its vast electricity-generation plans went awry. When the company began using some of the money in a way that the hedge funds believed skirted covenants written in its loan agreements, they sued. Later, two of Calpine's top executives were ousted, and Calpine was forced into bankruptcy. "Taking aggressive litigation positions, being aggressive with the company, and having the company move in the direction the hedge fund wants happens fairly routinely," notes Feldman.
Regulators see another problem: insider trading. Hedge funds, by definition, often play both sides of the fence. In these debt plays, that sometimes means they are buying a company's debt at the same time they are making a financial bet against the company's stock. Over the past few months, several hedge funds have been accused of profiting from confidential borrower information or information gained during private placements. Regulators in France, Britain, and the United States are pursuing investigations.
One U.S.-based hedge fund has already settled regulatory charges. Last year, the Securities and Exchange Commission censured Van Greenfield of the hedge fund Blue River Capital for failing to protect insider information he gained while serving on several bankruptcy committees--including WorldCom's, in the largest bankruptcy case in American history. The SEC also alleged that Greenfield had backdated two trades to gain access to the WorldCom creditors' committee and then canceled those trades once he was assured a seat. Greenfield and Blue River Capital, without admitting guilt, paid a $150,000 fine to the SEC to settle the charges.
Despite such issues, nobody is betting hedge funds will move out of the debt market anytime soon. Their interests and those of the companies they fund are too closely aligned. Debt watchers say the real fireworks will erupt in a year or two as more companies that took such loans file for bankruptcy and hedge funds wrestle with other creditors for control of the highly leveraged assets. Of particular interest is how second-lien loans will be treated, bankruptcy lawyers say, noting that the covenants in these loans have been virtually untested in bankruptcy cases. "People will have to be more nimble going forward," says Steven Gross, chair of the Bankruptcy and Restructuring Practice Group at Debevoise & Plimpton.
Just how rough could it get? Take a look at the case of FiberMark, a Vermont-based specialty paper manufacturer. Last August, an independent, court-appointed examiner chastised three prominent firms that trade in distressed debt, including Silver Point Financial, for turning FiberMark's "simple, uncomplicated reorganization case" into a full-scale intercreditor war. Even the scheduling of meetings was fraught with "tension and recriminations," and good-faith efforts "broke down because of rigidity and intense self-interest fueled by individual rancor and distrust," the examiner found. Silver Point, which held most of the second-lien debt, won the war. But the protracted fight cost FiberMark about $60 million over the course of seven months.
FiberMark's management apparently didn't hold a grudge. Despite offers from others, the company snatched an additional $155 million in exit financing from Silver Point to ease its transition from bankruptcy back onto the market.
This story appears in the April 10, 2006 print edition of U.S. News & World Report.
Hedge funds find there's money to be made in lending to distressed firms and start-ups
By Kit R. Roane
Posted 4/2/06
San Francisco start-up Pay By Touch didn't take venture-capital money when it sought $130 million in new financing for its biometric fingerprint-reading system. The battered baker Krispy Kreme Doughnuts shunned banks when it wanted to refinance its debt. And the management buyout of British clothier Peacock Group didn't tap private equity shops to do the deal.
Instead, all three turned to another group of investors who were both flush with cash and quick on the draw: the nation's hedge funds and their more than $1 trillion in assets. Many of these 8,000 or so funds have been eating their way up the lending food chain and are becoming increasingly powerful forces in U.S. debt markets.
Hedge funds are providing loans for everything from small outfits, like payday lenders and start-up technology firms, to large automotive companies, airlines, and retailers. They are snapping up securitized loan bundles tailored to sate their appetite for risk, scooping up higher-risk loans on the open market, and swooping in to provide companies with bailout funds.
"These guys have a ton of cash on their hands, and they are trying desperately to put it to work," explains Rob Polenberg, an associate director with Standard & Poor's. He adds that hedge fund participation in the debt markets "has just become huge."
Corporate default rates are near historic lows, and that means "pretty slim pickings" in the debt areas traditionally traveled by hedge funds, says Prof. Edward Altman, a debt expert with New York University's Stern School of Business. But at the same time, many companies want to retire higher-yielding bonds, make acquisitions, or shore up operating funds without giving up more equity to do it. With banks shedding some of their corporate loans and becoming tighter in their lending, yield-hungry hedge funds have rushed in to exploit other areas of the debt market.
Big yields. Some hedge fund companies, like Ritchie Capital Management, have formed new divisions that focus only on direct lending. Bill DeMars, who heads the Ritchie Technology & Life Sciences Finance Division, says that hedge funds are attracted to such loans because they help diversify their investments, have had low default rates, and offer "double digit" yields. He says it's a good deal for the companies, too. Many of the firms don't generate a lot of cash flow, so traditional bankers "avoid getting involved."
Hedge funds are also continuing to take ground in the public debt markets. Standard & Poor's data show that hedge funds accounted for 12 percent of all loans allocated to institutional investors last year, compared with less than 1 percent in 2001. Some experts estimate that they now account for 70 to 80 percent of the entire volume in one popular product, a loan called the second lien, which is squeezed out of the equity left between first-lien creditors and bondholders.
The use of second-lien loans, which are seen as transitional loans and usually carry variable interest rates and shorter terms than bonds, has ballooned in recent years. They now account for $16 billion in trades, up from only $600 million in 2002. The size of individual loans has also risen dramatically. Among the beneficiaries: embattled Krispy Kreme, which took a $225 million loan backed by Credit Suisse First Boston and the hedge fund Silver Point Financial. The company said the cash would be used to pay down $90 million in other debt and provide a cash cushion.
Hedge funds have helped bring liquidity to these debt markets while driving down lending costs for some companies and giving others in a rough patch a chance to breathe. But it's not always clear that these companies should have been kept afloat, says David Feldman, a partner at the law firm Kramer Levin Naftalis & Frankel, which has many hedge funds as clients. While default rates have remained low, he says that easy access to debt, particularly second liens, "has really been a band-aid" for many companies, forestalling an eventual and inevitable fall into bankruptcy.
Even for those companies that stay afloat, owing money to a hedge fund can be trying. Salton Inc. is most famous for its George Foreman line of grills. But in the financial world, it is also famous for its contentious relationship with one of its debt holders, the hedge fund Third Point Management Co.
Traditional lenders usually don't write and then publish angry screeds about CEOs. But Daniel Loeb, Third Point's chief executive, did just that, repeatedly, when dealing with Salton's CEO, Leonhard Dreimann. In one, sent in April 2005 (and copied to the Securities and Exchange Commission, on whose website it is posted), Loeb wrote that while he was aware of Dreimann's "reputation for extravagance, poor judgment, and ... overall limitations as a manager ... it was only over time that we came to recognize the magnitude of your incompetence." Loeb then added that he looked forward to "personally dedicating my considerable energy to serving on the creditors' committee and seeking your ouster at that time."
Calpine's case. Dreimann is lucky compared with some; he's still at the helm. Executives at Calpine turned to hedge funds to prop the company up as its vast electricity-generation plans went awry. When the company began using some of the money in a way that the hedge funds believed skirted covenants written in its loan agreements, they sued. Later, two of Calpine's top executives were ousted, and Calpine was forced into bankruptcy. "Taking aggressive litigation positions, being aggressive with the company, and having the company move in the direction the hedge fund wants happens fairly routinely," notes Feldman.
Regulators see another problem: insider trading. Hedge funds, by definition, often play both sides of the fence. In these debt plays, that sometimes means they are buying a company's debt at the same time they are making a financial bet against the company's stock. Over the past few months, several hedge funds have been accused of profiting from confidential borrower information or information gained during private placements. Regulators in France, Britain, and the United States are pursuing investigations.
One U.S.-based hedge fund has already settled regulatory charges. Last year, the Securities and Exchange Commission censured Van Greenfield of the hedge fund Blue River Capital for failing to protect insider information he gained while serving on several bankruptcy committees--including WorldCom's, in the largest bankruptcy case in American history. The SEC also alleged that Greenfield had backdated two trades to gain access to the WorldCom creditors' committee and then canceled those trades once he was assured a seat. Greenfield and Blue River Capital, without admitting guilt, paid a $150,000 fine to the SEC to settle the charges.
Despite such issues, nobody is betting hedge funds will move out of the debt market anytime soon. Their interests and those of the companies they fund are too closely aligned. Debt watchers say the real fireworks will erupt in a year or two as more companies that took such loans file for bankruptcy and hedge funds wrestle with other creditors for control of the highly leveraged assets. Of particular interest is how second-lien loans will be treated, bankruptcy lawyers say, noting that the covenants in these loans have been virtually untested in bankruptcy cases. "People will have to be more nimble going forward," says Steven Gross, chair of the Bankruptcy and Restructuring Practice Group at Debevoise & Plimpton.
Just how rough could it get? Take a look at the case of FiberMark, a Vermont-based specialty paper manufacturer. Last August, an independent, court-appointed examiner chastised three prominent firms that trade in distressed debt, including Silver Point Financial, for turning FiberMark's "simple, uncomplicated reorganization case" into a full-scale intercreditor war. Even the scheduling of meetings was fraught with "tension and recriminations," and good-faith efforts "broke down because of rigidity and intense self-interest fueled by individual rancor and distrust," the examiner found. Silver Point, which held most of the second-lien debt, won the war. But the protracted fight cost FiberMark about $60 million over the course of seven months.
FiberMark's management apparently didn't hold a grudge. Despite offers from others, the company snatched an additional $155 million in exit financing from Silver Point to ease its transition from bankruptcy back onto the market.
This story appears in the April 10, 2006 print edition of U.S. News & World Report.
Hedge Funds Get Clipped
Hedge Funds Get Clipped
Slim gains and scandals turn off investors
By Kit R. Roane
Posted 1/1/06
Think hedge funds mint money? Consider this: The Standard & Poor's hedge fund index posted gains of just over 2.4 percent in 2005--after meager gains of 3.6 percent in 2004--or about half the performance of the S&P 500.
That track record hasn't hurt the earnings of the average hedge fund manager, who took home about $1.2 million in 2004. But with the number of hedge funds--thinly regulated investment pools for the well-to-do--having mushroomed from a few hundred to more than 8,000 worldwide, with combined assets now around the $1 trillion mark, many investors are finding that storied hedge fund edge elusive. It's pretty hard, after all, to make the case that all 8,000 funds are being run by the best and the brightest. And in such a crowded field, many of the tactics that have made hedge funds so profitable in the past are oversubscribed.
Compounding such troubles is the fact that even high-profile funds have gotten caught up in legal and regulatory probes. Some pension funds are grumbling about the high fees that funds charge. And new research suggests fund returns were never quite so good as they first appeared. It's enough to leave some former hedge fund bulls to conclude that the party's over--for good. "Our day has come and gone," complains Joseph Aaron, whose California investment firm Wood, Hat & Silver has put money in hedge funds. "There's no edge left. The returns are just not there, and they aren't coming back."
In the dark. Most retail investors have only a vague idea of what hedge funds do to make money, or why hedge fund managers are able to charge fees that would be seen as obscene in any mutual fund. What they know is that hedge funds are hot and that they wield enormous power over the financial markets and the companies whose stocks they invest in.
They aren't totally off the mark. But the general rule of thumb is that hedge fund managers make sizable salaries by pledging to make money for their investors even when the stock market is tanking and the bond market is in the doldrums. They promise an absolute return and don't mind betting against the stock market, leveraging investor assets, or delving into all sorts of esoteric derivatives and volatile markets to do so. And over the past few years, at least until recently, many hedge funds have done well by the exclusive investors who often plop down minimum investments of $250,000 to $1 million to fund these financial excursions. Many received high double-digit returns.
Some of the old guard may continue to do well by their investors. But Aaron, who is pulling back from the sector, is not the only hedge fund watcher to be concerned that many others won't. Hedge fund inflows have dropped to about half the level of 2004. Withdrawals have also risen, as have the number of funds not reporting their results in 2005. And more bad news could be on the way.
William Wechsler, a vice president with financial services consultants Greenwich Associates, points out that hedge funds have flourished in a protracted investment environment where investors were confronted by both low interest rates and sluggish equity markets. "But that is a very unusual set of circumstances," he says.
Wechsler says that hedge funds will go through a cycle similar to the one they endured after becoming a favorite of investors in the late 1970s. When the sweet spot disappeared, only a few hedge funds remained. The rest were forced to shutter. Another wave of hedge fund consolidation could be on the horizon, with the industry contracting, then bifurcating with a few supersize hedge fund companies rising out of the ashes and the rest of the survivors becoming small boutiques specializing in very specific styles of investment. "History shows that you can always find somebody to give you money," says Wechsler, "but it is going to get more difficult for hedge funds."
While few have imploded with the ferocity or fanfare of Long Term Capital Management, whose highly leveraged and badly hedged bets in emerging markets ended in a $3.5 billion bailout in 1998, they do continue to fail or close at a regular clip. Researchers studying Tremont Capital Management's database have estimated that 10 percent of all hedge funds close each year and that most last only a few years.
Closing time. Securities and Exchange Commissioner Roel Campos noted worriedly in a speech to the Managed Funds Association in London last July that some of those closing shop are pretty established funds. Among them, EBF & Associates Lakeshore International fund, which had $669 million under its wing and, as Campos noted, was "among the oldest" and among the most successful funds that specialized in convertible bonds.
Hedge funds were the subject of more than 38 SEC enforcement decisions from January 2004 to the middle of October 2005, the latest date for which figures are available. That is more than half the total number of enforcement actions undertaken against hedge funds since the beginning of 1999, SEC documents show.
Further scrutiny will follow in February when new SEC accounting and disclosure guidelines take effect, although the regulations may be struck down soon afterward. They are currently the subject of a lawsuit brought by Phillip Goldstein, manager of Opportunity Partners in New York. Goldstein asserts that the SEC has overstepped its authority, and in questioning the SEC, two of three U.S. appeals court judges have signaled they may agree. Their opinion is expected within the next few months.
Either way, hedge funds have a growing public-relations problem on their hands. Some notable cases:
A few days before Christmas, the SEC accused the head trader and the manager of Montvale, N.J., hedge fund HMC International of operating a "Ponzi scheme" that looted investors of $5.2 million. Mark Schonfeld, regional director of the SEC's Northeast office, said the hedge fund was "pure fiction," adding that the defendants "led lifestyles of the rich and famous at the expense of their investors." One defendant has claimed he was among those swindled. The other's lawyer told U.S. News he had no comment.
Also in December, hedge funds controlled by Millennium Management and four of the firm's executives paid $180 million to settle regulatory charges that they made more than 76,000 illegal market-timing trades in and out of mutual funds. The trades, which regulators say amounted to some $52 billion and netted tens of millions in profits over several years, tend to raise mutual fund expenses and dampen profits for other shareholders.
In October, the SEC alleged that John Whittier, principal manager of Wood River Partners, misrepresented to investors that he was creating a broadly diversified portfolio and that the fund would be overseen by an auditor. Instead, the SEC alleges, Whittier conducted no audits and amassed a position in one small-cap stock, Endwave Corp., equal to 65 percent of the entire $265 million that the fund claimed to have under management. Through his lawyer, Whittier said that he always worked in the best interests of his shareholders.
The SEC filed a complaint in November against Mark Conway, founder of the $43 million hedge fund Ground-swell Partners, alleging that the well-known trader had defrauded clients by hiding millions in losses and misleading them about the assets in its fund. The fund, the SEC says, now holds only $14 million. Conway's lawyer did not return calls.
In September, the once highflying Bayou Group's founder, Samuel Israel III, and chief financial officer, Daniel Marino, both pleaded guilty to mail and investment adviser fraud charges. The fund took in more than $450 million from investors, but so far investigators have been able to find only a portion, which had been briefly stashed in an Arizona account.
New York University history major Hakan Ya lincak is perhaps the most interesting character to face fraud accusations this year. Federal prosecutors say Yalincak and his mother, Ayferafet Yalincak, convinced investors they were buying into a group of hedge funds and Yalincak-controlled companies. But the Greenwich, Conn.-based adviser allegedly spent about $7 million of his investors' money on items like Tiffany diamonds and a new Porsche. Prosecutors say Yalincak also used the money to increase his renown, donating $1.25 million of investors' money to NYU, then promising about $20 million more. He intended to have the university name several buildings in the family's honor. Both Yalincak and his mother, who has a previous conviction for posing as a doctor, have pleaded not guilty to all charges. Their trials are now set for April.
Running scared. Andrew Sterge, who runs AJ Sterge Investment Strategies, a hedge fund specializing in derivatives based on insurance risk, says that if the number of investigations continues to climb, investors may be scared off from investing in the sector as a whole and "invest in a stock fund or an index fund instead."
No matter what, hedge funds are likely to face increased scrutiny in the form of regulatory oversight. That could hasten their undoing, as exemption from tight regulation has long been the funds' calling card. Alfred Winslow Jones, a sociologist, created the first hedge fund in 1949 after researching a business article and finding out some traders were doing a lot more than buying and holding. He put their ideas together in a limited partnership to exempt it from normal regulatory control.
The SEC is among a group of regulators now flexing their muscle. The International Organization of Securities Commissions, which monitors global finance, said in October that it is considering new hedge fund regulations. And Connecticut, which is home to the second-highest concentration of hedge funds in the country after New York, is studying what regulations it might impose. "The absence of federal regulation so far may open doors that would otherwise be shut," says Connecticut Attorney General Richard Blumenthal. "The idea that the investors are all wealthy and sophisticated and can protect themselves is no longer as true as it once was."
In fact, retail investors can gain easy, if costly, exposure to hedge funds by investing in "funds of hedge funds," some of which require only $25,000 in initial assets. The practice has caused enough concern that David Swensen, chief investment officer for Yale University and a longtime user of hedge funds in managing Yale's $14 billion investment portfolio, recently called for the elimination of such hedge fund baskets in a New York Times opinion piece. He also goaded regulators to "prohibit unsophisticated players" from investing in hedge funds at all.
Some investors may not even be aware that their money is already tied up in a hedge fund. Institutional firms that manage small investors' money, such as pension funds, are becoming increasingly big users of hedge funds. The California Public Employees' Retirement System, the nation's largest pension plan, has about $1.2 billion of its $200 billion portfolio invested in hedge funds and plans to nearly double that stake soon to increase returns amid an increase in expected retirements. Charitable money is ending up there, too. The Jewish Federation of Metropolitan Chicago, for instance, says it lost $4 million in the Bayou implosion.
Universities, such as Harvard, and religious institutions, like the Roman Catholic Church, among others, are hedge fund investors. Although private investors and money managers may be cooling to the investment vehicle, U.S. institutional investors, such as pension funds, are expected to increase their stake in hedge funds to $300 billion by the end of 2008, a 400 percent increase from 2004.
Maybe all these hedge fund investors will make a killing. It's not that there aren't opportunities left. Hedge funds are finding an increasingly wide array of investments to dip into, from buying distressed debt and emerging market assets to taking positions in complicated and sometimes illiquid derivative products. Some funds are attempting to tackle the competition, the risk, and the lackluster returns by diversifying into several strategies at once. Others are looking for the next big thing, like debt instruments tied to lawsuit payouts, or life-insurance financing, or catastrophe bonds, also known as CAT bonds, which are a form of insurance for insurance companies if their losses from a hurricane or other natural disaster exceed a prescribed limit.
But successful strategies draw a crowd, and none are foolproof--just ask the hedge funds that got burned on CAT bonds when Katrina hit. And there is no telling whether most or even many of the 8,000 hedge fund managers out there are nimble enough to stay ahead of the curve--or whether investors can find the ones who truly are.
In the long run, hedge funds are likely to prosper only as long as their returns beat the market over time, and Aaron for one is unwilling to take those odds. "You're either in with one of the truly great managers of the world or you're not, and if you're not in with one by now, they won't let you in because they don't need your money," he says. What's left? "Pretty mediocre pickings."
This story appears in the January 9, 2006 print edition of U.S. News & World Report.
Slim gains and scandals turn off investors
By Kit R. Roane
Posted 1/1/06
Think hedge funds mint money? Consider this: The Standard & Poor's hedge fund index posted gains of just over 2.4 percent in 2005--after meager gains of 3.6 percent in 2004--or about half the performance of the S&P 500.
That track record hasn't hurt the earnings of the average hedge fund manager, who took home about $1.2 million in 2004. But with the number of hedge funds--thinly regulated investment pools for the well-to-do--having mushroomed from a few hundred to more than 8,000 worldwide, with combined assets now around the $1 trillion mark, many investors are finding that storied hedge fund edge elusive. It's pretty hard, after all, to make the case that all 8,000 funds are being run by the best and the brightest. And in such a crowded field, many of the tactics that have made hedge funds so profitable in the past are oversubscribed.
Compounding such troubles is the fact that even high-profile funds have gotten caught up in legal and regulatory probes. Some pension funds are grumbling about the high fees that funds charge. And new research suggests fund returns were never quite so good as they first appeared. It's enough to leave some former hedge fund bulls to conclude that the party's over--for good. "Our day has come and gone," complains Joseph Aaron, whose California investment firm Wood, Hat & Silver has put money in hedge funds. "There's no edge left. The returns are just not there, and they aren't coming back."
In the dark. Most retail investors have only a vague idea of what hedge funds do to make money, or why hedge fund managers are able to charge fees that would be seen as obscene in any mutual fund. What they know is that hedge funds are hot and that they wield enormous power over the financial markets and the companies whose stocks they invest in.
They aren't totally off the mark. But the general rule of thumb is that hedge fund managers make sizable salaries by pledging to make money for their investors even when the stock market is tanking and the bond market is in the doldrums. They promise an absolute return and don't mind betting against the stock market, leveraging investor assets, or delving into all sorts of esoteric derivatives and volatile markets to do so. And over the past few years, at least until recently, many hedge funds have done well by the exclusive investors who often plop down minimum investments of $250,000 to $1 million to fund these financial excursions. Many received high double-digit returns.
Some of the old guard may continue to do well by their investors. But Aaron, who is pulling back from the sector, is not the only hedge fund watcher to be concerned that many others won't. Hedge fund inflows have dropped to about half the level of 2004. Withdrawals have also risen, as have the number of funds not reporting their results in 2005. And more bad news could be on the way.
William Wechsler, a vice president with financial services consultants Greenwich Associates, points out that hedge funds have flourished in a protracted investment environment where investors were confronted by both low interest rates and sluggish equity markets. "But that is a very unusual set of circumstances," he says.
Wechsler says that hedge funds will go through a cycle similar to the one they endured after becoming a favorite of investors in the late 1970s. When the sweet spot disappeared, only a few hedge funds remained. The rest were forced to shutter. Another wave of hedge fund consolidation could be on the horizon, with the industry contracting, then bifurcating with a few supersize hedge fund companies rising out of the ashes and the rest of the survivors becoming small boutiques specializing in very specific styles of investment. "History shows that you can always find somebody to give you money," says Wechsler, "but it is going to get more difficult for hedge funds."
While few have imploded with the ferocity or fanfare of Long Term Capital Management, whose highly leveraged and badly hedged bets in emerging markets ended in a $3.5 billion bailout in 1998, they do continue to fail or close at a regular clip. Researchers studying Tremont Capital Management's database have estimated that 10 percent of all hedge funds close each year and that most last only a few years.
Closing time. Securities and Exchange Commissioner Roel Campos noted worriedly in a speech to the Managed Funds Association in London last July that some of those closing shop are pretty established funds. Among them, EBF & Associates Lakeshore International fund, which had $669 million under its wing and, as Campos noted, was "among the oldest" and among the most successful funds that specialized in convertible bonds.
Hedge funds were the subject of more than 38 SEC enforcement decisions from January 2004 to the middle of October 2005, the latest date for which figures are available. That is more than half the total number of enforcement actions undertaken against hedge funds since the beginning of 1999, SEC documents show.
Further scrutiny will follow in February when new SEC accounting and disclosure guidelines take effect, although the regulations may be struck down soon afterward. They are currently the subject of a lawsuit brought by Phillip Goldstein, manager of Opportunity Partners in New York. Goldstein asserts that the SEC has overstepped its authority, and in questioning the SEC, two of three U.S. appeals court judges have signaled they may agree. Their opinion is expected within the next few months.
Either way, hedge funds have a growing public-relations problem on their hands. Some notable cases:
A few days before Christmas, the SEC accused the head trader and the manager of Montvale, N.J., hedge fund HMC International of operating a "Ponzi scheme" that looted investors of $5.2 million. Mark Schonfeld, regional director of the SEC's Northeast office, said the hedge fund was "pure fiction," adding that the defendants "led lifestyles of the rich and famous at the expense of their investors." One defendant has claimed he was among those swindled. The other's lawyer told U.S. News he had no comment.
Also in December, hedge funds controlled by Millennium Management and four of the firm's executives paid $180 million to settle regulatory charges that they made more than 76,000 illegal market-timing trades in and out of mutual funds. The trades, which regulators say amounted to some $52 billion and netted tens of millions in profits over several years, tend to raise mutual fund expenses and dampen profits for other shareholders.
In October, the SEC alleged that John Whittier, principal manager of Wood River Partners, misrepresented to investors that he was creating a broadly diversified portfolio and that the fund would be overseen by an auditor. Instead, the SEC alleges, Whittier conducted no audits and amassed a position in one small-cap stock, Endwave Corp., equal to 65 percent of the entire $265 million that the fund claimed to have under management. Through his lawyer, Whittier said that he always worked in the best interests of his shareholders.
The SEC filed a complaint in November against Mark Conway, founder of the $43 million hedge fund Ground-swell Partners, alleging that the well-known trader had defrauded clients by hiding millions in losses and misleading them about the assets in its fund. The fund, the SEC says, now holds only $14 million. Conway's lawyer did not return calls.
In September, the once highflying Bayou Group's founder, Samuel Israel III, and chief financial officer, Daniel Marino, both pleaded guilty to mail and investment adviser fraud charges. The fund took in more than $450 million from investors, but so far investigators have been able to find only a portion, which had been briefly stashed in an Arizona account.
New York University history major Hakan Ya lincak is perhaps the most interesting character to face fraud accusations this year. Federal prosecutors say Yalincak and his mother, Ayferafet Yalincak, convinced investors they were buying into a group of hedge funds and Yalincak-controlled companies. But the Greenwich, Conn.-based adviser allegedly spent about $7 million of his investors' money on items like Tiffany diamonds and a new Porsche. Prosecutors say Yalincak also used the money to increase his renown, donating $1.25 million of investors' money to NYU, then promising about $20 million more. He intended to have the university name several buildings in the family's honor. Both Yalincak and his mother, who has a previous conviction for posing as a doctor, have pleaded not guilty to all charges. Their trials are now set for April.
Running scared. Andrew Sterge, who runs AJ Sterge Investment Strategies, a hedge fund specializing in derivatives based on insurance risk, says that if the number of investigations continues to climb, investors may be scared off from investing in the sector as a whole and "invest in a stock fund or an index fund instead."
No matter what, hedge funds are likely to face increased scrutiny in the form of regulatory oversight. That could hasten their undoing, as exemption from tight regulation has long been the funds' calling card. Alfred Winslow Jones, a sociologist, created the first hedge fund in 1949 after researching a business article and finding out some traders were doing a lot more than buying and holding. He put their ideas together in a limited partnership to exempt it from normal regulatory control.
The SEC is among a group of regulators now flexing their muscle. The International Organization of Securities Commissions, which monitors global finance, said in October that it is considering new hedge fund regulations. And Connecticut, which is home to the second-highest concentration of hedge funds in the country after New York, is studying what regulations it might impose. "The absence of federal regulation so far may open doors that would otherwise be shut," says Connecticut Attorney General Richard Blumenthal. "The idea that the investors are all wealthy and sophisticated and can protect themselves is no longer as true as it once was."
In fact, retail investors can gain easy, if costly, exposure to hedge funds by investing in "funds of hedge funds," some of which require only $25,000 in initial assets. The practice has caused enough concern that David Swensen, chief investment officer for Yale University and a longtime user of hedge funds in managing Yale's $14 billion investment portfolio, recently called for the elimination of such hedge fund baskets in a New York Times opinion piece. He also goaded regulators to "prohibit unsophisticated players" from investing in hedge funds at all.
Some investors may not even be aware that their money is already tied up in a hedge fund. Institutional firms that manage small investors' money, such as pension funds, are becoming increasingly big users of hedge funds. The California Public Employees' Retirement System, the nation's largest pension plan, has about $1.2 billion of its $200 billion portfolio invested in hedge funds and plans to nearly double that stake soon to increase returns amid an increase in expected retirements. Charitable money is ending up there, too. The Jewish Federation of Metropolitan Chicago, for instance, says it lost $4 million in the Bayou implosion.
Universities, such as Harvard, and religious institutions, like the Roman Catholic Church, among others, are hedge fund investors. Although private investors and money managers may be cooling to the investment vehicle, U.S. institutional investors, such as pension funds, are expected to increase their stake in hedge funds to $300 billion by the end of 2008, a 400 percent increase from 2004.
Maybe all these hedge fund investors will make a killing. It's not that there aren't opportunities left. Hedge funds are finding an increasingly wide array of investments to dip into, from buying distressed debt and emerging market assets to taking positions in complicated and sometimes illiquid derivative products. Some funds are attempting to tackle the competition, the risk, and the lackluster returns by diversifying into several strategies at once. Others are looking for the next big thing, like debt instruments tied to lawsuit payouts, or life-insurance financing, or catastrophe bonds, also known as CAT bonds, which are a form of insurance for insurance companies if their losses from a hurricane or other natural disaster exceed a prescribed limit.
But successful strategies draw a crowd, and none are foolproof--just ask the hedge funds that got burned on CAT bonds when Katrina hit. And there is no telling whether most or even many of the 8,000 hedge fund managers out there are nimble enough to stay ahead of the curve--or whether investors can find the ones who truly are.
In the long run, hedge funds are likely to prosper only as long as their returns beat the market over time, and Aaron for one is unwilling to take those odds. "You're either in with one of the truly great managers of the world or you're not, and if you're not in with one by now, they won't let you in because they don't need your money," he says. What's left? "Pretty mediocre pickings."
This story appears in the January 9, 2006 print edition of U.S. News & World Report.
Dueling Over Derivatives
Dueling Over Derivatives
Alan Greenspan and Warren Buffett do not agree on the trillion-dollar market for credit derivatives
By Kit R. Roane
Posted 7/17/05
When a debt downgrade at GM took a bite out of several hedge funds last month, part of the blame fell on their participation in the credit derivatives market, a world of high finance that most investors know little or nothing about and that many simply don't understand. Ignorance, however, may not be bliss.
Credit derivatives are, in essence, insurance policies against the possibility that a corporation will default on its debt. They are traded by large investors like banks, insurance companies, pension funds, and hedge funds. For a premium, one investor assumes some of the default or credit risk in another investor's loan or bond portfolio. But just as many hedge funds do more than hedge, instead opting to take more-aggressive positions, credit derivatives are about more than just managing risk; they are also about speculating on it and trading it.
Just how well-capitalized and how smart those speculators are is a looming question. As is the kind of trouble they could cause for the markets should their gambles go bust.
As a tool for risk management and as an early-warning system of credit problems, the derivatives market has many fans. The demand for such insurance has created a lucrative business and made credit derivatives one of the fastest-growing financial markets in the world. Today, investors are holding credit derivatives with an underlying value of somewhere between $4 trillion and $8 trillion--no one really knows for sure--up from about $1.2 trillion in 2001. And none other than Federal Reserve Chairman Alan Greenspan has generally praised the trade, saying earlier this year that "credit derivatives [have] contributed to the stability of the banking system by allowing banks . . . to measure and manage their credit risks more effectively." This, along with the transfer of risk to an ever widening group of investors, Greenspan adds, has helped the economy avoid bank failures or credit crunches when big corporations, such as Enron, have defaulted.
Lethal weapons. But another master of high finance, Warren Buffett, has a different view. He famously railed against derivatives in a 2003 letter to shareholders, calling them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The problem is that while credit derivatives are great tools for moving risk, they do nothing to help extinguish it. And because investors can write multiple layers of protection on the same debt, they could actually magnify the market effect of a default.
As the desire for credit derivatives has grown, so has the chorus of concern. Even Greenspan has noted that the rapid growth and increasing complexity of credit derivatives have made it harder for banks and regulators to assess the risks being assumed in a market that is virtually unregulated.
Some data suggest that major banks--the most important participants in terms of steadying the credit derivatives market during any upheaval--may be using the market to increase their risk profiles instead of to reduce them. Add to that the broadening of derivative products to include some based on lesser-quality debt, and others tailor-made for specific clients that are ever more complicated and illiquid, and you have a market that even the most sophisticated players worry about.
Then there are the hedge funds, which are among the most active traders of these derivatives. "What happens if a hedge fund has $5 billion in a given name, and it blows?" asks Wilbur Ross, who made a killing buying up old steel assets and who runs two hedge funds and six private equity firms. "The problem with this market is that nobody knows."
Ross sees one possible scenario: Some investors who thought that they had bought protection from a hedge fund might be "left naked" if the hedge fund can't pay off the claim. This could cause the investor who bought the insurance to default, creating a dangerous ripple effect through the whole economy.
Unlike banks and insurance companies, hedge funds are only loosely regulated. Since many of them are newly minted, there is no assumption that they have the same expertise at gauging risk as a bank might. And the search for yield may be making them take on more risk than is prudent.
The role of hedge funds has been steadily increasing over the past few years, providing an ever larger portion of the liquidity necessary to oil the market. Fitch Ratings surveyed market participants last year and found that insurance companies have been leaving the market, while hedge funds have grown to account for about 30 percent of current trading volume.
But the rush to the exits following GM's and Ford's descent into junk-bond status was a clear sign to some that leveraged hedge funds' appetite for credit derivatives could also be dangerous. The downgrade came on the heels of Kirk Kerkorian's announcing that he would add to his position in GM stock. Because many assumed that the debt was safer than the stock, the combined events upset the model being used by some investors, particularly hedge funds, to set up and price their risk in correlation trades--deals whose profit depends on the idea that something happening in one place will have a predictable effect elsewhere.
Hedge funds, which often take positions that are highly leveraged, began facing margin calls and had to unwind some trades, exacerbating price swings and forcing more traders to exit. Liquidity dried up. And there was, according to the Bank for International Settlements, "a circle of deterioration."
No bailouts. The fallout in the credit derivatives market from the GM debt debacle, of course, was far less severe than many had predicted. Despite all the doomsday scenarios, no hedge funds imploded. Nor did the markets see a rampant sell-off, although the bond market did suffer some temporary jitters. Americans did not wake up to find a repeat of 1998, when the spectacular flameout of a fund named Long-Term Capital Management roiled markets around the globe, requiring an emergency $3.6 billion bailout orchestrated by the Federal Reserve Bank of New York.
Matteo Mazzocchi, head of global derivatives at the Europe-based in-vestment bank Dresdner Kleinwort Wasserstein, says that most of those currently involved in the credit derivatives market are "buy and hold" investors who plan to keep their positions until they mature. They were not damaged, he says. The only ones hurt were the hedge funds that piled into an illiquid trade on leverage and then stormed the same exit.
Many of these hedge funds are said to be nursing material losses and could be hit with investor redemptions down the line. One large hedge fund manager, GLG Partners, said the ratings downgrade was partially to blame for a 14.5 percent drop in its $1 billion Credit Fund. But as a group, hedge funds managed to eke out a tiny profit for the first five months of the year.
And probably the worst result from the troubles in the credit derivatives market will be lower earnings from the big investment banks most active in facilitating the trades, such as Merrill Lynch and Deutsche Bank, which could be stung by the temporary reduction in deals.
Instead of portending economic devastation, the GM event might even have been salutary. Mazzocchi says that such market hiccups can help reveal and regulate the risks being taken on. "If there are gigantic positions out there that we didn't know about, the market will show us," he says. They are also extremely valuable in stress testing and steering what is still a very young market, adds Cornell University's Robert Jarrow, known for his decisive work on interest rate modeling.
Jarrow believes that the credit derivatives market, when run right, contributes greatly to the financial health and flexibility of the economy and that hedge funds, although the weakest link in the chain, are still unlikely to make the sort of dangerous miscalculations pioneered by the financial wizards at Long-Term Capital Management. "As long as the people who issue the contracts are responsible, then credit derivatives are welfare improving and make the system work better," says Jarrow. "But there will always be things that can't be anticipated, and there will always be human error and human greed."
Risky business
The global market for credit derivatives--insurance that protects against corporations defaulting on their debt--has grown quickly.
In trillions
1997 $ .180
'06 $8.2*
*Estimate
[Other labels]'04,'03,'02,'01,'00,'99,'98
Source: British Bankers' Association
Graphic by Rod Little-- USN&WR
This story appears in the July 25, 2005 print edition of U.S. News & World Report.
Alan Greenspan and Warren Buffett do not agree on the trillion-dollar market for credit derivatives
By Kit R. Roane
Posted 7/17/05
When a debt downgrade at GM took a bite out of several hedge funds last month, part of the blame fell on their participation in the credit derivatives market, a world of high finance that most investors know little or nothing about and that many simply don't understand. Ignorance, however, may not be bliss.
Credit derivatives are, in essence, insurance policies against the possibility that a corporation will default on its debt. They are traded by large investors like banks, insurance companies, pension funds, and hedge funds. For a premium, one investor assumes some of the default or credit risk in another investor's loan or bond portfolio. But just as many hedge funds do more than hedge, instead opting to take more-aggressive positions, credit derivatives are about more than just managing risk; they are also about speculating on it and trading it.
Just how well-capitalized and how smart those speculators are is a looming question. As is the kind of trouble they could cause for the markets should their gambles go bust.
As a tool for risk management and as an early-warning system of credit problems, the derivatives market has many fans. The demand for such insurance has created a lucrative business and made credit derivatives one of the fastest-growing financial markets in the world. Today, investors are holding credit derivatives with an underlying value of somewhere between $4 trillion and $8 trillion--no one really knows for sure--up from about $1.2 trillion in 2001. And none other than Federal Reserve Chairman Alan Greenspan has generally praised the trade, saying earlier this year that "credit derivatives [have] contributed to the stability of the banking system by allowing banks . . . to measure and manage their credit risks more effectively." This, along with the transfer of risk to an ever widening group of investors, Greenspan adds, has helped the economy avoid bank failures or credit crunches when big corporations, such as Enron, have defaulted.
Lethal weapons. But another master of high finance, Warren Buffett, has a different view. He famously railed against derivatives in a 2003 letter to shareholders, calling them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
The problem is that while credit derivatives are great tools for moving risk, they do nothing to help extinguish it. And because investors can write multiple layers of protection on the same debt, they could actually magnify the market effect of a default.
As the desire for credit derivatives has grown, so has the chorus of concern. Even Greenspan has noted that the rapid growth and increasing complexity of credit derivatives have made it harder for banks and regulators to assess the risks being assumed in a market that is virtually unregulated.
Some data suggest that major banks--the most important participants in terms of steadying the credit derivatives market during any upheaval--may be using the market to increase their risk profiles instead of to reduce them. Add to that the broadening of derivative products to include some based on lesser-quality debt, and others tailor-made for specific clients that are ever more complicated and illiquid, and you have a market that even the most sophisticated players worry about.
Then there are the hedge funds, which are among the most active traders of these derivatives. "What happens if a hedge fund has $5 billion in a given name, and it blows?" asks Wilbur Ross, who made a killing buying up old steel assets and who runs two hedge funds and six private equity firms. "The problem with this market is that nobody knows."
Ross sees one possible scenario: Some investors who thought that they had bought protection from a hedge fund might be "left naked" if the hedge fund can't pay off the claim. This could cause the investor who bought the insurance to default, creating a dangerous ripple effect through the whole economy.
Unlike banks and insurance companies, hedge funds are only loosely regulated. Since many of them are newly minted, there is no assumption that they have the same expertise at gauging risk as a bank might. And the search for yield may be making them take on more risk than is prudent.
The role of hedge funds has been steadily increasing over the past few years, providing an ever larger portion of the liquidity necessary to oil the market. Fitch Ratings surveyed market participants last year and found that insurance companies have been leaving the market, while hedge funds have grown to account for about 30 percent of current trading volume.
But the rush to the exits following GM's and Ford's descent into junk-bond status was a clear sign to some that leveraged hedge funds' appetite for credit derivatives could also be dangerous. The downgrade came on the heels of Kirk Kerkorian's announcing that he would add to his position in GM stock. Because many assumed that the debt was safer than the stock, the combined events upset the model being used by some investors, particularly hedge funds, to set up and price their risk in correlation trades--deals whose profit depends on the idea that something happening in one place will have a predictable effect elsewhere.
Hedge funds, which often take positions that are highly leveraged, began facing margin calls and had to unwind some trades, exacerbating price swings and forcing more traders to exit. Liquidity dried up. And there was, according to the Bank for International Settlements, "a circle of deterioration."
No bailouts. The fallout in the credit derivatives market from the GM debt debacle, of course, was far less severe than many had predicted. Despite all the doomsday scenarios, no hedge funds imploded. Nor did the markets see a rampant sell-off, although the bond market did suffer some temporary jitters. Americans did not wake up to find a repeat of 1998, when the spectacular flameout of a fund named Long-Term Capital Management roiled markets around the globe, requiring an emergency $3.6 billion bailout orchestrated by the Federal Reserve Bank of New York.
Matteo Mazzocchi, head of global derivatives at the Europe-based in-vestment bank Dresdner Kleinwort Wasserstein, says that most of those currently involved in the credit derivatives market are "buy and hold" investors who plan to keep their positions until they mature. They were not damaged, he says. The only ones hurt were the hedge funds that piled into an illiquid trade on leverage and then stormed the same exit.
Many of these hedge funds are said to be nursing material losses and could be hit with investor redemptions down the line. One large hedge fund manager, GLG Partners, said the ratings downgrade was partially to blame for a 14.5 percent drop in its $1 billion Credit Fund. But as a group, hedge funds managed to eke out a tiny profit for the first five months of the year.
And probably the worst result from the troubles in the credit derivatives market will be lower earnings from the big investment banks most active in facilitating the trades, such as Merrill Lynch and Deutsche Bank, which could be stung by the temporary reduction in deals.
Instead of portending economic devastation, the GM event might even have been salutary. Mazzocchi says that such market hiccups can help reveal and regulate the risks being taken on. "If there are gigantic positions out there that we didn't know about, the market will show us," he says. They are also extremely valuable in stress testing and steering what is still a very young market, adds Cornell University's Robert Jarrow, known for his decisive work on interest rate modeling.
Jarrow believes that the credit derivatives market, when run right, contributes greatly to the financial health and flexibility of the economy and that hedge funds, although the weakest link in the chain, are still unlikely to make the sort of dangerous miscalculations pioneered by the financial wizards at Long-Term Capital Management. "As long as the people who issue the contracts are responsible, then credit derivatives are welfare improving and make the system work better," says Jarrow. "But there will always be things that can't be anticipated, and there will always be human error and human greed."
Risky business
The global market for credit derivatives--insurance that protects against corporations defaulting on their debt--has grown quickly.
In trillions
1997 $ .180
'06 $8.2*
*Estimate
[Other labels]'04,'03,'02,'01,'00,'99,'98
Source: British Bankers' Association
Graphic by Rod Little-- USN&WR
This story appears in the July 25, 2005 print edition of U.S. News & World Report.
Can Icahn Do It One More Time?
Can Icahn Do It One More Time?
The famed corporate raider is pressing Time Warner for change
By Kit R. Roane
Posted 9/25/05
On a July day in 1999, Carl Icahn sat down with William Beslow over lunch to hear one final plea to end the divorce battle that had waged for nearly six years.
Beslow, one of the lawyers representing Icahn's first wife, Liba, says Icahn was likely to prevail in court later that day. But Beslow was asking Icahn to look beyond that cold calculation. He wanted the well-known and feared corporate raider to see his opponent in a new frame, that of his wife of nearly two decades and the mother of his two children.
Icahn took a deep breath, thought about it for a moment, then agreed to settle. "He didn't have to, but in the end, he formed an enlightened view that this was the one negotiation in his life not driven completely by business, and he made an exception," recalls Beslow. "He said it was the first time he had changed his mind about anything."
And possibly the last. Icahn, 69, has been called many things during his 40-plus years trolling the waters of Wall Street in search of blood and treasure. Irresolute is not one of them. Icahn has grown immensely wealthy--around $7.8 billion--by being right the first time and by not allowing the niggling tug of empathy to enter into the equation. Corporations that thought they could ignore his wishes, reason with him, or wait out his assaults have generally been gobbled up, partitioned out, or forced to pay a hefty premium to get Icahn to go away.
The list of companies that have bowed to his will, or paid dearly, includes Tappan Co., Marshall Field, Dan River, ACF Industries, Gulf & Western, USX Corp., TWA, Pennzoil, Texaco, RJR Nabisco / Nabisco Group Holdings, Marvel Entertainment, XO Communications, Blockbuster, and Kerr-McGee.
In the cross hairs. Now the man whose sharklike prowess defined the go-go '80s era of junk-debt-financed leveraged buyouts, of "white knights," "black hats," and "poison pills," has a new target--media and cable conglomerate Time Warner--and a new way to finance his attack--billions of dollars locked up in hedge funds he either controls or has enlisted in the war. Asked why he picked Time Warner to flex his muscle, Icahn says simply: "It is very undervalued, and the risk-reward ratio is greatly in our favor."
Icahn and his allies control about 120 million shares, or 2.6 percent, of Time Warner, through purchases of common stock and option contracts that are being converted into stock. He says management has been too timid in restoring the company's tarnished glory. Icahn proposes that the company separate its cable business from its media businesses and immediately buy back at least $20 billion of its stock. Otherwise, Icahn says, he will continue to add to his position, appeal to other shareholders, and lead a proxy fight to install some new representation on Time Warner's board next May.
So far, Time Warner's chairman and CEO, Dick Parsons, hasn't blinked. Instead, when Icahn delivered news of the assault, Parsons invited Icahn over for a chat, then told attendees at the Goldman Sachs investor conference last week that the company was considering Icahn's proposals but believed its cable business--the second largest in the country--"is still a strategically important asset for us." Although he says the company is open to a larger stock buyback, Parsons adds that he is a "big bull" on the cable business and doesn't think it is the right time "to cast it off."
Parsons's balancing act is calculated to show investors that he is both unafraid and reasonable, a move that might help defang the beast at his door. Parsons also has some ammunition to beat Icahn back: He has been leading the company down the very path Icahn proposes, albeit at a much slower pace. And Icahn, although playing shareholder advocate, doesn't yet have nearly the number of shareholders necessary to make a real run on the company.
But Icahn may not be seeking a showdown. Time Warner's stock, down 7 percent for the year, could rise if Icahn keeps up the pressure. And the publicity can help him in other ways. Icahn has launched his new hedge fund company, Icahn Partners LP, after reportedly raising from investors about half of the $3 billion he had hoped. A high-profile clash with a corporate titan might draw in more money.
Whatever the motive, Icahn's ability to raise even $1.6 billion is a testament to his reputation, particularly given the steep management fees he plans to charge and the length of time for which he is asking investors to lock up their money--three times the one-year industry average. Most hedge funds struggle to raise $100 million in seed capital.
Asked if he has changed, Icahn says no. "I have always believed that too many companies are not properly managed, that the major problem is a lack of accountability," he says. "I haven't really changed my views at all, but the perception has changed. With all the scandals, just that more people agree with me."
Self-interest. So does Icahn see himself as a shareholder savior? "What I do certainly enhances shareholder value, but I'm not going to tell you that I do it only for that reason," he admits. A workaholic with an obsessive personality, he continues to construct deals mainly because he enjoys the challenge. "He just loves it. It is his hobby, in a sense," says Alfred Kingsley, who worked with Icahn for more than two decades before starting his own firm, Greenway Partners LP, in 1993. Not bad for a public-school kid from Queens who graduated from Princeton, quit three years into a medical degree at New York University, and made his first small fortune--a few thousand dollars--playing poker in the Army.
Icahn's tactics, no matter what companies or workers may think of them, tend to produce at least one result: profits for him and his backers. For the most part, it hasn't mattered whether Icahn has been successful in taking over the companies he has pursued. In 1982, for example, a successful leveraged buyout of textile company Dan River netted Icahn an $8.5 million profit on a $14 million investment. When the then bankrupt energy giant Texaco spurned his advances in 1987, Icahn still walked away $700 million richer. Icahn has consistently made annualized returns of 38 percent over the past 15 years, while his hedge fund company has returned 15 percent since its inception last November.
Not that there haven't been mistakes--most famously when Icahn outmaneuvered airline deal maker Frank Lorenzo, another Queens native, to take over TWA in 1986. It was a pyrrhic victory for Icahn. Once he was in, the tangled business proved hard to retreat from with a profit. Icahn was left with an airline facing immense competition and carrying debilitating debt, which only increased when he took it private in a leveraged buyout. His relationship with the union workers, who had once greeted him as the anti-Lorenzo "Uncle Carl," soured fast, with flight attendants picketing in front of his suburban mansion.
Icahn walked away from the bankrupt airline in 1992, leaving behind a $200 million loan and eating a $30 million loss. He was also personally liable for about $1 billion in pension shortfalls. However, Icahn somehow wended his way back to the top. Always a master negotiator, he ended up settling with the government for a fraction of the pension liabilities, then cut his part further by profitably managing $1.4 billion of the pension fund's money. And when TWA emerged from bankruptcy the following year unable to pay back his loan, Icahn cut a deal with the airline to provide him with wholesale tickets instead. Icahn then sold them to the public at a deep discount from published fares. The move netted Icahn millions of dollars and was blamed by TWA for its poor fiscal performance until American Airlines bought the still-ailing competitor in 2001 and successfully voided Icahn's contract.
Icahn says he is not without compassion. "Where my empathy dries up completely is with some of these corporate managers," he says. But episodes like the one at TWA expose what critics say is the flip side of his approach. He may enjoy his new title as shareholder advocate, but he is also the man closely associated with the Wall Street ethos of the 1980s. And a case now in the courts shows that Icahn remains single-minded in his pursuit of profit. In 1984, a holding company controlled by Icahn purchased rail-car maker ACF Industries. He trimmed it down, recouping his investment, then leveraged its assets and used the funds to attack other companies, such as TWA. Now, looking for more cost savings, the company is suing retirees to reduce the retirement benefits granted them in labor contracts. The company says that the plan ended when the union contract expired but that it is still willing to pay a lot of benefits. Asked what he thought of this response, ACF retiree Basil Chapman, the named party in the lawsuit, says that Icahn is "playing with a lot of people's lives." Right now, Time Warner's Dick Parsons might agree.
TimeWarner
Corporate raider Carl Icahn's latest target is the media conglomerate Time Warner. The once dominant Time Warner has struggled since it agreed in 2000 to a merger with Internet pioneer America Online. The move, which came just weeks before the Internet bubble burst, turned out to be a huge blunder. But Time Warner CEO Dick Parsons, who took over in 2002, has stabilized the company, which recently even held talks with Microsoft about a possible alliance with AOL. Parsons is resisting Icahn's demands to spin off Time Warner's cable business.
This story appears in the October 3, 2005 print edition of U.S. News & World Report.
The famed corporate raider is pressing Time Warner for change
By Kit R. Roane
Posted 9/25/05
On a July day in 1999, Carl Icahn sat down with William Beslow over lunch to hear one final plea to end the divorce battle that had waged for nearly six years.
Beslow, one of the lawyers representing Icahn's first wife, Liba, says Icahn was likely to prevail in court later that day. But Beslow was asking Icahn to look beyond that cold calculation. He wanted the well-known and feared corporate raider to see his opponent in a new frame, that of his wife of nearly two decades and the mother of his two children.
Icahn took a deep breath, thought about it for a moment, then agreed to settle. "He didn't have to, but in the end, he formed an enlightened view that this was the one negotiation in his life not driven completely by business, and he made an exception," recalls Beslow. "He said it was the first time he had changed his mind about anything."
And possibly the last. Icahn, 69, has been called many things during his 40-plus years trolling the waters of Wall Street in search of blood and treasure. Irresolute is not one of them. Icahn has grown immensely wealthy--around $7.8 billion--by being right the first time and by not allowing the niggling tug of empathy to enter into the equation. Corporations that thought they could ignore his wishes, reason with him, or wait out his assaults have generally been gobbled up, partitioned out, or forced to pay a hefty premium to get Icahn to go away.
The list of companies that have bowed to his will, or paid dearly, includes Tappan Co., Marshall Field, Dan River, ACF Industries, Gulf & Western, USX Corp., TWA, Pennzoil, Texaco, RJR Nabisco / Nabisco Group Holdings, Marvel Entertainment, XO Communications, Blockbuster, and Kerr-McGee.
In the cross hairs. Now the man whose sharklike prowess defined the go-go '80s era of junk-debt-financed leveraged buyouts, of "white knights," "black hats," and "poison pills," has a new target--media and cable conglomerate Time Warner--and a new way to finance his attack--billions of dollars locked up in hedge funds he either controls or has enlisted in the war. Asked why he picked Time Warner to flex his muscle, Icahn says simply: "It is very undervalued, and the risk-reward ratio is greatly in our favor."
Icahn and his allies control about 120 million shares, or 2.6 percent, of Time Warner, through purchases of common stock and option contracts that are being converted into stock. He says management has been too timid in restoring the company's tarnished glory. Icahn proposes that the company separate its cable business from its media businesses and immediately buy back at least $20 billion of its stock. Otherwise, Icahn says, he will continue to add to his position, appeal to other shareholders, and lead a proxy fight to install some new representation on Time Warner's board next May.
So far, Time Warner's chairman and CEO, Dick Parsons, hasn't blinked. Instead, when Icahn delivered news of the assault, Parsons invited Icahn over for a chat, then told attendees at the Goldman Sachs investor conference last week that the company was considering Icahn's proposals but believed its cable business--the second largest in the country--"is still a strategically important asset for us." Although he says the company is open to a larger stock buyback, Parsons adds that he is a "big bull" on the cable business and doesn't think it is the right time "to cast it off."
Parsons's balancing act is calculated to show investors that he is both unafraid and reasonable, a move that might help defang the beast at his door. Parsons also has some ammunition to beat Icahn back: He has been leading the company down the very path Icahn proposes, albeit at a much slower pace. And Icahn, although playing shareholder advocate, doesn't yet have nearly the number of shareholders necessary to make a real run on the company.
But Icahn may not be seeking a showdown. Time Warner's stock, down 7 percent for the year, could rise if Icahn keeps up the pressure. And the publicity can help him in other ways. Icahn has launched his new hedge fund company, Icahn Partners LP, after reportedly raising from investors about half of the $3 billion he had hoped. A high-profile clash with a corporate titan might draw in more money.
Whatever the motive, Icahn's ability to raise even $1.6 billion is a testament to his reputation, particularly given the steep management fees he plans to charge and the length of time for which he is asking investors to lock up their money--three times the one-year industry average. Most hedge funds struggle to raise $100 million in seed capital.
Asked if he has changed, Icahn says no. "I have always believed that too many companies are not properly managed, that the major problem is a lack of accountability," he says. "I haven't really changed my views at all, but the perception has changed. With all the scandals, just that more people agree with me."
Self-interest. So does Icahn see himself as a shareholder savior? "What I do certainly enhances shareholder value, but I'm not going to tell you that I do it only for that reason," he admits. A workaholic with an obsessive personality, he continues to construct deals mainly because he enjoys the challenge. "He just loves it. It is his hobby, in a sense," says Alfred Kingsley, who worked with Icahn for more than two decades before starting his own firm, Greenway Partners LP, in 1993. Not bad for a public-school kid from Queens who graduated from Princeton, quit three years into a medical degree at New York University, and made his first small fortune--a few thousand dollars--playing poker in the Army.
Icahn's tactics, no matter what companies or workers may think of them, tend to produce at least one result: profits for him and his backers. For the most part, it hasn't mattered whether Icahn has been successful in taking over the companies he has pursued. In 1982, for example, a successful leveraged buyout of textile company Dan River netted Icahn an $8.5 million profit on a $14 million investment. When the then bankrupt energy giant Texaco spurned his advances in 1987, Icahn still walked away $700 million richer. Icahn has consistently made annualized returns of 38 percent over the past 15 years, while his hedge fund company has returned 15 percent since its inception last November.
Not that there haven't been mistakes--most famously when Icahn outmaneuvered airline deal maker Frank Lorenzo, another Queens native, to take over TWA in 1986. It was a pyrrhic victory for Icahn. Once he was in, the tangled business proved hard to retreat from with a profit. Icahn was left with an airline facing immense competition and carrying debilitating debt, which only increased when he took it private in a leveraged buyout. His relationship with the union workers, who had once greeted him as the anti-Lorenzo "Uncle Carl," soured fast, with flight attendants picketing in front of his suburban mansion.
Icahn walked away from the bankrupt airline in 1992, leaving behind a $200 million loan and eating a $30 million loss. He was also personally liable for about $1 billion in pension shortfalls. However, Icahn somehow wended his way back to the top. Always a master negotiator, he ended up settling with the government for a fraction of the pension liabilities, then cut his part further by profitably managing $1.4 billion of the pension fund's money. And when TWA emerged from bankruptcy the following year unable to pay back his loan, Icahn cut a deal with the airline to provide him with wholesale tickets instead. Icahn then sold them to the public at a deep discount from published fares. The move netted Icahn millions of dollars and was blamed by TWA for its poor fiscal performance until American Airlines bought the still-ailing competitor in 2001 and successfully voided Icahn's contract.
Icahn says he is not without compassion. "Where my empathy dries up completely is with some of these corporate managers," he says. But episodes like the one at TWA expose what critics say is the flip side of his approach. He may enjoy his new title as shareholder advocate, but he is also the man closely associated with the Wall Street ethos of the 1980s. And a case now in the courts shows that Icahn remains single-minded in his pursuit of profit. In 1984, a holding company controlled by Icahn purchased rail-car maker ACF Industries. He trimmed it down, recouping his investment, then leveraged its assets and used the funds to attack other companies, such as TWA. Now, looking for more cost savings, the company is suing retirees to reduce the retirement benefits granted them in labor contracts. The company says that the plan ended when the union contract expired but that it is still willing to pay a lot of benefits. Asked what he thought of this response, ACF retiree Basil Chapman, the named party in the lawsuit, says that Icahn is "playing with a lot of people's lives." Right now, Time Warner's Dick Parsons might agree.
TimeWarner
Corporate raider Carl Icahn's latest target is the media conglomerate Time Warner. The once dominant Time Warner has struggled since it agreed in 2000 to a merger with Internet pioneer America Online. The move, which came just weeks before the Internet bubble burst, turned out to be a huge blunder. But Time Warner CEO Dick Parsons, who took over in 2002, has stabilized the company, which recently even held talks with Microsoft about a possible alliance with AOL. Parsons is resisting Icahn's demands to spin off Time Warner's cable business.
This story appears in the October 3, 2005 print edition of U.S. News & World Report.
Office Buildings Make A Comeback
The New York
Times
March 30, 1997, Sunday,
Late Edition - Final
NEW
JERSEY & CO.;
Office Buildings (Remember the 80's?) Make a
Comeback
BYLINE:
By
KIT R. ROANE
SECTION:
Section
13NJ; Page 5; Column 2; New Jersey Weekly Desk
LENGTH: 763 words
They bought the land
nearly a decade ago when New Jersey was awash with new
construction. It was a time when buildings were rising with little
or no money down and speculators roamed the landscape to buy up
parcels for new office complexes or commercial parks.
Now, six years after building virtually stopped, SJP Properties, a
development and construction concern, is finally getting back into
speculative office building, rolling the dice on a new eight-story
office tower that was begun before it had any tenants.
"It was a risk but one that has paid off," said Peter Eppie, the
company's vice president, at its headquarters in Parsippany. "No
one had signed a lease on it until two months ago and now it's 80
percent taken."
"This shows the market is getting tight and demand is picking up
again," he added. "We're so confident now, we're planning a second
tower later this year. And it's being done completely on spec
too."
The 240,000-square-foot building being erected in Bridgewater
Township is perhaps the first commercial site developed completely
on spec in the state since 1991, when SJP built one of the last.
But this developer is not alone in seeing a rebound in New Jersey's
commercial real-estate market. Dozens of other office buildings are
popping up to meet the needs of corporations that are expanding and
require technological amenities like fiber optic cable, rooftop
communications and computer-friendly climate controls.
Noting that the state has already made up 85 percent of the jobs
lost at the deepest point of the recession five years ago, James W.
Hughes, an economist and dean of the Edward J. Bloustein School of
Planning and Public Policy at Rutgers, said that other economic
indicators, including steep occupancy rates in existing commercial
buildings, pointed to a resurgence in the real-estate market.
Commercial vacancy rates in New Jersey are 16 percent now, trimmed
from 23 percent in 1992, Dr. Hughes said. He added that class A
spaces, the newest and best located buildings, were reporting
vacancy rates around 9.2 percent in the most heavily populated
central and northern sections of the state. Other economists, like
Bob Cotter, director of planning for Jersey City, said that real
estate investment trusts were selling well again and that banks
were lending on proposed buildings with less collateral.
"While it is still in its early stages, the commercial real estate
market does appear to be coming back," Dr. Hughes said.
"It remains to be seen how deep the demand really is," he added.
"At least it's not a free-for-all of excess, like in the 1980's,
when everyone pretended to be a builder. This is a much more
rational and slower trend."
The 1980's building boom has come to be remembered as a sea of
extravagance, when banks and thrifts lent millions to developers
who offered little collateral and often no more than a promise of
tenants. Buildings rose at such a pace that by the early 1990's,
supply had greatly outstripped demand. Banks began to fail, and
investors and taxpayers absorbed the losses.
By 1994, office construction virtually halted throught the country,
with only 1.6 million square feet being completed that year in the
United States. That was less office space than was erected in some
weeks during the previous decade, Dr. Hughes said. In fact, 85
percent of all office buildings in New Jersey were built in the
1980's, he said.
"We have gone from one extreme to another and now we are going the
opposite way again," said John Maddocks, manager of Somerset
County's economic development office, listing several construction
sites. "Not long ago you had tenants demanding the first year free
to sign a five-year lease," he said. "You don't see that anymore.
The market is tight."
Among the desirable areas are stretches along Jersey City's
waterfront, often called the Gold Coast; Route 1 as it approaches
Princeton, and the intersection of Routes 287 and 78, where SJP
Properties is beginning development of six buildings on a 118-acre
site.
Few of them suggest the excesses of the 80's, either in design or
in financing. Still, the trend is toward more risk, with lenders
granting more money for less commitment every day and builders
seeing old plots as potential cash cows.
"Builders are becoming more aggressive and lenders are becoming
more willing to lend," said Robert J. Wolfe, president of Picus
Associates Inc., whose four-million-square-foot Princeton Forrestal
Center is now 80 percent occupied.
"The real estate industry has a very short memory," he
said.
LOAD-DATE:
March 30,
1997
LANGUAGE:
ENGLISH
GRAPHIC:
Photo: The
skeleton of a new corporate center in Bridgewater is reflected in
windows on a portion of the facade parked near the site (Norman Y.
Lono for The New York Times)
Job Security Dwindles
The New York
Times
February 16, 1997,
Sunday, Late Edition - Final
NEW
JERSEY & CO.;
Job Security Dwindles as Rent-a-Job Companies
Surge
BYLINE:
By
KIT R. ROANE
SECTION:
Section
13NJ; Page 6; Column 2; New Jersey Weekly Desk
LENGTH: 968 words
DATELINE:
NEWARK
Like more than 43
million others over the past two decades, Douglas E. Owens was
downsized, unemployed, rented out, and basically left to survive by
his wits. His resume went out to hundreds of companies and his feet
walked miles of carpet in and out of interviews after he was cast
out of the cradle-to-grave corporate world that he had e inhabited
for 23 years.
Unlike many others still grappling with the uncertainty of today's
labor market, Mr. Owens, 50 has a real job again. More importantly,
he knows he probably won't keep it.
And he knows the same thing is true for a lot of the people he
hires in his new job as vice president of human resources at Origin
Technology in Business.
"It used to be that if you saw a resume full of two-year stints at
different companies, you were shocked. Now it's normal," he said at
his Murray Hill office, where he now sits perusing hundreds of
resumes. "I would like to say I will keep this job forever, but I
know the percentages aren't there anymore and that I will probably
end up working interim on into retirement. That's the way the world
works now; we are all disposable."
Mr. Owens has seen both sides of one of the fastest-growing sectors
of the American economy. The growth is spurred by the need for new
workers at downsized companies that are unwilling to take on
additional full-time employees. Instead, they outsource the work,
hiring outside contractors. Besides making the labor market more
fluid and allowing business to operate more efficiently, the
practice has spurred a new line of work: companies that channel
workers into a series of jobs that are rarely permanent.
According to Federal labor figures, the number of temporary workers
in New York and New Jersey rose by 35,000 in the first half of the
decade, with 151,007 workers registered in 1995, the last full year
that such statistics are available. During that period, the number
of temporary hiring offices (many owned by the same company)
increased from 1,522 to 1,874.
Nationally, the trend is much the same, with temporary work moving
from a $16 billion to a $31 billion industry from 1990 to 1995. And
now Manpower Inc. is the largest employer in the nation, offering
up 750,000 temporary workers a year.
"It is part of the great economic transformation that we are going
through," said James W. Hughes, dean of the Edward J.
Blousteinready School of Planning and Public Policy at Rutgers,
adding that New Jersey, with its concentration of manufacturing,
communications and pharmaceutical companies, has been at the center
of the trend. "It is the result of a drive for efficiency, an
attempt to insure that a company is only paying for work that is
done and not for workers who are idle."
Outsourcing has many facets, but the chief aim is to cut employment
at a company to a core of individuals focused on its main business.
All other activities, from handling mail and copying to accounting,
information services and building maintenance, may be farmed out to
other companies or individuals on contract. Even in the core
business, if projects require additional hands, the company often
opts to hire an engineer or executive as a consultant, rather than
put him on the payroll.
According to Mr. Owens, who saw his own salary nearly halved during
his two years of temporary jobs, one in six of the employees his
company now asks him to hire are project workers who will never be
put on the company payroll.
The crush of workers looking for jobs combined with the need of
companies to find quick sources of labor, has caused a staggering
growth in job clearinghouses, including those that specialize in
executive and management positions. The Ascher Group, a Roseland
company that began in 1981 as an executive head-hunting firm, began
channeling its energy into temporary placements six years ago.
Since then, revenues have approached $5 million, nearly five times
what they were in 1992.
The company is itself a model of outsourcing, hiring other
contractors to do its payroll, accounting, advertising, printing,
legal and travel services. Susan P. Ascher, the company's
president, added that one of the companies that uses her executives
is itself an outsource firm that runs warehouses for other
companies.
Many economists and business specialists believe that the trend may
have reached its peak, that companies have cut to the bone, and in
some cases trimmed too many workers from their staff.
"They are finding out that they can't move the raw data up the
chain of command after they have carved out much of the chain,"
said Stanley Deetz, a professor of communication at Rutgers who has
studied the corporate culture of downsizers such as AT&T. "And
there is some thought at major corporations that things went too
far, too fast."
But the business world is unlikely to revert to its old ways.
Downsizing and outsourcing have been one of the chief bolsters of
the American economy and American stock prices in recent years.
economists say. It has also helped to further weaken unions and
reduce wage inflation, with median wages now 3 percent below what
they were in 1979. And while companies may slow their outsourcing
of existing jobs, economists say they are likely never to
internalize many of the jobs that will be tomorrow's boon,
particularly those in information technology.
"Most of the obvious outsourcing targets have been consummated
already, but technology is moving so quickly that few companies
will be able to develop these as internal functions," said Mr.
Hughes, noting that up to 43 percent of the jobs lost in corporate
America over the past decade were later outsourced. "Everything
from the Internet, to data processing and information handling will
probably be purchased outside from ground zero. This is the
future."
Shaping the New World of Welfare
The New York
Times
January 5, 1997,
Sunday, Late Edition - Final
GOVERNMENT;
Shaping the New World of Welfare
BYLINE:
By
KIT R. ROANE
SECTION:
Section
13NJ; Page 7; Column 1; New Jersey Weekly Desk
LENGTH: 912 words
In Essex County, which
has the largest welfare system in the state and the eighth largest
in the country, debate is heating up -- as it is around the nation
-- about how much of the program will remain in government hands
and how much will fall into the private sector.
County Executive James Treffinger, a Republican, has proposed
placing all social services required under the new Federal welfare
law in the hands of nonprofit agencies, a proposal that worries
government unions and local church groups.
In fact, Texas and several other states have gone further, opening
the door to bidding by for-profit private companies to handle their
welfare programs. And nothing is keeping Essex County from doing
the same.
"We are not closing the door on anything," said County Freeholder
Sheila Y. Oliver, the Democratic in charge of the committee that
will make final recommendations after a Jan. 13 meeting involving
200 people interested in welfare.
"The government and nonprofits cannot do it alone," she added. "It
will require input from everyone, including the private
sector."
Right now the focus of welfare workers in Essex County is getting
benefits to their 75,000 clients.
Changes in Federal welfare law, as well as the state initiative
called Work First, require more extensive efforts to get people off
welfare: job and education placement, child care and counseling for
drug, alcohol and psychological problems.
Ms. Oliver said the freeholders are likely to vote in March on the
proposal that emerges from her committee; any change taking
administration of the program out of county hands would need the
approval of the state's Human Services Commissioner, William
Waldman.
Last year a bill that would have eased such a change stalled in the
state Senate. The measure, which could be taken up again this year,
would extend the time Essex and Hudson counties could contract
welfare services to outside businesses from one year to five years.
It also would have allowed the two counties to contract out some
services that government has historically handled, including
determining who is eligible for benefits.
The Essex freeholders passed a resolution opposing the legislation
on the ground that it gave outside bidders too much leeway. This
does not mean, Ms. Oliver said, that there is no role for outsiders
if the county is going to meet the new state and federal
goals.
"I maintain that we cannot do this alone," she said. "We need the
assistance of outside institutions."
Mr. Treffinger supports the bill, calculating that it could save
the county up to $10 million. The county's share of the cost of its
welfare program is now more than $25 million a year and at times
its spending has topped $58 million, he said.
Even if the legislation doesn't pass, he wants to use nonprofit
groups, though he doesn't think the savings would be as
great.
"My goal is to replace a large and often unresponsive bureaucracy
with community-based organizations that have meaningful
relationships and ties to their community," he said.
Representatives from Lockheed Martin IMS have contacted the county
about delivering some welfare services, according to Ron Jury, a
spokesman for the company, in Teaneck, N.J. He said that the
company is one of several interested in administering the Texas
welfare system and parts of those in other states.
"We do not want to control policy but I think that with our
experience, resources and technology we can run a welfare system,"
he said, adding that the company has 10 years experience in helping
states run social service programs, including child support
collection to and training.
None of this sits well with Local 1081 of the Communication Workers
of America, which includes 956 welfare workers in Essex County.
David Weiner, the president, said his union is being used as a
scapegoat, that Essex County has one of the lowest administrative
costs per client in the state. Saying that a hiring freeze had left
the welfare program short 300 workers, he asserted that the county
should increase the staff, not farm out their work to outsiders or
let the state take over the program, as it threatened to do in
1995.
Many church groups agree, including the 300-member Newark North
Jersey Committee of Black Churchmen.
"This is one of the largest welfare systems in the nation," said
Dr. Edward W. Verner, minister at St. James AME Church in Newark.
"To turn its duties over to community-based organizations is
inconceivable. They don't have the staff, the training, nor the
expertise to do this. It would be a grand mess."
Other authorities on welfare say that whatever Essex County does,
the effectiveness of its welfare programs will depend more on the
services provided rather than on who provides them. Judith M.
Gueron, president of the Manpower Demonstration Research
Corporation, a nonprofit study group, said that one of its recent
studies in California found no discernible differences between
privately run work programs and their state-run counterparts.
Richard P. Nathan, director of Rockefeller Institute of Government
of the State University of New York, offered this analysis:
"Congress said give it to the states and New Jersey passed it along
to the counties and so forth. There is great tension and
frustration about welfare and what it stands for. And this whole
episode is really about people saying, 'We can't do it right and
don't want it, so who else can we give it to?'
"
BOSNIA SERB ECONOMY DRAGGING
Chicago
Tribune
January 7, 1996 Sunday,
CHICAGOLAND EDITION
BOSNIA
SERB ECONOMY DRAGGING;
FIRMS LOSE MARKETS, FALL BEHIND TECHNOLOGICALLY
BYLINE:
By
Kit R. Roane. Special to the
Tribune.
SECTION:
NEWS; Pg.
9; ZONE: C
LENGTH:
775
words
DATELINE:
BANJA LUKA,
Bosnia-Herzegovina
Every weekday like
rote, 25-year-old Suzana Stanivukovic puts on her work clothes to
start another day as a hearing aid assembler down the street.
There she sits in a small room bundled against the cold and talks
to her co-workers about the time before the war when there were
hearing aids to assemble and substantial salaries.
"I have a job, but no work to do," she said, gazing at dozens of
empty cubicles formerly occupied by workers. "I haven't produced
one hearing aid in nearly two months . . . The best we can get is
about 10 people a week wandering in and asking us to fix theirs. My
only hope is that things will get better now that the war is
over."
Her complaint is familiar. Economic recovery is the key to a
sustained peace in this region, and if it does not happen soon, the
former Yugoslavia could face new unrest.
The Bosnian Serbs' war for ethnic purity has left people trapped
here in a fragile land disconnected from the Muslim and Croat
suppliers and markets they spent nearly four years fighting
against.
Electricity and rail lines have been destroyed, while their access
to ports is cut. And far from being able to sell products in the
West or elsewhere, the Bosnian Serb republic can barely hawk its
own merchandise at home. Nobody has the money to buy it.
"Our industry and our banking system have not functioned for four
years," said Serb economist Mladen Ivanic. "We produce at about 20
percent capacity. We have lost our markets and we have fallen
behind technologically. Unless we open ourselves to the outside,
both politically and economically, we will become an armed
ghetto."
Stanivukovic and her colleagues at Medicinska Clektrinika are paid
roughly $20 a month to come and sit in the drafty electronics firm,
where the clean room remains spotless because no one has any reason
to enter it.
"We keep them around to give them something to look forward to,"
said her boss, Kamenko Kasikovic. "We want to give them a feeling
of purpose and being useful. We want them to have a sense that
nothing has really changed."
With years of bloodshed on the wane, the Bosnian Serbs are
predicting a new life with cable TV, microwave ovens and
refrigerators. They dream about Western banks and industrialists
eager to form partnerships and invest in their tiny militant
republic, and of the thousands of Serbs living abroad who will soon
come back, bringing cash with them.
Yugoslavia was about to privatize its industry when the war started
in Croatia and Bosnia, with workers shelling out up to two months
of pay for stock in their companies. Those shares are worthless
now, and the Bosnian Serb government has yet to formulate a plan
that would safeguard future investors in the region.
This has done little to stall capitalists like Kasikovic, who says
he is busily putting together letters for old suppliers in Germany
and Austria, asking them not only for parts to make his hearing
aids, but also for a commitment to buy some of the company when the
opportunity arises.
Many in the government are also eager to sell off state-run
enterprises.
Without foreign investment, the approximately 300,000 people
employed by companies and state institutions will slowly lose their
symbolic positions. Most factories still producing goods wait
months, and sometimes years, for the materials to complete a single
project and the money paid to keep their workers sitting around
will run out soon.
Already the vouchers used as currency have dropped to one-third
their value.
"It used to be that even the janitors went home with $800 a month,"
said Branko Davidovic, manager of the now-defunct Unis Cold Rolling
Mill, a manufacturer of steel wire. "We had 560 employees and put
out 8,000 tons of steel a month. Now we just have some people in
administration doing make work and their pay is poverty."
More than $60 million went into building the Unis steel plant, a
monstrous shed now full of idle stamping and rolling machines where
British troops are housed temporarily as they move from town to
town policing the peace. To start the factory again, raw materials
will have to be shipped from European countries and railroad lines
controlled by their Bosnian foes. And even if the materials
arrived, the plant would be hard pressed to cajole its old buyers
and ertswhile combatants, the Croats, into accepting the
shipment.
"We have had no direct talk at our end with the Croats or the
Bosnians, but our government has said that we are ready to make
relationships again," said Davidovic. "It's really up to them,
though I guess it's a little early yet to do
business."