Does Financial Services Demand Good Management?

There was an interesting quotation at the end of King of Capital. Authors Stone and Brewster wrote:

"A list of the most influential corporate leaders of the twentieth century-Lee Iacoccca, Roberto Goizueta, Jack Welch, Sam Walton-would include very few financial services professionals.

One of the reasons for this dearth is that, for the most part, banks and brokerages have traditionally offered little incentive for the development of managerial skills. Within financial services, there has been so much opportunity for short-term gain that true executive development has never been emphasized." p282

There is truth to this comment. The industry generally does not laud management like manufacturing/operating companies. My question: is this rational, or is there just as large a need for managerial skills in finance (perhaps even a larger need given the 2007-08 swoon), but because of industry mores and culture management has not been emphasized to the same extent?

Financial Crisis Inquiry Commission

Just a quick link here. Click only if you're really geeked out on this stuff like me...

Genesis of the Financial Crisis

We're a year past the financial crisis, but I still am fascinated by it. The more I read about it -- from House of Cards to Too Big to Fail and Gods at War -- the more I am amazed at how close our nation came to collapse of its financial plumbing. The people that were most familiar with the arcane and exotic intracacies of our modern financial system (such as Jamie Dimon, John Mack, and Hank Paulson) were seriously concerned about its collapse.

Depending on what your political stripes are, you are likely to blame the crisis on the Community Reinvestment Act ("CRA") (a Republican gripe) or you blame it on the Gramm-Leach-Bliley "Financial Modernisation Act" of 1999 ("FMA" - which ended the 1933 post-Depression Glass-Steagall act) (a Democrat gripe). I've heard both arguments. Each has their merit, but neither is sufficient to explain the events of 2008. Rather, both rationales appear to be a conclusion that drives one's determination of relevant facts. It should be the other way around.

So when I was reading King of Capital (biography of Sandy Weill) on my train ride home today, I was pleasantly surprised to learn of the interwoven nature of the CRA and the FMA. The strengthening of the CRA (it was originally legislation of 1977) was part-in-parcel of the FMA legislation:

• Amidst horse trading in October 1999, "several last-ditch compromises were made addressing bank compliance with the CRA, and an agreement was reached on [FMA]." p257
  
• "Early in 1999, conservative politicians and commentators began worrying that President Clinton would veto the reform legislation. Clinton at one point decided to support an element of the legislation that called for protecting CRA." p255

It's also interesting to read how glowingly the author speaks of Citigroup's "impenetrable" business model that is "so big and so global" that it's nearly immune from any economic downturn.

Of course all things are obvious in hindsight.

What's a Board's Revlon Duties when the Deal's 'Too Good to be True'?

Yesterday I had breakfast with a friend who’s quite accomplished in Corporate Law. Among other things, we had a good conversation regarding a Board’s Revlon duties when BuyCo uses significant leverage in its proposed acquisition.

In particular, we discussed the obligation of a Board of Directors when a bid for the company is so large that its likely consequence is to saddle the company with so much debt that its future cash flows may be insufficient to pay its obligations. Said simply: what if the bid is “too good to be true” – it’s a boon to current stockholders but a death sentence for the company’s ongoing viability?

I was prompted to ask him this question because of Tender Offer (Dormans). Dorman, reflecting on the offer Natomas received from Diamond Shamrock, reflectively poses the question: “when management is faced with the threat of a takeover, the question becomes: To which shareholders should one feel responsible? Investors seeking short-term profits will be best served by the highest takeover price, but those who want to see the best long-term results and have the strongest company emerge may be better served by [incumbent management fighting the takeover].” (p30). And later he again asks, “how strong a company would the new Diamond Shamrock be? What would be the impact on future profits of its borrowing $700 million to complete the transaction?” (p36).

The answer is straightforward: it depends. If the consideration is straight cash, then management should only look to the highest bidder. But if the consideration is stock from BuyCo, then management must be more careful. In that case, the Board has to consider that its shareholders will become owners in the new company (and its accompanying higher debt load).

This obligation of the Board is partially absolved by obtaining a “solvency opinion” (also from WSJ Deal Blog) from a banker. The solvency opinion is needed whenever the post-acquisition company acquires a significant amount of debt relative to its size. This is likely to occur either in a merger-of-equals or in a leveraged buyout. Thus, there the growth in private equity-led M&A during the “sixth wave” of M&A (2004-2007) made the solvency opinion increasingly important.

What was the consideration in the Natomas bid? It was a bit tricky. Diamond-Shamrock offered $23/share for the first 51% of outstanding Natomas stock, and then offered Diamond-Shamrock stock worth $23 for the remainder. So that transaction fell somewhere in the middle; not all cash, but not all securities. Though this offer probably moves into a gray area, I would guess that the Board has an obligation to ensure the resulting company is solvent. Therefore, simply seeking the highest bid will not do. Instead, the Board would have to be confident that the resulting corporation would have sufficient cash flow to service its debt.

"Deal" Reading List

It's getting colder, and maybe you're thinking about escaping to a beach for an otherwise-frigid January week.

What to read?

Well, if you're a deal-geek like me, there's plenty of good stuff out there. Here's what I've been reading, and what's on my list:

Books Recently Read:

1. Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion, by Steven Davidoff (aka, the "Deal Professor" on NYT's DealBook).
   Awesome book outlining the legal consequences, drivers, and limitations to many deals that happened in the last 24 months. The book provides great 'color' to the otherwise "surfacy" coverage provided my the media. Davidoff delves into the purchase agreements of numerous deals with scrupulous details and illuminates, with reference to DE Chancery Ct decisions, the "whys" behind numerous nuances of the deals. Awesome, but technical read.
2. House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, by William Cohan.
   This book gives vivid detail to the collapse of Bear Stearns.
   It's written in 3 parts: first, an up-close look at the 2 weeks in March '08 when BS' cash account went from $18B to a Chapter 11 filing. It shows the weakness of the public investment bank model that depends on overnight financing, prime brokerage accounts, and trust. Vicous circles -- whether rumors are true or false -- will kill the company. Second, it zooms out and shows the long history of BS. This part I found more helpful. It showed the firm's cultural penchant for risk, its bad-boy attitude on Wall Street, its conduct during LTCM, and how all of those events culminated in March '08. Third (perhaps most boringly), it detailed the creation of its two exotic funds - remember the "Enhanced Leverage Fund" - that killed the firm.
   Reading this portion was particularly interesting in light of the Securites Fraud case ongoing in 'real time' regarding Ralph Cioffi and Matt Tannin. (As an aside, this book made me want to learn to play Bridge - yet, after asking dozens of friends, it seems that that game is, almost without exception, played by the older generation.)

3. Big Deal: The Battle for Control of America's Leading Corporations, by Bruce Wasserstein.
   This is "Bid 'Em Up Bruce" 's tome, written from the insider's perspective, of the 80s' and 90s' battles for corporate control (No surprise there, given the title!). At 791 pages, I'm not sure whether the reader needs to read each page in gripping detail. But Bruce does a good job of both entertaining and teaching the reader about the industry from a strategic, financial, and legal standpoints (he went to HBS/HLS, and worked at Cravath before CSFB, then founding Wassersten Perella, and then CEO of Lazard). The last section, "Doing the Deal", is particularly educational for the aspiring deal professional.

4. Barbarians at the Gate: The Fall of RJR Nabisco, by Burrough and Hellyer. This is an absolute classic. And for good reason, too. The book is an absolute thriller - with amazing detail and great characters, it's impossible not to be drawn into this account of KKR's "coming out party" in its 1989 LBO acquisition of one of America's largest corporations. The $26B takeover remained the biggest deal ever consummated for well over a decade.
   But the book had some good info/technical info, too. It showed the value of creativity in putting together an offer (First Boston's bid was entertained b/c of its tax structure), plus the personality-dynamic (the Board's aversion to Mgmt/Shearson's offer due to F. Ross Johnson's personal handling of the offer).
   From a CorpFin standpoint, one thing the book reinforced was the valuable role PE plays in the market for corporate control through the disciplining of management. Part of the attraction of making a bid on RJR was the abuse, by RJR management, of the principal-agent problem. FRJ abused his role through the use of perquisites (the RJR Airforce and his squad of favored athletes on retainer) at the expense of the true owners of the firm. KKR fixed that problem by realigning mgmt-S/H interests.

5. Tender Offer: The Sneak Attack in Corporate Takeovers, by Dorman Commons. This 1985 book chronicles the at-first hostile, and then friendly takeover of Natomas Company by Diamond Shamrock. What makes this book excellent is that it's essentially a first-hand narrative by the CEO of TargaCo of what he did during those 10 days between announcement of hostile takeover and deal agreement. From the strategic, legal, and financial standpoints, this book gives good insight into why the deal industry is so multi-disciplinary.
   Another interesting part of this book is that the DS-Natomas deal fits into the larger en vogue corporate strategy of the 1980s: conglomeration. Barbarians at the Gate -- which chronicled the breakup of RJR/Nabisco -- serves as a natural bookend to this movement, since private equity helped the market learn that conglomeration is not a value-maximizing strategy: the sum of the parts is greater than the whole. Wasserstein chronicles this evolution very well.
6. Billion Dollar Turnaround: The 3M Spinoff that Became Imation, Bill Moynihan. Moynihan is the former CEO of Imation, and led it through its spinoff and its subsequent winnowing to its core competency of data storage.
   During that time, he shrunk the firm from 12,000 employees to 2,000. More impressively, he took the company from one that was saddled with debt to one that was lean and a strong cash generator. The book does a good job of describing the morale and management issues inherent in the spinoff of a brand new company from a staid, stable, and secure parent company. (The spinoff also fits into the time period where corporate America's lost its affection for conglomerates).
   My biggest disappointment was that Moynihan never discussed the rational that led to his financial decisions. What did the balance sheet look like upon spinoff? What did he get for the divisions he sold? And what was the multiple of that sale? This information would be more educational, as opposed to the chest-thumping that more often padded the book.

Books to Read:

1. Too Big to Fail, by Andrew Ross Sorkin. Sarkin -- the editor of NYT's DealBook -- gives a first-hand account (based on his contacts within High Finance professionals in Manhattan) of the backroom deals struck during the last 24 months.
   I've watched Sorkin's interview with Charlie Rose concerning the book, and am on the waiting list with Hennepin County for the book. I can't wait; it should be another thriller.

MPLS: Small City, Big Companies

After a fairly thorough reading, I throw away most of my magazines (Fortune, Barron's, TC Business). But I always keep my copy of Fortune
"Fortune 500". (May 4, 2009)

Last year, Minnesota had 20. But due to NWA's merger with Delta we are back into the teens. And, due to PepsiAmerica's merger with PepsiCo (which was featured in this week's Barron's), we'll be down to 18 next year!

But something else caught my eye this week: F500's HQ'd by city. More specifically, what caught my eye is that only NYC, Houston, and Dallas have more F500's than Minneapolis! We have more HQ'd here than Los Angeles or San Francisco, and are tied with the midwestern heavyweight of Chicago.

In the end, this may be somewhat of a moot point. The more relevant measurement is F500's by Metro area, and by that measure I'm sure MSP would fall somewhat compared to Chicago, SFO, LAX.

Nonetheless, I find it something to be proud of. Another way of conducting this assessment would be F500's per capita. In other words, there are 5.2 million Minnesotans and 19 F500s. That equates to a F500 for every 273,000 Minnesotans!

In comparison:

• Texas has a F500 for every 380,000 residents (64 : 24.3 million residents)
• California has a F500 for every 664,000 residents (51 : 33.9 million residents)
• New York has a F500 for every 348,000 residents (56 : 19.5 million residents)

I think this statistic indicates Minnesota's ability to maintain a "Big City" feel with a "Small City" touch - perhaps a unique combination.

Just this weekend, a friend was visiting from Silicon Valley. We were hanging out in Peavey Park on Friday evening. It was full of people coming-and-going from Holidazzle, as well as people on their way to Orchestra Hall.

While there, I "just knew" I'd run into a friend in the local finance community. Sure enough, my Securities Law professor walked by. It didn't surprise me, but my Silicon Valley friend was amazed. The "closeness" that we have here (as evidenced by my story) separates us from the Gotham City-ness of NYC, Chicago, or Silicon Valley. We get the best of both worlds.

Forstmann: "When it came to dealmaking...he was Picasso, and [his partners] were holding the ladder"

With my interest piqued after my visit to KKR's offices, I've finally taken the time to read Barbarians at the Gate. It is truly an astounding story: pride, hubris, rivalries, limousines, private investigators...all bankrolled by billions of dollars in junk-bonds and the glorious optimism of the BOOM that always preceeds the bust.

And I have a hard time reading books nowadays without the internet nearby. I'm constantly scribbling notes, looking up websites, etc. Of course KKR continues to exist, but with the book highlighting Ted Forstmann's bloodcurling rivalry with Henry Kravis, I wondered: whatever happened to Forstmann Little? No website existed, only a Wikipedia entry!

Well, a little more google digging and I found this article from Fortune magazine. Nowadays, you can find interviews of him opining with his good friend Charlie Rose.